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Financial Analysis of Monterey Gourmet Foods -
February 21st, 2011
Monoline insurers such as AMBAC and MBIA write a single type of insurance contract, usually for bonds or asset-backed securities. This insurance lets a company with mediocre financials or a middling debt rating buy an insurance policy that gives its debt a sterling rating, allowing the company to pay lower interest rates and raise money from a broader range of investors. For example, a company or local government trying to borrow money by selling bonds could buy insurance from AMBAC or MBIA; the insurance company would promise to pay back the loan if the original borrower defaulted. Because AMBAC and MBIA have AAA debt ratings, the bonds would also have an AAA debt rating, regardless of the financial health of the borrower.
Monoline insurers have been hit hard by increasing defaults on subprime loans, as they are on the hook for a lot of mortgage debt that isn't getting paid back. As losses stack up, these companies risk losing their AAA debt rating - a death-blow to their business, as their clients are ultimately paying for this superior debt rating that they can attach to their bonds. Any downgrade would also have serious repercussion on companies that hold a lot of debt insured by AMBAC and MBIA - if the insurer's credit rating falls, so does the rating for the bonds it has insured, making them less valuable - leading to a concern that if Moody's or Standard & Poor downgrade AMBAC or MBIA's credit rating, the effects could cascade around the financial services industry as debt held by banks around the world suddenly drops in value.
In order to stave off financial ruin, some monoline insurers have proposed splitting their companies in two - one half would insure relatively stable bonds such as those issued by municipal governments, and the other half would be responsible for insurance on more exotic instruments such as mortgage-backed securities, the area that has been most dramatically impacted by the subprime lending crisis. A split would protect the more conservative municipal bond business, but it would leave the part of the company insuring mortgage backed securities weakened and fending for itself.
Ambac Financial Wikichart
What Happens if Monoline Insurers Split?
Ambac is reportedly considering a plan to split its operations into two subsidiaries, one responsible for securities including mortgage-backed CDOs, and another for municipal bonds. This split into two "houses" of Ambac would allow the municipal bonds side of the house to keep its high credit rating while thrusting the massive debt problems related to subprime lending onto the other half of the business. FGIC has already told the state of New York that it needs a similar split. Investment banks that have bought insurance on mortgage-related securities through Ambac and FGIC will use the court system to oppose this business practice, as they are concerned such a move would leave their insurance contracts suddenly backed by smaller, less financially stable companies that will not have AAA credit ratings. MBIA, meanwhile, opposes the concept and has raised doubts that such a split can be legal. As the largest of the three insurers it is best equipped to survive the current crisis without halving itself, and it has already raised over $2.5 billion to cover its debts and regain stability.
FGIC- Calling FGIC a "winner" here is a bit of a misnomer, as this would be a desperate play to save its business. But a split could save the firm from bankruptcy and keep some cash flow alive. Banks are still willing to invest in municipal bond insurance, and a newly created subsidiary solely focused on this business could benefit from a sudden infusion of loaned capital. Furthermore, since concerns about a future drop in credit rating will have abated, the new business could resume underwriting new municipal bonds.
Ambac- As above, it would be a desperate move for Ambac to save its business with a split into two companies, but it could save its traditional business and continue insuring municipal bonds. Regulators and investors are relatively confident in Ambac's ability to raise capital, however, and new funds could help the firm avoid the risk of splitting and conceding the failure of the CDOs it insures. Ambac is currently engaged in talks about both proposed solutions.
MBIA - MBIA has two advantages over Ambac and FGIC - it is larger than its two closest competitors, and it has already raised some of the capital it needs to cover its losses. It is least likely of the three firms to need a split, but in mid-February 2008 the company changed its leadership, with the new group indicating that it will explore dividing the business. Again, calling MBIA a "winner" here is misleading, as regardless of the outcome it will sustain billions of dollars in losses paying out claims.
Federal, state, and local governments- Monoline firms insure a variety of fundraising projects for local governments, including everything from health care to transportation to tax-backed municipal bonds. New insurance subsidiaries created to focus specifically on public finance will most likely retain the old firm's AAA rating, and previously issued securities will retain their value.
Individual investors- If municipal bonds hold their credit rating, they will also hold their low-risk value and their low interest rates. This will benefit the wide variety of investors that hold these bonds.
Rating agencies- Agencies like Moody's and Standard & Poor's benefit from the presence of monoline insurers. Ratings agencies currently only rate the insurance company, not each individual bond, saving them time and resources. If the insurance firms split, little will change for the ratings agencies; if they stay whole and go bankrupt, rating agencies will have to make difficult choices about how to deal with a new landscape in public finance.
