Monday, 29 October 2007

The failure of a monoline

One of the many threats to the ABS market at the moment is the perceived decline in the credit worthiness of the large bond insurers, aka the monolines. There are a small number of these firms, and most of them carry either a AAA or AA credit rating. They are vital to the functioning of the ABS market in that they wrap bonds, providing a guarantee that if the underlying collateral does not pay timely interest and ultimate principal, then the monoline will. This solves the information problem on less well understood ABS collateral, and lowers funding costs for pools with non-standard characteristics.

Unfortunately the monolines have wrapped a significant amount of subprime collateral. This is causing a drag on earnings with both AMBAC and MBIA reporting losses last week. Investors are concerned that this is only the beginning and have bid up default protection on the monolines. Five year CDS spreads have gone from a few tens of basis points to 300 for AMBAC and 200 for MBIA.

The monolines typically have very diverse pools of risk that they have wrapped, considerable claims paying ability, and fairly large capital bases. However they are also highly leveraged and, since much of their protection is legally insurance, they do not mark all of it to market, and even where they do have MTM instruments, these are often sufficiently illiquid that they are marked to model. They also engage in transactions other than public bond insurance, wrapping risk in private transactions and, in MBIA's case, managing a SIV. Given rising default and rising default correlations across ABS, then, investors are concerned that the monolines' capital models might not be robust and hence that their AAA status is questionable. Certainly were a monoline to fail the impact on the market would be very considerable. MBIA alone, for instance, from 2005 to mid 2007 insured $35B of bonds, their RMBS portfolio is over $45B, and their CDO book over $100B. The muni market would also suffer a massive case of illiquidity as investors scramble to understand bonds that previously had traded on the strength of their wraps.

Note finally that since the monolines are insurers, they are not regulated by the FED or the SEC. Any bail out would have to be coordinated between the insurance commissioners and the capital markets regulators. The threshold for 'default' is also higher, since a monoline cannot operate unless rated at least AA: a downgrade below that level would probably be taken by the market as more or less equivalent to failure. Meanwhile 300 over isn't a typical AA credit spread: the market evidently views a monoline failure as a real possibility.

Update. As at the 1st of November, according to the FT, the (AAA-rated) debt of Ambac and MBIA costs 345 bps and 310bps respectively to protect in the CDS market. XL Capital is trading at 445bp.

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