The Shoe Drops

No small part of the Sturm und Drang that has unsettled markets in recent weeks has stemmed from growing apprehension over the potential fallout from a ratings downgrade at one of the major bond insurers.

The reason? With so many institutions either required by charter to hold securities with a certain minimum credit rating, and others forced to allocate proportionally larger amounts of capital against holdings of securities with lower credit ratings (according to risk-based capital guidelines), fear has grown that a downgrade at a formerly AAA-rated institution that guaranteed thousands of bonds and other financial instruments could trigger a mad dash to sell securities and raise cash that could turn more than a few markets upside down.

Based on the following report from Bloomberg's Christine Richard, "FGIC Loses AAA Rating at Fitch After Missing Deadline," it looks like we'll soon find out whether those worries were warranted.

Financial Guaranty Insurance Co., the world's fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital.

Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody's Investors Service and Standard & Poor's are also reevaluating their ratings.

The loss of the AAA stamp jeopardizes ratings on bonds Financial Guaranty insured and limits the company's ability to generate new business. FGIC, along with MBIA Inc. and Ambac Financial Group Inc., are paying a price for expanding beyond their traditional business of backing municipal bonds to guaranteeing debt linked to riskier subprime mortgages and home- equity loans, as well as collateralized debt obligations.

"This announcement is based on FGIC's not yet raising new capital, or having executed other risk mitigation measures, to meet Fitch's AAA capital guidelines within a timeframe consistent with Fitch's expectations," the ratings company said today.

FGIC is controlled by Walnut Creek, California-based PMI Group Inc., Blackstone Group LP, and Cypress Group. PMI dropped 32 cents, or 3.4 percent, to $9.11 in New York Stock Exchange composite trading. Blackstone fell 34 cents to $18.65.

"We're examining our options," Blackstone spokesman Peter Rose said.

Subprime CDOs

The insurance unit's top rating was placed under review by Fitch, Moody's and S&P in December after downgrades of securities backed by subprime mortgages. Fitch gave the company until this week to boost capital by $1 billion.

About 71 percent of FGIC's guarantees are on municipal bonds, 23 percent are structured finance and 6 percent are international transactions, according to the company's Web site. FGIC guaranteed $21 billion of home-equity securities, $8.8 billion of subprime mortgage debt, and $10.3 billion of CDOs backed by subprime mortgages and other loans, the Web site shows.

The once unquestioned strength of AAA rated bond insurers is being reassessed on concern by Fitch, Moody's and S&P that they don't have enough capital to cover losses stemming from downgrades on securities they guarantee.

Blackstone Writedowns

Fitch this month cut Ambac to AA from AAA and sliced Security Capital Assurance Ltd. five levels to A.

CDOs, which repackage assets such as mortgage bonds and buyout loans into new securities, have accounted for the biggest portion of the more than $133 billion in writedowns since the third quarter at the world's biggest banks.

Blackstone Group President Hamilton James said on Jan. 10 his company may write down its stake in FGIC after the collapse of the subprime-mortgage market.

"We have some realizations in the pipeline but also some writedowns we are facing such as FGIC," James said on a conference call to discuss the purchase of hedge-fund firm GSO Capital Partners LP.

Blackstone, based in New York, bought Financial Guaranty with PMI Group and Cypress Group from General Electric Co. for $1.9 billion in 2003.

Comments

[Rocky]

It's too bad that the rating agencies and the insurance regulators didn't take the appropriate steps when the bond insurers started to branch out to higher risk areas (mortgages and buy out loans). A 150:1 risk to capital ratio, which was considered acceptable when the bond insurers were guaranteeing only municipal debt, should have been adjusted downward when these companies got into riskier guarantees. Maybe the risk to capital for these riskier products should have been set at 25:1 or even 10:1. The bond insurers are now effectively in run off mode. Who would want to rely on their guarantees with all these risky guarantees lurking in the background? Will they have enough income and assets to cover all the loans that are expected to go bad in the next few years? That's the big unknown.

[Jes]

Michael, please consider adding an acronym list. (I'm referring to the acronyms in the cited sources, not usually in your own text.) I'm a regular reader, and I find myself looking up acronyms rather often. This time is was CDO. A few days ago it was CDS. People forget that these letters have no meaning outside their own small clicques.
As a general observation, acronyms contribute greatly to confusion, particularly when experts from different areas come together. In meetings I run, presentations are rejected if the authors don't spell out what they mean. This is because we'd had some expensive blunders due to misunderstandings of these letter clumps.