Confidence Game - Christine Richard [109]
If ACA Capital was downgraded to triple B, however, it would be required not only to “absorb” those losses on its income statement but also to terminate the contracts and pay its counterparties in cash for the decline in the market value of the CDOs.
An analyst on the call asked Roseman to run through the downgrade scenario just to be sure he understood the implications: “So right now, you’d have to meet about $1.7 billion, or whatever the number would be,” the analyst said. “Something is wrong here.”
“One point seven billion dollars was our negative mark at the end of the third quarter,” Roseman explained.
“So that’s the amount you’d have had to meet at that point,” the analyst said.
“Approximately,” Roseman replied. “I mean I can’t tell you exactly.”
The analyst nearly apologized for the question: “Just hypothetical, and we understand you’re nowhere near breaking through that.”
“That’s correct,” Roseman said.
But at 4:25 p.m. that afternoon, S&P placed ACA Capital’s A rating under review for a possible downgrade. There was no way the bond insurer could meet termination payments if it was downgraded, JPMorgan Chase & Company analyst Andrew Wessel told Bloomberg TV. “ACA is a likely candidate to get thrown to the wolves first,” Wessel said.
It was a hint of what was to come in the credit-default-swap market.
JUST WHEN IT SEEMED that no sensible person could believe in the bond-insurance business anymore, Warren Buffett tossed his hat into the ring. The Wall Street Journal reported that Berkshire Hathaway might provide capital to the bond-insurance industry. On November 13, 2007, the day the story ran, MBIA shares surged on the prospect of a capital infusion, though there was no indication Buffett was considering investing in the company. Investors hoped that Buffett—who coined the adage “Be fearful when others are greedy and be greedy when others are fearful”—believed the worst was over for the bond insurers.
The industry remained on the defensive. At a Bank of America conference in New York on November 27, 2007, executives from the bond-insurance companies sought to assure investors. “We’re going to defend the triple-A credit rating,” Ambac’s chief financial officer Sean Leonard told the assembled group.
“Job No. 1 is to show that we have the stability around our triple-A ratings that investors expect,” said Edward Hubbard, president of XL Capital Assurance, the bond-insurance unit of a company called Security Capital Assurance.
Chuck Chaplin, MBIA’s chief financial officer, reminded the group that all the bond insurers, also referred to as monolines because they insured only debt, were in this together. “If any major monoline were to have a rating change, it would have a real impact on all the business of the monolines,” Chaplin said.
That’s what made Domenic Frederico’s comments so shocking. Frederico, the CEO of Assured Guaranty, explained why his company had not followed its competitors into the business of guaranteeing CDOs backed by subprime mortgages.
“When we ran the correlations, the model [for such underwriting] blew up,” Frederico told the group.
CDOs backed by subprime mortgages were much more vulnerable to a complete wipeout than bonds backed by mortgages.
As homeowners default on their mortgages and the underlying properties are sold for less than the amount of the mortgage, losses begin to build up in the pools of loans backing bonds. If a bond insurer guaranteed a security with a 30 percent subordination cushion beneath it, then the insurer would start to pay claims once losses on the pool hit 30 percent. Every percentage point increase of loss beyond 30 percent would translate into a dollar-for-dollar loss for the bond insurer. For a bond insurer to lose 100 percent on a guarantee, every mortgage would have to default and every foreclosed house would have to be sold at a complete loss. That scenario