The AIG bailout may not be the end of the credit insurance problem

[Draft originally posted  September 17th and revised– comments about errors would be appreciated].

 

The Federal Reserve System socialized AIG because of their CMO credit insurance exposure. Is this the last chapter in that book? Can we now sleep better?

Alas, no, I don’t think so. It’s chapter one of what may turn out to be a long, sad story. As they say, it is still a dark and stormy night.

Most of you know the outline of the AIG bailout because it was roundly discussed in The Wall Street Journal and on CNBC, in addition to the press in general, blogs, and other media sources. So I won’t revive the details of the intervention, just a brief summary.

AIG is a holding company that owns subsidiaries in all areas of traditional insurance (life, fire, property, fixed and variable annuities) and businesses unrelated to insurance, such as aircraft leasing. But AIG, through its subsidiaries, had also invested directly in CMOs and wrote insurance against CMOs in the form of mortgage guaranty insurance and credit default swaps. According to a Standard and Poor’s stock report on AIG dated September 16, 2008 (yesterday) 11% of AIG’s $860.2 billion of invested assets were comprised of this mix of mortgage obligations.  That number, $94 billion, goes a long way toward explaining why the Federal Reserve and Treasury Secretary Paulson came up with the number of $85 billion in their 2-year line of credit extended with FRS money to AIG.

And that is what was extended – a line of credit (rather than, say, a direct cash transfer loan) priced at LIBOR plus 8.5% that AIG can draw on as needed for up to two years. The “socialization” part arises from warrants given to the U.S. government for up to 79.9% equity stake in AIG if the company does not dance when Paulson pulls the strings.

Well Paulson has to get something for losing face. He just said that he wasn’t going to save any banks, and let Lehman fail to prove it, then he turns around and has the FRS save an insurance company, an area of business not normally regarded as under the jurisdiction of the FRS. Not even close. Unprecedented.

AIG’s salvation was made necessary by a downgrade in their Standard and Poor’s credit and debt rating from AAA to AA+ after market close on Monday. This downgrade set off trigger clauses in AIG’s mortgage insurance contracts that required AIG to post more collateral than it had access to and might have allowed third parties to back away from their swap obligations to AIG (I am not sure about the latter but I think it is true). AIG didn’t have the cash to cover their collateral requirements.

We were told that they were too big to fail. The domino effect. All that.

This is what nagged at me as I watched this drama unfold on CNBC and read about it in The Wall Street Journal. Sure, AIG is big, huge in fact, but 90% of their business is in insurance subsidiaries whose assets are completely insulated from their credit insurance subsidiaries (although I did read somewhere that AIG was considering at one point swapping assets with one or more of their traditional insurance subsidiaries to gain temporary liquidity, which, if true, was not only inadvisable but probably illegal). So what was described as too big to fail was only the credit insurance business.

But AIG didn’t have 100% of the market share in credit insurance. So far as I knew they weren’t even the largest insurer. Given that, how far does this “too big to fail” obligation extend.

There are about $650 billion in credit insurance liabilities out there in an unregulated industry held by a host of companies that have only $54 in reserves dedicated to coverage of this insurance. (See Gretchen Morgenson, “Credit Default Swap Market Under Scrutiny,” International Herald Tribune, August 10, 2008. This article also points out that as of that date, AIG had already written down its mortgage-related portfolio by nearly $30 billion).

Today I looked into that. I began by listing the other companies that I knew or suspected were in the business. That list included MBIA, Ambac Financial, MGIC Investment, XL Capital, Security Capital Assurance, FGIC Corporation, CIFG Holdings, Syncora Holdings Limited, and also potentially included large European re-insurers like Swiss Reinsurance and Munich RE.

I first looked at the latter, the two large European reinsurance companies and could find little reliable data, but what I did find gave me the impression that their exposure is not all that great.

I decided to then look at the two that are probably best know in the U.S., Ambac Financial and MBIA. I knew that Ambac had been scrambling around as of late, but I couldn’t find hard data.

I found hard data on MBIA though in the Standard & Poor’s stock report for the company dated September 13, 2008. Just as I thought, based on 2007 year-end data, they have much more exposure than AIG. Just to insure accuracy I’ll quote from page 2 of the document:

“At December 31, 2007, the net par value of the company’s insured debt obligations was $678.7 billion, of which ...[a long list of bond insurance obligations expressed as a percentage of this amount] ... U.S. structured finance obligations (asset/mortgage backed) 23%, and international structured finance 12%.”

Although some of this may be linked to credit card or commercial property CDOs (which are also in trouble and will provide future headlines), this seems to suggest that MBIA has exposure to at least $235 billion in mortgage-linked credit obligations and most of this “structured finance” is simply default insurance.

That is a lot more than $94 billion.

Now even though we have still only accounted for, at most, about one-third of the troubled mortgage credit insurance that is floating (sinking) around out there, it may not be time to panic. MBIA and Ambac Financial are supposed to be in much better financial shape than AIG. In June 2008 Standard & Poor’s dropped MBIA’s and Ambac’s bond insurer ratings from AAA to AA and put them on a CreditWatch. On August 15^th Standard and Poor’s removed the CreditWatch and affirmed the AA standing, which was a positive development and implied that capital holdings as of that date were above the amount required to maintain AA status.

Of course, as we know, Standard & Poor’s is not always ahead of the curve on credit ratings.

MBIA seems to have about $42 billion in liquid assets. In normal times that would seem like a lot but these days I’m not so sure.

In contrast to MBIA, the traditional bond insurance company, AIG, the general insurance company,  has been in an accounting scandal not unlike Fannie Mae and has had to remark their books accordingly, forcing veteran CEO Hank Greenberg out of his chair. The company has been through a maze of regulatory tangles in recent years.

Nonetheless,  little of this gives me a confidence in the hypothesis that AIG is the end of it. AIG may have been too big to fail but AIG is no more than a piece of a bigger jigsaw puzzle.

Credit default insurance is sort of like earthquake insurance along the San Andreas fault. You make a fortune in high fees until the day the 7.8 hits, and then every insurer is wiped out.

 Credit insurance is much like this because the statisticians that rated all of these insurers high assumed statistical independence between the CMOs that are insured, and just like global bond markets, there is no statistical independence in times of crisis.

By the way, despite hoary Hank Greenberg’s appeal to CNBC’s Maria Bartiromo (who never asks a hard question and seems to fall head over heels over whomever she interviews) to save AIG, it will be chopped up. One of strongman Paulson’s conditions for socializing AIG was to displace newly minted CEO Robert Willumstad before he had a chance to do his job and replace him with Bush/Paulson/Rove crony Edward Liddy whose last job was to chop Sears, Roebuck, and Company into pieces. Sorry Mr. Greenberg. Your legacy and cash have gone the way of Lehman and Bear. Nobody respects tradition anymore.