Confidence Game - Christine Richard [116]
Moody’s was the first to act on its warning that the downgrades of mortgage securities might undermine the triple-A ratings of some bond insurers. On December 14, 2007, it put two bond insurers—FGIC and XL Capital Assurance—formally under review. MBIA and CIFG were assigned negative outlooks, although their AAA ratings were affirmed. The ratings of Ambac, Assured, and FSA were affirmed and assigned stable outlooks. Over the next few days, Fitch put nearly every bond insurer under review. S&P assigned negative outlooks on the ratings of several bond insurers, including MBIA and Ambac. In any other industry, these rating changes would be trivial tinkering. But for the handful of companies whose businesses were built on their mainly AAA ratings, this rethinking of the ratings was a shot fired across the bow.
One company, however, took a direct and apparently fatal hit. S&P cut ACA Capital’s rating 12 levels from A to CCC. The slide was so precipitous because once S&P determined that ACA should be rated in the triple-B category, just two notches below its existing rating, the downgrade itself effectively bankrupted the company. At a triple-B rating, ACA’s counterparties had the right to terminate their contracts.
That changed the nature of ACA’s exposure dramatically. Instead of requiring ACA to cover any defaults on the CDOs as they occurred, the termination required an immediate payment to cover the decline in the market value of the CDOs. There was no way that ACA, with less than $500 million of capital, could cover the $1.7 billion decline in the market value of the CDOs it had guaranteed.
Shortly after the announcement, Canadian Imperial Bank of Commerce said it might have $2 billion of writedowns on $3.5 billion of subprime-mortgage securities guaranteed by ACA. Thirty other counterparties also were going to have to admit losses.
But not just yet.
ACA announced that their counterparties had agreed to forbear on their contracts. They would not demand that any collateral be posted or any contracts terminated. ACA had not defaulted on its obligations. It just had no way to pay them. Wall Street was going to pretend for a while longer that the credit-default-swap market—with $62 trillion in outstanding contracts—had not just suffered its first catastrophic failure.
CREDIT-DEFAULT SWAPS were causing embarrassment all over Wall Street. On December 19, 2007, Morgan Stanley revealed a $7.8 billion loss due to subprime exposure. “I know everyone has been dancing around it, but my question would be . . . how could this happen?” an analyst asked Morgan Stanley’s chief financial officer during a call to discuss earnings.
His explanation: A single trading desk at Morgan Stanley had sought to profit from the subprime collapse by purchasing protection through the CDS market on $2 billion of low-rated mortgage-backed bonds. The trade would have been a home run, except the traders came up with the cash to put on the trade by selling protection on $14 billion of top-rated subprime mortgage securities. What they thought was free money quickly turned into a massive loss as the value of the top-rated securities collapsed. Morgan Stanley’s CFO called it “a very expensive, and by the way, humbling lesson.”
A few minutes before 11 p.m. on December 19, Jim Chanos, the fund manager famous for shorting Enron, was reading through his e-mail when he spotted a research report on MBIA sent out that evening by Ken Zerbe, the insurance analyst at Morgan Stanley.
“What’s New: MBIA published an updated list of its CDO exposures. It disclosed that it has a massive $8.1 billion of exposure to CDO-squared transactions,” Zerbe wrote. “We are shocked that management withheld this information for as long as it did.” A CDO-SQUARED is a CDO backed by tranches of other CDOs. The market distrusted these securities and their added layer of complexity and risk even more than