giants insured by midgetsrobert gottliebsen

The huge pools of Middle Eastern and Asian equity capital which have rescued Citibank and Merrill Lynch from very nasty fates, are going to be tested again and again.

Here in Australia they will almost certainly be required to contribute the Centro rescue, but their biggest test will come as the so called 'monoline insurers' seek to cover their losses with capital.

There are nine of these insurers and they are backing an incredible $US2.3 trillion in loans globally – that’s $US2,300 billion. If the weaker monoline insurers are not rescued, then the consequences to the global capital markets will be severe – an issue Business Spectator first raised in November (Bonds lose their facade).

Centro and others need to get their money lined up quickly in case a few of the key mortgage insurers fail. And, as I will explain later, the enormity of the insurer problem contributes to the fall in Australian bank shares.

Monoline insurers guarantee the repayment of principal and interest when an issuer defaults. Some of the nine monoline insurers insured sub-prime risks with no thought of the consequences and risks. If a few fail, then a whole series of groups who insured their sub-prime and other loan exposures will suddenly be caught. It could have severe consequences for the derivatives market.

Incredibly, the rating agencies gave these nine insurers triple-A ratings which enabled borrowers to issue high risk securities yet enjoy very low borrowing costs, because the monoline insurers did not charge fees that anywhere near matched the risks they were taking on. Worse still, lenders usually simply took the triple-A monoline insurer rating as the prime security and never looked at the underlying security.

I must emphasise that not all the $2.3 trillion in monoline insurer risk is sub-prime, but research reports indicate that it is in the vicinity of a quarter – about $600 billion. I am not going to even stab at the likely monoline insurer loss levels because I don’t know what has been insured. But they will not be small. Citibank was looking at a 40 per cent-plus loss rate in some areas

Just less than 30 per cent of the total $2.3 trillion risk is held by a US public company MBIA. Only around one fifth of the MBIA insured portfolio is in sub-prime, so it was not seen as high on the vulnerability list. Indeed, when Moody’s did a sub-prime stress test in September, it said MBIA was unlikely to lose its triple-A rating over sub-prime. A Fitch stress test at the same time also gave MBIA a low probability of losing its triple-A rating.

But its shares have fallen from $US76 to $16, which capitalises the giant insurer at just $2 billion, down from $95 billion. With only $2 billion in capital, on a market basis, plus a few other sources of help, MBIA is insuring about $650 billion worth of risk.

Clearly the stock market has done the work the rating agencies should have done. No company with a $2 billion market capitalisation can offer triple-A guarantees on $650 billion worth of mortgages. So for those holding the $650 billion worth of securities and relying on MBIA insurance, they must look to the real value of the securities. Remember that the majority of the $650 billion in MBIA insured risks don’t really need insurance because they are government bodies.

The Fitch stress tests isolated two other insurers who were very vulnerable to sub-prime CIFG and FGIC. CIFG was owned by the French bank Natixis, but in November the bank transferred ownership of its problem child CIFG to Natixis’s two major shareholders, Caisse Nationale des Caisses d'Epargne (CNCE) and Banque Fédérale des Banques Populaires (BFBP). The two banks injected $US1.5 billion.

FGIC is owned by FGIC Corporation, and is seeking to recapitalise.

These are unknown companies in Australia, but FGIC has around $US300 billion in total insurance commitments and CIFG around $US70 billion. FGIC's $US1.5 billion equity contribution is just too small.

Other insurers are in similar boats. The danger is that some these companies have unsustainable business models and will need to be replaced by new insurers who understand risk. In the process, the capital financing and derivatives markets will be thrown into turmoil.

Neither the Australia Treasury or Treasurer Wayne Swan appear to understand that a huge slice of Australian bank deposits come from New York and are vulnerable to this turmoil. Most initial Australian bank borrowing in New York is negotiated in US dollars and it is then converted to Australian dollars via the derivatives market. The cost of doing this has already risen and if the mortgage insurers start falling over it will rise again.

Hopefully when Prime Minster Rudd and Treasurer Wayne Swan visited the Reserve Bank yesterday, Glenn Stevens explained the problem to them.

Citibank and Merrill Lynch will come through this because they have enormous businesses, but when Citibank plunged into sub-prime everyone followed and no one understood the risks.

Many people cannot understand why Australian bank shares have fallen. Our banks might not be caught in sub-prime on the asset side but their exposure to Centro and the US Countrywide group shows they have been lax in their lending over the last year. More importantly, we are exposed to sub-prime via liabilities or bank deposits because the people who are directly or indirectly involved in sub-prime are also involved in supplying Australian banks with the funds they need to lend on houses and businesses.