HomeMy WebLinkAboutStatus of Insurers'STATUS OF TH8 MUNICIPAL BOND:MARKET BOND INSURERS`
IMPACT To CREDIT MARKETS PARTICIPANTS FROM THE SUBPRIME MORTGAGE CRISIS
As of May 5, 2008
Background: Mid-2006 to Present
Dual factors of a deflating U.S. housing market bubble and a rise in default rates on "sub -prime" mortgage
borrowers (the least creditworthy individual borrowers) point to the beginning of the sub -prime mortgage crisis in
late 2006. The crisis became a global financial issue during 2007 and into 2008, as banks, individual and
institutional investors, and financial guarantors recorded significant financial losses associated with the
"securitized" bonds that were comprised of mortgage -backed securities.
Securitized bonds, also known as collateralized debt obligations (CDOs), are portfolios of asset -backed
securities (ABS) or residential mortgage -backed securities (RMBS) that include pools of leased property,
residential mortgages, home equity loans, student loans, credit card and other debts, among others. It was
anticipated that the "bundled" assets should have associated steady and predictable cash flows, from which risk
profiles are determined, and eventually, the bundled assets are parsed and repackaged according to the
relative risk assessments.
As the housing market declined and rates on sub -prime adjustable rate mortgages (ARMs) rose, homeowners
were unable to meet mortgage payments, with foreclosures occurring. Due to the complexity of the securitized
bond financial structure, it was difficult to determine the exact underlying RMBS assets. This resulted in an
inability to analyze the causes of the unpredictable cash flows supporting bond payments.
Bond Insurers
Interestingly, as recently as January 2008, rating agency articles noted that it was likely that sub -prime credit
turmoil would only indirectly impact bond issuers. In a January 2008 Moody's article, "Sub -prime Fault Lines:
How Bank Stress Could Touch Other Markets", the analysts noted that while the monolines do have direct
exposure to banks, "...the credit implications associated with any reasonably likely bank stress scenarios are
expected to be modest for the guarantors."
in a summary of a discussion among S&P U.S. managing directors published on January 7, 2008, "Where The
Credit Markets And U.S. Economy May Be Heading In 2008", the question of expected impacts to bond insurers
in 2008 was met with the response that insurers are generally stable. "The insurers weren't that active in
structured finance."
Since then, the concerns of the rating agencies have been exacerbated due to the two prong action of specific
RMBS and CDOs downgrades that are guaranteed by the bond insurers, and the ensuing valuation declines,
increase in loss projections and need for additional capital reserves. The result has been that over the past
several weeks, most of the bond insurers either have had their credit ratings put on notice for a potential
downgrade or have actually been downgraded by the rating agencies. Although rating analysts initially believed
that only the premiums would be affected by the diminished amount of CDO and RMBS deal activity, the reality
was that the decline in value of their current insured product required the need for additional capital reserve to
cover the bond insurers' ability to pay claims.
In the absence of insurers improving their capital position to accommodate the increased risk, the rating
agencies have begun to revise their ratings in this sector. The following table is a summary of rating agency
bond insurer activity since the beginning of 2008. A summary of current bond insurer ratings is located in
Appendix I.
Appendix I is a summary of the current outstanding ratings and outlooks of monoline bond insurers as reported
by Moody's Investors Service, Standard and Poor's Corporation, and Fitch Ratings.
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RATING ACTIONS TAKEN SINCE JANUARY 1, 2008
Date
January 16
Action
• Moody's places Ambac's "AAA" rating on "Watchlist for Possible Downgrade"
• Fitch affirms MBIA's "AAA" rating with a Stable Outlook
January 17
• Moody's places MBIA's "Aaa" rating on "Watchlist for Possible Downgrade"
January 18
• Fitch downgrades Ambac' rating from "AAA" to "AA", and rating is placed on "Rating Watch
Negative"
• S&P places Ambac on "CreditWatch Negative"
January 24
• Fitch affirms FSA's "AAA" rating and Stable Outlook
• Fitch downgrades XL Capital's rating from "AAA" to "A", and rating is placed on "Rating Watch
Negative"
January 30
• Fitch downgrades FGIC from "AAA" to "AA", and rating is placed on "Rating Watch Negative"
January 31
• S&P downgrades FGIC from "AAA" to "AA", and the rating is placed on "CreditWatch
Developing"
• S&P places MBIA's "AAA" rating on "CreditWatch Negative"
• S&P places XL Capital's "AAA" rating on "CreditWatch Negative
February 5
• Fitch places MBIA's "AAA" rating on "Rating Watch Negative"
• Fitch places CIFG's "AAA" rating on "Rating Watch Negative"
February 7
• Moody's downgrades XL Capital's rating from "Aaa" to "A3" with a Stable Outlook
February 14
• Moody's downgrades FGIC from "Aaa" to "A3" with the rating remaining on review for possible
downgrade
February 22
• Moody's places CIFG "Aaa" rating on review for possible downgrade
February 25
• S&P announces bond insurer rating actions as follows:
• XL Capital and XL Financial Assurance Ltd. were lowered to 'A-' from 'AAA' and remain on
CreditWatch with negative implications;
• FGIC was lowered to 'A' from 'AA' and remains on CreditWatch with developing implications;
• MBIA's "AAA" rating was removed from CreditWatch and a negative outlook was assigned;
• Ambac's "AAA" rating was affirmed and remains on CreditWatch with negative implications;
and
• "AAA" ratings on CIFG Guaranty, CIFG Europe, and CIFG Assurance NA Inc. were affirmed
and retain a negative outlook.
