Several years ago bond insurers branched out from their traditional business of insuring municipal bonds to insuring collateralized debt obligations (CDOs) and other securities relating to subprime mortgages. Now, with the subprime contagion sweeping the world, the bond insurers are facing significant losses. The bond insurers have begun to lose their own AAA credit ratings as the ratings of many of the CDOs related to subprime mortgage securities have been downgraded or put on watch with the threat of downgrading.
In a February 19, 2008 article posted at Bloomberg.com, Mark Pittman and Christine Richards reported that the plan of Eric Dinallo, the New York Superintendent of Insurance, to split the bond insurers into two companies ? one of which would insure the municipal bonds and the other which would insure the CDOs and other subprime mortgage securities ? may preserve the AAA rankings of municipal securities but allow the continued slide of the rankings of asset-backed securities. This could cause the credit ratings on $580 billion of asset backed securities to be cut and spark further losses for investors and writedowns by financial institutions of their subprime mortgage securities. Oppenheimer & Co. analyst Meredith Whitney estimated last month that the investment banks might have to record additional writedowns of $70 billion if the bond insurers fail.
Dinallo’s plan to separate the two lines of the bond insurance business has been roundly criticized by Wall Street. “This is one of the worst possible outcomes for the market,” said Gregory Peters, the head of credit strategy at Morgan Stanley. He estimated that lower ratings would force banks to write down the value of subprime mortgage securities by as much as $35 billion. Such writedowns would affect subprime investors all over the world.
Dinallo proposed his plan after billionaire investor Warren Buffet offered last week to take over $800 billion of municipal debt guaranteed by three of the largest bond insurers for a payment of $ 9 billion. Dinallo has also been working to inject more capital into some of the bond insurers. Dinallo is also prepared to give a preference to municipalities over the holders of CDOs, which is what splitting the insurers’ lines of business will do. Such a plan will, according to Bank of America analysts, trigger “years of litigation.”