Investment Banks- The investment banks that invested heavily in mortgage-backed securities and then insured them with FGIC or Ambac will suffer if Ambac or MBIA cannot pay the claims that they insured. More importantly, banks whose existing investments are insured by a monoline want to hold onto the value of their assets. A split destroys any hope that these banks have of retaining the rating, and value, of their securitized debt, and if this happens they will have to write down assets and report billion dollar losses. Citigroup, Merrill Lynch and more than 20 other banks and securities firms are still hurting from $146 billion in trading losses and writedowns after the subprime lending collapse, and they stand to lose even more if the bond insurers fail.
An international group of banks is engaged in talks with New York state regulators in an attempt to pull together the capital to save Ambac from a split. These include:
Royal Bank of Scotland (RBS)
Societe Generale (GLE)
BNP Paribas (BNP)
Each of these banks is sufficiently invested in Ambac's health to participate in these talks, but it is not confirmed that any own insurance on their securities through Ambac. Ambac and its competitors do not publicly release the names of clients that purchase insurance on structured private securities.
Other forms of insured assets, and their owners- Ambac ensures a variety of assets, and even its largest clients represent less than 1% of revenues. With only the most secure policies rating inclusion with municipal bond contracts in the event of a split, other types of assets that the firm insures will lose value when their rating declines. Other types of assets that Ambac insures, but that may be grouped with CDOs in a new subsidiary firm, include securities backed by:
Student loans- Ambac insures the bonds that student loan organizations rely on to raise financial aid funds for colleges and universities. A large percentage of this aid is funded by investors who purchase bonds from state and federal programs, and these buyers are hesitant now as they fear a drop in the rating of these assets. Colleges could have difficulty fundraising for financial aid in this fiscal year, resulting in cutbacks to their programs. In the long term, student loan organizations will find another stable source of insurance, but the turmoil in the sector has unfortunately coincided with the 2008 college admissions season. It will likely be more difficult for students to fund their educations this fall. 
Auto loans and leases- Similar to securities backed by mortgage payments, monoline companies insure securities backed by collections of auto loan payments, lease payments, or fleets of rental cars. These securities are likely to decline in value, and pay less interest, after a split, which will lead investors to avoid these assets. The auto industry could struggle with cash flow in the short term, until a stable insurer can be found and confidence in these investments can be rebuilt. Hertz Rental Car, for example, relies on bonds insured by Ambac to finance its new acquisitions of rental cars. These acquisitions allow Hertz to increase its customer base, and revenue growth will slow without the capital to fund fleet expansion.
What if Monoline Insurers Don't Split?
There are major obstacles to a plan to split these insurers into separate subsidiary businesses. The reach of the potential crisis is wide enough that banks and lawmakers are working together to find the necessary capital to alleviate the debt burdens faced by the insurers. This would in turn ease the pressure of a potential credit rating drop and allow Ambac and MBIA to jump start their revenues once again. MBIA has already raised $2.5 billion in concert with the private equity firm Warburg Pincus, and Ambac is working with a coalition of banks in a similar effort (for a list of these banks, see above). There are two possible permutations of this scenario - in one, the firms stay whole and through the ongoing joint efforts retain their ratings. In the second, the firms don't split but are unable to raise sufficient funds to cover their debt and lose their credit rating.
Investment banks- The same banks that are losers in the event of a split are winners if legal action, loaned capital, or something else rights the ship and allows Ambac and MBIA to stay whole and keep their credit ratings intact. These banks were attracted to the insurance offered by MBIA and Ambac because their less stable investments (mortgage-backed securities) could attain the same class as a low-risk municipal bond via the insurer's credit rating. If these securities keep their ratings, the investment banks will not have to write down their value and could potentially avoid billions of losses on their balance sheets.
Issuers of other forms of insured assets- Organizations that issue securities backed by debt obligations, like student loan organizations and auto companies, are already losing in the short term as it is hard for them to attract buyers for securities with murky ratings status. In the long term, however, credit ratings will stabilize, and so will the market for loan-based securities.
Owners of insured assets, other than municipal bonds- Current owners of securitized assets insured by monolines will also benefit, just as investment banks will, if these assets continue to be grouped with municipal bonds. Grouping stable municipal bonds with other securities drives up the firm's overall rating and those of every asset it currently insures. MBIA, Ambac, and FGIC insure a wide variety of assets - MBIA issues policies on assets backed by commercial real estate leases, credit card payments, and auto loans, among other receivables.
FGIC Corp.- FGIC, in the worst shape of the big three monoline insurers, is most in need of an approved split. This will protect its municipal bond insurance business and allow it to begin rebuilding its revenues. On the other hand, a legal decision to prevent a split, or a decision by ratings agencies to issue one credit score for the combined company, will deal a crippling blow to FGIC.
