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UBS, Citigroup, Merrill Seen Exposed Heavily To Bond Insurers

January 18, 2008: 02:09 PM EST


NEW YORK -(Dow Jones)- Merrill Lynch & Co. (MER) on Thursday opened the door a crack on how seriously banks may be exposed to the spiraling decline of companies that insure bonds and complex structured securities, such as collateralized debt obligations.

As part of $16.7 billion of write-downs it took in the fourth quarter, $3.1 billion represented losses (or reserves for expected losses) on insurance contracts Merrill purchased to hedge its highest-rated CDO holdings. It set aside $1.9 billion alone for contracts insured by ACA Capital Holdings' (ACAH) ACA Financial Guaranty Corp., the most troubled of the so-called monoline bond insurers. Merrill in essence said the ACA "credit enhancement" was worthless.

Using Merrill as a rough model, Oppenheimer analyst Meredith Whitney says the top 10 bank underwriters of collateralized debt obligations last year may have to write off $10.1 billion of the $12.7 billion of their bonds insured by ACA. And that estimate is based on her assumption that the insurance is worth 20 cents on the dollar - above the level of Merrill's reserve.

At the top of the list is UBS AG (UBS), which was the biggest underwriter of asset-backed CDOs in last year's third quarter when ACA was most active issuing CDO insurance. UBS will have to write down $1.4 billion of its ACA-backed hedges, Whitney estimates. It is followed by Citigroup Inc. (C) - the biggest CDO underwriter in last year's second quarter - with an estimated $1.398 billion of losses, and Merrill, according to Whitney.

Representatives for Merrill and Citigroup declined to comment, and UBS did not immediately respond to requests for comment.

ACA likely sold protection on about 7% of all asset-backed CDO insurance sold in 2007, Whitney estimated, and on 32% in the third quarter when UBS was most active.

CDOs are packages of bonds that generate interest from payments on mortgages and auto, credit-card and other consumer loans.

Canadian Imperial Bank of Commerce (CM) in December questioned ACA's status as a "viable counterparty" after Standard & Poor's cut ACA Financial Guaranty's ratings to triple-C from A. CIBC said it will likely take a big charge for its ACA exposure in its first quarter that ends later this month.

What bothers investors, however, is that neither the bond insurers nor the banks that bought the so-called credit enhancement are giving details. And when banks do give details of their exposure to risky subprime mortgages and CDOs, they do so on a net basis that assumes they have effectively hedged assets that are often illiquid and notoriously difficult to value.

"There is literally no disclosure and therefore no way for us to know who ACA's actual counterparties are," Whitney said in a note to clients.

The problems aren't limited to ACA, which is partially owned by a unit of Bear Stearns Cos. (BSC), although its credit backing is lower than its competitors and it is the only monoline insurer that has to put up collateral for its own financing.

Shares of larger monoline insurers Ambac Financial Group Inc. (ABK) and MBIA Inc. (MBI) are tumbling as the triple-A credit ratings that are the backbone of their guarantees are in danger of downgrades. Ambac shares have fallen about 70% this week, and MBI's are down about 51%.

Radian Group (RDN), another large insurer, is off 34%. PMI Group (PMI), which has a big stake in bond insurer FGIC Corp., is off 30%. Shares of ACA have lost 97% of their value over the past 52 weeks, including a 16% drop since last Friday.

Ambac said earlier Friday that it has scrapped a plan announced Wednesday to raise $1 billion in capital, blaming soured market conditions. Investors sneered at the dilutive plan, which Ambac announced after Moody's Investors Service warned of a downgrade.

Moody's on Thursday placed ratings of MBIA and its insurance affiliates on review for possible downgrade. MBIA on Friday expressed "surprise" at Moody's action, saying that it continues to work toward stabilizing its capital strength.

Merrill's posse of bond guarantors, to be sure, includes some strong insurers - among them a unit of insurance monolith American International Group Inc. ( AIG). The company has bought credit enhancement from more than 15 insurers, according to a person close to Merrill, and it also has hedged some of its exposure by buying credit default swaps against the insurers.

But that is cold comfort to many analysts. Merrill was able to cut its exposure to CDOs from more than $40 billion six months ago to $4.8 billion at the end of December. But that represents "net" exposure, inclusive of hedges that may prove ineffective in part because they are based on bond insurance.

"Given ... that most of these hedges use financial guarantors (some of which are facing credit downgrades) as counterparties, we remain very uncomfortable with MER's CDO balance sheet exposure," Sanford C. Bernstein analyst Brad Hintz wrote in a note to clients Friday. Merrill's gross exposure to CDO assets is $ 30.4 billion, he said.

The immediate effect of a downgrade to a monoline insurer is that the value of the protection it sold also declines, and must be marked to fair value on banks' books. That's precisely the process that has led banks in recent weeks to take billions of dollars of write-downs and losses, as they revalue their moribund portfolios of subprime mortgages and related assets.

If the insurers fail, they would not technically be bankrupt, but instead go into "runoff," meaning that some buyers of their contracts might be made good on some of their exposure after much negotiation, said a banker familiar with the process.

While banks' exposure to bond insurers is only a small part of their broad credit problems, they can't be happy about the outlook for the insurers. "We believe management teams and the rating agencies have been underestimating how bad losses will be, so we expect that it will be necessary for the mortgage insurers to raise capital," Lehman Brothers mortgage analyst Bruce Harting told clients in a note Friday.

Indeed, Merrill Lynch is working with several other investment and commercial banks on a plan to help ACA forestall bankruptcy by giving it more time to unwind some of its $60 billion of insurance contracts, said a person familiar with negotiations.

Bond insurers got into the CDO market relatively recently. They were founded, and continue to do the bulk of their volume, insuring municipal bonds. This presents less of a direct credit risk to the banks, but it could expose them to lawsuits from clients who buy municipal bonds that were sold as guaranteed by the insurers.

That partly explains why New York state Insurance Commissioner Eric Dinallo has been seeking new infusions of capital for the bond insurance market. A unit of Warren Buffett's Berkshire Hathaway Inc. (BRKA, BRKB) conglomerate recently began insuring municipal bonds at Dinallo's request, according to a published report.

Merrill Chief Executive John Thain on Thursday let employees know just how concerned he is about the bond insurers. "We should all be helping and hoping that MBIA and the others get recapitalized," he told employees after the brokerage giant announced a $9.8 billion fourth-quarter loss. "ACA is the most difficult one."

Below is a list of the 10 banks with the biggest exposures to ACA, according to estimates from Oppenheimer's Whitney. They are based on her assumption that the carrying values of the insurance contract will be marked down to 20% of their value. However, she cautions that the bonds being insured have widely varying credit quality, ranging from zero value for CDO squared assets (CDOs issued on other CDOs) to 70 cents on the dollar for high-grade assets.

BANK EXPOSURE TO ACA (IN $ BILLIONS)
Potential Markdown
Bank Est. Exposure @80% Discount
UBS $1.76 $1.41
Citigroup $1.75 $1.39
Merrill Lynch $1.65 $1.33
Wachovia $0.854 $0.68
Morgan Stanley $0.736 $0.59
Lehman Brothers $0.734 $0.59
Bank of America $0.574 $0.46
Goldman Sachs $0.550 $0.44
Deutsche Bank $0.310 $0.25
Royal Bk Scotland $0.340 $0.27
Source: Oppenheimer, Dealogic

-By Jed Horowitz, Dow Jones Newswires; 201-938-4047


(END) Dow Jones Newswires
01-18-08 1409ET
Copyright (c) 2008 Dow Jones & Company, Inc.


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