Thursday, February 21, 2008

Markets assess the costs of a monoline meltdown

(FT) In recent years the residents of Wilkes-Barre, a small city in Pennsylvania, have been nurturing dazzling dreams. For years their local ice rink lay vacant, while the park in which it stood suffered from neglect. Yet Thomas Leighton, the town mayor, had plans to turn the area into “the region’s premier recreational facility”.

Indeed, the local ice hockey team – dubbed the Wilkes-Barre/Scranton Penguins – were plotting to make the newly refurbished Ice-A-Rama their practice facility.

Now, however, the Penguins’ hopes are facing into the chill headwinds of credit turmoil. Although the underlying finances of his authority are in good shape, last week Mr Leighton told a congressional subcommittee in Washington that “under the current [bond] market conditions, this necessary development will be extremely difficult for the city of Wilkes-Barre to complete”.

The tale is one being echoed in many other unlikely corners of America – as well as other parts of the global financial system. When losses on securities linked to risky subprime mortgages started to appear a year ago, many bankers hoped that the problem would be easily “contained” – meaning that it would not spread beyond the most esoteric niches of finance on Wall Street or in the City of London.

Now, however, the rhetoric of containment is being replaced by a new buzzword: contagion. It has become increasingly clear that the losses in the credit world are being felt far beyond the subprime mortgages market. More pernicious still, it is also becoming clear that these defaults are creating some complex financial chain reactions – which, in turn, are hurting institutions such as the Wilkes-Barre authority.

The fundamental problem is that this decade’s wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand. This is epitomised by the issue currently causing headaches for entities such as the Wilkes-Barre government – the increasingly precarious position of a group of companies known as the monoline insurers.

These companies essentially offer insurance to investors against the possibility that their bonds might default. They initially sprang up three decades ago to guarantee the municipal bond market – a line of business that has hitherto produced a steady, albeit unexciting income stream. Over the past decade, however, the monolines shifted their business into the realm of structured finance too, offering guarantees against the chance that complex bundles of mortgage-linked assets would default by writing derivatives contracts known as credit default swaps (CDS).

Monolone insurance liabilities

Until recently, the monolines insisted that this structured finance “sideline” was as safe as their main business of guaranteeing municipal bonds. However, in the past year default rates have risen sharply on subprime mortgages, with economists now estimating that as many as one in four of the mortgages written since 2005 will not be repaid – an unprecedented level of non-payment and foreclosure.

These defaults have already triggered more than $120bn (£62bn, €82bn) of writedowns at western banks. However, analysts now calculate that the monolines, too, could eventually face $34bn of losses as insurance contracts are activated. While this estimated hit – if it materialises – should be spread out over many years, it has caused huge alarm given that, in last year’s accounts, the monolines only had $48bn of funds on hand with which to pay claims. Indeed, credit rating agencies have already removed the all-important AAA tag from some small monoline groups and are threatening to downgrade the largest companies, most notably Ambac and MBIA.

This has caused losses for investors holding monoline equity, as the share price of companies such as Ambac and MBIA has plunged. It is also threatening to trigger painful new writedowns at banks, since a ratings downgrade of the monolines means institutions that bought insurance from them will no longer be able to assume that this protection is water-tight. What were considered to be risk-free securities, in other words, will suddenly become risky – at least on the banks’ books. Indeed, Moody’s Investors Service estimated this week that associated bank writedowns could range from $7bn to $30bn, with about 20 banks exposed.

The potential implications are so severe that Eliot Spitzer, governor of New York, warned last week that if the authorities did not soon produce effective action to address the monoline problem, the consequence “could be a financial tsunami that causes substantial damage throughout our economy”.

“All of a sudden, the world has been gripped by monoline fever,” observed a recent report from Citigroup, the investment bank. It says that investors are now scrambling to see if the monoline problems are the next example of the “glue which holds together the world financial system” coming apart.

However, the chain reactions extend well beyond Wall Street. As the monolines come under stress, the public-sector bond world also faces upheaval. In the UK, for example, a host of private finance initiative projects, such as hospitals, are being forced to rethink their funding plans. These public-private partnerships have relied on monoline companies such as Ambac to insure their bonds in recent years but can no longer rely on this ­protection.

