Spitzer probe threatens MBIA bond guarantees

Investigations by New York attorney general Eliot Spitzer and US regulator the Securities & Exchange Commission into market abuses by the insurance industry have focused firmly on two of the industry giants, AIG and MBIA Insurance. Accounting irregularities at the two firms have made April another worrying month for insurance sector spreads and sentiment towards ratings.

MBIA overstated profits by $54 million and was forced to restate seven years of results based on incorrect accounting for two insurance deals in 1998, spurring several class action lawsuits. More worryingly, the firm was hit with additional subpoenas from Spitzer and the Securities and Exchange Commission over and above those it received in late 2004. The investigations relate to MBIA’s accounting treatment of advisory fees; how it determines loss reserves and case reserves; purchasing credit default protection on itself; and documents relating to Channel Reinsurance, part-owned by MBIA.

Triple-A trouble

Maintaining its triple-A rating is paramount to MBIA and, by extension, a large proportion of the market. The elite status is transferred to nearly all of the roughly 100,000 bond issues the firm guarantees. MBIA Insurance has been, and still is, rated at the highest level by Standard & Poor’s (since 1974), Moody’s (1984) and Fitch (1995).

The importance of the nine ‘A’s is not lost on MBIA. According to its 2004 report, the insurance giant firmly states that having the highest rating possible is “the keystone of our franchise”. John Hallacy, managing director of public finance, adds that MBIA’s “objective is to maintain that triple-A, and we’re not going to do anything to put that at risk”.

MBIA’s immense clout in the market is evidenced by the volumes of debt it guaranteed last year, a whopping $585.6 billion. Of this, $367.2 billion was municipal bonds, 18% of the market. MBIA also backed $218.4 billion in domestic and foreign structured finance deals, which include asset- and mortgage-backed securities, as well as foreign public finance bonds and collateralised debt obligations.

Though analysts say that any risk to MBIA’s financial strength is not thought to be immediate, they do warn that the prospect or threat of a downgrade, such as a change to a negative outlook, would be severely detrimental to the firm’s business. According to Deutsche Bank, MBIA has guaranteed 5% of all triple-A asset-backed bonds launched since 1999. If the company was cut to double-A plus, 80% of the securities MBIA insures would suffer a ratings cut, leaving a paltry 20% at triple-A.

“A downgrade would have significant repercussions in the structured credit market. Because MBIA guarantees so many triple-A tranches of asset-backed issues, a ratings downgrade would cause those bonds to widen sharply,” says Rob Haines, insurance analyst at CreditSights in New York.

The importance of the triple-A rating to MBIA’s business, adds Haines, makes the firm’s debt and equity vulnerable to any news that its ratings are at risk. This was borne out by MBIA’s bond market valuations weakening substantially on news of the accounting problems. Five-year credit default swaps were trading more like a triple-B credit last month, widening from 39/42 to wides of 100bp before resting at 80/85 on April 18. “Spreads have been pretty beaten up, but they have not just moved on MBIA-specific news; Spitzer’s investigations into AIG and others in the industry have also buffeted spreads,” says Arun Kumar, insurance analyst at JPMorgan.

Question marks over MBIA’s credit quality have been raised before (see Credit, March 2003, pp. 26–29), when US hedge fund Gotham Partners published a report on its website entitled Is MBIA triple-A?. The hedge fund claimed that MBIA was excessively leveraged and had incurred estimated losses of between $5.3 billion and $7.7 billion on its underwriting exposure to CDOs.

Sean Egan, managing director of Egan-Jones Ratings, says that MBIA’s new policy sales dropped from $568 million in 2003 to $220 million in 2004 because of reduced demand and increased competition. And Egan expects fines and curtailment of business lines on the back of the investigations. “MBIA and MBIA Insurance are not triple-A credits because of the slim capital and soft demand and margins. The level of cushion is not enough to sustain triple-A ratings,” he says.

Nonetheless, a host of others are not as critical of MBIA. One favourable voice is CreditSights’ Haines, who believes that fears have been overplayed and though the spotlight on the company has affected its valuations, this could provide investors with good trading ideas. “We expect spreads to materially tighten from current levels. Consequently, we believe MBIA represents one of the more attractive relative values in the insurance sector,” he says.

Tarnished

AIG has also come under regulatory pressure. The insurance company surprisingly delayed the filing of its 10-K until April 30 after allegations that it had used improper finite reinsurance contracts to inflate its net worth and smooth earnings figures.

On March 30, AIG management disclosed that a number of questionable transactions since 2000 would result in a decrease to AIG’s shareholder equity of $1.7 billion, triggering the resignation of Maurice ‘Hank’ Greenberg, the firm’s CEO for the last 38 years. Other concerns relate to bonuses being paid to AIG staff via subsidiary Starr International and questionable ties with other subsidiaries.

Confidence in AIG was not helped when a number of employees tried to remove documents from AIG’s Bermuda office at the start of April.

The rating agencies were quick to take action. Fitch led the charge against AIG on March 15 by removing the firm’s coveted triple-A crown, leaving the firm on AA+. Standard & Poor’s and Moody’s matched Fitch at the end of March, downgrading AIG to the same level. All three agencies left the company on review for downgrade.

Despite their speed of response, some have questioned the actions of the rating agencies. For Rafael Villarreal, insurance analyst at BNP Paribas in London a review for downgrade was reasonable but he believes it would have been better to wait until submission of the 10-K and all relevant information had been disclosed before taking rating actions. “The rating agencies have pulled the trigger before all the facts are known. This is not the right way to proceed,” he says.

Fitch has kept AIG on negative outlook since March 2003, an example of “poor rating management” for Villarreal, who believes that sitting on the fence with positive or negative outlooks for so long does not help investors at all. “Except on limited circumstances, unresolved outlooks and long lags in rating actions are useless to the market they serve,” he says.

Villarreal believes that investigations into AIG’s non-life insurance business will have little effect. The unit represents roughly 30% of operating profits and the adjustments will impact only a small proportion of that division. More importantly one cannot ignore the fact that AIG has been successfully writing profitable business across the globe for many years. The firm has $83 billion in shareholders’ funds, substantial income from a diversified business and strong business fundamentals, superior to all European insurance groups.

Haines at CreditSights is another strong advocate of AIG’s creditworthiness. “Although the loss to its triple-A rating is clearly a significant event for AIG, we do not expect the company to fall out of the double-A ratings bracket. The company’s capitalisation remains strong, its financial leverage is conservative and its coverage ratios remain solid,” he says.