In something we all knew a year ago if not far longer, Bloomberg says Bill Ackman Was Right: MBIA, Ambac on ‘Ratings Cliff’.

Bill Ackman was right: the world’s largest bond insurers aren’t worthy of a AAA credit rating and may be headed for the bottom of the scale. That once-unthinkable scenario would trigger clauses in $400 billion of derivative contracts written to insure collateralized debt obligations and other securities, allowing policyholders to demand immediate payment for market losses, which have reached $20 billion, according to company filings. Downgrades of the insurers would cause a drop in rankings for the $2 trillion of debt that the companies guarantee, wiping out the value of the CDO insurance held by Wall Street firms, analysts at Oppenheimer & Co. said.

CIFG North America may fall first. The company’s credit rating has been cut by 17 levels to CCC from AAA by Fitch since March because of concern it won’t be able to make payments on $57 billion of the contracts.

Downgrades may cause Citigroup Inc., Merrill Lynch & Co. and UBS AG to write down the value of insured-debt holdings by at least $10 billion, according to Meredith Whitney, an analyst at Oppenheimer in New York. Banks and insurance companies would also be required by regulators to hold more capital to protect against losses on lower-rated debt, according to analysts at Charlotte, North Carolina-based Wachovia Corp.

Instead of writing standard insurance policies for the CDOs, the companies provided guarantees in the form of credit-default swap contracts, financial instruments that allow one party to assume the risk of a security defaulting in exchange for a fee from another.

The contracts were designed to mirror insurance policies, said Bob Mackin, the Albany, New York-based executive director of the Association of Financial Guaranty Insurers.

Unlike insurance, the swaps include so-called termination clauses that can be triggered if a company becomes insolvent, Mackin said. The feature requires insurers to compensate CDO holders for any drop in value, or mark-to-market loss, on the securities.

The credit ratings of some CDOs have tumbled so far that the insurers have recorded combined unrealized losses of at least $20 billion. Some companies’ termination payments would eat up all their claims-paying resources, according to filings and rating company reports.

If a company’s surplus to policyholders — or assets over liabilities — falls below zero, it’s considered insolvent under New York State Insurance Department rules and would be taken over by Superintendent Eric Dinallo, unless it comes up with a plan to correct the impairment, Deputy Superintendent Michael Moriarty said in an e-mailed statement.

Even in an insolvency, regulators may step in to halt the payments or banks may decide not to demand compensation, Abruzzo said. ACA Financial Guaranty Corp. has reached five agreements with banks since December, allowing it to avoid posting collateral on CDOs it guaranteed using swaps. ACA has been cut to CCC by S&P.;

In the past two quarters, MBIA’s insurance unit set aside reserves of $2 billion to cover losses on $51 billion of guarantees on home-equity securities and CDOs backed by subprime mortgages.

Ambac booked about $2 billion of loss reserves, leaving it with a statutory surplus of $3.6 billion. It guaranteed around $47 billion of CDOs and home-equity debt.

While both companies are above the regulatory capital requirements, S&P; said in a February report that in a “stress case scenario,” MBIA may be forced to pay a total $7.9 billion in claims on a present-value basis and Ambac may be forced to pay $6.2 billion.

S&P; Stress Scenario A Farce

Clearly the S&P; stress scenario is a farce. Ambac (ABK) set aside a mere $2 billion for $47 Billion of guarantees on CDOs backed by subprime mortgages. MBIA (MBI) set aside a mere $2 billion for $51 Billion of guarantees.

A stress test loss in the current environment would have to assume losses of at least 33% or ($15.7 billion minimum each). 75% losses would not be surprising at all. The S&P; stress test number is a mere $6.2 billion on Ambac and $7.9 billion on MBIA. Those numbers are more like a picnic in the park than a “stress test”.

But let’s assume that’s all it is. The number would more than eat up 100% of Ambac’s and MBIA’s cash on hand as the following tables show.

Ambac’s Cash Position

MBIA’s Cash position

Cash positions from Yahoo Finance.

Notice Who Takes The Hit

Notice how the typical culprits Citigroup (C), Merrill Lynch (MER), and UBS (UBS) are poised to take the hit. All it takes is reality to set in and for a termination clause to kick in if the companies are insolvent. Is there any doubt that they are? So what’s holding up the New York State Insurance Department from making that determination? Here’s the answer: $400 billion of derivative contracts are on the line. The odds of a derivatives cascade event over this is not insignificant.

Just one more thing: Anyone remember Greenspan’s comment on derivatives? I discussed the answer in The Fed And The Henhouse.

Greenspan May 5th 2005: “Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth.

Mike “Mish” Shedlock
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