A trick too far

Troubled monolines have underwritten a plethora of subprime mortgage-linked collateralised debt obligations for dealers. But with further deterioration in the subprime mortgage market, are these guarantees worth the paper they're written on? Mark Pengelly investigates

Monoline insurers have pulled off some dazzling tricks over recent years. Having moved out from their traditional business of wrapping municipal bonds, long-established monolines entered into the higher-margin arena of structured finance. With onlookers aghast, a neat tap of the wand caused dealer exposures to collateralised debt obligations of asset-backed securities (CDOs of ABSs) to disappear. But with heightening losses on US subprime mortgages, these exposures have leapt out to startle bond insurers and banks - and have revealed the vanishing act of monolines to be a hoax.

Two of the last remaining monolines to retain AAA ratings, New York-based Assured Guaranty and Financial Security Assurance (FSA), were put on review for a downgrade by Moody's Investors Service on July 21. Meanwhile, New York-based bond insurers Ambac and MBIA lost their coveted AAA ratings in June, when Moody's took them to Aa3 and A2, respectively, and Standard & Poor's (S&P) downgraded both to AA. Both Ambac and MBIA remained on watch for a possible further downgrade with S&P on July 24, and the ratings of both were given negative outlooks by Moody's. In separate statements, Ambac said it disagreed with the rating actions, while rival firm MBIA described itself as "baffled" by the downgrades.

Like a real magician, such protestations lead one London-based head of structured credit at a large European bank to joke the monolines have moved into the business of entertainment. But for dealers, the situation could not be more serious.

The downgrades from Moody's and S&P reflect a heightened risk of default for the principal monolines. But in most cases, the market has reached its own verdict. "On a mark-to-market basis, it's pretty clear these guys are already bankrupt," says the London-based head of structured credit at a large European bank. Since early July 2007, five-year credit default swap (CDS) spreads on the operating companies of some monolines have widened out by almost 10,000%. Meanwhile, dealers report some second-lien monoline-wrapped loans have been trading at wider spreads in the secondary market than those of unwrapped loans.

The ramifications for banks are severe. In recent years, dealers relied on monolines to help them remove exposures to CDOs of ABSs on their books. Among bond insurers that have lost their AAA ratings, Ambac and MBIA have insured $29.195 billion and $30.6 billion of CDO of ABS tranches, respectively, according to figures compiled by Bank of America. Equally embattled XL Capital Assurance provided guarantees on $17.996 billion of CDOs of ABSs, while $10.932 billion had been underwritten by Financial Guaranty Insurance Company and $9.4 billion by CIFG. Collectively, monolines have insured $100 billion in exposures to CDO of ABS tranches, according to Bank of America.

Those tranches have fallen victim to credit deterioration of the underlying mortgage loans at a rate never seen before. Bank trades with bond insurers have consequently swung in favour of dealers, although the fast-diminishing creditworthiness of monolines gives them little to celebrate. Dealers might have succeeded in temporarily removing the default risk of subprime-linked credit assets from their balance sheets, but they merely swapped it for a heavily correlated counterparty exposure to monolines.

Bank disclosures on the level of counterparty risk connected to bond insurers are sparse. But statistics gleaned from first-quarter filings by Royal Bank of Scotland (RBS) analysts show that, in dollar terms, US and European banks may well have almost $100 billion of counterparty risk exposures to monolines - counterparties that aren't required to post collateral (see table A).

Aside from guarantees on CDOs of ABSs and residential mortgage-backed securities (RMBSs), banks are exposed to monolines through other businesses - notably, municipal and inflation-linked bonds and insurance-linked securities, often wrapped by guarantors, or through negative basis trades. Monoline insurers also participated heavily in the single-name CDS market, although counterparty exposures on these transactions won't have hit dealers as hard.

"You need to look back at which underlying assets are being smoked the most," explains Corinne Cunningham, senior financials analyst at RBS in London. "Anything with subprime, mezzanine or ABS CDO collateral will be affected the most. Higher-quality exposures to the US mortgage market should see smaller marks. It all depends on the underlying assets you're buying protection on."

