The recent ratings action that saw Moody's Investors Service downgrade Ambac and MBIA to Aa3' and A2', respectively, and XL Capital Assurance/XL Financial Assurance to B2' from A3' is causing further concerns for the European banking sector.
At the moment, the biggest risk is the guessing game behind how the ratings debacle will end.
Societe Generale analysts said that although the latest spate of downgrades changes little in the European banking sector, the uncertainty regarding where the bottom is will ultimately delay the recovery of the European market.
"Banks have already struck large provisions against this exposure that are based on management's views on where monoline ratings will finish," SocGen analysts said. "So far, it seems that the banks expect the largest monolines to be cut no lower than the high-single-A range, but if monoline-wrapped bonds fall below the ratings of the underlying obligors, it is likely that banks will rely on the latter ratings if they are higher."
There are several European banks with material monoline exposures, most of which are through holdings of wrapped structured finance instruments, SocGen analysts said. UBS is the most exposed to monoline insurers and is most at risk. It is followed by Credit Agricole, Royal Bank of Scotland and Barclays Capital, which also have sizeable exposures that could require additional value adjustments in 2Q08.
However, determining the overall impact the downgrades will have will depend on the specific monoline to which they are exposed, the nature of the underlying assets and the existence of hedges against these exposures.
"The danger for banks is that when quantifying their exposure to monolines, the answer offers little insight," SocGen analysts said. "The quantum of exposure has little correlation to the likely loss caused by any further downgrades."
They added that the agencies could add a considerable amount of disclosure by announcing who is exposed to the identified stressed losses. If this is well distributed, SocGen analysts said, the systemic risk is limited. At this point, the market, according to analysts, would take most comfort from disclosure by each institution of total exposure and the mark-to-market value of underlying assets. Anything less than that is probably going to worsen the subprime debacle, the analysts said.
In total, 1,017 European synthetic CDO transactions have exposure to at least one affected monoline. According to Standard & Poor's, the numbers of European deals referencing the "affected" monolines are: 969 tied to MBIA, 829 tied to Ambac, 695 to XL Capital and 132 to FGIC.
The majority of these deals have more than one of the affected monolines referenced in their portfolio. Of these transactions, 119 reference three monolines, 302 are tied to two monolines and 114 are tied to one monoline.
"No indication has been given with respect to the potential number of downgrades, and it's hard to estimate given the many factors at play, namely how many monolines are in the portfolio and which, how much excess credit enhancement in the tranche, deal maturity, deal seasoning, etc," Royal Bank of Scotland analysts said. "The downgrade of Ambac and MBIA by Moody's Investors Service, though not a direct input in S&P's rating process, does add to the negative background (e.g., the prospect of further rating actions on the monolines may have to be subjectively factored in)."
Moody's has already stated that MBIA's insured portfolio remains vulnerable to further economic deterioration, particularly given the leverage contained in its sizable portfolio of resecuritization transactions, including some commercial real estate CDOs, which could lead to further rating actions.
It's likely that the age of the monoline wrap in European securitization deals is headed for a long period of silence, if not death. According to a European Merrill Lynch report, the main issuers of monoline wraps - whole business securitizations and the emerging markets originators - will have to start considering how to come to market to raise needed funds without the support of the wrap.
On the whole business side, Merrill Lynch believes that originators will access the market with lower ratings, as low as triple-B, through inflation-linked bonds.
"Emerging market originators may need to seek support from the good old multi-laterals, who were somewhat starved for business in the boom times, and many predicted their demise, but which are now coming back with a vengeance and providing a substitute for the monoline wraps in emerging markets," the report said.
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