Uncertainty Over Bond Insurer Downgrades Leaves Investors Wary

February 6, 2008

Municipal bond investors were in a wary frame of mind Monday as they waited to learn whether ratings agencies will downgrade some ailing bond insurers.

Uncertainty about the fate of the companies that insure municipal bonds has cast a pall over the normally robust municipal market since the start of the year.

Bob Nelson, of Thomson’s Municipal Market Data group, said he is surprised that more downgrades have not occurred yet as the strained finances of the bond insurers have been in view for weeks.

The agencies may be waiting to give nascent efforts by top banks to rescue the troubled insurers a chance to succeed.

“I think there is hope that some sort of relief package will come through,” Nelson said, adding that further extensions of the review process are possible.

The next two to four weeks are critical for both the insurers and the ratings agencies. The problem for the agencies is that their perceived slowness in issuing the downgrades further tarnishes reputations diminished last year by their handling of the subprime and SIV crises.

However, there is speculation the ratings agencies are being pressured privately by New York Insurance Superintendant Eric Dinallo and other regulators and by banks to hold off on downgrades. Moreover, the severity and the complexity of the situation, and the large number of impacted parties, likely is making the process unusually long and difficult.

“We can only suspect that there are a lot of things going on behind the scenes,” said John Flahive, director of fixed income for BNY Mellon Wealth Managment. “It could be that New York State is brokering a deal or that commercial banks are involved.”

“This appears to be a very sporadic and uneven and unsythesized process, with downgrades coming out just one at a time here and there,” Flahive said. “I find it unusual but then the situation is very unusual. We could get our answer in an hour or we could be left hanging for another four weeks. But time is of the essence and the ratings agencies are likely to grow impatient.”

To date the most aggressive agency in issuing downgrades has been Fitch Ratings, which has cut ratings on the insurers Ambac Financial Group Inc, Financial Guaranty Insurance Co. and XL Capital Ltd. Those downgrades made it nearly impossible for the insurers to insure new issues.

Investors are waiting to see whether MBIA Inc. manages to avoid a Fitch downgrade. The insurer raised some capital to strengthen a balance sheet hurt by its bad investments in subprime assets.

Standard & Poor’s Corp. and Moody’s Investors Service have been slower to take action on insurers’ ratings. Standard & Poor’s last week downgraded FGIC and put MBIA Inc and XL Capital on notice for possible downgrades. Previously, Standard & Poor’s put Ambac on its negative watch list.

Moody’s said Friday it would not wrap up its decision on downgrades in the sector until mid- or late February.

The uneasiness in the market was compounded Monday by a report in the Financial Times that major private equity firms including Bain Capital, Carlyle Group, Kohlberg Kravis Roberts & Co. and TPG, have concluded the risks of investing in the troubled insurers are too great. This steps up the pressure on banks to find and fund a solution for the insurers.

The uncertainty surrounding the insurer’s downgrades have caused debt insured by Ambac and MBIA to fall sharply in price. Those bonds now are trading as if they did not carry insurance.

Meanwhile, last month new issuance of municipal bonds slowed to levels not seen since September 2001. The crisis of confidence followed two years of heavy issuance.

New Thomson’s Municipal Market Data group figures Monday showed that in January $16.5 billion in new muni bonds were sold, roughly half of the $31.2 billion that came to market in the year-earlier month. Insured new issues last month came to just $5.2 billion, about a third of the $17.5 billion seen in January 2007.

Despite the skittishness in the muni market, bond investors hold out hopes that the rescue efforts will succeed. “I think there will be some sort of bailout because otherwise there is too much of an avalanche effect on the marketplace and the economy if municipalities can’t issue bonds,” said Tom di Galoma, head of Treasurys trading at Jefferies & Co.

At this juncture it appears the most likely bailout would take the form of banks with exposure to particular insurers banding together to seek solutions on a case-by-case basis. Media reports have said Citigroup Inc., Wachovia Corp. and six European banks are working together to rescue Ambac.

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