February 26
• Moody's confirms MBIA's "Aaa" rating and revises outlook to "Negative".
March 4
• Moody's places XL "A3" rating on review for possible downgrade
March 5
• Fitch announces that Ambac's "AA" remains on watch negative following an announcement
that the company plans to raise at least $1 billion in common stock and $500 million in equity
units.
• S&P announces that Ambac's "AAA" will remain on CreditWatch with negative implications.
March 6
• Moody's downgrades CIFG to "Al" from "Aaa", with a stable outlook.
March 7
• Fitch downgrades CIFG to "AA-", outlook remains on Rating Watch Negative.
March 11
• Moody's affirms FSA at "Aaa" stable outlook.
March 12
• S&P lowers CIFG to "A+" from "AAA"; outlook remains Negative.
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• Fitch affirms Ambac at "AA", and revised outlook to Negative.
• Moody's confirms Ambac's "Aaa" rating, and changes outlook to Negative.
March 14
• Moody's affirms Assured Guaranty's "Aaa" rating and stable outlook.
March 21
• S&P revises FGIC's "A" outlook to CreditWatch with Negative implications from Developing
implications.
March 26
• Fitch downgrades SCA, including subsidiary XLCA, to "BB" from "A". The rating outlook is
Negative; revised from Rating Watch Negative.
• Fitch downgrades FGIC to "BBB" from "AA" and revises the outlook to Negative from Rating
Watch Negative.
March 28
• Moody's affirms Radian Asset at Aa3, with the rating outlook changed to negative
from stable.
• S&P downgrades FGIC to "BB" from "A", and revised the outlook to Negative from Credit
Watch Negative.
March 31
• Fitch downgrades CIFG to "A-" from "AA-", and revises outlook to Negative from
Rating Watch Negative.
• Moody's downgrades FGIC to "Baa3" from "A3". Outlook remains under review for
possible downgrade.
April 4
• Fitch downgrades MBIA to "AA" from "AAA". Outlook was revised to Negative from
Rating Watch Negative.
April 8
• S&P places the Radian Asset Assurance (Radian) "AA" rating on Credit Watch
Negative from Stable.
April 11
• S&P assigns "AAA" financial strength and enhancement ratings to Berkshire
Hathaway Assurance Corp. (BHAC). The BHAC ratings are based on a guaranty
from Columbia Insurance Company (Columbia), which was also assigned a "AAA"
rating. Both entities were assigned a stable outlook.
April 25
• Moody's assigned "Aaa" financial strength ratings to Columbia and BHAC (a new
municipal bond insurer established by Berkshire in late 2007. All policies written by
BHAC on or after March 31, 2008 are unconditionally guaranteed by Columbia. The
outlook for both entities is stable.
May 2
• Fitch withdraws its ratings on Radian.
Issuers
The uncertainty of the current bond insurance market results in a substantial reduction in the number of bond
insurance companies that can provide value to issuers through the issuance of "nine -A" rated bond insurance
(Aaa/AAA/AAA). This will result is less competition, higher premiums, a tightening of underwriting standards for
new bond issues, and more focus on higher margin businesses.
Issuers will have to thoroughly evaluate the use of insurance versus relying on their underlying ratings. For
example, in pricing bond issues, different interest rate spreads are occurring among the financial guarantors
based on whether the insurer credit strength has been affirmed, downgraded and/or put on credit watch. As of
February 8, 2008, the difference in interest rate spread between a stronger insurer and a weaker insurer was as
much as 50 basis points. Additional impacts to issuers on new issues include the likelihood that debt service
reserve fund surety policies will no longer be underwritten to cover reserve funds dictated by revenue bond
ordinances, requiring issuers to fund future debt service reserve funds from cash or bond proceeds. With
respect to existing transactions, issuers should consult with their financial advisor and bond counsel about the
potential impact related to existing surety policies, bond covenants, minimum rating threshold contained within
swap documents as well as review their investment holdings.
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Issuers of short term auction rate securities and variable rate demand bonds should review their documents and
be aware of the maximum interest rates that could occur should their auction fail. The phenomena of failed
auctions began during the first week of February 2008, when multiple firms failed auctions across a spectrum of
credits. Since that time many auction rate securities have been converted to fixed rate bonds, issuers
themselves are now bidding in some auctions, and long term investors continue to bid in high rate auctions, with
clearing rates ranging from 7.0% to 9.0%, which are below the highs of 15% to 20% that occurred last month.
