Moody’s Investors Service has reviewed the impact of the financial guarantors’ mark-to-market losses relating to CDS’ in a new report released Wednesday.The report is titled Interpreting Financial Guarantors’ Mark-to-Market Losses.

Wallace Enman, a vice president at Moody's, said that  market-to market losses recorded for CDS contracts  don’t represent a true indicator of actual credit deterioration.

Over the past several quarters, significant mark-to market losses have been recorded on financial guarantors' CDS contracts. These have raised questions about the nature and degree of exposures and the interpretation of this information in the context of a guarantor’s financial strength.

According to Enman, the financial guarantors' claims-paying resources are not directly affected by mark-to-market charges on derivative contracts. Charges do convey that the market would require an additional premium to insure the same exposures today, which may or may not reflect an actual increase in default risk among the reference obligations.

The guarantors have indicated in public disclosures that they believe expected actual credit losses on their insured CDS portfolios will be materially lower than implied by the estimated market values.

Enman said that although mark-to-market hits may not represent actual credit deterioration, these can limit a guarantor's financial flexibility by adding to already negative market sentiment.

Clients may choose to avoid additional transactions with certain guarantors, and large “mark-to-market losses may also dampen investor appetite for a guarantor's debt or equity securities, inhibiting its ability to raise capital in a stress-loss scenario,” Enman said.

Over the past few weeks, Moody's downgraded the ratings of MBIA and Ambac by several notches on the basis of the firms' impaired financial flexibility and dampened business prospects as well as the substantial risk within their portfolio of insured exposures.

Enman also noted that the CDS contracts of some guarantors contain provisions stipulating that counterparties may request a termination at market value in the event of insolvency of one of the parties. Such terminations could result in significant cash payments being required if a guarantor was deemed insolvent under the terms of a contract.

Regulators could be expected to play a significant role in determining insolvency. Moody's believes that they would be reluctant to take preemptory action that might have the effect of worsening the financial condition of the insurer and reducing resources available for prospective claimants.

Moody's said that the risk of insolvency is low for most rated guarantors because they have regulatory capital cushions well above minimum levels. However, proximity to minimum regulatory capital requirements recently helped to drive Moody's rating actions for FGIC, CIFG, and XL Capital Assurance to below investment-grade.


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