NEW YORK (Reuters) - Bond insurers would be better off targeting AA ratings than trying to protect their top "AAA" ratings by splitting their businesses, which could damage their bank policyholders, Bank of America said in a report on Thursday.
The ratings of bond insurers including MBIA Inc (MBI.N: Quote, Profile, Research) and Ambac Financial Group (ABK.N: Quote, Profile, Research) may be cut because of expected claims from their guarantees on risky residential mortgage backed debt, including collateralized debt obligations.
A rating downgrade would dry up demand for their business of insuring municipal bonds and could make it more expensive for local governments to sell debt.
Regulators and some bond insurers have proposed splitting off the companies' risky structured finance operations into a separate company as a way to protect the ratings on more than a trillion dollars of municipal bonds.
However, this would likely prompt a credit ratings cut for the structured finance unit, Bank of America analyst Jeff Rosenberg said in a report sent on Thursday. That would force banks to write down the value of securities guaranteed by the structured finance units by as much as $30 billion.
"That plan, while limiting the damage to the municipal market comes at significant cost to the broader financial markets," Rosenberg said.
An alternative option would be for insurers to target an "AA" rating. The capital requirements to hold this rating would be significantly lower than those required for the top "AAA" ratings, Rosenberg said.
Bank write downs from insurance policies they have purchased on CDOs would likely fall to around $5 billion, he said.
"The AA level limits the spread of systemic risk while reducing the amount of new capital required," Rosenberg said. "Targeting the AA level would also reduce the risk of further capital requirements as loss expectations change," he added.
Damage to the municipal bond market would also likely be limited from this scenario, as triggers for tax-free money market funds to sell municipal debt is often below "AA."
However, Rosenberg noted that a downgrade below AA could limit the number of buyers and force banks to absorb $100 billion in short-term municipal bonds.
While a rating of AA will likely lead to some losses for municipal bond investors, Rosenberg notes that breaking up the insurers would likely face significant legal hurdles and may not offer any greater protection of their investment.