Spiralling debt

Asian financial institutions hold exposures to US monoline insurers that are struggling to maintain their much-vaunted AAA credit ratings. Who is at risk, and what is the likely fallout from the latest bout of credit contagion? By Kathleen Kearney

Financial institutions in Asia, like their peers elsewhere, have been hit by new credit shocks from Europe and the US in the aftermath of the subprime lending problems that emerged in mid-2007. The latest bombshell is that highly rated monoline insurers - which have insured $125 billion of structured credit products, according to rating agency Standard & Poor's (S&P), as well as billions of dollars of US municipal bonds - face downgrades or even defaults (see box).

The latest developments are coinciding with the implementation of the Basel II capital-adequacy rules, which require increased disclosure of financial information in several Asian jurisdictions. While these new capital rules potentially offer market participants a better look at local banks' exposures, they might also be adding to market jitters and volatility.

There are several ways Asian banks may have exposure to US monoline insurers. The first is via a guarantee, dubbed a 'wrap' in the industry, whereby the insurer guarantees to make payments on the senior tranches of a structured credit product, such as a collateralised debt obligation (CDO) in the event of a default by the obligors.

Market participants believe few investment banks have needed or sought a guarantee from the big monolines for products structured in Asia. One Singapore-based structured credit executive says his bank has not called on US monolines to guarantee structured credit products in Asia.

But many Asian investors, including financial institutions, have bought products wrapped by US monolines. So it is likely that many banks in Asia have some exposure to monolines. And a downgrade of a monoline might require a downgrading of the product it has insured. This would further require the bank that bought the products to put aside more risk capital aside as well as possibly charging mark-to-market losses on the P&L.

The potential exposure of banks could be "roughly in parallel to their exposure to CDO structures or less. If you look at banks' exposure to CDO structures, it is fairly limited in Asia", says Scott Wilson, a banking analyst at Royal Bank of Scotland in Singapore. "Most structures that Asian banks are exposed to do not come with monoline wraps, so the exposure levels to the monoline wraps is not a big issue." Statistics to support this were not readily available.

A second, common way in which Asian financial institutions will have exposure to monolines is in the CDO structure itself. Synthetic CDO structures, which package the credit default swaps (CDS) of 100 or more corporate names, will often include the CDS of AAA-rated monoline insurance companies. These were used to boost the credit rating of the structure and thereby its attractiveness. Industry sources suggest that Asian banks' exposure to monolines in this manner would be equal to between 2-4% of their total exposure to structured credit products.

Standard Chartered's special investment vehicle (SIV) Whistlejacket is an example of this second type of exposure. Whistlejacket's assets, as disclosed at the end of January, were composed of "40% financial institutions debt with a minimum rating of A, and 87% of which is rated Aa or higher; 7% Aaa monoline financial guarantors (over 50% MBIA and over 40% Ambac); 48% asset-backed securities (excluding CDOs), with a minimum rating of single A, and 98% of which rated Aa or higher; and 5% CDOs with a low level of exposure to sub primerelated assets, all of which were super senior tranches", according to a document issued by Moody's in late January. Since that announcement, Standard Chartered said it would wind up the Whistlejacket SIV.

In addition, the bank has an outstanding structured credit product portfolio of $719 million, 12% of which was wrapped by US monolines, with Ambac and MBIA accounting for 35% of the wraps, says Julian Wan, the bank's Asia chief financial officer.

Another way monolines may have been active in Asia would be in providing a guarantee to the super-senior tranche of a balance-sheet structure typically called a balance-sheet synthetic securitisation. These would typically be done on the back of large, granular pools of the banks' corporate exposures. The balance-sheet transaction typically allows the banks relief of regulatory capital against the asset pool, but increasingly, these deals are being driven by the need to reduce risk in order to facilitate more risk origination.

Australian banks may be the exception to the rule that banks in the region have not used monolines to wrap or guarantee products structured by their investment bankers in a significant way. ANZ Bank gave the market a fairly clear picture of its exposure to the subprime contagion, including its association with a monoline insurer, in a report issued on February 19.

ANZ chief executive Mike Smith says that while the bank achieved good operating results, these had been overshadowed by higher credit costs on commercial lending. "(This) includes the potential impairment of a monoline counterparty with a $200 million mark-to-market exposure," he says, "although we believe the accounting treatment overstates the likely loss over the life of the transaction."

That accounting treatment, which will be required of all banks worldwide, according to new accounting guidelines from the big-four global accountancy firms, requires that any impairment loss be deducted directly from profits in the period in which the impairment occurs, rather than charged to reserves.

Under the new accounting guidelines, which appear to have no formal name, ANZ detailed specific instances in which it had made material provisions for exposure to US monolines. The first was an exposure to a US monoline insurer between 2005 and February 2007. "ANZ entered into derivatives transactions, which involved selling credit protection on a portfolio of corporate names and simultaneously buying matching protection from highly rated US financial institutions to remove market risk," says Smith. "This was perceived to involve little credit risk and generated modest trading income."

