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| Friday, November 20, 2009 |
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ANALYSIS
March 2, 2009
Sagging Index no longer reflects what’s going on in the market, some say, Replacements? Google it, to start.
March 2, 2009
Downward price spiral will actually boost the cost of capital for most companies. CFOS, take note.
March 2, 2009
The latest bailout at AIG could be a preview of how the president will deal with Wall Street.
March 2, 2009
No corporate defaults. Big debt offerings. Percolating CP issuance. Things may be looking up in the capital markets.
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Bloomberg
OOPS: AIG chief Martin Sullivan watched losses from credit swaps quintuple in just two months as a result of faulty valuation.
February 18, 2008 12:01 AM ET
Bank's losses, already exceeding $100 billion since the beginning of the credit crunch, are likely to grow much larger if the problems starting to show up in credit default swaps spread. That threat was underscored last week when insurer American International Group announced a larger than projected decline in the value of its CDS portfolio and said its losses could grow even larger by the time it releases 2007 results, which are due before the end of the month. The problem is by no means limited to AIG. Indeed, banks are even more exposed as counterparties to CDS underwritten by bond insurers such as Ambac Financial Group and MBIA. CDS function as insurance contracts on the risk of default by bond issuers. AIG said last week that paper losses on its CDS portfolio climbed to over $5 billion as of the end of November from a previously estimated $1 billion. Counterparties to CDS contracts written by AIG are mostly banks, which bought them to hedge their exposure to collateralized debt obligations. “Counterparties tend to be banks that wrote the mortgages and then packaged them,” said Chris Winans, spokesman for AIG, who said that AIG executives weren’t available to comment since the company is in a quiet period before releasing 2007 earnings. AIG said last week that the change in estimated losses came after its auditor, Pricewaterhouse-Coopers, noted a “material weakness” in AIG’s internal control over the financial reporting and fair valuation of the CDS portfolio, which is held by its subsidiary, AIG Financial Products. The AIG subsidiary writes CDS on the super-senior tranches of CDOs on residential mortgage-backed securities. AIG underwrote a little over $500 billion in super-senior CDS, mostly on securities such as corporate loans, but also including some $78 billion related to CDOs, which have some exposure to subprime and have been losing value. Despite the losses, analysts estimate that AIG will be able to fulfill its contracts even in the event of widespread defaults. “We continue to think the firm has ample financial resources to shoulder a reasonable worst-case scenario, which we define as paying out about $10 billion in losses in its credit default swaps business that insure multisector CDOs,” Matt Nellans, a Morningstar analyst, said in a research note last week. “This $10 billion loss would equate to about 10% of the firm’s equity and about three quarters of earnings.” So while AIG calls attention to the potential for spiraling losses in credit default swaps, bond insurers pose the greater systemic risk. Unlike AIG, the less diverse “monolines” remain greatly undercapitalized, and might not be able to pay claims to banks under the contracts they’ve sold. That means downgrades and defaults would cost the banks a lot more where protection was written by the monolines than where written by AIG. As the credit ratings of CDOs fall, the likelihood of defaults rises, which means that bond insurers need to keep higher capital reserves to keep their triple-A rating as insurers. Meanwhile, fresh capital is becoming more expensive. Credit rating agency Egan-Jones said about $200 billion is needed to bail out bond insurers. But it’s anyone’s guess at this point. “It’s going to be big but nobody knows,” said Jim Keegan, senior vice president and senior portfolio manager at investment firm American Century Investments. “I’m not sure the monolines themselves know.” As to the cost to the banks, Standard & Poor’s estimated that they have as much as $125 billion of exposure to bond insurers via hedges through CDS for assets such as CDOs. If the hedges covered about 40% of the face value, this would imply an absolute worst-case loss of $50 billion, S&P added, with Merrill Lynch being the most vulnerable of all banks. Barclays thinks it could cost banks over $140 billion, while Goldman Sachs sees it as between $70 billion and $100 billion. Jamie Dimon, chief executive officer at J.P. Morgan Chase, said during the Credit Suisse Financial Services Forum this month that a downgrade of a bond insurer could prompt the bank to lose on the order of a “couple hundred million” dollars, according to a report by independent credit research firm CreditSights. And the default of a monoline would have much greater impact, comparable to that of the failure of a major financial institution, CreditSights said. Merrill Lynch, for example, took a hit to earnings of $3.1 billion as a result of losses on hedges arranged through CDS issued by bond insurers, mostly ACA Capital, after the bond insurer lost its investment-grade rating last month. This is why banks have been enlisted to help bail out the monolines. Greenhill & Co. is working with Ambac and a consortium of eight banks including Citigroup and UBS, to craft a plan. At the same time, New York State insurance superintendent Eric Dinallo has offered his own bailout project. A separate consortium of banks is looking at plans for Financial Guaranty Insurance, another bond insurer. “Current talk is that the negotiations are focused on unwinding a portion of the swaps used to insure riskier CDOs,” Rob Haines, analyst at CreditSights, wrote last week in a report. “In exchange for commuting a portion of these contracts, the banks would receive an equity stake through warrants.” Gov. Eliot Spitzer of New York said last week during a congressional hearing that if a recapitalization wasn’t possible and couldn’t be done in a timely fashion, the next step would be to split bond insurers’ business between insuring municipal bonds, which is still sound, and insuring structured finance products, which is where insurers have been struggling. “Certainly in the near term, we’d like to see a recapitalization,” he said. “If that doesn’t happen, we’d be forced to act sooner than later. We would peel off the municipal business…to restore municipal bonds.” He called it a “good bank/bad bank structure,” which was last seen prominently during the S&L bailout of the late 1980s. “The concern with a downgrade [of a bond insurer] is that it would have a cascading effect,” Mr. Spitzer said. “It could then generate write-downs at financial services companies.” But while Mr. Spitzer acknowledged that the potential downgrade of bond insurers would have an “enormous impact” on the financial services sector, he said that the priority was to deal with governments and municipalities, which have seen an increase in their cost of debt as a result of the problems surrounding some bond insurers. That increase could be passed on to taxpayers if the pressure persists. So even if regulators come up with a bailout plan, it seems inevitable that banks will have to raise more capital to bulk up their reserves as they face more write-downs, with the next round resulting from credit default swaps gone bad. FW
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