Monday, January 28, 2008

Moody's and S&P MBIA and Ambac reviews?

(Naked Capitalism) Why have the rating agencies failed to deliver on actions they promised to take? Remember the announcements that helped feed into the overseas market rout last Monday? This story ran January 16 on Bloomberg:
Standard & Poor's will start a new examination of bond insurers, one month after affirming the companies' AAA ratings, because losses on subprime mortgages will be worse than the firm anticipated.

The ratings company will examine whether insurers including MBIA Inc. and Ambac Financial Group Inc. have enough capital to withstand reductions in the ratings of the mortgage-backed securities they guarantee. The credit test will be completed within a week, said Mimi Barker, a spokeswoman in New York.

Standard & Poor's must define a week differently than I do. If you are generous and assumed S&P started its review January 17, a week later is Thursday January 24. Even if you allow another day to draft a press release, we should have heard something by the end of last week.

You may recall that Moody's also put MBIA on review for a downgrade on January 16, although they did not say when they expected to complete their process. From the Wall Street Journal:
Moody's said late Wednesday that it had placed its ratings on Ambac on review for a downgrade, after the country's second-largest bond insurer significantly stepped up its expected losses from insuring complicated securities backed in some cases by subprime mortgages. Moody's also said it will be evaluating "in the near term" the extent to which its ratings of other firms in the industry will be affected by the sector-wide pressures that produced the losses at Ambac.

Now it goes without saying that the rating agencies don't dare downgrade the insurers while New York State insurance superintendent Eric Dinallo's effort to cobble together a rescue package is underway. They'd be walking into a buzzsaw of criticism for Destroying the Financial World as We Know It and Not Letting the Private Sector Devise a Solution.

So the failure to act is understandable. But what has my paranoid juices going is the failure to make a statement that the ratings reviews were being held in abeyance. Of course, that would put the onus on the agencies to declare Dinallo's effort failed if it became evident no deal would happen but the regulator was still failing around.

But what does this behavior point to instead? An angle that should have occurred to me sooner.

Last week, I gave an initial and then a more thought-out assessment , both concluding Dinallo's initiative was highly likely to come to naught. But I was looking at this from the "can they raise enough dough" standpoint.

That is a mistaken perspective. It assumes the agencies are the immovable object in this equation, when they are in fact the most malleable.

Remember, the markets have already given a huge vote of no confidence in the debt of Ambac and MBIA. Their credit default swaps are trading at distressed level. Distressed means "serious risk of bankruptcy." Now even if you think the market reaction is a tad histrionic, given the rating agencies' track record with structured credits, I would place my faith in the markets' perception of risk. And even if you are merely democratic and split the difference, say, between an AAA and a CCC (and even CCC may be a tad generous), you get a BBB. A downgrade of that magnitude, even while still leaving the bond guarantors with an investment grade rating, makes their guarantees effectively worthless and will create chaos. Barclays estimated that a downgrade of MBIA and Ambac to a mere single A would produce $143 billion of losses to banks and brokerage firms.

Consider further that the amount Dinallo is seeking is likely to prove insufficient. His target of $5 billion now and an additional $10 billion down the road sounds very much in keeping with hedge fund Pershing Square's estimates. But those were made based on end of third quarter data. A current requirement is certain to be lower. And other experts have come up with mind numbing requirements. Rating agency Egan Jones said the bond insurers as an industry need $200 billion to keep their AAA ratings. Even if that is high by, say, 400%, it is still a vastly bigger total than Dinallo is seeking.

But the name of the game is getting the rating agencies not to downgrade the big bond insurers. There already is evidence of a tacit understanding that there will be no downgrades while the negotiations are in play, particularly since Moody's and S&P are participating.

And the very fact that the agencies are part of the process means that they will be subject to both subtle and explicit pressure to knuckle under and accept any package, no matter how inadequate.

Social psychologist Robert Cialdini, in his classic book, Influence: The Psychology of Persuasion, wrote about the power of social assent. One well documented finding from studies of cult members and victims of brainwashing is if you take a person and put him with a group of people who believe in something strongly that is opposed to what he believes and they keep working on him, it is almost certain he will eventually capitulate.

Now the rating agencies could easily protect themselves from that dynamic by sending a mere note-take to the sessions. Conversely, it would be a very bad sign if they senior people who could make commitments participated.

But aside from the dynamics in the room, there is every reason to expect the rating agencies to knuckle under if Dinallo can raise a modest amount of dough, even as little as, say, $2 billion. The agencies through their mistakes have now created the situation where they could be the ones to Destroy the Financial World as We Know It. They will take any route offered to keep from pushing the button, in the hopes that either the economy will miraculously recover or other events will lead to credit repricing, so that the eventual downgrade of the insurers has far less impact than one now.

I still don't think a bailout is likely to succeed, despite the considerable costs of a bond guarantor downgrade. But the fact that the rating agencies will probably go along with any remotely plausible scheme means that a smoke and mirrors version might be put into place.

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