Meanwhile, in the US, the monoline woes have caused parts of the municipal bond market almost to break down in recent weeks. The most dramatic sign of pressure has occurred in the $330bn auction-rate securities market, a sub-sector of the municipal bond world (see chart). This market has arisen in recent years to match long-term funding needs with investors seeking short-term investments. For although municipal debt is typically issued with a long-term maturity – say, 10, 20 or even 30 years – in the ARM securities sector, investors can opt to sell the debt every week or month, when the interest rates are reset. This has proven very popular among mainstream investors, since ARM securities are typically insured by a monoline – meaning that they are ultra-flexible but also carry the all-important AAA tag.

However, in recent days the ARM market has essentially ground to a halt. This has led to a fall in the value of these securities, leaving holders such as companies and investors with potential losses. In the meantime, municipal borrowers are scrambling to refinance their debt elsewhere to avoid sharply higher interest costs. “Similar to many other mid-sized cities across the nation, we rely on monolines,” says Mr Leighton of Wilkes-Barre. “When they are faced with volatility in the market, there is inevitably volatility for us.”

Or as Congressman Spencer Bachus, the Republican representative for Alabama, puts it: “Unlike other events that have destabilised markets since the credit crunch began last summer – where the pain has been felt largely on Wall Street – the fallout from the troubles in the bond insurance industry is already hitting Main Street.”

Unsurprisingly, the finger-pointing has already begun. In the US the bond insurers are regulated at state level, and it seems that the regulators have been slow to recognise the scale of problems that have been developing in the monoline world. Creditsights, a debt analysis company, said the regulatory capital bases of the monolines grew by 29 per cent between 2003 and 2006 to $22bn. However, guarantees of structured finance – much riskier than the traditional municipal bond business – grew 175 per cent in that period to $1,600bn. “The industry got greedy,” says Rob Haines, an analyst at Creditsights.

Indeed, Eric Dinallo, the New York insurance superintendent, admits that regulators have failed fully to comprehend the link between ratings and the guarantees from bond insurers. As a result, regulation will be reformed to focus on ratings rather than on solvency, he says. “This [bond insurance] might be the only area of insurance where the ratings are as important as the solvency,” he says.

In the short term, however, the more immediate problem for policymakers is how to prevent the chain reaction inside the financial sector from extending even further. Frantic efforts are under way to shield the politically sensitive municipal borrowers from further pain – through discussions that involve the world’s biggest banks, billionaire investors including Warren Buffett and Wilbur Ross, sovereign wealth funds and an army of lawyers and advisers. This could result in the businesses of companies such as Ambac, MBIA and FGIC being split into two, to ensure that bond insurers can ringfence the riskier assets (such as mortgages) from the municipal guarantee business.

But although such a split currently seems attractive in political terms – most notably because it would enable policymakers to protect the municipal bond market in an election year – it will not necessarilly prevent further turmoil on Wall Street. On the contrary, as Jeffrey Rosenberg, analyst at Bank of America, says: “A split may limit losses in the municipal market, but it would likely exacerbate losses to structured finance . . . To the extent that those losses further constrain financial institutions’ balance sheets, broader credit constaint may follow.”

That could create more potential chain reactions. For example, another issue that is raising levels of concern is the health of the wider credit default swap market. This sector has exploded in size this decade, as a swath of investors – such as mainstream asset managers – have used CDS to protect themselves from the risk of corporate default. Until the monoline companies started to face problems, few of these investors worried about whether CDS counterparties would be able to honour their contracts if defaults occurred.

But the monoline issue has raised anxiety about whether other counterparties in the CDS world, such as hedge funds, will be able to honour their contracts if corporate defaults rise. While the International Swaps and Derivatives Association, the main trade body, vehemently insists this risk should be offset by the fact that most trades are backed by collateral, levels of investor unease are nevertheless rising.

That, in turn, is contributing to a wider rise in anxiety about all manner of complex debt vehicles, many of which are also tied – directly or indirectly – into the CDS and monoline world. There is an alphabet soup of structured products that could unravel, such as tender option bonds (TOBs), which are linked to municipal debt.

Indeed, Tim Bond, analyst at Barclays Capital, likens current events to nothing less than the “demise of the shadow banking system” that has sprung up in recent years around the structured world.

