An old Wall Street adage says that you should never plan to bring a new offering to market right after a three-day weekend because you never know what could happen from Friday night to Tuesday morning. US markets were closed today for the Martin Luther King, Jr. holiday but it was an event-filled weekend that will cause further market turmoil on Tuesday when the markets re-open.
On December 18, 2007, The Wall Street Journal wrote “Credit Crunch Could Worsen if . . . Bond Insurers Sink, ‘Buck Breaks’.” According to Dennis K. Berman of the Journal, the two events that are of most concern to Wall Street bankers, traders, and regulators are ratings downgrades of bond insurers and money market funds losing value below $1. Unfortunately, recent events suggest that this very scenario may be playing out.
First, on Saturday, January 19, 2008, Christine Richard of Bloomberg.com reported that Fitch Ratings announced that it had downgraded the credit rating of Ambac Assurance Corporation from AAA (the highest rating available) to AA after Ambac abandoned plans to raise new equity. This in turn caused a downgrading by Fitch of approximately 140,000 municipal and non-municipal bonds insured by Ambac.
Fitch said that Ambac may be downgraded further. Without its AAA rating, Ambac may be forced to stop writing the bond insurance that comprises 74% of its revenue, according to the article.
One reason that municipal bonds have been widely regarded as safe investments is that municipal bond insurance policies guarantee the payment of principal and interest on a bond if the issuer defaults. Since the claims-paying ability of bond insurance companies is of critical importance to the bond market, those companies are rated by credit rating agencies such a Standard & Poors, Moody’s, and Fitch. Being insured by a AAA-rated insurer enhances the value and liquidity of the bonds.
There are, or rather were, seven AAA-rated bond insurers. MBIA Insurance Corporation is the largest, and Ambac Assurance Corporation is the second largest.
The other credit rating agencies are expected to act to lower not only Ambac’s rating, but the ratings of MBIA as well. “The likelihood is quite high the others will follow,” said John Tierney, credit market strategist at Deutsche Bank AG in New York. “Barring some significant development on new capital, it’s just a matter of time before S&P and Moody’s act on MBIA and Ambac.” Other bond insurers could soon lose their AAA ratings as well.
Bloomberg explained: “The seven AAA rated bond insurers place their stamp on $2.4 trillion of debt. Losing those rankings may cost borrowers and investors as much as $200 billion according to data compiled by Bloomberg. The industry guaranteed $100 billion of collateralized debt obligations linked to subprime mortgages, $22 billion of on-prime auto loans and $1.2 trillion of municipal debt.”
The potential cascade of losses in the bond markets resulting from these downgrades is enormous. After downgrading Ambac, Fitch adjusted its ratings of 137,990 municipal bonds and 114 non-municipal bonds insured by Ambac, according to Bloomberg.
According to Dennis K. Berman of The Wall Street Journal, the downgrading of the rating of municipal bond insurers like Ambac could create a cascading effect of other bond downgrades. This would have severe consequences for many institutional investors who are contractually obligated to carry only AAA bonds and may find that the AAA-rated credit tranche they had invested in had suddenly become AA or even A rated.
Last week, Merrill & Co., the world’s largest brokerage firm, took $3.1 billion of writedowns on the value of default protection from bond insurers.
Like municipal bonds, some money market funds, thought to be a safe haven for risk- averse investors, have been downgraded because of their exposure to illiquid, high-risk investments linked to subprime debt. The fear, according to The Journal’s Berman, is that a money manager of a fund with massive exposure to risky SIV paper and subprime mortgages may “break the buck” ? that is lower its net asset value to less than the traditional $1.00 per share ? rather than have the issuing institution pay billions to bail the fund out to keep its reputation intact.
When world markets opened on Monday, stocks nosedived and the demand for safe haven bonds and currencies soared, according to Jeremy Gaunt, Reuters European Investment Correspondent, because of investor fear that the deteriorating US economy would drag others down with it.
The MSCI main world stock index, a benchmark gauge of global stock markets, sank 2.6%. The pan-European FTSEurofirst 300 was down 4.2%. The Nikkei lost 3.86%, and the MSCI emerging market stock benchmark lost 3.9%.
According to the Reuters article, the Asian and European investors were acting on Wall Street’s concern that the fiscal stimulus proposed by President Bush would not be enough to stop the US economy from falling into a recession.
The trifecta of bad news was completed by Justin Lahart’s article in today’s on-line Wall Street Journal reporting that various economists believe that the looming recession will be harsher than the last two we suffered in 2001 and 1991.
According to the Journal: “Housing is in the midst of its worst downturn since at least the 1970s. That has led to a meltdown in the mortgage market; with financial firms struggling to make sense of their losses, they are making it harder for even credit-worthy borrowers to get loans. The combination of heavy debt loads, still-high energy and food prices and a weakening job market has households tightening their belts. Consumer spending, long a bulwark of the economy, is faltering.”
When the “safest” pillars of the market are wobbly, the rest of the world is in a sell-off, and we are told that the oncoming recession will be deep, is market panic here?
Page Perry is an eight lawyer Atlanta-based law firm with over 125 years collective experience representing investors in securities related litigation and arbitration. While past results are not necessarily indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. The firm is currently involved in representing both institutional and retail investors who lost money in the collapse of the sub-prime mortgage market and related structured investments, including the Bear Stearns hedge funds and Morgan Keegan bond funds. For further information, please contact www.pageperry.com.