Federal, state, and local governments- If the monoline insurers lose their ratings, it would strip the implied triple-A rating from thousands of municipal bonds that are insured by these firms. The plummeting value of these bonds will scare investors away from purchasing new ones. This will increase the borrowing costs of cities, states and other issuers in the short term, as they will have to offer higher interest rates to attract buyers. In time, however, stable insurers will emerge and investor confidence will rebound, allowing interest rates to return to normal and governments to resume their typical fundraising activities. Governments will could also emerge unscathed if plans to save the firms and preserve their credit ratings succeed.
Owners and traders of municipal bonds- A blow to insurers' credit ratings would smart most for the individual investors that bought the bonds that lost their ratings. Owners of mortgage-backed securities have already written down billions of dollars in assets, but the crisis has not spread to all reaches of the bond market. If the companies stay whole and lose their ratings, it will hit the foundation of the bond market, low-risk municipal bonds. This crisis, however, is almost too serious to actually happen - those who stand to lose billions will funnel the necessary capital into the companies, one way or another, to keep them afloat.
Why Subprime Lending Might Impact Credit Ratings
Companies like Ambac and MBIA depend on their credit ratings to operate - each customer comes to a monoline insurer to guarantee an asset at the most secure level. Bonds that are not insured with a AAA rating are called junk bonds, and these carry a higher level of risk and serve a different class of investor. The stable business of insuring municipal bonds allowed the monoline firms to build their ratings, but they risked this status when they decided enter the booming mortgage-backed securities market in the past decade. The spectacular failure of many of these securities has left the insurance companies with billions of dollars in unpaid claims, and these debt obligations have thrown their balance sheets into instability. The leading credit agencies, Moody's (MCO), Standard & Poor's, and Fitch Ratings, have threatened to downgrade the bond insurers from their currently AAA levels due to these huge debts. However, this decision will have sweeping impact, and banks, legal professionals, and politicians are working together to avoid this crisis. All of the bonds insured by MBIA and Ambac, worth billions of dollars, would suddenly plummet in value in the event of a ratings downgrade. Investors would sustain huge losses as they wrote off these devalued assets. The monoline insurance firms might not survive at all, as without a AAA rating they would struggle to find new customers to build revenues and cover their debts.
Anticipating this situation, the third-largest bond insurer, FGIC Corporation, owned by the mortgage insurer PMI Group and three private equity firms, has proposed splitting its business in two, with one half focusing on municipal bonds while the other is left with the mortgage-backed securities mess. FGIC was forced to take desperate measures after all three major credit ratings agencies downgraded its status. Moody's lowered FGIC's score a full six notches in February 2008, from AAA to A3, threatening further demotion if the firm did not demonstrate progress in raising capital to cover its debts. An A3 rating will prohibit FGIC from doing business with municipal borrowers, the lifeblood of its revenues. In FGIC's proposed solution, a new company would inherit a total of $224 billion in existing insurance contracts on municipal bonds, while the existing FGIC would hold guarantees on about $72 billion in mortgage-backed securities. The new entity focusing on municipal bonds would theoretically retain a AAA rating, while the other half of the business would deal with the fall-out from a rating downgrade. Questions persist, however, about the legality of such a move, and about whether credit agencies will view the split company as two separate entities, as FGIC hopes, or whether they will continue to apply one rating to both sides of the split firm.
Investor Warren Buffet proposed another solution for the industry's other leading firms when he offered to reinsure Ambac and MBIA's municipal bonds through his own newly created subsidiary of Berkshire Hathaway. This would guarantee stability in the credit rating for bonds that Ambac and MBIA had already insured and allow them to resume underwriting new bond insurance contracts, with Buffet's firm receiving a cut through their role as a third party backer. As beleaguered as the two firms were at the time of the offer, however, both declined. Buffet was asking them to surrender a slice of revenues from the stable side of their business, without offering any solution to the problems plaguing the other part of the house.
Since then, the prospects have improved for both firms - in a February 14, 2008, meeting of the House Financial Services Committee, all parties involved agreed that neither Ambac nor MBIA are in danger of defaulting on their obligations. The firms are still exploring their options, but all three companies are under pressure from financial institutions and government officials to find a solution to the perceived gap between their debt obligations and ability to pay claims. The proposed plans to split FGIC and Ambac would allow the insurers to continue to operate the "good" side of their house, the original business of insuring municipal bonds. But what about the "bad" side of the house, now concentrating mainly on mortgage-backed CDOs and other types of securitized debt? Splitting the firm would essentially admit defeat in this market, as the new firm would be highly leveraged with little chance of attracting new business given its low credit rating. The firms would divert capital to covering existing claims, and once these were stabilized they would decide to dissolve the business, sell, or possibly to resume insuring certain types of securities and rebuild credit rating over time.
Last edited by netrashetty; February 21st, 2011 at 05:49 PM..