Bond insurers have built a business on paying close attention to risk. For the most part, these monolines have earned their esteem by establishing triple-A portfolios. However, recent drops in the ABX index and the widening of CDO spreads, as well as subprime downgrades, have turned the scrutiny back on these insurers, with market participants questioning the security of their highly rated RMBS exposure.
Indeed, the monoline business has gotten some bad press lately in connection with their exposure to subprime RMBS. Some market players - particularly ones that are shorting these insurers - have rubbed salt in the wound. For instance, a report by Pershing Square Capital Management Partner Bill Ackman called "Who's Holding the Bag?" asserts that some of these financial guarantors took on risky subprime investments without sufficient reserves.
Market participants have also started to be pessimistic about the validity of these monolines' triple-A ratings. Furthering this point is the difference between credit default swap (CDS) spreads on some of the triple-A monolines and on other triple-A companies outside the bond insurance business. Early last week, a five-year CDS on MBIA was trading at 52 basis points, while Ambac Assurance Corp.'s five-year CDS paper was trading at a bit more than 40 basis points, according to a market participant. By contrast, CDS paper for General Electric and AIG, both triple-A companies, traded at 16 and 17 basis points, respectively, a significant distinction indicative of the risk that the market perceives in the monolines, the market participant said.
While not concerned about the company's exposure to subprime, John Uhlein, executive vice president at Ambac, noted the lack of liquidity in the CDS market (a situation that does not require a lot of commotion to move spreads). "It is a thinly traded market and [questionable subprime exposure] is clearly a perception."
Speculation has not stopped with spreads. Some market players have even reminisced about the troubles of Capital Markets Assurance Corp. (CapMAC) in the late 1990s, when a decline in the credit quality of its Asian obligors in Korea, Indonesia and Thailand threatened the company's triple-A rating, until it was eventually acquired by MBIA in 1998.
Careful Exposure
Despite misgivings about monolines' subprime exposure, some have defended the credit quality of these monolines' portfolios. Merrill Lynch research analyst Robert Ryan called the bond insurer's share price a "good buying opportunity." Insured mortgage exposures, Ryan said, are structured to withstand multiples of historical loss levels with protection provided to insured tranche holders through performance-related triggers. He also noted that there was not an increased concern from the rating agencies about the potential for MBS or CDO claims or capital adequacy due to recent MBS rating actions.
Just last week, moreover, Moody's Investors Service upgraded bond insurer Assured Guaranty to Aaa' from Aa1'. The company joins five other financial guaranty organizations, including Ambac, CIFG Guaranty, MBIA, FSA Insurance Co. and XL Capital Assurance, in being awarded triple-A ratings by Moody's, Standard & Poor's and Fitch Ratings.
Structurally, these bond insurers do not appear to be on shaky ground. The monolines are pretty well insulated, said Thomas Abruzzo, managing director at Fitch. He noted that most of the subprime RMBS exposure written by these insurers has been done at fairly high attachment points. "A lot of the [subprime] exposure has been done at triple-A levels or better, and for the most part, a good bit of the exposure that has been underwritten has also been done for some of the better [originators] in the industry," he said, citing Countrywide Financial as an example.
Another example is Assured Guaranty. All of the U.S. subprime RMBS business that Assured Guaranty has written in its direct segment since its April 2004 IPO has been attaching at the triple-A level, said Andrew Pickering, chief surveillance officer at Assured Guaranty.
Indeed, most bond insurers seemed to be aware that underwriting standards slipped in 2006, market observers said. These sources said that monolines, which do their own due diligence, have been frustrated by the ratings on these subprime deals, which did not assess fully or accurately the potential risk in the transactions.
As a result of the lower-quality loans, monolines began to pull back from the sector. Ambac's subprime mortgage book declined to $1.2 billion in 2006 from $15 billion in 2002. Assured Guaranty decided to pull back from subprime in early 2004, around the time of its initial public offering, when the company decided not to underwrite direct subprime RMBS deals with ratings less than triple-A, Pickering said.
