As the turmoil intensifies in the European asset-backed market, it's beginning to look as if not even the titans of the monolines are immune to subprime aftershock. The monoline industry, which recently saw some of its major players reporting significant third-quarter losses, is the latest target in the firing line. And now, as the market remains plagued with fear, all eyes are on the monolines' future actions.
"They need to maintain confidence," said one analyst for a European-based investment bank. "While monoline credit profiles haven't changed dramatically, the ratings agencies are keener to pull the trigger sooner than later, as they are currently viewed as being slow to downgrade others in the recent past."
Last week, Financial Security Assurance (FSA) announced a third-quarter 2007 net loss of $121.8 million due primarily to net after-tax unrealized mark-to-market losses totaling $190.9 million in its insured derivative portfolio, which consists mainly of insured credit default swaps (CDS). Assured Guaranty Limited reported a net loss of $115.0 million, based on a $162.9 million CDS loss. Financial Guaranty Insurance Co. (FGIC) lost $65.3 million. Ambac Assurance Corp. reported a third-quarter net loss of $360.6 million. MBIA Insurance Corp. reported last week that its wrapped paper remains resilient in the face of the negative sentiment surrounding the wrappers.
In response to the announced losses, Fitch Ratings reported that it was reviewing the ratings of bond insurers' which could possibly lead to a downgrade based on the results of capital adequacy. "We are undertaking additional analysis of the structured finance CDOs," said Tom Abruzzo, a managing director at Fitch. "Those companies designated as high probability' appear most likely to experience deterioration in their capital cushion, which may put them at risk of being placed on Rating Watch Negative. This may impact their ability to underwrite new business."
According to stress tests run by Fitch, FGIC has the most exposure of the big four monolines to problem credits. That company is followed by Ambac, and then MBIA. FSA places a distant fourth, with relatively little exposure to problem areas of credit. Abruzzo said that if some of the more at-risk monolines do not begin to initiate internal changes within the next four to six weeks, then those companies will no doubt go on Rating Watch Negative for a period of one month.
Standard & Poor's, on the other hand, has said that it feels the monolines have "sufficient capitalization to weather this challenging period," and it believes "improvement in fundamentals" is necessary for monoline improvement.
The monolines quickly point out, however, that the losses reported are unrealized. "Assured's accomplishments in the quarter, including the upgrade of Assured Guaranty Corp. to Aaa' by Moody's Investors Service and record new business production, have been overshadowed by the current concerns in the credit markets," said Dominic Frederico, President and CEO of Assured Guaranty. Frederico added that the monoline had limited exposure to the major areas of market concern and the company does not expect major problems with its subprime RMBS investments. "Our expectation is for cumulative losses to be in the range of 14% to 15% of the original pool balance," he said. "Cumulative losses on average would have to exceed 29% of the original pool balances before we would incur losses."
Ian Dixon of Ambac said the demand for monoline products is growing because skittish investors look for the protection that additional underwriting provides. Furthermore, the monoline is changing its approach to fall more in line with changing guidelines, adding that they have already turned away some deals that didn't appear to be correctly valued. "The [loss] reflects a mark-to-market loss, and this is an unrealized loss because we hold all CDOs to term, so for instance, we can't trade them," he said. "We underwrite the full tenure, undertake our own analysis, so any adverse effects are from market perception."
Michael Cox, a real estate and corporate securitization analyst for The Royal Bank of Scotland, said he believes the monolines have manageable exposure to problem areas of credit. Further, if the companies face threats to their corporate ratings, they would act to shore up balance sheets, tapping the equity markets or shareholders if necessary. Of the big four, Cox said that FSA is best placed, followed by MBIA, Ambac and FGIC.
Encouragingly, FGIC was quick to respond to the new Fitch methodology, pledging its commitment to work on plans for risk mitigation and capital enhancement alternatives. FGIC CEO Frank Bivona emphasized in a statement that "management and shareholders respect the importance of all our triple-A ratings and intend to take actions necessary to preserve those ratings."
Nonetheless, Europe's jittery investors were quick to trade on fears of capital adequacy and rating risks last week, triggering a sharp sell-off of monoline insurer risk on the back of the third-quarter reported losses. According to RBS, there is an estimated GBP17.1 billion (nearly $36 million) outstanding in fixed-rate wrapped bonds issued in sterling. The total is broken up among the monolines as follows: Ambac GBP7.8 billion, MBIA GBP5.2 billion, FSA GBP3.2 billion, FGIC GBP0.7 billion and XL Capital GBP0.2 billion.
"In Europe the use of primary financial guarantees in the public European securitization market is less prevalent compared to the U.S., with wrapped bonds limited mostly to off-the-run financings such as future-flow ABS and infrastructure deals," reported analysts at Deutsche Bank. "But the influence of monolines in structured finance goes beyond the provision of primary guarantees. In recent years, this constituency has played an increasingly important role in demand technicals as both protection seller in ABCDS and leveraged synthetic structures (mostly CDOs), as well as provider of secondary negative basis wraps."
Whether these companies have the ability to change quickly enough in the face of such a rapidly changing market remains to be seen. "Our activities can sometimes be slow moving," said a source at one monoline. "And if we lose our triple-A ratings, we're finished."
To be sure, the consequences of a downgrade would be catastrophic for the monolines' ability to write new business. In a time of high demand for their services, there could be implications for the market's view of the credit quality of wrapped bonds. "It's an issue of timing," said one analyst from a European-based investment bank. "They can pay out their losses over time, as is the monoline structure, but if all the losses start coming at the beginning of next year, their capital base is going to become eroded." However, a senior observer from one monoline company dismissed the latter possibility and said that his company did not have a liquidity risk.
"While we believe the monolines can survive the storm intact, there is a very real risk posed from spread-widening on negative sentiment," said Cox. "If losses in U.S. subprime and CDOs containing subprime collateral prove worse than anticipated by the rating agencies, it is feasible that some of the monolines may need to raise fresh capital in order to maintain their triple-A ratings."
Cox added that a very real outcome from last week's announcements is that the market will start differentiating between different wrapped bonds by both the monoline insurer providing the guarantee, and the credit quality of the underlying paper.
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