In that almost mystical way in which co-incidence happens, a real time occurrence of the risks I outlined in A Beginners Guide To Credit Default Swaps has appeared. With excellent timing S&P downgraded the rating of ACA Capital Holdings Inc to CCC or, as it is known, junk. Whilst not a happy occurrence, it does give us the chance to walk through the consequences.

ACA Capital Holdings Inc. provides financial guaranty insurance on municipal obligations, asset-backed and corporate financings, bank certificates of deposit and surety risks through its insurance subsidiary, according to Bloomberg. The downgrading of ACA means that the insurance given to municipal bonds and derivatives is also downgraded, effectively downgrading the assets themselves. This has consequences to those who bought the protection from ACA.
It works like this. ACA are in trouble, big trouble. They look unlikely to survive the credit crunch and with liabilities already higher than assets, any call made on the insurance they issued will cause a default. That default means the assets insured by the protection buyers become fully exposed to the market and therefore become riskier to hold. As with any risky asset, the price falls / yields rise because potential buyers of the assets would need a higher risk premium.

The fall in asset prices is also reflected in the same assets held by other institutions and banks and downward pressure on the asset type as a whole appears. This causes the risk exposure on the holding company to increase, putting its ratings under review, normally with a negative bias. Some Institutions have to sell any asset of derivative they hold if it falls below a certain grade or price, increasing selling pressure and lowering prices. Buyers meanwhile lower their offers in a falling market.
 

As can be seen above, the effect of a single default can have widespread and very damaging consequences, not just to derivative and asset prices but to the gradings of the banks and institutions that hold such paper.

In fact the risk was so great that as it appeared inevitable that ACA would be downgraded to junk, Merrill Lynch and Bear Stearns tried to launch a rescue package to postpone the event. S&P went ahead anyway.

You will notice in the diagram I have used CIBC, Canadian Imperial Bank of Commerce , as an example. For a very good reason too. Within hours of the downgrade of ACA, CIBC announced that it ” believes there is a reasonably high probability that it will incur a large charge in its financial results for the first quarter”. The fifth largest bank in Canada said that ACA insured about $3.5Bn of US subprime investments.

Unfortunately, S&P didn’t just look at ACA, they also placed AAA rated Financial Guaranty Insurance Co. on negative credit watch meaning there is a 1 in 2 chance of a rating downgrade in the next 13 weeks.
They also placed Ambac, MBIA and XL Capital Assurance on a negative outlook. This means the chances of a downgrade in the next 24 months is 1 in 3.

The importance of this move cannot be understated. If ML and BS felt threatened enough to attempt a rescue on ACA then everyone should take note. The fallout has only just begun. The tipping point may well be in the municipal bond markets. Municipal bonds gain the same rating as the Insurer who sells protection (a CDS on a MB) and that rating is oft transferred to the local government too.

If the rating on the Insurer is downgraded, so is the rating on the CDS, MB and the local government. Not only will yields rise on current issues but with the local government also “downgraded” future debt issues by them will have to be at a higher yield. This would require higher taxes and lower spending to service the higher debt payments.

In an economy already showing signs of stress, further burdens on the consumer and businesses would guarantee a recession.

Market Snippets

Morgan Stanley is the latest bank to receive a cash infusion from a foreign investor. MS said Wednesday it sold part of the company to China Investment Corp., for $5 billion to raise capital after taking $9.4 billion in writedowns on mortgage-related investments. In October, Bear Stearns Cos. agreed to a $1 billion cross-investment from Citic Securities Co.of China, while Citigroup received a $7.5 billion infusion from Abu Dhabi government last month.
Richmond Fed Pres Lacker in a speech in North Carolina, said “I am uncomfortable with the inflation picture” as November core PCE prices will accelerate; he added GDP is to be ‘very weak’ for several monthss before improving. He also said that financial markets will find ways to work through their problems and tighter credit may restrict spending, but if oil prices stay high monetary policy will be more difficult.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.