Credit Market’s Recovery Grinds to a Halt
By Eva Woo, Caijing, June 6, 2008

On the afternoon of June 5, the Standard & Poor’s* rating agency downgraded its ratings of monoline bond insurers MBIA and Ambac from AAA to AA.
According to the Financial Times, MBIA immediately proposed investing US$900 million to establish a new bond insurance arm to separate the company’s public finance and municipal insurance business from the large number of high-risk bonds it insures.
The market had been showing increasing apprehension regarding the monoline insurers since June 4; on that afternoon, rating agencies warned that they intended to downgrade the two large monolines, and as soon as the news came out, MBIA’s stock price fell to its lowest level since 1988, and Ambac’s to its lowest level in history. This caused the credit market to suffer its most severe repercussions since the mortgage crisis began last year.
“This is extremely bad news, and if the situation is not corrected, it could cause the collapse of the entire bond insurance market. Loss of confidence could make it very difficult for bond insuring companies to gain new business.” So says structured finance expert Sylvain Raynes, who previously worked in the structured finance products department of Moody’s, and went on to become a founding partner of the New York-based structured finance consultancy R&R Consulting…
Raynes revealed that rating agencies normally give prior notice to companies before issuing downgraded ratings, but the public reaction of MBIA and Ambac management to the Moody’s downgrade indicates that the companies’ managers were taken by surprise.

*The FT article only refers to a Moody’s downgrade.

Caijing Article Link

Related FT story, “MBIA may set up new unit to help bolster credit ratings”

First, the team.

The client (let’s call it Equilox) was a company formed by a disgruntled managing partner of a well-branded equipment lessor. Equilox had adopted their same systems and same basic underwriting approach. Equilox understood securitization. They knew the static pool, not the portfolio, was the unit of measurement. They knew that credit scores could be used to discern relative value between deals with similar partial loss curves. Equilox had a contract with a credit scoring firm (let’s call it Scorex) for the equipment lease sector. Scorex had a modeler from a well-branded credit scoring firm. Equilox had also lined up a monoline insurance company to wrap the senior notes, and an investment bank to underwrite the transaction. What the monoline’s endgame was, is now topic du jour. The investment bank had no stake in any outcome other than a sale. R&R’s role, as usual, was to build the transaction model to find the cheapest cost of capital consistent with robustness using Scorex inputs to modulate cash flows, and then offer that analysis to the bank and the monoline as a negotiating tool, for a fee.

Now the dilemma.

Credit scores cannot be used in a securitization as raw scores. They first must be mapped to the distribution. It may have changed. If it has changed, they must be revalidated. This mapping exercise showed something much worse. Scorex had no predictive value. Furthermore, the modeling exercise using pure static pool data showed the target ratings were wrong, given the structure. It is amply evident today that ratings (like credit scores) must also be validated by relating them to a distribution of risk. But since, at the time, the monoline did not understand the relationship between the rating and the risk distribution, our analysis was rejected in favor of the investment bank’s counsel.

Now comes the punch line. How many Equilox tranches do you think are out there in today’s market. Some are much better than you think. Some are much worse than you think. You won’t know which to trust.