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

The immediate market reaction to the downgrades tells its own story. Five-year credit default swaps (CDSs) for Ambac Assurance have moved from 957.4 basis points a week ago to 1,587.9bp by close of trading on Thursday, while the cost of protection on MBIA Insurance has risen from 919.4bp to 1,281.9bp over the same period. The picture is even bleaker for the holding companies of the two monoline insurers: five-year CDSs for Ambac Financial now stand at 1,651.6bp, up from 1,196.2bp on May 28, with MBIA Inc spreads rising from 1,088bp to 1,438.1bp.

The financial guarantors have been teetering on the brink of downgrades since late December, when ACA, a relatively small monoline, was drastically downgraded from A to CCC by S&P. The agency cited concerns that ACA and its fellow monolines would be unable to meet all their insurance commitments on collateralised debt obligations and asset-backed securities experiencing losses through their exposure to the US subprime mortgage market.

In January, the situation worsened, with Financial Guaranty Insurance and Security Capital Assurance downgraded to AA and A respectively. On January 18, Ambac experienced its first downgrade when Fitch cut its AAA appraisal to A, although the guarantor had managed to secure a stay of execution from the other two ratings agencies until today’s news.

In its ratings announcement, S&P cited its "belief that [Ambac and MBIA] will face diminished public finance and structured finance new business flow and declining financial flexibility” as the reason for the action. “In addition, we believe continuing deterioration in key areas of the US residential mortgage sector and related CDO structures will place increasing pressure on capital adequacy," the agency added.

MBIA, which has guarantor commitments of $668 billion, and Ambac, with an insurance obligation worth $511 billion, remain respectively the biggest and second-biggest bond insurers in the market, although their ability to continue writing business looks to be in serious jeopardy following the ratings action.

In its June 4 announcement that the two monolines were to be placed under review for potential downgrade, Moody's expressed "growing concerns regarding Ambac's overall credit profile, including the company's significantly constrained new business prospects." The S&P downgrade will make similar action by Moody's almost inevitable.

A number of proposals to resolve the uncertainty and stabilise the guarantors’ ratings have been under consideration since January, including proposals to split the insurers' structured credit arm from those funding commitments untainted by subprime exposures. Predictions early in the year that the monolines could see a government bailout failed to materialise, however.

As the uncertainty rumbled on, MBIA and Ambac managed to cling on to their AAA ratings in late February by successfully raising new capital, but losses of $2.4 billion and $1.66 billion respectively for the first quarter of 2008 proved to be the final nail in the coffin for their AAA ratings.

See also: MBIA losses climb to $2.4 billion
FGIC could be first to split
Two monolines face legal action
Monolines - the nuclear option

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