Friday, December 21, 2007

Nouriel Roubini's Global EconoMonitor

It is now time to downgrade the monoliners: a business model that cannot survive without an AAA rating is a business model that cannot fundamentally deserve an AAA rating

Nouriel Roubini | Dec 20, 2007

The shocking and surprising revelation by MBIA – one the leading monoliners, i.e. bond insurers – that it has guaranteed $8.1 billion of collateralized debt obligations repackaging other CDOs and securities linked to subprime mortgages (i.e. it is holding the very risky CDOs of CDOs) – is the last drop in this monoliners’ farce: it is time for the credit rating agencies to downgrade most of these monoliners from their AAA rating status. One can spend a long time discussing the relative riskiness of each of these monoliners and whether the capital injections that some of them are now receiving is enough to prevent the downgrade that rating agencies are considering. But discussing these important details risks losing the vision of the forest while being obsessed with watching the trees or individual leaves on each monoliner tree.

The forest issues is simple: a business – the monoliners’ insurance of securities and holding of risky ABS securities – that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place: it is clear to all that if a monoliner were to lose its AAA rating the essence of its business model would fail and such monoliner would have to close shop. But in any industry you have firms that can do business and thrive with an AA or A or even lower rating, even among major financial institutions. Here we have instead an industry that would go bankrupt as soon as its AAA rating is lost: by definition this is not an industry that can deserve a AAA rating. So the issue is not one of how sound these monoliners are managed or whether they have enough capital or whether they can raise new capital to maintain their AAA status. There is a fundamental and conceptual flaw in a business model that is conditional on a AAA rating and that is in a business that insures assets and firms that do not have a AAA rating. This is analogue to the voodoo finance of taking subprime and BBB mortgage backed securities and turning them into AAA by the black magic of CDO tranching.

Add to this mess the fact that monoliners collectively insure $3,300bn of principal and interest (less than 30% of it ABS) with only a $22bn capital base. Of course a downgrade of monoliners will have a severe knock-on effect of potential downgrade on muni and other bond markets; analysts have estimated that such downgrades could cause losses writedowns of about $200bn. But these risks cannot be an excuse for not admitting that the monoliners don’t deserve an AAA rating. As long as monoliners were only in the muni bonds insurance business one could have made the argument that a prudent monoliner did deserve an AAA rating; but now that monoliners have vastly expanded in the ABS world of insuring toxic RMBSs, CDO, CDOs of CDOs and in some cases even holding these assets on their portfolios such an AAA rating does not make any sense.

So enough of wasting time on dissecting the assets and liabilities and capital of individual monoliners; their business model is conceptually flawed in the first place; and their actual business practices have been even more flawed as they have now insured for years toxic RMBS, CDOs, and CDOs of CDOs. The wariness of rating agencies to downgrade the monoliners is understandable: such a downgrade will imply an instant death sentence for any monoliner that is downgraded; it will lead to loss of business for the rating agencies themselves; and it will trigger massive losses on muni bonds.

But the current charade of pretending that the monoliners are under review to give them time to raise more capital to avoid such a downgrade is another case of rating agencies supporting a rotten business model. The actual behavior of such monoliners has proven that they are not transparent, that they hold or insure a mass of skeletons and toxic waste securities and they have been dishonest in hiding from investors the toxic waste that they hold and insure. So it is time to stop this charade of rating forbearance and admit that the emperor has no clothes: a business model that cannot survive without an AAA rating is conceptually a business model that cannot deserve under any circumstance an AAA rating; period! Arguing otherwise is believing in voodoo black magic.

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