Safer Risk
Of the triple-A bond insurers, Ambac's exposure to the 2006 subprime vintage at the end of the year appeared to have the lowest average rating, according to a report issued last month by S&P. While the company had only 2.01% of its total net par insured portfolio in subprime mortgages, 11.62% of that represented by the 2006 vintage, the weighted average rating was A-minus. This differs from a company like Assured Guaranty, which had a larger percentage in subprime at 6.85%, with 77.96% of total subprime mortgage net par in the 2006 vintage - but with a higher double-A-plus rating.
Relative to its peers, Ambac is clearly a higher-risk position, said Robert Green, director of global bond insurance at S&P. However, the company has a track record of very sound underwriting, he said.
On Ambac's transactions, which included triple-B-plus subprime deals done last year, the company has been very selective about the mortgage lenders it deals with, Ambac's Uhlein said. "You read about the casualties in the market; we are happy to say we have not been involved in those," he said, noting that the company focused mainly on fixed rates, while a lot of the subprime problems have occurred on the adjustable-rate side. Ambac did three transactions last year, including two with Countrywide and one for Home Loan Bank in Warwick, R.I. Ambac also did a deal in the first quarter of 2007 for Option One.
Part of Ambac's business strategy is to focus on transactions that pay better, S&P's Green said. While single-A is low for a triple-A bond insurer - coupled with the possibility for ratings migration - what gives the company comfort is that Ambac's earnings in one year are greater than the 10.6% that is its speculative-grade percent of qualified statutory capital, Green said. "So even assuming that all of that speculative grade has defaulted and the loss is 100%, it is still less than what Ambac can earn in a typical year," he said, adding that not every speculative-grade transaction will default and lose 100 cents on the dollar. "The exposure relative to capital is a much lower percentage," he said.
And while potential losses are not a "day at the beach for these companies," they are not a threat to the ratings, he added.
Some of the more niche monolines, such as Radian, which maintains a double-A rating from Moody's, have a somewhat higher risk profile due to the greater amount of subprime exposure they took on to increase their businesses. But in the context of lower ratings and the capital cushion they have, [Moody's] does not see any potential ratings threatening issues, Green said.
Fitch's Abruzzo echoed Green's thoughts. "In general, I think the underwriting dynamics are fairly consistent with the industry," Abruzzo said. More niche monolines "might have more of an appetite to possibly underwrite a greater percentage of ABS CDOs than what some of the other guys do, but I think they are doing it with the same discipline that is typically done at a high triple-A level, with the same protections in place that we would expect to see at some of the other major monolines."
CDO Exposure
ABS CDO exposure has also come into play as subprime tranches have begun to face losses. Merrill's Ryan did not, however, expect subprime damages to be particularly severe for these monolines, noting that he was not worried about losses hurting the bond insurers' capital cushions because the companies had "manageable levels of mark-to-market losses on corporate bond CDOs early in this decade." Specifically, mark-to-market losses on CDO guarantees issued as credit derivatives would not have much of an impact, except in the rare case of a claim, since offsetting gains would occur as maturity approaches, he said.
But some monoline CDO exposure may warrant concern. Market participants have called attention to the monolines' exposure to mezzanine ABS CDOs (triple-B and below), where losses on the triple-B level of the underlying credit would affect the triple-A-rated holders.
MBIA, one of the insurers in question, fired back in a recent release that since 2003, it has underwritten only four U.S. multisector CDOs with mezzanine collateral, totaling $1.2 billion of net par. Its total multisector portfolio contained $6.3 billion of net par of deals with mezzanine collateral - out of a total $109 billion in CDO exposure - with guarantees at the super-triple-A support level or 1.5 to 2 times the credit support level of the triple-A tranche below it.
However, while default does not seem likely, Pershing's Ackman did not feel MBIA was capitalized enough to endure potential losses while maintaining its triple-A reputation. He noted that the company has progressively been decreasing its unallocated reserves - which are on the company's balance sheet as a reduction of capital in anticipation of potential losses - from six basis points in 2001 to 5.4 bps in 2004 and down to 3.5 bps in 2006 and 3.2 bps in the first quarter of 2007.
But despite some of the market's concern, for now, monolines' triple-A ratings remain untouched.
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