PrefBlog

The bond insurance story is just getting bigger and bigger!

Accrued Interest points out:

According to data from Thomson Financial, only about 28% of municipal bonds issued in January carried insurance from a monoline insurer. That’s down from 46% in 2007. Meanwhile, according to Merrill Lynch, new insurance was dominated by FSA and to a lesser extent, Assured Guaranty. FSA insured $3.8 billion of new issues, about 70% of all new issue munis which carried insurance. Assured picked up most of the remainder ($1.3 billion or 23% of new insured issuers).
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The fact is that confidence in insurance has never been lower, and yet buyers continue to demand insurance at all tells you something. MBIA and Ambac may never be able to regain AAA levels of confidence, but municipal bond insurance as a concept will survive.

Yesterday‘s rumours that the New York insurance regulator would pursue a Good Insurer/Bad Insurer solution to the problem have been confirmed:

One part would operate the profitable municipal bond insurance business, while the other would handle so-called structured finance products, according to testimony prepared for Eric Dinallo, the New York State insurance superintendent. Dinallo is scheduled to address a U.S. congressional committee today.

“Our first priority will be to protect the municipal bondholders and issuers,” according to Dinallo’s testimony. “We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses. Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects.”

Naked Capitalism observes:

the priorities have been turned on their head. Before, the reason for a rescue was to prevent carnage on Wall Street. That objective has now been shunted aside as municipalities are hit by the seize-up in the auction rate securities market.

And yes, the Auction Rate Municipals market is getting worse by the day:

UBS AG won’t buy auction-rate securities that fail to attract enough bidders, joining a growing number of dealers stepping back from the $300 billion market, said a person with direct knowledge of the situation.
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As much as $20 billion of auctions didn’t attract enough buyers yesterday, an 80 percent failure rate, based on estimates from Bank of America Corp. and JPMorgan Chase & Co.

Merrill Lynch is also cutting back its support. Auction Rate Municipals were introduced to PrefBlog readers on February 6. From esoteric trivia to world crisis in eight days! I feel certain that, like the Canadian ABCP market, this is all the fault of the credit rating agencies. Did you know they get paid by the issuers?

There’s another interesting piece of trivia about the insurers … apparently many brokerages considered them such stellar credits that they didn’t have to put up collateral on their CDS exposure:

Goldman Sachs has made plenty of canny decisions in relation to the credit crunch. One of the smartest might have been its treatment of MBIA, the world’s biggest bond insurer.

While many rivals have in recent years been cheerfully using bond insurers to hedge their structured credit bets, Goldmans has refused to do so due to concern about counterparty risk.
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In taking $2bn and $3.1bn writedowns in hedges with insurers whose ability to honour those commitments is in doubt, CIBC and Merrill Lynch respectively have become the face of Wall Street’s nightmares.

It’s always the same thing, eh? Times are good and leverage increases, which only deepens the downturn when it finally arrives. Not just leverage, but also sector concentration of cowboys’ portfolios, witting or unwitting. The importance of correlation has been discussed before: briefly, for example, a husband and wife might each be in jobs that have a 10% chance of disappearing in any given year. A naive analysis (zero correlation) will assign a 1% chance to them both losing their jobs in a year … but if they both work for General Motors at a SUV plant, the chance of them both losing their jobs could be as high as the 10% risk they face individually.

Aleablog has noted in a post picked up and expanded by FT Alphaville that was linked by Naked Capitalism a story by Reuters [I love the Internet] that states:

Correlation on the five-year investment-grade Markit iTraxx Europe index — a measure of investor fears of a system-wide crash — reached new highs of 45 percent on Tuesday. Analysts said the figure had room to go higher still, but some said investors who are now trading based on high correlation could get burned if companies start to default.
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Over the past six months, the credit crisis and a low corporate default rate have pushed correlation up, which means the equity tranche has gained relative to the triple-A tranches.Analysts at UBS, in a recent note to investors, said one reason was that banks and financial entities such as conduits, which accumulated billions of dollars of triple-A tranches of CDOs, have needed to unwind or hedge against those tranches.
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“Now in a world where leverage has to come down, the pressure is on the piece that is the most leveraged, and that’s the super-senior tranches,” Charpin said.
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UBS analysts said the latest rise in correlation may have come also from hedge funds’ needs to raise cash. “If you are a cash-strained hedge fund, that may be a cheap trick to get quickly money back in your pocket,” the analysts wrote. “This is all the more relevant in the last weeks as prime brokers are clamping down on hedge funds’ funding.”

This is where smart analysis is worth money. A mechanism is at work that is pushing up the price of one analytical variable (correlation) without [necessarily] having anything to do with the the actual value of that variable. Therefore, a thorough analysis might show that shorting that variable is a smart thing to do – subject, of course, to a host of risk-control measures. In the preferred share market, for example, I might determine (with the use of HIMIPref™ that convexity is cheap. I might not be able to buy convexity directly, but the valuations of each investible instrument will be adjusted to reflect that view. And, perhaps, a portfolio with an increased convexity might then become cheap enough to the current portfolio that a trade is signalled. And … sometimes it works!

Monoline woes are also spreading into the LBO market, as noted yesterday and on February 11. It seems that formerly reliable Negative Basis Trades are turning positive:

Banks’ exposures through bond insurers, or monolines, is far from limited to mortgage-related MBS and muni bonds. There’s a third big exposure – to leveraged buyout loans – that banks will have to deal with if monolines hit the rocks.

Negative basis trades have been around for a while. A bank buys a bond – say it’s AAA – and then it takes out a CDS against that bond with a monoline. Since spreads in the CDS market for such tranches have been typically much lower than in the cash market, the bank pockets the difference.

But as well as banks’ much-dissected CDO exposures, there have been two other big markets for that kind of trade: on infrastructure bonds and – most interestingly – in structured finance, on CLOs (collateralised loan obligations) – CLOs being the vehicle of choice in which to park massive buyout loans.

Monolines, of course, are no longer in a position to be writing new contracts for banks to use as one half of their negative basis trades. The consequence of that has been that banks have stopped buying AAA tranches of CLOs. Unable to sell those, CLOs have faltered and banks in turn, have found themselves with lots of big buyout loans stuck on their books. No new financing is available for private equity deals.

The monoline FGIC was downgraded by Moodys today, which won’t help things much. The last sentence of the quoted analysis might be of interest to BCE speculators! 

Meanwhile, with a continue plunge in US real-estate values, there are desperate pleas for a government bail-out:

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers….

The risk: If delinquent borrowers default on their refinanced loans, the federal government would have to absorb the loss…

*Yawn*. Speaking of bail-outs, the German government bailout of IKB was mentioned yesterday. Willem Buiter is not happy:

If ever a bank was sufficiently systemically insignificant and small enough to fail by any metric except for the political embarrassment metric, it is surely IKB, the German small and medium enterprise lending bank that got itself exposed fatally to the US subprime crisis through a conduit (wholly owned off-balance sheet entity) devoted to speculative ventures involving instruments it did not understand.
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I can think of no better way of encouraging more appropriate future behaviour towards risk by German banks than letting IKB go into insolvency now. The institution gambled recklessly and irresponsibly. It lost. Liquidation and sale of its assets would be the market-conform reward for its failures.

Light-ish trading again today, but holy smokes, this market is on FIRE! PerpetualDiscounts are up 2.84% month-to-date; I noticed yesterday that the S&P/TSX Preferred Share Index (as proxied by CPD) had erased its post-new-issue losses to return to the level immediately prior to the BNS new issue announcement. And more today. So there.

There were fifteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Thursday, February 14th, 2008 at 9:49 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.