High-yield/macroeconomics (fka YIELD)

[Preciouslife1]

Credit Crunch/You Should Worry About Ambac
Liz Moyer, 01.17.08, 4:47 PM ET

http://www.forbes.com/home/wallstreet/2008/01/17/ambac-debt-credit-biz-wall-cx_lm_0117ambac.html

A growing crisis at Ambac Financial, one of the biggest bond insurers, is raising questions about Wall Street's exposure as counterparties to the bond-insurance industry coming off a period in which the big banks are reeling from more than $100 billion in write-downs of mortgage-related securities.

Late Wednesday, Moody's Investors Service said it might downgrade Ambac's (nyse: ABK - news - people ) all-important triple-A financial-strength credit rating after the company forecast significantly higher-than-expected losses from insuring credit derivatives, many of them tied to subprime mortgages.

Raising the level of alarm a notch, Moody's and Standard & Poor's said they will be evaluating their ratings of other bond insurers.

Bond insurers use their top credit ratings to insure bonds issued by municipalities and others against default. That makes it easier for the issuers to sell the bonds at an attractive rate to institutional investors, like pension funds.

In recent years, Ambac, MBIA (nyse: MBE - news - people ) and others have ventured into insuring credit derivatives and other relatively newfangled fixed-income products invented by and peddled by Wall Street. Ambac guaranteed $38 billion of debt linked to subprime mortgages and has exposure to $45 billion of other mortgage investments.

The banks, as counterparties, are on the hook for billions in insurance they bought to hedge credit-derivatives positions. The insurance policies, called credit default swaps, have exploded in popularity in the last few years, with some $45 trillion outstanding.

Closely watched bond guru Bill Gross of Pacific Investment Management calls banks' participation in the CDS market a ponzi scheme that may trigger losses of $250 billion.

Bank disclosure is sketchy, and the market is hard to evaluate for lack of information. Credit default swaps are sold over the counter, are not traded on an exchange and are outside the close scrutiny of regulators.

"The ultimate systemic risk caused by the weakened positions of the monoline insurers is overwhelming and scary," said CIBC World Markets analyst Meredith Whitney in a late-December research note. "The impact will be sizable and very negative for the banks."

On Wednesday, Merrill Lynch (nyse: MER - news - people ) said it wrote down $3 billion of hedges with a counterparty that had slipped to junk grade during the fourth quarter, $2.6 billion of that write-down for hedges to asset-backed collateralized-debt obligations.

The counterparty was the troubled bond insurer ACA Financial Guaranty, which Moody's cut dramatically from A to triple-C one day in December. Canada's CIBC is also on the hook for $2 billion in insurance it bought from ACA to hedge its CDO positions.

On Monday, the Canadian bank said it has bought insurance for U.S. real estate exposure from other financial guarantors. "In the event that the credit ratings for one or more of these financial guarantors were downgraded, or if CIBC's own assessment of the credit status of any of the financial guarantors deteriorated significantly, it is possible that CIBC would make additional fair-value adjustments," the bank said. In other words, more write-downs are possible.

According to Fitch Ratings, Morgan Stanley (nyse: MS - news - people ), Deutsche Bank (nyse: DB - news - people ), Goldman Sachs (nyse: GS - news - people ) and JPMorgan Chase (nyse: JPM - news - people ) were the biggest counterparties in terms of notional value outstanding at the end of 2006, and the market expanded substantially in 2007. Merrill Lynch, Citigroup (nyse: C - news - people ) and UBS (nyse: UBS - news - people ) were the top three underwriters of structured finance CDOs last year.

"There is systemic risk," says Eileen Fahey, managing director at Fitch Ratings and head bank credit analyst. "This could really damage the overall derivatives market."

Shares of Ambac swooned 60% in trading Thursday, and rival MBIA fell 40%. Fitch Ratings, which affirmed MBIA's triple-A rating on Wednesday, is still reviewing Ambac.

The company is struggling to hold on to the top financial-strength rating, as its capital position is severely strained by exposure to subprime mortgage securities that have deteriorated in value, triggering the possibility that Ambac and other bond insurers will have to pay out on the policies they wrote.

That business is unraveling. Earlier this week, Ambac ousted Chief Executive Robert Genader and said it expected a $5.4 billion mark-to-market loss in the fourth quarter, which, coupled with a $143 million loss provision, will bring the quarter's net loss to $32 a share. Ambac announced plans to raise $1 billion by selling equity and equity-linked securities.

Those plans seem seriously in jeopardy now that the stock has been pounded. "Ambac's ability to raise sufficient capital to avoid a downgrade is now in significant doubt," said CreditSights analyst Rob Haines in a research note Thursday.

"In view of the uncertainty generated by Moody's' surprising announcement, Ambac is assessing the impact of this action on the company's previously announced capital plan," the company said in a statement.

The New York State insurance regulator, who said Thursday he continues to monitor the Ambac situation closely, invited other companies to open up for business to ensure that there would be bond insurers to go around in case any of the big ones fell apart. Berkshire Hathaway (nyse: BRKA - news - people ) jumped in last month with a newly formed bond-insurance company. Others are in the works.