When it comes to risk management, one thing is for certain: in practice it’s actually something of a conundrum.
That’s because the more that you actually believe that you are protected from risk, the more risky your behavior truly becomes.
That’s why perfectly reasonable people continue to build wildly expensive oceanfront homes in areas where hurricanes are as common the seagulls.
It’s not because they’re stupid, it’s because they’re insured. Otherwise the risks that they take would be far too great to contemplate.
The problem with that though is that when you place your risk on the shoulders of someone else, your hedge is only as good as other person’s ability to pick up the pieces after disaster strikes.
That’s kind of tough when the person that you are counting on is teetering on the brink insolvency, because in that case all of those risks suddenly come right back where they started.
That of course, is the situation today with the bond world where insurers both big and small don’t actually have enough money to cover all of the losses that they might be looking at in the CDO mess.
I wrote about it last month in a post entitled "Bond Insurers Staring Down 20 Katrinas"
Since then it’s only gotten that much closer to the crisis mode since the value of some 90,000 bonds partly depends upon the integrity of the companies that are insuring them.
Here’s a look at what happened today as numerous bond insurers were moved to negative and one of them was cut to junk.
From Bloomberg by Christine Richard entitled: Ambac, MBIA Outlook Lowered by S&P, ACA Cut to CCC.
"The ratings outlook for MBIA Inc. and Ambac Financial Group Inc., the world’s largest bond insurers, was lowered to negative by Standard & Poor’s, while ACA Financial Guaranty Corp. was cut to a level that suggests potential default.
S&P also reduced its outlook to negative from stable for XL Capital Assurance Inc. and placed Financial Guaranty Insurance Co.’s AAA rating under review for a possible downgrade. The actions were “prompted by worsening expectations” for insured nonprime residential mortgage bonds and collateralized debt obligations of asset-backed securities, New York-based S&P said.
The ratings cut on ACA Financial, a unit of ACA Capital Holdings Inc., may lead to writedowns at Merrill Lynch & Co. and Canadian Imperial Bank of Commerce. Toronto-based CIBC said today it will likely take a large writedown because New York-based ACA insures about $3.5 billion of its U.S. subprime investments.
Merrill Lynch may have used contracts with ACA Capital to pass off the market risk of $5 billion in CDOs, Roger Freeman, an analyst covering the brokerage industry for Lehman Brothers Holdings Inc., wrote in a Nov. 5 report. If ACA Capital defaults on its swap contracts, Merrill Lynch could recognize unrealized losses on those securities of about $3 billion, Freeman wrote.
ACA Capital is required to post $1.7 billion in collateral if its rating falls at least two steps to below A-, management said on a Nov. 8 conference call. The rating was cut 12 levels today to CCC from A. The company said Nov. 19 it wouldn’t be able to post that much or make termination payments on the contracts.
ACA Capital as of June 30 had sold protection to 31 counterparties through credit-default swaps on $61 billion of highly rated securities, including CDOs backed by subprime mortgage securities, according to filings. CDOs are created by packaging debt or derivatives into new bonds with varying ratings.
“The hits keep coming,” said Gregory Peters, head of credit strategy at Morgan Stanley in New York. “It’s been our view that these guys are in a much more difficult predicament than investors or the companies themselves believed.”
The wave continues to build
