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Monday, February 25, 2008 3:50 PM

S&P Sniffs Horse Hockey, Calls It A Rose

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In a widely expected move, the S&P proved they have an iron stomach for gall and/or a nose that cannot distinguish horse hockey from a rose. Today the S&P Affirmed The AAA Rating Of Insurers MBIA, Ambac Ratings.

Standard & Poor's reaffirmed the Triple A rating on the two biggest bond insurers, MBIA and Ambac Financial Group, sparking a rally by both stocks and the market in general. S&P ended its downgrade review for MBIA's (MBI) Triple A rating, citing success by the largest U.S. bond insurer in raising new capital.

The action reflects the company's ability to successfully access $2.6 billion in extra capital that can be used to pay claims, S&P said in a statement. The outlook is negative, indicating a rating cut may still be likely over the next two years.

The "AAA" ratings of Ambac (ABK) were affirmed but remain on review for downgrade. A group of banks has largely finalized a deal to recapitalize Ambac and is now trying to sell the plan to the rating agencies to save Ambac's triple-A rating, CNBC has learned.

S&P's affirming of Ambac doesn't take into account the recapitalization plan, but the review will continue until details of the plan are clearer. S&P's affirming of Ambac doesn't take into account the recapitalization plan, but the review will continue until details of the plan are clearer.

A tentative structure for up to $3 billion in capital for Ambac has been agreed to by the consortium, which includes Citigroup (C)and Wachovia (WB). The banks are trying to save Ambac, as well as other bond insurers, because a ratings downgrade could force the banks to write down billions more of their own debt.
Citing ability to raise $3 billion in capital (a deal that is not even finalized), and in the face of monolines holding $70-$150 billion of worthless CDOs, the S&P held its nose and confirmed horse hockey smells like a rose.

Following is a recap of what I said last Friday in Ambac Bailout Hopes Excite Bulls.
Who's Holding The Bag?

If you want to know who's holding the bag if the monolines fail, simply look at the who's who list of sponsors.

Who's Who Bagholder List
  • Citigroup (C)
  • UBS AG (UBS)
  • Royal Bank of Scotland (RBS)
  • Wachovia Corp (WB)
  • Barclays (BCS)
  • Societe Generale SA
  • BNP Paribas SA
  • Dresdner Bank AG
The two key sponsors (Citigroup and UBS) were on the list of recommended shorts by Meredith Whitney. See Analyst Meredith Whitney Asks Banks "Where's Waldo?" for more on expected bank writedowns and dividend cuts.

Some Problems Can't Be Solved

A $2-$3 billion infusion simply cannot fix a gaping long term $70-$150 billion problem (depending on who you believe) in the monolines. Should an attempt to do so be made, I confidently predict the banks will have to go back to the well again and again to provide additional capital.

If instead the banks agree to an upfront writeoff of the entire amount of worthless CDOs in return for an equity stake, exactly where are the banks going to come up with the necessary cash? Even if they do manage to pull that off, they will have accomplished nothing but buying a business model that is slowly dying and facing competition from Buffett as well.

"Sometimes there are problems that just can't be solved", and this is likely one of them. Oh sure, the market may rally a bit, especially if Moody's, Fitch, and the S&P keep their collective heads buried in the sand and reaffirm the AAA ratings on a mere $2 billion infusion, but long term the problem cannot go away until the entire package of CDOs guaranteed by the monolines is properly marked to market at a value close to zero.
What's interesting is that Citigroup did not even rally today (It closed down 1.5%), while the S&P 500 closed up 1.25% and Ambac and MBIA closed up 16% and 20% respectively.

Insurers' Day of Reckoning

Minyan Peter was writing about Insurers' Day of Reckoning earlier today before this news hit. Nothing happened to change the relevance of what he had to say so let's take a look.
A hurricane comes through your town and levels your house. A few weeks later, you receive a letter from your insurance company telling you that unless you buy some of its stock, it won’t be able to pay your insurance claim. What do you do?

As far fetched as this question may feel, this is, in principle, what’s behind the bailout of the monoline insurance companies. Unless their biggest CDS counterparties step up with more capital, the insurance companies won’t be able to make good on their CDS and the banks will be forced to take write-downs.

How this all plays out remains to be seen, but I would suggest that until additional capital comes into the financial services system from organizations other than other financial services companies, I am afraid that all that is happening is the further leveraging of an already leveraged and highly interdependent financial system.

Now there are those who suggest that creating a “good bank/bad bank” out of the insurance companies will create the opportunity for the incremental outside capital that I suggest is so much in need. And in general I would agree. Adding capital to the “good” municipal business would put that business on more solid footing. But what about the “bad” CDO business?

A review of history suggests that there was really no such thing as a good bank/bad bank strategy – only a good bank/dead bank strategy. For one to live, the other had to die. And to be clear, looking back in time, no matter how the good and bad eggs were unscrambled, the banks’ equity holders (and some holding company lenders) ultimately lost it all.

So until losses are taken, I continue to believe there is a day of reckoning to come for the monoline insurance companies. And, more sadly, I sense the same day of reckoning for those multinational banks who are stepping up to help. For rather than spreading risk beyond the financial system, it appears that every bailout effort seeks to concentrate it more and more onto the balance sheets of world’s largest banks.

And, while I truly wish it weren’t the case, because of the financial system’s interdependence, we continue to postpone the inevitable.
Raising Capital

Professor Sedacca was talking about the need to raise capital earlier today. Let's tune in.
It now appears that most everyone agrees that most financial institutions are woefully undercapitalized and they have bloated balance sheets that have nary a clue how to value.

So what do they do? Bring on more garbage to the balance sheet via Ambac (ABK) and avoid, for a short time, marking down their other garbage? Remember back in September when Citi (C) said it was marking bonds 'at a reasonable stab'?

Surely Citi jests.

They are shoring up money funds, allowing ARS to fail daily and, yep, raise capital. Today it is Suntrust's (STI) turn to raise 200 million at 8% via a trust preferred.

We continue to be short credit via the preferred market as I think issuance, if anything, will crank up.
By providing precious capital to the monolines they can ill afford to lose, the banks did two things
  1. Threw good money after bad
  2. Delayed the day of reckoning
There may be some financial incentives to delay the day of reckoning, but I suspect it really makes matters worse. Here's how: Instead of addressing the monolines today, the banks pretend they do not need to. Six months from now, the problem with the monolines is not going away. If anything it will be worse. In addition, banks are going to need to raise more capital as "walk aways" continue to add unwanted housed to balance sheets, credit card defaults rise, and commercial real estate plunges.

In the long run, the S&P did not do anyone any favors by their actions today. However, the S&P did manage to further damage their own reputation, presuming of course that was even possible, or they even care.

Mike "Mish" Shedlock
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