Policymakers pray that this chain reaction of financial implosions can still be contained without sending the economy into a tailspin. After all, they point out, the processes that created the credit bubble have been marked by a circularity. Institutions such as banks, hedge funds or monolines have essentially been cutting contracts with each other, raising overall levels of debt; thus, the hope goes, if this complex network of financial flows is imploding, it may be the financial sector – not the real economy – that ends up bearing the greatest pain.

Nevertheless, the more that financial problems hit sectors outside Wall Street, the more danger there is of a loss of confidence among consumers and companies. Or, as Malcolm Knight, head of the Bank for International Settlements, recently observed: “The longer this [uncertainty] goes on, the greater the risk that this will create a negative feedback loop [with the real economy].” Economists and investors, in other words, now have every reason to watch closely to see what happens next to the Wilkes-Barre Ice-A-Rama – together with all the other corners of the US economy whose fate is now entwined with that of the monolines.

Lenders raise the bar on corporate buy-outs

A year ago, the Bank of England published a report discussing the similarities between the subprime mortgage market and the so-called leverage finance market, in which private equity firms raise capital to fund the purchase of target companies, writes Henny Sender. The bank identified signs of deterioration in the mortgage market and concluded that such episodes “could provide a warning of corporate stress to come”.

Today, that assessment looks prophetic. On the face of it, the factors that prompt a homeowner in Florida to default on a mortgage seem quite distinct from the pressures that might spell trouble for private equity groups such as Apollo Management and TPG in financing their buy-out of Harrah’s Entertainment, a gaming company in Nevada.

However, as the Bank of England observed, what the US mortgage market and corporate debt world have in common is that lending standards have crumbled in recent years – partly because banks have been repackaging this debt and selling it on to investors rather than holding it themselves.

Consequently, there are now rising fears that problems that have already unfolded in relation to mortgages could be replayed in the corporate debt world, with potentially painful implications for growth.

“Since the first subprime scare nearly a year ago, credit conditions have tightened for all types of loans,” note economists at Goldman Sachs in a recent report. “The impact of tighter credit conditions could directly subtract 1¼ percentage points from first-quarter growth and 2½ points from second-quarter growth.”

Part of the problem is that the investors who have been financing mortgages in recent years have often been the same group financing big buy-outs. These have both been driven by the same desperate need for yield – meaning that credit risks have been increasingly overlooked. “There is so much liquidity in the world financial system that lenders are making very risky credit decisions,” wrote Bill Conway, co-founder of Carlyle Group in a letter to his partners just over a year ago. “This debt has enabled us to do transactions that were previously unimaginable.”

Another reason for parallels between mortgage and corporate debt is that both asset classes have become sucked into a relatively new kind of financial engineering machine this decade, which has typically been taking up to 200 individual loans or bonds, slicing them and then creating new debt parcels, subdivided according to risk.

Many of the securities that emerge at the end of this complex “slicing and dicing” chain are ultra sensitive to market movements – meaning that even a small move in price can involve huge losses. Or, as the Bank noted last year: “The embedded leverage [in these instruments] . . . could magnify the market response if there was a particularly sharp deterioration in the performance of underlying assets.”

This meant that when losses started to emerge in the mortgage world last year, many investors panicked – and then pulled out of corporate debt as well. That, in turn, has created a supply-demand mismatch. Data from TPG, for example, suggests that there was six times more buy-out debt available in the summer of 2007 than there was in 2006.

As a result, the price of corporate debt has plunged – particularly for debt deals concluded over the past year. Today, the banks financing the big deals still in the works, such as the buy-outs of Clear Channel Communication and BCE, are looking at huge losses. Indeed, at least one bank in the underwriting group has already written Clear Channel down to 85 cents on the dollar.

Some investment bankers hope that if prices fall further – say to 80 cents on the dollar – more buyers will come into the market again. And they are doing their best to attract skittish purchasers. Recent deals have had so-called Libor floors, which made the new loans less vulnerable to rate cuts.

Today, private equity firms wanting to buy companies have begun writing equity cheques for the whole thing, reasoning that they can eventually go to the debt market to refinance, according to Doug Warner, a lawyer at Weil Gotshal & Manges in New York.

But the main ghost haunting the market is the uncertainty about the economy. If the economy really slows dramatically, corporate cash flows will dry up. Then, companies with heavy debt burdens will find it even harder to pay their debt – creating even more trouble ahead.

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