But the significant increase in derivatives market credit spreads and volatilities resulted in a positive mark-to-market position with the sellers of the credit protection. "One counterparty, a US monoline insurer, has been downgraded to CCC," says Smith. "The uncertainty around the ability of that firm to meet its obligations under the hedging agreement has resulted in an accounting requirement to raise an 'individual provision' of $200 million based on the current mark-to-market exposure to that monoline." The identity of the insurer appears likely to be ACA Financial Guaranty.

Failure of the monoline would mean ANZ takes on direct exposure to a high-quality portfolio of corporate names. The portfolio has a higher proportion of investment-grade corporates than ANZ's existing institutional portfolio, and for an actual loss to emerge, around 20% of the names would need to default, Smith says.

ANZ also has some loans to corporate clients on which it has bought credit enhancement from US monoline insurers. "The mark-to-market on these exposures is not material, and ANZ is comfortable with the strength of underlying assets, which are themselves investment-grade and primarily high-quality infrastructure assets, such as transmission networks and airports," says Smith. The purpose of the credit enhancement was to achieve an AAA rating, he adds, with the associated reduction in economic capital costs offsetting the cost of buying protection.

The level of detail in the ANZ report and the need for large provisions are being driven by the new requirements for banks under new International Financial Reporting Standards and Basel II, says Garry Grimmer, a New Zealand-based risk management consultant and former board member of ANZ National. "If you look at the recent announcements from Australian banks, they are having to disclose movements in their provisioning much more quickly than before," says Grimmer, adding that this is causing substantial volatility.

Whereas previously banks would look to write off held-to-maturity assets such as straight bonds over several years, they must now disclose all potential exposures in the following 12-month cycle. "So that doesn't necessarily reflect a weakness in the banks; the issue is to be much more transparent in their disclosure," Grimmer says.

Recapped Japan

Banks in Japan made a late and relatively cautious entry into the market for subprime-related investment products. And while their exposure has climbed substantially, it is believed to be small relative to the strength of the recapitalised banking industry. In its latest report issued in mid-February, domestic regulator the Financial Services Agency (FSA) said Japanese banks held a total of Yen1.52 trillion ($14.1 billion) in securities linked to US subprime-linked loans at the end of December. This was up from the Yen1.41 trillion reported for the end of September.

"Appraisal (subprime-linked) losses for the April-December period came to Yen158 billion, against Yen135 billion reported for the April-September period," the FSA said. "Realised losses amounted to Yen442 billion and Yen141 billion (for the same periods)." The country's 38 major banks held more than 91% of the assets and were able to cope with any losses due to their healthy capital-adequacy ratios, the regulator added.

Mizuho Financial Group, Japan's second biggest bank in terms of assets, is believed to have one of the largest exposures to residential-mortgage-backed securities (RMBSs) among all Asian banks and, through Mizuho Securities, it also has exposure to the monolines. "Mizuho has about Yen700 billion in RMBS and CDO exposures, which are mainly foreign-currency investments in Europe and other countries," says RBS' Wilson. "They have also bought Australian and US plain-vanilla packaged loans, where default rates and loss rates are very low. These should not be a problem."

But Mizuho Securities has disclosed significant monoline exposure, says Wilson. The dealer has gross exposure to CDOs valued at Yen250 billon, which both reference US monolines and are wrapped by two monolines: One is a non-investment-grade US monoline and the other an investment-grade monoline. The group has charged Yen98 billion to its reserves for these positions. In December, the group injected Yen150 billion into Mizuho Securities, which in turn made a new share allotment to its parent to bolster its capital base.

Banks with an international footprint or aspirations in investment banking, such as Mizuho, are likely to have boldly bought a variety of structured products, many of which would have been guaranteed by US monolines. For example, Woori Bank - South Korea's third largest bank, which is majority government-owned - has one of the largest structured credit portfolios among Asian banks. The bank disclosed that it is holding CDOs and MBSs totalling 494 billion Korean won ($520 million), including 147 billion won in subprime related securities.

The bank reported fourth-quarter profit of 199.3 billion won, a fall of more than 50% year-on-year, chiefly due to losses from its investments in US subprime loans. In all, Woori Bank has made loss provisions for $445 million of its investments in US subprime mortgage-related instruments, according to financial regulators. But it has not disclosed its exposure to monolines.

Lion's den

Singapore's major banks were probably some of the first Asian financial institutions to use structured credit instruments, and their experience has largely been a profitable one, say market professionals. Most Singaporean banks appear to have invested in portfolios of high-grade corporate loans or collateralised loan obligations (CLOs).

"The regulators are fine with structured credit, and they are not now advising banks not to buy (as of mid-February)," says the unnamed Singapore-based structured credit banker. Domestic banks are seen as having a solid capital base and being able to weather the storms erupting in global financial markets. In addition, their exposure to monoline insurers is believed to be no greater than the 2-4% average of other regional Asian banks, as estimated by dealers.

Development Bank of Singapore (DBS) was criticised last year as being too slow at writing down the value of its structured credit portfolio. With the announcement of its fourth-quarter results, the bank demonstrated more robust action was being taken ahead of the arrival of its new chief executive, Richard Stanley, who takes over in May from Jackson Tai. DBS said it would take writedowns of nearly S$400 million ($283 million) for the fourth quarter of 2007, which included S$291 million of additional losses arising from its CDO exposures, as well as a larger-than-expected S$67 million impairment charge against its investment in Thailand's TMB Bank.

