Downward Spiral of Deep Junk

By: Mike Shedlock | Sat, Nov 3, 2007
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Reuters is reporting credit default swaps on Ambac, MBIA trading as deep junk

Credit derivative traders are valuing bond insurers Ambac Financial Group (ABK) and MBIA Inc (MBI) as deep junk credits, belying the companies' strong "Aa1" ratings, according to data by the credit strategy group at Moody's Investors Service.

Credit default swaps on Ambac are trading at around 620 basis points, or $620,000 per year for five years to insure $10 million in debt, according to data provided by CMA DataVision.

At Thursday's close, Ambac's swaps implied a rating of "Caa1," seven levels below investment grade and 14 notches below its actual rating.

MBIA Inc's default swap spreads, meanwhile, are trading as though they carry a rating of "B2," five levels below investment grade, and 12 notches below the company's "Aa2" rating, according to Moody's data.

Homebuilders Cut To Junk

In other news, S&P downgrades five US home builders

Standard & Poor's on Friday cut its ratings on five U.S. homebuilders, three of them to junk status, citing weak earnings and challenging conditions in the housing market.

Ratings of D.R. Horton Inc (DHI), Pulte Homes Inc (PHM) and Lennar Corp. (LEN) were cut into junk territory. The downgrades reflect the vulnerability of the home builders to the deteriorating housing market and macroeconomic conditions, S&P said in a statement.

D.R. Horton and Pulte were cut one notch to "BB-plus," one level below investment grade, from "BBB-minus." Lennar Corp was cut by two notches to "BB-plus" from "BBB." The outlook for all three companies is negative, indicating an additional cut is likely over the next two years.

S&P also cut Centex Corp's (CTX) debt rating by one notch to "BBB-minus," one step above junk status, from "BBB," with a negative outlook. It downgraded Standard Pacific Corp (SPF) by one notch to "BB-minus," three levels below investment grade, from "BB," with a negative outlook. And it changed the outlook on Ryland Group (RYL) to negative from stable. Ryland is rated "BBB-minus."

Downward Spiral of Junk

Homebuilders are just as sideshow. Homebuilder debt ratings affect a mere $15 billion in debt. Ambac (ABK) and MBIA (MBI) are the "real deal". Let's look further.

Bloomberg is reporting Merrill, Citigroup Debt Risk at 5-Year High on Subprime Concern

The risk of Merrill Lynch & Co. and Citigroup Inc. defaulting on their debt rose to the highest in at least five years on speculation that losses on mortgage-related securities will worsen, trading in credit-default swaps shows.

Credit-default swaps on Merrill Lynch, the third-largest U.S. securities firm, rose after a Deutsche Bank AG analyst said the firm may write down $10 billion more in assets linked to mortgage debt.

Credit-default swaps are used to speculate on a company's ability to repay its debt or hedge against losses. A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Merrill Lynch, which last week reported an almost $8 billion writedown on securities tied to subprime mortgages, may mark down more for losses on collateralized debt obligations, Deutsche Bank analysts said today. Regulators also may be investigating whether New York-based Merrill Lynch violated accounting rules to delay reporting of the losses, the Wall Street Journal reported today.

"We have increasingly lost confidence in the financials of Merrill," Deutsche Bank equity analyst Mike Mayo in New York wrote in a note to clients today. "Our concern is relying on a company's statements that has no CEO and is facing a potential SEC investigation and may have engaged in questionable private transactions."

Credit-default swaps tied to MBIA Inc., the world's biggest bond insurer, rose 60 basis points to 480 basis points, the widest in at least three years, according to CMA Datavision in New York.

Ambac Financial Group Inc., the second-biggest bond insurer, climbed 63 basis points to 689 basis points, CMA prices show.

The last two sentences in the above snips hold the key to a cascade of defaults. Let's continue with that thought to see why.

Bloomberg is reporting a potential Industry Wide Downward Spiral in Bond Insurance.

Ambac Financial Group Inc. and MBIA Inc. shares fell, along with other bond insurers, as Morgan Stanley said the industry may face a "downward spiral" and Goldman Sachs removed its "buy" rating on the two companies.

The bond insurance industry has guaranteed more than $1 trillion of bonds issued by U.S. cities and states as well as bonds backed by mortgages, credit cards and other assets, and the guarantee allows borrowers to use the insurers' AAA rating. A loss of confidence by investors in the insurers' credit quality threatens the survival of the industry and the price of the thousands of bonds it guarantees.

Ambac, the world's second-largest bond insurer, fell $6.06, or 20 percent, to $23.51 today in New York Stock Exchange Composite trading. On Friday, Oct. 5, the shares closed at $70.11. MBIA, the biggest bond insurer, slid $2.55, or 6.7 percent, to $35.51. Four weeks ago they closed at $67.78.

"As the credit market continues to weaken, our confidence that guarantors will survive the credit meltdown is waning, prompting us to take a more conservative view of the financial guarantors," said Ken Zerbe, an analyst with Morgan Stanley in New York.

Zerbe said a worsening of defaults on mortgage, home equity loans and credit card balances "could prove to be the proverbial straw that starts the downward spiral in the viability of the guarantors' business model."

For more on Zerbe and Ambac please see Stock Buybacks: A Good Thing Or Slipped DISCs?

What Zerbe is missing this time is that the guarantors' business model was never viable. It was all sleight of hand and wishful thinking. Here is the key paragraph.

The bond insurance industry has guaranteed more than $1 trillion of bonds issued by U.S. cities and states as well as bonds backed by mortgages, credit cards and other assets, and the guarantee allows borrowers to use the insurers' AAA rating. A loss of confidence by investors in the insurers' credit quality threatens the survival of the industry and the price of the thousands of bonds it guarantees.

Because of the "guarantee", god only knows what kind of garbage got rated as AAA. In return for the "guarantee" , companies like Ambac collect a fee. When times are good they keep collecting fees. When the proverbial * hits the fan, the guarantee is worthless. Is this a viable business model?

What we do not know is how much of that "AAA" paper banks are holding is really deserving of "AAA" status as opposed to being rated "AAA" because someone "guaranteed" it.

Ambac (ABK) Daily Chart

MBIA (MBI) Daily Chart

At Thursday's close, Ambac's swaps implied a rating of "Caa1," seven levels below investment grade and 14 notches below its actual rating.

MBIA Inc's default swap spreads, meanwhile, are trading as though they carry a rating of "B2," five levels below investment grade, and 12 notches below the company's "Aa2" rating, according to Moody's data.

Ambac was down another 20% on Friday. MBIA was down another 6.7%. Clearly the market is beginning to wonder just how much those "guarantees" are worth.

 


 

Mike Shedlock

Author: Mike Shedlock

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Mike Shedlock

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.

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