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Ratings Collapse by Martin D. Weiss Ph.D. 12/24/2007
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I'm getting some R&R in the interior of Brazil right now.
So I was planning to save this particular discussion for after the holidays.
But a major debacle is brewing in the bond market, and the first major shock waves could hit in the early days of the New Year.
So I wanted to give you a heads-up right away.
Here's what's happening:
First, MBIA, the world's largest bond insurer, is on the verge of losing its triple-A rating.
Second, that single event could trigger a veritable ratings collapse — downgrades on the one hundred and seventy-three thousand municipal bonds, mortgage-backed securities and other collaterized debt obligations (CDOs) that MBIA guarantees.
Third, the three other large bond insurers — Ambac, FGIC and CIFG — could also lose their triple-A ratings, spreading the crisis to nearly all of the nation's $2.3 trillion of insured securities.
Fourth, since lower-rated bonds are invariably lower-valued bonds, when they're downgraded, there will be an across-the-board downward adjustment in bond prices — a bond market crash.
Fifth, investors may begin to seriously question Wall Street's entire system for rating the nation's $2.6 trillion in municipal bonds … $10.6 trillion in corporate bonds … and $1.9 trillion of commercial paper and other money market instruments.
In short, this crisis could raise doubts about the true value of all non-Treasury securities — whether insured or uninsured, long term or short term, at risk or not at risk.
The net result:
An Unprecedented Flight
From Risk to Safety
Investors will rush to sell any bond or money market instrument in doubt — not only the mortgage-backed securities and CDOs that are already pariahs of the investment world today, but also …
Local and state tax-exempt bonds
At the same time, investors will rush to buy …
Treasury securities
Needless to say, the Fed will respond with massive money pumping. And if MBIA can receive a massive capital infusion, a bond market panic may be avoided for now.
But any capital infusion is unlikely to be more than a temporary band-aid. No matter how the crisis is ultimately resolved, you're bound to see a substantial flight to safety.
Consider the Facts Already
Revealed Last Week …
Fact #1. MBIA has guaranteed $8.1 billion in securities that are among the most dangerous in the world — an especially risky variety of CDOs which themselves are made up of CDOs (called "CDOs squared").
In other words, MBIA doubled up its risk on an already-risky investment; and it did so in huge amounts.
Fact #2. On September 30, 2007, more than two months before the latest revelations, MBIA's stockholders equity was only $6.5 billion. That means the $8.1 billion in these double-risk CDOs alone represent 125% of MBIA's total capital.
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Fact #3. In total, MBIA has guaranteed $30.6 billion in mortgage-backed securities and CDOs — and these are now plunging in value due to rapidly spreading mortgage defaults and widespread investor flight.
This broader category of risky investments represents 470% or nearly five times MBIA's capital.
Fact #4. The company has not provided estimates of how much money it could ultimately lose. But based on the latest price of MBIA's shares, the market is estimating that its losses are more than $7.5 billion.
Reason: As of Friday's close, MBIA's share price was off 73% this year alone.
The Entire Rationale of Bond Insurer
Ratings Is Now Out the Window!
When bond default insurance was first introduced years ago, my father and I questioned the methodology used to evaluate the risk on something that never existed before.
But the bond insurers hauled out an obscure, never-published Ph.D. dissertation about municipal bond failures in the Great Depression.
Their rationale: "All we need is enough capital to cover the worst-case depression scenario. Then, as long as actual default rates stay below those levels, we'll be in good shape."
The Wall Street rating agencies bought this argument hook, line and sinker. And the bond insurers have received triple-A ratings ever since.
But in recent years, in tandem with the housing bubble, the bond insurers have also insured massive amounts of mortgage-backed securities and other CDOs, for which there was no historical precedent whatsoever — not even an obscure thesis.
In other words, they abandoned the original basis for bond insurance and marched off into completely unchartered territory.
Now, a large percentage of these new investments are in default … or soon will be. And now, the entire rationale underlying bond insurance is out the window.
Investors Are Finally Waking Up
And Smelling the Coffee
We've been warning about this for a long time.
Over 12 years ago, we sent out a press release to more than 2,000 reporters, denouncing serious conflicts of interest in the insurance company grades awarded by Wall Street rating agencies. (See our 1995 press release, "Fees Taint Insurance Company Ratings.")
Years later, we provided proof after proof of a similar bias in Wall Street stock ratings in …
- "Crisis of Confidence on Wall Street"
- "47 Brokerage Firms Recommended Shares of Failing Companies Even as They Filed Chapter 11 in 2002"
- "46 Brokerage Firms Continue Pattern of Recommending Failing Companies Despite Intense Regulatory Scrutiny"
- "Publicly Available Ratings From 66% of Brokerage Firms Continue to Recommend Failing Companies"
- "New Rules for Broker Research Fail to Resolve Conflicts of Interest"
… just to cite a few.
And now, we've stepped up our warnings about the coming bond insurance debacle in "Next Phase of the Crisis: The Great Ratings Debacle" and "Wall Street Downgrades about to Hit Hard."
Until recently, few observers agreed with us, and fewer still heeded our warnings.
But the new facts coming to light in recent days are so blatant, it's now hard for all but the most optimistic of Pollyannas to ignore …
Morgan Stanley:
"We are shocked that management withheld this information for as long as it did. … This new disclosure completely changes our view of MBIA being a 'more conservative underwriter' …"
RBC Capital Markets:
"This is … a major event. The complexity of these deals and the amount of leverage involved is incomprehensible."
Reuters:
"Triple-A ratings are a core part of the business model for the industry, and lower ratings may cause a ripple effect that forces more Wall Street banks to take billions of dollars of losses on the insured securities."
Times Wire Services
"[This is] calling into question the safety of tens of billions of dollars of corporate and local government debt held by investors.
"MBIA is the largest of the AAA-rated bond insurers. Because of its size, many analysts have warned of dire consequences for the bond market if MBIA is downgraded, which would in effect prevent it from issuing new policies. Such a downgrade would have a domino effect: It would cause an immediate downgrade of many of the bonds insured by the company."
This Is Abundant Evidence
Warranting Quick Action!
I recommend the following steps:
Step 1. Sell all mortgage-backed securities — not only those that are already in trouble, but also those issued by government-sponsored agencies such as Fannie Mae and Freddie Mac.
Step 2. Sell any medium- and long-term municipal and corporate bonds.
Step 3. Get out of most mutual funds that invest heavily in these bonds.
Step 3. Avoid money market funds that have significant holdings in commercial paper.
Step 4. For hedging purposes, seriously consider inverse ETFs that are designed to protect you against the decline in specific stock market sectors. (For instructions, see my free report: "How to Protect Your Stock Portfolio From the Spreading Credit Crunch.")
Step 5. Stay on board with investments that we've recommended to help you transform this crisis into a major wealth-building opportunity.
Step 6. Move your keep-safe funds to short-term U.S. Treasury securities or Treasury-only money market funds such as …
- American Century's Capital Preservation Fund,
- U.S. Global's U.S. Treasury Securities Cash Fund, or
- Our affiliate's Weiss Treasury Only Money Market Fund.
Step 7. To help balance against the risk of another dollar decline, allocate some of your money to foreign currency ETFs, such as Rydex's Japanese yen ETF (FXY).
Good luck and God bless!
Martin
P.S. We're off tomorrow. So our next issue will be Wednesday.
P.P.S. I'd hate to see you miss out on my 5 Emergency Investment Guides. But they're available free only until December 31, one week from today. Click here for all the details.
