The fallout of bond insurers - sorry, but it's time of judgment
For long, bond insurers have been selling out their premium credit which they borrowed from credit rating agencies. Now, those rating agencies are trying to call back their “loan” amid the “credit” squeeze, as they realized (or pretended just aware) that bond insurers are no fancy but merely a kind of derivative of the lucrative bond products. Bond insurers are not quite same as the insurance company that we normal Joe have in mind. In focusing their job in insuring against bonds, those insurers are not diversifying their exposure. In many ways, the nature of bond insurers is very different from their life counterparts: Risk
Life insurance
One’s death does not lead to another, if no catastrophic disasters. That means life insurers can have good estimates of how much claims will actually occur, given a long history of life statistics and a large pool of clients. Bond insuranceIt is difficult to truly diversify the underlying credit risk in the pool: when the economy goes bust, all residential bonds, commercial bonds and etc will see decline in value. Unlike life insurers, they cannot insert clauses in their customer contract to exempt for extraordinary events such as war or terrorist attack.In fact, bond insurers has been exposing too much on the US mortgage market. No meaningful diversification has been achieved.
Assets / liabilities match
Life insurers have totally different risk profiles on each side of the balance sheet: risks on liabilities rest on the death rate, while value on the asset side depends on their investment performance. Unfortunately, when the market or the economy collapses, bond insurers screw up on both side of the balance sheet (assets cut in value, while they see sudden explode in claim liabilities).
Reguation
Bond insurers are regulated by states, not federal agencies They are massively leveraged – some had guarantees amount to 150 times capital, while banks and life insurers only leverage by around 10 times. So, bond issuers are exposing a lot more risks than the market once thought. How can they insure AAA bonds if they do not worth the honorable AAA status? When those bond insurers are being downgraded, we will see those pitiable banks announce another series of write-downs on those insured bonds. Insurance regulators are now lobbying banks to inject cash into bond issuers – crossholding among financials – looks similar to their Japanese friend?
Some “random” facts:
Ambac, a leading bond insurer (and the first one being downgraded)- Had US$67 billion exposure on CDOs, US$12 billion of auto and credit card finance, but had equity of only HK$2.3 billion
http://www.ambac.com/pdfs/CDO.pdf
http://www.ambac.com/CABS/CABS.asp
http://www.ambac.com/pdfs/OperatingSupplements/4q07_OpSup.pdf
- Some of the AAA graded CDOs had over 1/3 of assets in subprime
- 86% of Ambac’s total guarantee exposure are in the US
- When searched for “hedge” in the latest quarterly report, nothing would come out
Bank of Amercia (which is believed to be the safest major US bank)
- Had 1/3 of CDO being insured. See page 30 of BOA’s 4Q07 results: http://library.corporate-ir.net/library/71/715/71595/items/276157/4Q_supp.pdf
- I believe not a penny of those insured CDO has been written down
Who says the elephant can’t fall?