Issuers also have a responsibility to bond market participants to stay up-to-date regarding reporting of material
changes that may impact outstanding bonds, per their continuing disclosure requirements. This applies not only
to situations of downgrades to the underlying credit of the issuer, but also if the insurer's credit ratings are
revised. The actual time of disclosure occurs when the rating agency lists the individual bonds affected by the
rating change. Please contact First Southwest Company if you have any questions concerning your disclosure
obligations.
Short -Term Market Credit Effects
The turmoil of the credit markets created by the sub -prime mortgage crisis has extended into the short-term
market and is now affecting yields in the remarketing of variable rate demand obligations and auction rate
securities. This is because some sub -prime securities were packaged and marketed using an auction rate
structure, When those auctions began failing, meaning there were more sellers than buyers, investors lost
confidence in the liquidity of the auction rate structure in general, which spilled over to many other issuers.
As most auction -rate securities are insured, the erosion of confidence is compounded by the downgrades and
negative credit watch outlooks of insurers, ultimately leading to billions of dollars in failed auctions. The ensuing
flight to quality has benefited only the most secure short-term investments.
Money market funds sold questionable insured VRDOs and replaced them with irrevocable direct pay letters of
credit. The impact to issuers of failed remarketings and auctions is a dramatic increase in borrowing costs,
which require the use of interest rates as determined by the terms of the loan agreement.
First Southwest Company will continue to monitor these market dislocations and advise our clients of
the issues surrounding conversions and the progress or lack thereof of the monoline insurers to
recapitalize as well as any pertinent rating agency activity. In this rapidly changing market, issuers
should consult their financial advisor and bond counsel with any questions that may arise.
Appendix 11 is a summary timeline of the effects of the sub -prime mortgage crisis on the municipal market since
June of 2007.
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Long -Term Market Credit Effects
The subprime contagion spread to another seemingly unrelated asset class during the last week of February —
long term municipal bonds. Bonds backed by the impaired insurers have suffered from an illiquid market for
some time, and there had been little trading as a consequence. This effect was magnified on February 28th and
29th with rumors that large hedge funds were forced to meet margin calls and liquidate their holdings. The
sudden influx of several billion dollars in supply, coupled with the fear of how much more supply might follow,
adjusted yields upward by as much as 50 basis points and more.
This municipal borid sell off, combined with the rally in Treasuries, left the ratio of tax-exempt yields to Treasury
yields at extremely high levels across the yield curve, resulting in tax-exempt yields at historically cheap levels
relative to Treasuries. A Monday, March 3rd article in the Wall Street Journal extolled the virtues of 5.00% tax-
exempt yields versus historical equity returns, and retail buyers showed up from the opening bell, soon to be
followed, reluctantly, by institutional investors.
At the present time, ratios of tax -exempts to Treasuries exceed 100% from one to 30 years, meaning municipal
bonds are yielding more than Treasuries. There is no doubt that the short end of the muni curve is being
heavily influenced by the problems in the auction market, which has resulted in some very high muni rates for
both auction rate securities and VRDNs. This influence likely extends out to five years, due to the possibility
that some auction rate or VRDN securities could get refinanced using bonds with five year mandatory puts.
However, even the much maligned auction market has seen an influx of new buyers, albeit at much higher
yields than issuers would like.
How long this situation lasts is not really predictable at the present time. With the potential for further unwinding
of leveraged portfolios and a possible increase in supply from both new issues and refinancing of variable rate
debt, it is possible that munis could continue to trade at levels higher than comparable treasuries.
What is known today is that munis (blue line in chart below) are at historically cheap levels relative to Treasuries
(red line), with yields relative to taxable rates well above the average percentage of the Treasury yield that has
been previously experienced (green line).
Bond Buyer 25-Bond Revenue Index vs. 10-Year Treasury
January 1993 to May 1, 2008
percent)
0%
7.0% — —
6 0% —
50%-
(bast, points)
200
150
100
--50
(50)
2.0% . � . . . . . . . . . . . . . . . . . � . . , (150)
-Bond Buyer 25 Revenue Yield -10 Year Treasury -Basis Point Differential (BBRBI -10 Year Treasury)
• The Bond Buyer 25-Bond Index is comprised of revenue bonds maturing in 30 years and has a rating roughly equivalent to Al/A,
Disclaimer- This paper is intended for issuers for educational and informational purposes only and does not constitute legal or investment
advice, nor is it an offer or a solicitation of an offer to buy or sell any investment or other specific product. Information provided in this paper
was obtained from sources that are believed to be reliable; however, it is not guaranteed to be correct, complete, or current, and is not
intended to imply or establish standards of care applicable to any attorney or advisor in any particular circumstances. The statements within
constitute First Southwest Company views as of the date of the report and are subject to change without notice. This paper represents
historical information only and is not an indication of future performance.
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