The credit rating house of cards

Never mind whether a recession is coming or not. The real thing to worry about is the health of the bond insurance industry.

Published December 17, 2007 6:20PM (EST)

Could anything be more comforting, in financial terms, than the words "assured guaranty" coming from an insurance company? Some might call the phrase redundant -- doesn't a guarantee already imply a certain level of assurance? But still, in uncertain times, the double layer of semiotic protection is, uh, reassuring.

On Thursday, Assured Guaranty, a Bermuda-based financial services company that provides "credit enhancement products" to other financial institutions, announced that it was reinsuring $29 billion worth of securities already insured by Ambac, another financial services company in the credit enhancement business.

Both Assured Guaranty and Ambac fall into the specialized category of "monoline bond insurance" companies. The word "monoline" just means that the company so described focuses specifically on one type of financial service -- in this case, insuring against the possibility of bond default. It's not glamorous work, but the seven or so major monoline bond insurers play a pivotal role in the world financial system -- they provide insurance that backs up the high credit ratings structured finance products must have in order to function as viable investment opportunities.

On Friday, Moody's announced that it had put the Aaa ratings of two major bond insurers "under review for possible downgrade" and that the outlooks for two others were "negative." On Monday, Bloomberg reported that the decision "casts doubt on $1.2 trillion of municipal, corporate and asset-backed securities."

The problem is that if a bond insurer loses its Aaa rating, then so too may the bonds that it insures. Many institutional investors -- pension funds and the like -- are required by their own rules to only invest in Aaa securities. If credit ratings are downgraded, they would be forced to dump their holdings into a market where no one is particularly eager to buy. The resulting plunge in market value across the globe could be enormous.

Bloomberg reported one hedge fund analyst as saying that "Everyone understands the systemic risk if even one of these companies is downgraded," but Calculated Risk is less confident that the true severity of the problem has gotten through to the general public.

Does everyone understand the systemic risk? I'm not so sure. This warning puts 89,709 public finance issues on negative watch and probably impacts most communities in the U.S.

Ambac however, did not get its credit rating put on alert, because of its success in purchasing reinsurance from Assured Guaranty. Unlike the other monoline bond insurers, Assured Guaranty is regarded by the ratings agencies as in excellent health. The reason? It somehow managed to avoid the same level of exposure to collateralized debt obligations linked to subprime mortgage bonds as suffered by everyone else. As far back as Aug. 1, Assured Guaranty was telling the market that it was comfortable with its exposure to that sector, and in retrospect the company appears to have been telling the truth.

How this happened is unclear. But there's an interesting little back story. Assured Guaranty was spun off in an IPO in 2005 from Ace Limited, a Bermuda-based insurance conglomerate run by Evan Greenberg. Ace still owns a big chunk of Assured Guaranty.

If the name Greenberg sounds familiar, it's only because it is one of the most famous in the global insurance business. Evan Greenberg is the younger son of Maurice "Hank" Greenberg, who for many years was the CEO of AIG, the mighty insurance colossus, until brought down by the investigations of then-New York State Attorney General Elliot Spitzer. The younger Greenberg worked for his father for almost 20 years, until he either jumped or was pushed out. His decision to join Ace, a smaller version of AIG, stocked with a number of ex-AIG employees, was seen by some as an attempt to gain revenge for his ouster.

Evan's older brother, Jeffrey Greenberg, also went on to fame in the insurance industry, eventually becoming CEO of Marsh & McLennan, before he too was dismissed as a result of a Spitzer investigation.

But in the beginning, Evan was the family member considered least likely to succeed -- he did not graduate from college, and bounced around from small-time job to small-time job -- a cook in a nursing home, bartending -- before going to work for his father. Now, somehow, a partially owned subsidiary of the company he runs has, so far, managed to escape the subprime contagion. We'd like to know his secret -- how is it that while all the rest of Wall Street was getting stuck up to their necks in the subprime tarpit, Assured Guaranty danced right around it?

UPDATE: A bounty of more detail on monolines from a reader.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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