Downgrades for the Lesser Financial Guarantors, so Who's Next?

1) I posted the following at RealMoney yesterday:
Moody’s Downgrades XL Capital Assurance

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance (XL) from Aaa to A3, and Security Capital Assurance (SCA) from Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac (ABK), MBIA (MBI) and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if it hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

Now after the close yesterday, MBIA offered stock at a 14% haircut to the closing price. Let’s see where the price closes today. It almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level. We can buy and flip for an easy profit.” In this case, though, there are 60%+ more shares after this issuance. That’s some level of dilution. MBIA may keep its AAA, but that says little for the value of holding company common stock.

2) One reader wrote me, “Mr. Merkel — would you care at all to expound on this point you posted on financial guarantors:

The main difficulty with a bailout of the guarantors is that most interested parties have different interests. That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.

It’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing Ambac, MBIA et al at least get to a point where they can run off their obligations. However, I must admit, I’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”

My point was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors. Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors. Coming up with an equitable allocation of concessions would be tough, but not impossible. Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises. A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly. Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.

3) Another reader, Bill Luby of VIX and More, wrote: If you don’t mind, I’d be interested to get your take on the current status of the bond insurer problem and how you think it might play out. In addition to what happens to MBI and ABK, I am also interested in whether you think others with a stronger financial position - Assured Guaranty? (AGO) - might make significant gains in this space.

Yes, AGO, Dexia [FSA], and Berky (BRK.A) all do well from the turmoil. Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.