Further monoline downgrades likely

So-called legacy firms are ones that existed before the credit crisis hit the market in July 2007; since then Warren Buffett has secured a Aaa rating for his Berkshire Hathaway Assurance, which started trading in January 2008.

That company focusses on writing protection for the municipal bond market, and, along with FSA and Assured Guaranty, is the only company to have remained active in writing new bond insurance in recent months. According to Moody's, FSA and Assured Guaranty - both based in New York - insure between 40% and 50% of new issuance in the muni market.

It had been thought that FSA and Assured Guaranty had emerged from the crisis unscathed because they remained focussed on writing business backed by corporate credit default swaps (CDS) rather than collateralised debt obligations backed by asset-backed securities. Both companies have also written some protection for securitisation of residential mortgage-backed securities; Moody's estimated stress case losses on those exposures are at $1.5 billion for FSA and $330 million for Assured Guaranty.

"Most of the financial guarantors have large cumulative exposures to the structured finance sector," said Jack Dorer, managing director in Moody's financial guarantor team in New York. "Some of these transactions are quite large, and there is also high operating leverage among the companies themselves. Due to the complexity of certain of these transactions, performance volatility can be significant as cumulative loss expectations change."

As the structured finance market has ground to a halt, the firms have a higher concentration of risk backed by corporate names. This, along with the leveraged nature of their business model, has given the agency cause for concern.

"When things do go wrong for these companies, it affects not only their business opportunities but also their financial flexibility," said Dorer. "Some of our assumptions are being affected by how significantly credit events can influence things like market confidence and financial flexibility for these firms."

The action comes despite the fact that FSA, which is backed by Dexia (the Belgian bank), had received $500 million in capital and a $5 billion credit line from its parent bank.

This represents a sea change in the perception of the depth of the trouble at the monolines, which have all been raising capital in part to try to bolster their ratings.

"Capital is not necessarily the solution to a broader problem, you could argue that, if there are competitive or structural issues at some of the guarantors, capital would not entirely mitigate these problems," said Stanislas Rouyer, senior vice-president in Moody's financial guarantor team in New York.

FSA remains optimistic about the possibility of saving its Aaa rating, seen as a crucial component for securing future business in this sector.

"We take note of the concerns Moody's has expressed, and we will work closely with them to re-establish our Aaa-stable claims-paying ratings," said Robert Cochran, chief executive officer of FSA, in a statement released on the day of the announcement.

Assured Guaranty, meanwhile, has voiced concerns over the way the rating agency has handled the process.

"It is our view ... that Moody's decision to re-evaluate industry ratings, during a time of unusually high market volatility and lack of liquidity in many credit markets, could have been accomplished in a different manner without affecting municipal and other policyholders," said Dominic Frederico, chief executive officer of Assured Guaranty, in a statement released on July 22.

See also: Doubts over opportunities for more monolines

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