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Goodbye, Mr Bond

Created:
30 June 2008
Updated:
1 July 2008
Written by:
Simon Thompson

At the start of this year I opened this column with a quote from Henry Kaufman, chief economist at Salomon Brothers: "I never felt good about being called Dr Gloom, but I never worried about it either, because I think you should try to say it as it is. You're not in a popularity contest here." (Bad Tidings, 7 January 2008.) Unfortunately, I have more bad tidings.

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Monoline Madness

My primary concern for equity markets six months ago centred around the US monoline insurers. At the time, I noted that these insurance groups had underwritten credit default contracts on an eye-watering number of sub-prime mortgages. That is all well and good as long as default rates on the underlying mortgages remained low. However, this clearly has not been the case, as seen by the plunge in their secondary market values. As a result, the monolines have been writing off billions of dollars in the past six months to reflect the losses on these insurance contracts. Their shareholders have been nursing losses, too, with share prices in free-fall across this niche sub-sector of the insurance market. In turn, this makes it harder, or in some cases nigh impossible, for the insurers to raise new lines of capital to rebuild their battered balance sheets.

This financial weakness has not been lost on the credit reference agencies as Moody's recently downgraded the ratings on the two largest monoline insurers, Ambac and MBIA, from 'AAA' to 'double-A' and 'single-A', respectively. Both ratings have a negative outlook which means that the agency believes there is scope for further downgrades. You may ask what relevance this has to equity markets? The answer is a great deal, because I believe a chain reaction is about to be set off that will lead to carnage in the bond markets and which will, by consequence, lead to severe losses in the equity markets.

To put the size of the problem the bond market is facing into perspective, Ambac and MBIA between them have guaranteed over $1,000bn (£505bn) of bonds issued by municipalities and structured finance groups. As a result of these guarantees, the bonds also carry 'AAA' ratings which enable the issuer - for example, a US state looking to raise capital to finance an infrastructure or school-building project - to enjoy a lower cost of capital than would have been the case without the monoline guarantee.

Rating downgrades

The problem is that all the US monolines have lost their 'AAA' status, so some of the bonds these insurers have guaranteed against default now carry a higher rating than the insurers that are supposedly guaranteeing them! This is an untenable situation, and it seems to me only a matter of time before the rating agencies start downgrading the ratings of these bonds. The inevitable consequence is that such debt will be dumped, because many of the money market and fixed-income asset managers holding them are obliged to invest in 'AAA'-grade paper only. Unfortunately, it gets worse. If the bonds are downgraded, they'll have to go.

Worst-case scenario

The bond insurers are currently in talks with the banks, who are counterparty to the guarantees they have issued on risky debt securities, about wiping out $125bn (£64bn) of insurance to limit the financial damage to the insurers. However, even if an agreement is reached, the banks owning these risky investments would face further asset write-downs as these holdings would be devalued without an insurance guarantee against default.

It also seems a high probability that some of the weakest insurers, unable to honour their guarantees, will go into 'rehabilitation', a form of Chapter 11 bankruptcy. If this scenario plays out then the institutions holding the credit default cover issued by these insurers have a worthless insurance contract. This is most pressing for the insurance issued on defaulting sub-prime mortgages, as it will lead to another wave of asset write-downs on investment books of financial institutions to reflect these previously 'insured' losses.

Another round of sub-prime asset write-downs is not the only bad news for stock markets, though, as there could be pressure on some bond holders to raise cash quickly by selling equities to meet margin calls on the falling value of these bond holdings.

Corporate bond defaults

A rising tide of corporate defaults from over-geared companies affected by the economic slowdown is likely to exacerbate problems in the bond markets. Moody's forecast that default rates on speculative-grade bonds will increase from the current level of 2 per cent to 5 per cent by the year-end, and to 6.3 per cent by May 2009. To an extent, bond investors are taking this into account; the percentage of issuers with debt trading at distressed levels was 17.5 per cent in May, up from just 1.3 per cent a year ago. However, this is a far cry from the previous peak of 40 per cent, which came four months before stock markets last troughed out in March 2003. That is very significant, as investment bank Morgan Stanley notes that in past equity bear markets corporate bonds only start to rally four months before equities bottom out. Both asset classes have to trough out first.

Forced selling by US money market and fixed-income funds, rising corporate default rates, widening credit spreads (due to higher risk-aversion) and a steepening yield curve (reflecting inflationary worries) is a toxic mix that has clear potential to create turmoil in the bond markets. In the circumstances, I expect equity markets to endure a turbulent time, too.

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