Municipal Bond Forum
On The Reality Behind the Bond Market Shakeup contd #2
Q
I am deeply concerned about what’s going on in the market. I find it hard to believe that “the bond insurers have mostly insured only the mid to higher levels of CDOs,” as you say, since it’s become clear that most holders of CDOs don’t really understand the risk profile. Furthermore, you say “a large segment of the CDOs would need to be in default before the insured layers would be impacted. This is not anticipated.” Well, I don’t think any of the experts anticipated we’d be in the turmoil we’re experiencing today, so I’m not convinced their judgment is credible. I, too, am concerned about what would happen to the insurers if we truly had a meltdown. I’ve never understood how the insurers could cover the potential calamity that could arrive. How could insurers protect us in a crisis?
A
James A. Klotz responds:
First, the bond insurers have all published data on their exposures to the CDO market. This data has been thoroughly analyzed by Standard & Poor’s analysts who specialize in structured finance, including the underlying credits that have been “rolled up” into CDOs. Based on historical and worst-case scenarios, these analysts then apply such cases to the cash flows furnished by the underwriters to determine the impact of a high level of defaults of underlying subprime loans on the ability of a CDO to meet its payment obligations. It was based on this analysis that S&P and the other rating agencies took recent rating actions.
The fact is, bond insurers have generally insured the middle to upper levels of CDOs, and are, therefore, limited in the exposure they have to a CDO with problems. ACA, for instance, has published a list of the CDOs it has insured and the “attachment points” (or point exposure begins) at which their insurance kicks in. Clearly, if the entire, or substantially most of a CDO defaults, the insurer would be on the hook to make up the shortfall and this could be costly. However, the analysis by S&P referred to above indicates this to be highly unlikely. Unlike news reporters who base their analysis on cursory analysis, rating agency analysts do their homework using all of the analytical tools available to arrive at their conclusions.
Second, much of the news we read makes it sound like everyone with a subprime mortgage loan has stopped paying and is in default. This, of course, is patently false. Yes, default rates on such loans have climbed, but not stratospherically. If it had, we would see collateral indicators, such as high unemployment, sharply increasing defaults on consumer debt and car loans. Yet, this has not happened to any significant extent. So, we do not believe a “meltdown” is imminent. The data does not support the economic calamity scenario.
Finally, many of the financial institutions experiencing severe difficulties are doing so not because of mortgage payment defaults, but because of the need to “mark to market” the mortgage backed securities they hold. This means they have had to re-price severely downward the value of these securities because of the market reaction to the subprime sector. As a result, many have had to meet margin or collateral calls which some have had difficulty doing. This point is important: municipal bond insurers also need to mark to market those securities maintained on their books, but do not have to meet margin calls like other types of financial institutions. So, thanks to today’s accounting rules, bond insurers can have a portfolio of mortgage loans that are performing credit-wise, but must record losses to indicate decreased market value. Since most of these securities will be retained until maturity, it is unlikely they would actually suffer a loss.
We too are concerned about the impact of the CDO and subprime crisis on the bond insurers. We do rely on them to provide publicly disclosed information upon which we base our opinions. If such information is incomplete or incorrect, we might react differently. That being said, we closely monitor their financial condition and stay in contact with rating agencies and others to insure we react in a professionally appropriate manner. If our opinion should change, we will certainly let our clients know.
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The responses provided in this forum are meant to address specific questions posed by investors about their municipal bonds and to provide market insight for our general audience. Please note, your investments, objectives, results and experience may differ significantly. Our answers and any potential strategies discussed should not be construed as a solicitation to buy nor sell any security or investment product. All investing entails risk.