It is therefore no surprise that the US and European financial institutions with the biggest exposures are those formerly most active in securitising subprime assets. As shown by the statistics compiled by RBS analysts, AIG, Citi and Merrill Lynch had revealed the largest volume of gross positions underwritten or wrapped by monolines at the end of the first quarter among US financial institutions, at $41.5 billion, $23.89 billion and $18.752 billion, respectively. The size of the AIG figure is tempered by the fact that the majority of it - $31.5 billion - comes from wrapped municipal bonds. The only firm of the three for which an indicative monoline counterparty exposure is available is Citi - a figure placed at $7.286 billion in the first quarter. The Citi figures are only reflective of trading book risk and don't cover corporate or municipal bonds, according to RBS. Likewise, Merrill Lynch's $18.752 billion figure only covers its exposure to CDOs.

Information is scarce for other major US dealers. Morgan Stanley held $4.7 billion of assets backed by monolines at the end of the first quarter. Bank of America had a gross theoretical exposure of $3.353 billion, the RBS data reveals, of which around $3.15 billion is attributable to super-senior CDSs. The bank held a counterparty exposure of $1.5 billion to the bond insurers. Lehman Brothers held a counterparty exposure of $255 million to the monolines but offered no further details, while Goldman Sachs disclosed no information on its exposures.

Using March 31 exchange rates as a crude yardstick for comparison, UBS and RBS look most exposed among the major European banks. UBS held a theoretical gross exposure of Sfr24.6 billion, with counterparty exposures of Sfr8.949 billion stemming from this. RBS itself reported £25 billion of assets hedged with monolines, as well as subsequent counterparty exposures of £6.2 billion.

Following these, Dresdner Kleinwort reported EUR13.4 billion of assets hedged with monolines by the end of the first quarter, with a counterparty exposure of EUR1.7 billion. Societe Generale held a gross exposure of EUR7.3 billion and a monoline counterparty exposure of EUR2.4 billion, while French rival Credit Agricole was exposed by EUR6.5 billion on a gross basis, with a relatively large counterparty exposure of EUR4.9 billion.

UK bank HBOS had a gross exposure to the monolines of £5 billion, consisting of £2.8 billion in negative basis trades and £2.2 billion in wrapped bonds. According to the information gathered by RBS, its counterparty exposure at the end of the first quarter was £1.48 billion. Deutsche Bank's gross exposure totalled EUR8.897 billion at the end of the first quarter, while its counterparty exposure was EUR3.769 billion. Fortis had EUR2.8 billion of gross theoretical exposure, comprising EUR1 billion of CDOs of ABSs and EUR1.8 billion of underlying risk rated investment grade, but there were no counterparty exposure figures available for the Benelux bancassurer.

With a EUR2.7 billion gross exposure, BNP Paribas seems to come off well. But it has reported a larger counterparty exposure, at EUR2.9 billion. Swiss Re, meanwhile, held Sfr3.264 billion in wrapped assets, of which around half had subprime-related underlyings. No gross exposure figures were available for UK dealers Barclays Capital and HSBC. But the two had disclosed counterparty exposures of £2.784 billion and $1.556 billion, respectively, in the first quarter.

Brussels-based Dexia is perhaps a special case - the bank owns 99.13% of FSA, and has a 'conservative' gross exposure of EUR45.2 billion.

In contrast to the exposures made public by dealers such as Citi, Merrill Lynch and UBS, some of the information in the table is, in fact, flattering to various market players. Those that chose not to hedge using monolines have come out of the crisis perhaps not smelling of roses, but escaping the worst of the problems. Copious praise has been heaped on Goldman Sachs for its trading know-how and quick reactions during the subprime rout. In the context of monolines, Credit Suisse and JP Morgan also stand out as weathering the worst of the storm.

Strictly speaking, the figures do not provide a like-for-like comparison. A number of the banks have different reporting periods, while they may also differ in the methods they use for valuing and reporting their assets.

"There's a lot of accounting issues around these assets that I don't think people are aware of," says Eileen Fahey, senior analyst in the financial institutions group at Fitch Ratings in Chicago. "The US banks and broker-dealers largely have them in trading books that have to be marked-to-market. Several European banks have CDO of ABS exposures and hedges that are in a banking book and not in a trading book, so they don't have to take the mark-to-market."

