Thursday, December 20, 2007

MBIA Tanks on CDO Disclosure

(WSJ MarketBeat) Well, this is a fitting end to a subprimely crappy year. MBIA casually updated its list of exposure to various types of collateralized debt obligations yesterday in a release, detailing, among other things, exposure to $8.1 billion in some truly risky paper.

This seems to have been first spotted by Morgan Stanley analyst Ken Zerbe, who says he is “shocked that management withheld this information for as long as it did.” Mr. Zerbe notes that the exposure is to what’s called CDO-squared, because more than 75% of the underlying collateral is CDOs.

About $5.1 billion of this collateral was originated in 2006 and 2007, coinciding with the period of riskiest underwriting of subprime mortgages; shares of the stock are tanking today, losing 24% of their value. The company’s credit-default swaps, a measure of protection against debt default, rose to 595 basis points from 480 basis points, which means it costs $595,000 to insure $10 million in bonds from default for the next five years.

The insurer’s statement on its Web site, which links to the list of its CDO exposure, portrays it as an update to make things neat and tidy, so to speak, saying it has “has supplemented the listing of its exposure to CDOs that include RMBS as of September 30, 2007 to make it consistent with the CDOs that were included in Standard & Poor’s analysis.” Standard & Poor’s, in a release today, says its analysis released yesterday on MBIA and other monolines factored in this exposure.

That’s all well and good, of course, but if Standard & Poor’s was aware of it, along with MBIA, but nobody else really had a clue, that’s mighty alarming to investors who have had about all they can handle in terms of surprises this year. “This new disclosure completely changes our view of MBIA being a ‘more conservative underwriter’ relative to Ambac,” writes Mr. Zerbe, who was unavailable for comment. Citigroup analysts, however, term this a “disappointment,” but downplayed it because “the exposures are already accounted for in the rating agency reviews.”

But while the ratings agencies were able to downgrade ACA, a less important insurer, they seem to be engaging in a “cross this line and you die…ok, this line and you die” Yosemite Sam-style game with MBIA and others.

“The current charade of pretending that the monoliners are under review to give them time to raise more capital to avoid such a downgrade is another case of rating agencies supporting a rotten business model,” notes economist Nouriel Roubini, in his blog. “The actual behavior of such monoliners has proven that they are not transparent, that they hold or insure a mass of skeletons and toxic waste securities and they have been dishonest in hiding from investors the toxic waste that they hold and insure.”

The CDO exposure is rated high-grade, but the steady pace of downgrades makes that aspect unimportant, Mr. Zerbe points out.

Mike Shedlock of Sitka Capital Management has written on his blog in the past that MBIA should have been downgraded by now, but this revelation sends him over the edge. “Now let’s see if the rating agencies react. Will they find yet another lame excuse to avoid a downgrade of MBIA? The question at hand is not whether MBIA is “AAA” or “AA” but whether or not MBIA is complete junk,” he writes. “Another question is, if MBIA can withhold information like this for so long, who else is doing it?”

And a little something from JP Morgan report published today, but prior to this new revelation:

We await Fitch's decision on MBIA and Ambac, but we have final word from S&P and Moody’s on the financial guarantors. The conclusion from those two agencies in our view created more questions than answers. S&P specifically fails to address why ABK, MBI and SCA are able to retain their AAA ratings despite having capital shortfalls in the updated loss scenarios. Although trying to appear conservative, we feel S&P and Moody’s are merely sweeping the potential for significant future losses under the rug, hoping for the best and discounting the worst. In the end we feel these stress tests will be updated repeatedly in 08, and most of the monolines have been given time to consider additional capital plans. We recommend investors hit the sidelines until a final round of revisions are in and wait to build positions in future capital raises.

Fitch is the looming negative catalyst. Fitch has yet to release its verdict on both ABK and MBI from its updated capital adequacy test. Judging from its decision that SCA needs at least $2B of capital in four to six weeks to avoid downgrade, we do not expect the results to be as rosy. We go over the S&P analysis and give updated thoughts on each company later in this note.

Upside catalysts few and far between. Moody’s and S&P have for the most part doled out slaps on the wrist. The market has known for some time about wider credit spreads, an increasing demand for credit enhancement, etc. We therefore continue to find it difficult to identify a positive catalyst for the industry. On MBI specifically, S&P’s mention of a pending debt issuance and reinsurance transactions could provide upside depending on dilution.

What lies ahead? In our view, repeated updates to the rating agency tests, a continued decline in insured issuance, steadily rising loss reserves resulting in falling earnings and lowered estimates. We do not envision a return to business as normal at most firms for many years to come, and ROEs will suffer. At the end of the day, the key question left is will debt issuers continue to see value in the "AAA" guarantee and be willing to pay up for that insurance? If so, how many providers of that service will be needed?

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