Having just talked about hurricanes in Many Hurricanes, Many Eyes, this headline caught my eye: U.S. Muni Yields Soar as Insurer-Cut ‘Hurricane’ Hits.

Yields on floating-rate, tax-exempt debt insured by MBIA Inc. and Ambac Financial Corp. soared as high as 9 percent last week as investors dumped the securities after the companies’ credit ratings were cut by Moody’s Investors Service on June 19. The spiraling debt costs are reminiscent of those that followed the collapse of the auction-rate securities market in February.

“You survived the big waves, then the next thing you know, you’ve got the hurricane coming,” said Brian Mayhew, chief financial officer of the Bay Area Toll Authority, which saw costs jump as high as 7 percent on $1.8 billion of bonds backed by Ambac even before the downgrades. “This is clearly the storm. This is what we thought would never ever happen.”

More Than Meets The Eye

There is more to this hurricane than meets the eye. In this case I mean the eyes of Brian Mayhew at the toll authority. Rising yields are just one aspect of the storm. There are many others. Consider things from the point of view of Ambac (ABK) and MBIA (MBI).

Bloomberg is reporting MBIA Debt Rating Cuts Prompt $7.4 Billion of Payment.

MBIA Inc.’s credit rating downgrade by Moody’s Investors Service is likely to trigger $7.4 billion of payments and collateral postings.

“MBIA is leveraged through their own rating and that can make a downgrade very harsh,” said Matt Fabian, a senior analyst with Municipal Market Advisors. “It’s very hard for an outsider to piece together the impact of these downgrades.

In its report downgrading the debt, Moody’s said MBIA faced payments and collateral calls triggered by the reduction. MBIA this month decided against giving $900 million to its insurance unit. While that contributed to the downgrade of the subsidiary, the money now puts the parent company in a stronger position, Moody’s said last week.

The statement by Moody’s that the parent company is stronger because it is not funding its insurance unit is ridiculous. A piece of a company cannot go bankrupt.

[Addendum: I stand corrected about MBIA. A subsidiary company may or may not be setup so that debt obligations are guaranteed. In this case there is no guarantee. I am not the only one who thought there was one. It does not change my arguments much, MBIA’s business is all but dead and defaults are going to continue to be higher than expected. Please see Brown vs. Tilson On MBIA: Round 2 for more discussion of the debt obligations of MBIA.]

$125 Billion At Risk

Reuters is reporting Bond insurers want $125 bln of cover wiped out.

Bond insurers such as Ambac Financial Group (ABK), MBIA Inc (MBI) and FGIC are talking to banks about wiping out $125 billion of insurance on risky debt securities to limit the damage to the insurers from the credit crisis, the Financial Times reported on its website on Sunday.

Discussions about “commuting” these insurance contracts, which were sold by the bond insurers to banks in the form of credit default swaps (CDS), have taken on a renewed sense of urgency amid a rash of rating downgrades in the bond insurance sector, the report said.

The talks centre on CDS contracts issued by bond insurers to guarantee payments on collateralised debt obligations (CDOs), complex debt securities often backed by mortgages that have plunged in value amid a wave of foreclosures, the FT said.

The nominal value of these CDSs on CDOs is about $125 billion, according to estimates by Standard & Poor’s, the FT said.

Merrill Lynch & Co Inc (MER) has one of the largest exposures to these types of assets, with $18.8 billion in super senior asset-backed collateral debt obligations (CDOs) as of March 28, according to an S&P; report.

Merrill wrote down $1.34 billion of this exposure in the fourth quarter of 2007 and the first quarter of 2008.

Citigroup Inc (C) has purchased $10. 5 billion in protection of similar securities and wrote down $1.5 billion of this exposure in the first quarter of 2008, S&P; said.

Other Aspects Of The Hurricane

Those are just some aspects of the monoline disaster. One must also consider potential risk of a cascade of derivative defaults, the amount of capital Citigroup, Merrill Lynch, etc, will have to raise in response, further dilution in shareholder equity, and more unwillingness to lend by banks and brokerages. There is far more to the monoline hurricane than first meets the eye.

Mike “Mish” Shedlock
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