ASSURED GUARANTY LTD (AGO) 24.58 -$0.43 (-1.72%) 08:48PM (15 mins delay)

Moody’s (MCO) and Standard and Poor’s (S&P), the nation’s largest Nationally Recognized Statistical Rating Organizations, have faced a barrage of recent criticism over their ratings of structured finance assets. Continued criticism over past rating mishaps and reduced structured finance revenues are likely to pose the most significant challenges over the next year. However, it is interesting to consider whether the recent criticism has motivated Moody’s and S&P to provide competent and honest ratings. This will be done in two separate articles focused on two areas that have revealed major problems – ratings for residential mortgage backed securities (RMBS) and financial guarantors.

This article (Part 1) deals with financial guarantor ratings, which remain more troublesome than RMBS ratings. It suggests that Moody’s recent ratings are not as unrealistic as Standard and Poor’s ratings, some of which appear to be based on incompetence, fraud, or some combination of the two.

The table below outlines current ratings for three financial guarantors, Financial Security Assurance (FSA), Assured Guaranty Corporation (AG Corp.) (AGO), and MBIA Insurance Corporation (MBIA Corp.) (MBI). FSA was purchased on July 1 of this year by Assured Guaranty Ltd., AG Corp’s parent. The Moody’s ratings for FSA and AG Corp. are under review for possible downgrade.

FSA and AG Corp. will be discussed first. The following table, produced from the companies’ operating supplements, highlights the credit exposure by rating of each of these companies as of June 30, 2009. The ratings are internal, but they track closely with Moody’s and S&P ratings.

	Net Par Exposure (dollars in billions)
Rating	FSA	% of total	AG Corp.	% of total
AAA	71.6	17.2%	44.3	34.7%
AA	144.2	34.7%	17.2	13.5%
A	144.3	34.7%	43.7	34.2%
BBB	41.3	9.9%	16.2	12.7%
Below investment grade	14.48	3.5%	6.3	4.9%
Total	415.8	100.0%	127.7	100.0%

Net par exposure is the outstanding principal balance of amounts insured, less exposure ceded via reinsurance. The exposure transferred to reinsurers exposes FSA and AG Corp. exposure to reinsurer credit risk, but this is ignored for the purposes of this article.

Financial guarantors often refer to money available to absorb credit losses as “claims paying resources.” Claims paying resources are not quite as good as cash or risk free securities, because they include premium installments to be collected over a number of years, possibly after the funds are needed to pay losses. There is also a risk that future premiums turn out to be less than anticipated. For the purposes of this article, it will be assumed that claims paying resources are as good as cash.

The table below outlines claims paying resources for these two companies.

Claims paying	Billions of	% of net par
resources	dollars	exposure
FSA	7.28	1.7%
AG Corp.	2.72	2.1%

Under the assumption that future financial guaranty insurance writings will be adequate (but not more than adequate) to cover future operating expenses and credit risk on new policies, the tables above imply that $7.28 billion (1.7% of exposure) to fund losses is enough to boost the ratings of the $415.8 billion of credits insured by FSA to an S&P rating of AAA and a Moody’s rating of Aa3 Similarly, a $2.72 billion buffer (2.1% of exposure) is enough for a AAA S&P rating and a Aa2 Moody’s rating on the $127.7 billion of debt insured by AG Corp.

On the surface, this seems preposterous. Below investment grade exposure is twice claims paying resources for each company. Arguably, this might be enough to push the ratings below investment grade even if these credits were mostly rated BB (instead of CCC or lower), but the below investment grade credits are highly correlated and mostly at or near default.

Another way to evaluate the default risk on credits insured by the financial guarantors is to compare it with non-recourse debt issued by an investment fund that holds the assets insured by the financial guarantors. Assuming the fund holds equity capital equal to the financial guarantor’s claims paying resources and the average rate on the investment fund’s debt is the same as the rate earned on the fund’s assets, the risk of default on the fund’s borrowings should be very close to the risk that the financial guarantor defaults on insured obligations. The following table provides a simplified capital structure for two hypothetical investment funds that hold the bonds that FSA and AG Corp. insure, along with ratings that seem intuitively reasonable for different classes of debt issued by the funds.

Capital	Fund A	Fund B
structure	(FSA)	(AG Corp.)
AAA- rated debt	364.5	111.3
AA-rated debt	18.6	5.9
A-rated debt	12.9	4.0
BBB-rated debt	10.1	3.3
<BBB-rated debt	9.8	3.1
Equity	7.3	2.7
Total	423.1	130.4
AAA credit support	51.3	16.3
As % of total exposure	12.1%	12.5%
% of debt rated AAA	87.7%	87.2%
BBB credit support	17.1	5.9
As % of total exposure	4.0%	4.5%
Claims paying resources	7.28	2.72
As % of total exposure	1.7%	2.1%

Assuming these ratings are reasonably fair, this table implies that FSA and AG Corp. should be required to more than double their claims paying resources to justify BBB ratings. AAA ratings should require claims paying resources over six times as high as actual claims paying resources.

This oversimplified analysis does not consider the individual credits and the correlations between them. A more detailed analysis suggests more credit risk than this simplified analysis. Highly correlated mortgage-backed debt in or near default accounts for a high percentage of the below investment grade exposure for each company. In addition, a growing percentage of the remaining structured finance credits are facing increased stress, and insured municipal credits are facing budgetary challenges that are unprecedented in the past 70 years. Credit risk is highly correlated within each asset class, and is also correlated across asset classes. High mortgage defaults correlate with credit card defaults, and both correlate with municipal defaults, etc.

A strong case can be made that too much of the hypothetical investment funds’ debt is rated AAA (87.7% for FSA and 87.2% for AG Corp.), given the thin layer of equity capital (1.7% for FSA and 2.1% for AG Corp.) and relatively small percentage of AAA-rated assets. Some might also argue that more of the debt should be rated AAA. However, it is absurd that 98% should be rated AAA or AA, as implied by the S&P and Moody’s ratings.

MBIA Corp.’s ratings are amenable to a more rudimentary analysis than FSA and AG Corp. with the help of the table below, created from MBIA’s second quarter operating supplement.

Rating	MBIA Corp.
AAA	109.5
AA	16.4
A	25.8
BBB	38.8
Below investment grade	26.2
Total	216.6
Claims paying resources	7.78

Since June 30, additional insured credits have been downgraded, increasing the below investment grade exposure from $26.2 billion to over $30 billion. Of this $30 billion, over $20 billion is at or near default. Based on the below investment grade exposure alone, it is difficult to see how an investment grade rating can be justified without at least $20 billion of claims paying resources, or how a rating in the BB range is justifiable without at least $15 billion of claims paying resources. S&P rated MBIA Corp. BBB until last week, when the rating was downgraded to BB+.

If S&P’s ratings of the financial guarantors are as preposterous as they seem, then the agency is likely to face continued credibility damage, opening the door for other competitors to gain market share and push profit margins below the monopolistic levels where they have been for most of the past five years. Readers who believe that there is some reasonable basis for the S&P or Moody’s ratings of FSA or AG Corp. or the S&P ratings of MBIA Corp. are encouraged to present their arguments.

Disclosure: Short MHP, AGO, MBI