There are also discrepancies in the capital reserves banks are taking against monoline counterparty risk. In fact, some observers think dealers still aren't applying large enough haircuts to their exposures. "We did some research in February and put the right level at about 25%," says Adam Richmond, credit strategist at Morgan Stanley in New York, adding that the haircuts banks were applying were generally lower at the time. While dealer marks have now caught up, he and his colleagues revised their suggested haircuts again in late June. "We've had a sizeable deterioration in the credit market and also a sizeable deterioration in the credit quality of monolines. So we think a 50% haircut is more realistic, and if that were the case, it would mean banks are once again a little bit under."

According to Morgan Stanley research, provisions of 50% against monoline counterparty exposures would result in an additional $16 billion of mark-to-market losses at banks, assuming no further deterioration in the credit quality of underlying assets. Any move in tandem - a more likely scenario - could be devastating for monolines and for dealers. The high correlation between the deteriorating CDO of ABS market and monoline counterparty risk means that as the fair value of the guarantees increases, so does monoline counterparty risk. Richmond argues dealer hedges are reaching an inflection point, beyond which the souring credit quality of bond insurers could mean rising haircuts outweigh any marginal mark-to-market gains on the guarantees. "It's very tough to tell, but we're likely to be moving towards that inflection point where further deterioration in the underlying market could potentially be bad for both parties," he says. "Even though banks would get mark-to-market gains on their hedges, the amount of losses they'd have to haircut for the monolines would offset those gains - and then some."

Ongoing concerns about the financial health of monolines have been fuelled by the state of their asset-liability management - or guaranteed investment contract (GIC) - business. Historically, monolines have written GICs for a host of counterparties, including municipalities, corporations - and even CDOs. In return for an initial deposit left with monolines, these counterparties would receive interest and principal according to an agreed-upon schedule. Bond insurers would invest the proceeds in a portfolio of high-quality assets, making a profit from the difference between the spread on the GIC assets and the payments they have agreed to make.

"It's different for different monolines, but many of these portfolios are invested in subprime mortgage-related assets," explains Richmond. This has the potential to threaten monolines that are otherwise less exposed to the subprime mortgage crisis, such as FSA, he says. According to Morgan Stanley, 69% of the GIC portfolio assets held by FSA are subprime mortgage-linked, along with 28% and 84% of those held by MBIA and Ambac, respectively.

In some cases, GICs were used by CDOs as revolving funding facilities that are now being called upon as underlying assets run into trouble. Together, Morgan Stanley estimates Ambac, FSA and MBIA have written around $15.46 billion of GICs for CDO vehicles. Another problem arises from the fact that the performance of GICs is typically guaranteed by the operating companies of bond insurers. As some of these entities have now been downgraded, collateral posting requirements and termination provisions have come into effect. On July 7, Ambac announced rating agency actions during June had resulted in $506 million of collateral posting requirements and triggered termination provisions on $270 million of GICs. Meanwhile, MBIA said it would post $3.9 billion of additional collateral against GICs on June 30, while $3.6 billion of contracts would be terminated, assuming that holders of the contracts exercised their rights to collateralisation or termination. Both companies insist they have adequate capital to fulfil their obligations.

From the perspective of dealers, Richmond says the GIC business is unfortunate - because even though portfolios are ring-fenced, it could constrain their ability to pay on CDO of ABS hedges. "If this GIC business just cripples the monolines even more, it means potentially less ability for banks to collect on their CDO of ABS gains," he says.

Some observers believe monolines still have insufficient capital to cover potential realised losses from guarantees written on CDOs of ABSs. Tonko Gast, founder and chief investment officer of structured credit advisory and asset manager Dynamic Credit in New York, says his firm has looked at a sample of more than 100 CDO of ABS transactions underwritten by monoline insurers. "The cumulative liabilities the monolines are facing were massively underestimated by risk departments, banks, rating agencies and the monolines themselves," he claims.

By insuring super-senior tranches of CDOs of ABSs, monolines have in many cases guaranteed timely interest and principal payments. But in setting capital aside against these, Gast believes they have conducted back-of-the-envelope assessments - and not properly understood the importance of timely interest payments.

