Martin Vander Weyer on the next thing to cause heartburn in the financial markets.
The current market crisis sometimes feels like a Scrabble championship between financial pundits, in which most of us hesitate to challenge dubious words and strange jumbles of letters for fear of showing ignorance. First came ‘subprime’, which we learned to define as a category of mortgage borrowers so uncreditworthy they cannot even afford the hyphen the Spectator’s learned sub-editors would prefer to insert between the ‘sub’ and the ‘prime’. Then came a rash of acronyms encapsulating both the science of subprime lending and the alchemy of securitisation by which its poison has been spread around the world.
‘Nina’, for example, refers to ‘No Income No Asset’ mortgages granted without any financial information about the borrower except possibly his own undocumented assertion that he actually has a job with a salary. ‘Ninja’ is an even more exciting lending proposition: it stands for ‘No Income No Job No Asset’. And a Siv (as in ‘seaworthy as a…’) turns out to be a ‘structured investment vehicle’ which borrowed short in order to invest long in paper backed by bundles of Ninas and Ninjas.
So it goes on. Now we have ‘Federline’ – oh no, sorry, that’s Kevin, the chap who had the misfortune to father Britney Spears’s children – and ‘Monoline’. The latter really does notch up a big score in our Scrabble game: it refers to a group of US insurance companies that have operated since the early 1970s in such a trouble-free way until recently that most of us were unaware of their existence. Their role was to provide guarantees for municipal bonds – and to pursue no other line of business, hence the name. By purchasing a guarantee from a monoline such as Ambac Financial or MBIA, US state, city or county borrowers were able to obtain Triple-A ratings for their bonds, and therefore pay the lowest coupon, or interest rate, available in the market. Since municipal bonds very rarely defaulted, monolines were able, prudently and without attracting adverse comment, to issue guarantees which amounted to more than 100 times their own capital base.
This was a satisfactory system for all parties – until the monolines climbed into bed with the Sivs and the Ninjas. Now it turns out that in addition to their core municipal business, they have guaranteed billions of dollars worth of subprime mortgage-backed bonds – and as more and more of the underlying mortgages go into default, those guarantees are sure to be called, threatening rapidly to exhaust the monolines’ modest capital and reserves.
Last month, Ambac (which has issued $500 billion of guarantees against $5.7 billion of capital) lost its triple-A rating from Fitch, one of the three major ratings agencies which have themselves come in for severe criticism for failing adequately to signal trouble ahead. The downgrading automatically caused the bonds under its guarantee, including all those issued by reputable municipal borrowers, to lose their own top ratings.
If the other two rating agencies, Moody’s and Standard & Poor’s, follow Fitch’s lead, then a huge sell-off of municipal bonds is likely to follow, causing chaos in that hitherto orderly market. Not surprisingly, shares in monoline companies have plunged – making it temporarily impossible for them to raise new capital from the stock market. Now New York’s insurance regulator is talking of a $15 billion bail-out of the monolines, while market doomsters are predicting losses in the sector of several times that figure.
The only good news – if we can call it that – is that every big bank in the world is probably holding a bucketful of bad mortgage-backed paper guaranteed by monolines, and therefore has an interest in helping to prop them up and recapitalise them. And the biggest banks so far caught in the subprime mangle – Citigroup, UBS, Merrill Lynch – have had remarkably swift access to new capital for themselves in the form of injections from sovereign wealth funds in the Middle East and Asia.
Added to those factors, it’s worth observing that Hank Paulson, the bald-eagle US Treasury secretary, is a former Goldman Sachs chief executive who – unlike his opposite number in London, Alastair ‘rabbit-in-the-headlights’ Darling – speaks the language of the markets, carries personal authority in them, and is daily involved in the nitty-gritty of trying to save them from catastrophe.
But if the monolines are too important to be allowed to go under, that doesn’t mean that the subprime hurricane has passed its peak: much of the damage is surely still to come – and the lesson so far is that those financial entities with the cutest acronyms and nicknames are the ones most likely to be caught by the contagion. My tip is to watch what happens to the other big US mortgage insurers, the Federal National Mortgage Association and the Federal Home Loan Mortgage Association – known respectively as Fannie Mae and Freddie Mac.