How Credible Are Moody's, S&P Monoline Ratings?

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Includes: AMBC, MBI, MCO
by: Carl Dincesen

First, it is important to note that the ratings are "claims paying" or "financial strength" ratings applicable to the bond insurance companies, not their holding companies which have always carried lower ratings.

Second, "claims paying" ratings are based on a depression scenario. Moody's (NYSE:MCO) refers to this as a severe stress scenario and S&P refers to it as a simulated depression scenario. Moody's places severe stress losses for all risks insured at $13.7 billion for MBIA (NYSE:MBI) and $12.1 billion for Ambac (ABK). What is not generally understood is that the rating agencies have calculated and reported stress/depression losses near double digit $ billions for several years.

For instance, a Triple-A bond insurer with $10 billion in claims paying resources and no exposure to RMBS and CDO's would have stress losses of around $7.7 billion resulting in a capital adequacy ratio of 1.3x which is Moody's bench mark for a Aaa claims paying rating. The S&P bench mark is 1.25x, but each can arrive at different depression loss amounts based on different assumptions. The bond insurers have always operated within these parameters, not wanting to fall below the bench marks nor rise substantially above in order to limit the amount of excess capital, a drag on ROE.

Third, what has changed is "expected or probable loss" no further explanation needed except to say that it is the present value of claims to be paid over the life of the risk which can extend 30 years. Expected loss has always been a part of rating agency bond insurance company rating methodology, but, until recently, it was dwarfed by depression losses. Moody's places expected loss at $4 billion for MBIA and $4.1 billion for Ambac (February 26th and 29th announcements)

Ambac and MBIA, have seen their Moody's capital adequacy ratios decline, after capital infusions of $2.6 billion for MBIA and $1.525 billion for Ambac (adjusted for March 7th capital increase), to 1.20x and 1.26x, respectively. Essentially, since June of 2007, MBIA has been assessed an additional capital charge of $4.7 billion against the 1.3x standard. On the same basis, Ambac has been assessed $2.25 billion. All as a result of insuring sub prime RMBS and CDO's via CDS (credit default swaps). Ambac had a significantly higher capital adequacy ratio than MBIA as of mid year 2007. It appears likely that S&P will also affirm their AAA ratings on these bond insurers.

Are the current rating agency assumptions and resulting ratings reliable after having been so wrong? With franchises and reputations at stake and share prices down about 50%, I would say yes. At a minimum, they are either calling it as they see it or erring on the conservative side. With no direct dollars at stake there is no reason to paint a rosy picture which would only serve to further damage their reputations.

Outstanding Ambac and MBIA insured fixed rate tax exempt bonds are now trading at prices that value the insurance as worthless. At the end of the day, bond insurers never guaranteed ratings. They do, however guarantee timely payment of principal and interest as due, even in a depression. Even with double-A ratings, these bonds now represent an unusually attractive investment. Equity holders will have to be more patient.