Moody's Investors Service said that the deterioration in the credit risk profiles of financial guarantors may have significant implications for a number of banks and securities firms. The rating agency's review for possible downgrades of embattled monolines MBIA and Ambac is set to conclude soon.
In the report, entitled "Analytical Exposure on Guarantor Exposure at Global Banks and Securities Firms," the rating agency updated its ongoing analysis on monolines' exposures, breaking it down into four broad categories including credit default swaps (CDS) and derivatives; wrapped and direct exposures; liquidity facilities; and reputational exposure.
Although banks have exposure to monolines through a wide range of instruments, in terms of degree of impairment the greatest source is the exposure to CDS hedges on ABS and CDOs, said David Fanger, Moody's chief credit officer for financial institutions. The rating agency is set to give its opinion on the possible downgrades of both MBIA and Ambac at the end of the month, he said.
"Our initial assessment has identified CDS hedges with financial guarantors on ABS CDOs in notional amounts totaling approximately $120 billion, spread across approximately 20 different banks and securities firms," Fanger said, declining to name the banks, citing confidentiality. "We believe downgrades of financial guarantors could cause these firms to increase counterparty reserves by $7 billion to $10 billion in aggregate."
Two factors motivated banks that entered into this type of transactions, Fanger said. Some of them were underwriters of CDOs and retained some super-senior tranches, for which they bought protection from the monolines. Another group was engaged in negative basis trades - where the cost of the purchased CDS credit protection was less than the yield on the underlying security or CDS sold.
Tanya Azarchs, an analyst at Standard & Poor's and author of the report "Downgrades of Bond Insurers Can Add to Subprime Woes for Banks," agreed, saying that the area with the potential for the highest losses is the hedges that the bond insurers provide for the super-senior CDO tranches. Azarchs said in the report that, "$125 billion of subprime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is."
According to the S&P report, Citigroup reported that it had bought protection on $10 billion of super-senior tranches of high-grade CDOs, but not necessarily all from bond insurers. Merrill Lynch reported $19.9 billion of hedges with bond insurers, and Canadian Imperial Bank of Commerce $9.9 billion.
The value of those hedges has increased as the values of the underlying CDOs have fallen and now can be presumed to be 40%-60% of the notional amounts.
Azarchs said that a potential downgrade of the monolines could affect all the markets in which they are active, including municipal bonds, CMBS and other structured finance areas. And in turn, a dislocation in those markets could affect banks, and, in a few cases, lead to downgrades.
"The impact will depend on the extent of downgrades," she said. "If they go to D,' then the losses would be quite high - maybe $50 billion."
Banks with holdings of wrapped subprime, Alt-A and second-lien RMBS will also face impairment, Moody's Fanger said, although to a lesser degree since the holdings will likely be distributed more broadly across banks and securities firms globally. The agency is still in the process of identifying which banks might hold large concentrations in these positions, Fanger said.
For some market participants, the problem is that these banks are not being very forthcoming about the exposure they have to Ambac and MBIA. "The monolines haven't been downgraded yet because agencies are under pressure," a source said. "It doesn't make sense: when CDOs are in trouble they are downgraded right away, but it takes months for monolines."
As happened with the subprime debacle, there is a risk of market contamination with banks' exposure to monolines. As they have wrapped many emerging markets deals, their possible downgrade could have effects on toll roads in Chile, future flow deals in South Africa or Mexican mortgages, for example. Although the emerging market is a very small portion of monolines' portfolios, if half of them are wrapped, any downgrade could be very significant, said Arturo Cifuentes, a managing director at R.W. Pressprich & Co., a fixed-income broker dealer.
As for Europe, the capital reserves in some banks are linked to ratings, so if they are downgraded, they will have to have more capital reserves. In addition, there are more banks there that operate under Basel II. "So if a monoline is downgraded, the capital reserve requirements can go up," Cifuentes said.
Just last week, Melbourne, Australia-based ANZ announced it had taken an additional $200 million provision due to its exposure to a U.S. monoline insurer that had been downgraded to non-investment grade. "The effective economic impact if the monoline insurer fails is that ANZ takes on direct exposure to a high-quality portfolio of corporate names," the bank said in a statement. "In fact, this portfolio has a higher proportion of investment-grade corporates than ANZ's existing institutional portfolio. For an actual loss to emerge, around 20% of the names within the portfolio would need to default."
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