"Everybody talks about the principal amounts the monolines are on the hook for. They're on the hook for ultimate principal, but they're also on the hook for timely interest. And that's not 30 years from now, it typically starts just a couple of years from now - and it will last for many, many years."

Using fairly conventional loss assumptions, he says many of the A and AA subprime RMBSs in CDO of ABS collateral pools are likely to be wiped out within two years, as well as many remaining 'inner' tranches of other CDOs of ABSs. Once that occurs, the amount of performing underlying collateral in the deals will be reduced to around 10-30%. This is likely to result in coupon shortfalls on the 20-100% super-senior tranche, he asserts, causing guaranteed payments by monolines to kick in. As these payments are closer to the present, they will have a far greater impact than ultimate principal payments relative to their size - and will also cut into the money that would otherwise be used to amortise super-senior tranches. Due to this effect, Gast claims the total amount monolines should reserve against losses on CDOs of ABSs could be as much as 10 times higher than they currently hold.

Several leading monolines declined to comment for this article. However, Anthony McKiernan, managing director of global structured finance insured portfolio management at MBIA in New York, says the company has reserved enough capital against losses in its CDO of ABS portfolio. "We are confident that the structures of these transactions have been fully baked into the analysis that's been done and the assessments of the underlying collateral are thoughtful and reflective of those structures and market conditions."

Some commentators have recently claimed monolines are engaged in a programme to reduce their exposures to the subprime mortgage market by trying to find mutually agreeable terms on which to terminate - or in insurance parlance, to commute - CDSs written on CDOs of ABSs. While MBIA will occasionally consider commutation for individual contracts as a portfolio management tool, there is no widespread scheme under way, McKiernan says. "There is no wholesale programme here that is designed to try to reduce our exposure to CDS transactions."

More importantly, worries about the insurer's mark-to-market position with banks and its financial solvency are unfounded, he says. "Obviously our mark-to-market has been larger than normal, but as far as us having to realise that mark-to-market in a given period, we don't have to do that."

But despite the freedom they enjoy from collateral-posting obligations on CDS contracts, some analysts think monolines' mark-to-market losses remain important. "The negative impact for the guarantors of large mark-to-market losses is twofold," says Wallace Enman, New York-based senior accounting analyst at Moody's. "One, they make it more difficult for guarantors to raise capital now and in the future, if additional capital is needed to make good on claims."

The second effect is to scare away future potential counterparties, he adds. "There's no way of saying a potential client is not going to do business with a guarantor because of underlying credit risk. You can't quantify what percentage of new business they're not getting is due solely to the marks - but it's likely to be more than zero."

Under the circumstances, dealers would be ill-advised to continue using monolines to guarantee CDOs of ABSs. Jon Gregory, a Guildford-based independent credit consultant and former global head of credit quantitative analytics at Barclays Capital, has written an article in this month's Risk in which he argues the value of super-senior protection bought from both monolines and credit derivatives product companies (CDPCs) is of little or no value.

"The AAA rating of monolines is to a large extent only a facet of the fact that they deal in AAA-rated protection and as a result is of little value to a protection buyer. This is ultimately being realised by banks via significant writedowns of such protection," he says.

Because the counterparty risk of monolines is heavily correlated with the quality of underlying assets on which protection is purchased, monolines and CDPCs ideally need to have a credit quality in excess of AAA, he argues. Both monolines and CDPCs are often undiversified, he points out, having frequently entered into large amounts of business guaranteeing similar assets.

For the time being, monolines and banks are seemingly living in parallel universes. While dealers are largely governed by the economics of mark-to-market gains and losses, monolines are able to keep up an illusion of financial stability regardless. But like imploded Connecticut-based hedge fund Long-Term Capital Management (LTCM), Gregory says there's always a possibility the two worlds will collide. "It's probably the case that if they remain solvent, things will come back. But it can't go on forever," he says. "Maybe you can survive $2 billion of mark-to-market losses, maybe you can survive $3 billion. While it is reasonable to believe that mark-to-market losses will eventually be recouped since default losses are unlikely, one day the game will be up - just like LTCM."

See also

• Monoline market doubts

• Further monoline downgrades likely

• Fitch pulls coverage of monolines

• Ambac, MBIA finally succumb to S&P downgrade, Moody's to follow suit

• Going the wrong way