Monolines the next shoe to drop?

Australian Financial Review, February 2008

Investors have weathered the storm of sub-prime, the credit crunch, a possible US recession and falling local and global stock markets. But they’re not out of the woods yet. The next thing to worry about: monolines.

 Monolines are global bond insurers. They came into being in the US to insure US municipal bonds against credit losses. The best known are MBIA, AMBAC and FDIC and until recently they were seen as some of the strongest and most impregnable financial institutions in the world.

 Over the years they have expanded from their original market guaranteeing municipal bonds, and have started to ensure bonds issue by other groups such as utilities, toll road operators and other infrastructure assets. Since monolines have always had AAA ratings – the highest there is – they offered a simple proposition to bond issuers: involving a monoline raises the creditworthiness of the whole deal, and hence lowers its cost. In return, issuers pay a fee to the monoline itself.

 For the monolines, the AAA rating is everything. Without it, they don’t really have a lot to add because the economics no longer work: a lower rating would not improve the creditworthiness for a bond issuer, and so would not reduce the pricing enough to make it worthwhile to use the monoline in the first place.

 But now, the monolines have been caught up in the same sub-prime problems that have blighted the world’s investment banking industry over the last 12 months. They have had exposure to sub-prime collateralised debt obligations, which are basically bonds packaged together out of lots of low-quality assets, and this exposure is now coming back to haunt them.

 FGIC was the first to take a hit when Fitch Ratings, one of the three key rating agencies, downgraded the AAA rating from FGIC’s bond insurance arm. Then, on January 31, MBIA, the biggest of them all, posted its biggest every quarterly loss, of US$2.3 billion. At the time of writing, MBIA was fighting to convince rating agencies that it should keep its own AAA rating. And if it doesn’t, then the ratings of all the securities it guarantees – US$652 billion – are also put in jeopardy.

 This might all seem distant from Australia, but investors are increasingly worried that the effects will be felt here too. “For a number of infrastructure projects in Australia, in particular toll roads, various parts of the funding have been insured by the monolines,” says Matthew Hegarty, senior equity analyst at Global Value Investors in Sydney. “They bring their credibility and the triple A rating, and it also means for the arranger that the pricing is more competitive because the monolines have lent their reputation to it. But if their credibility is shot – and potentially it is irreparably damaged forever – then that will create a global crisis in being able to attract funding. It’s going to put up pricing for many transactions, and make it more difficult to source funds at competitive rates.”

 So one impact is that the construction of infrastructure in this country becomes trickier, because it’s harder to get the funding. But there’s a clear potential impact on stock markets too. “You would want to look closely at various sectors in global equities,” Hegarty says. He’s been going through his global portfolio to look for utilities companies who have monoline guarantees. “You also want to be steering clear of companies worldwide which have to roll significant funding, because they may not be able to roll that debt.” Many companies use a short term form of debt called commercial paper, which typically comes due within a year; in a healthy environment it’s easy to refinance that from year to year, but it credit suddenly stops being available they risk going into default. And if that happens, naturally the share price would plunge.

 In Australia, listed infrastructure vehicles and property trusts are obvious areas to look, particularly where heavy gearing through short term debt is involved (this is part of the reason Centro Properties hit bad times late last year). Financial companies are vulnerable too, although it’s the ones with weak capital positions who are the most vulnerable, and on a world scale Australia’s major banks are quite strong in the balance sheet.

 Whatever the knock-on effect, monolines, who have been a key part of the financial services industry for 30 years, will never look the same again. “This is an industry that has never recorded any significant losses,” says Hegarty. “And now, for the first time, it has losses and they are potentially catastrophic.”