Capital substitutes

Bloomberg reports that Ambac is doing something to try to stave off the loss of its AAA:

Ambac Financial Group Inc., struggling to avoid the crippling loss of its AAA credit rating, took out insurance on $29 billion in securities it guarantees.

The world's second-biggest bond insurer agreed to transfer the risk that the securities will default to Assured Guaranty Ltd., according to a statement today. Reinsuring the debt will free up capital backing those bonds, Ambac said. Ambac fell as much as 7.6 percent in New York Stock Exchange trading on concern the deal alone won't be enough to save its credit rating.

The market reaction is understandable: to be safe, Ambac needs $2-4B of new capital, and this deal won't free up nearly that much. To put it into context, it guarantees about $550B of securities, so this deal covers around 5% of its portfolio. With the ratings agencies on the prowl and considering downgrades, it is crunch time for the monolines.

``We're heading into maybe the most turbulent few weeks the bond insurers have ever seen,'' said Matt Fabian, a senior analyst and managing director at Municipal Market Advisors, an independent research firm in Concord, Massachusetts. ``There could be some very serious numbers floating around before Christmas.''

Ambac's agreement probably freed up $1 billion or less of capital, Fabian said. The ratings companies are likely to demand more, he said.

What is interesting, though, is the following comments from Robert Genader, Ambac CEO:

``Reinsurance is a valuable, capital-efficient and shareholder-friendly tool for managing risk and capital''.

He's right. You always have an alternative to increasing capital (as MBIA did with its share placing last week): you can decrease risk. Hedging and (re)insurance both achieve that: if you can reduce risk using either of them more cheaply than you can raise new capital, it makes sense to transform your capital requirement rather than your capital base. Anybody want another $100B of bond risk on a reinsurance basis?