"Against its S$267 million of subprime CDO exposure, the bank took additional losses of S$170 million in Q4, lifting the loss-coverage ratio to 90%," said Jason Roberts, a banking analyst at Barclays Capital in Singapore, in a February 15 research note. "The bank took another S$30 million general provision against its other CDO investment exposure of S$944, which still seems a little on the low side."

DBS also had CDO exposure of S$1.12 billion as at the end of September, via its investment in Red Orchid Secured Assets (Rosa), an asset-backed commercial paper conduit, which is fully funded by DBS. While this does not contain any subprime-related exposure and 98% of assets were rated AAA, the bank still took another S$91 million mark-to-market (MtM) loss on this exposure in the fourth quarter. It is unclear what exposure Rosa has to monolines.

These additional provisions have not been enough to satisfy some. "Overall, while we believe that further CDO losses are possible going into the first quarter of 2008, the large majority (especially direct subprime CDO-related losses) appear to have been addressed in Q4," says Roberts.

But others believe the bank is actually ahead of the market. The Singapore-based credit banker says: "If you look at the provisions DBS has made for transactions - their CDOs of ABS, for example - they provided for 90% of the capital that was in place already and they have started to provide more capital for the other CDOs, which are really CLOs and synthetic CDOs. These haven't seen the default rates that you have seen in mortgages, and my view is that even if they had to provide for that, they are still earning money."

In Hong Kong, Bank of East Asia (BEA) had a 21% jump in net profit to HK$4.22 billion ($541.17 million) for the year ended December 31, despite taking a total provision of HK$270 million in impairment losses and charges on the 14 synthetic CDOs that the bank is holding as investments. All but one of the portfolios was showing a loss on an MtM basis, says BEA chief financial officer Daniel Wan (see News, page 8).

Wan says he does not know if the bank had exposure to monoline insurers. However, the ratings of the names in the CDSs in the portfolios ranged from BBB plus to Aa, which would indicate the bank does not have direct exposure to AAA monolines through its synthetic CDOs - although the situation is unclear, as some monolines have lost their AAA ratings.

The bank's structured credit portfolios are managed by an in-house investment division, which is responsible for proprietary trading and investments that included a portfolio of HK$12 billion of available-for-sale assets. "When we structure our CDOs, we only look at those high-grade names, such as Citi and JP Morgan," says Wan. Yet these banks have exposure to subprime products, and so BEA certainly has indirect exposure to this market through them.

But Wan remains unconcerned about the blow-out in CDS spreads. "The blue-chip Hong Kong names have dropped by about 20% in the last few weeks, but I am still receiving interest income of about 200 basis points over Libor, so the spread is good," he says, referring to his personal investments. "For a new CDO, they are commanding 500bp over Libor. So this may be the right time to go in. I am still quite optimistic about the CDO investments."

Monoline mayhem

Before the 2007 financial results reporting season got under way in February, the monoline crisis was already in full swing. S&P had downgraded the financial strength and financial enhancement ratings of monoline insurer ACA Financial Guaranty, a unit of ACA Capital, from A to CCC on December 19.

On January 30, Fitch cut Financial Guaranty Insurance Co's rating from AAA to AA, and S&P did the same the next day. Moody's Investors Service followed suit on February 14, with S&P further slashing its rating to A on February 25. And Security Capital Assurance, a unit of Bermuda-based insurer XL Capital, lost its AAA status when it was downgraded six notches by Moody's on February 7, with S&P following suit on February 25.

Both agencies both placed Ambac Financial Group and MBIA's AAA ratings on 'review for downgrade' at the start of this year. This sparked concerns in the market, as Ambac and MBIA are the two biggest monolines. Dexia's Financial Security Assurance (FSA), however, retained its AAA rating from all three agencies with a 'stable outlook'.

And while Fitch cut Ambac's rating to AA on January 18, Moody's and S&P held off their rating decisions - a move some parties believe was evidence of the agencies bowing to US political pressure - although the two agencies could still downgrade Ambac as well.

Several options were open to the monolines. One was to recapitalise, which would involve securing funds from a consortium of banks; another was to split the companies in two, with one unit taking over the insurers' bread-and-butter business of guaranteeing municipal bond repayment and the other handling the exposures to structured credit, including subprime-related products. Alternatively, monolines could choose to wind up operations with an agreement not to take on any new business.

As of mid-February, only MBIA, the largest of the monolines, had been able to raise new capital in the markets and so take a step toward ensuring its future. Private-equity fund Warburg Pincus pledged to inject $1 billion into the firm in two instalments of $500 million starting in December.

On February 25, S&P said it would maintain its top rating on MBIA with negative outlook and Moody's affirmed Aaa rating on MBIA with negative outlook the next day. S&P left Ambac's AAA rating on review for downgrade. As of the start of March, Ambac appears to have finally secured $2 billion-3 billion from a consortium of banks to recapitalise, although its ultimate status is still uncertain.