The financial turmoil just keeps getting worse. This week S&P slashed the rating of small bond insurer ACA Capital from triple-A to junk, stating that mortgage-related losses could exceed its $650 million capital cushion by more than $2 billion. ACA has provided guarantees on billions of dollars of securities including $26 billion of CDOs. Since in almost all of these cases the triple A ratings of the guaranteed securities depends on the guarantees, these securities are likely to be subject to writedowns as well, leading to a new wave of additional writedowns at banks and other institutions.
But wait—there is more. While ACA is relatively small, S&P yesterday put two large bond insurers—MBIA and Ambac---on negative watch, meaning that it may downgrade their ratings in the near future, although it confirmed their triple A status for now. In addition MBIA, in a surprise move, indicated that it guarantees $8.1 billion of so-called CDOs-squared that have chances of losses. CDOs-squared repackage other CDOs and securities linked to subprime mortgages. If leading bond insurers were downgraded some $2 trillion of insured securities would lose their triple A rating, leading to another surge of massive writedowns at financial institutions throughout the globe along with additional severe credit problems in the world financial system.
We suspect that the only reason that S&P didn't downgrade these companies now was their fear of what it would do to the markets. We can't say that we blame them for their reluctance, but that does not change the stark reality of the situation. This is yet another glaring example of the lack of transparency and the completely justified fear that we still don’t know of all the dangers that have still not been exposed to the light of day. Last month alone, even before these new developments were revealed, delinquencies on subprime loans contributed to downgrades on 2,007 CDOs.
To date Washington has taken action on bank regulations, state bailout funds, FHA loans, SIV rescues, a mortgage rate freeze plan and tax relief for debt forgiveness. In addition the Fed has slashed fed funds rates and provided funds to the market by various means. All of this has had minimal effects on the housing situation or on the type of credit problems described above. At the same time the economy is either in recession or about to enter one while the Western Europe and Japanese economies are slowing as well. Together the U.S. the EU and Japan account for about 70% of world GDP with the developing nations accounting for the rest. This means that the so-called decoupling of the U.S. and global economies, so widely heralded until recently, will prove to be another mirage based on hope rather than reality.
In the last seven recessions the S&P 500 has declined by an average of 30% prior to or coincidentally with recessions. Since the maximum decline so far has been only 10% we think there is a long way to go on the downside, particularly with earnings estimates for 2008 looking far higher than is justified by the worsening fundamentals.
