The Rules, Part XI

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I wrote the following on April 20th, 2010:

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Could an investment bank go to junk status?

Some of my “rules” were phrased as questions. I wrote that one prior to 2002, possibly musing about downgrades in the credit ratings of investment banks. But today we know the answer: NO.

There are functions in the credit markets that only belong to strongly capitalized entities. Anything involving a large degree of credit risk requires an exceptionally strong balance sheet. Though my original question was about investment banks, think of mortgage and financial insurers. Where are they today?

Looking at my list of financial/mortgage insurers from three years ago, this is what I find:

Ambac Financial Group [ABK] — Aaa/AAA to C/CC (default in all but name)
ACA Holdings — A to default
Assured Guaranty — Aa3/A+ to A3/A+
MBIA Inc — Aa2/AA to Ba3/BB-
MGIC — A1/A to Caa1/CCC
PMI — A1/A to Caa2/CCC+
Primus Guaranty — Baa1/BBB+ to B2/CCC
RAM Re — Aaa/AAA — Ba3/NR
Radian — A2/A to Caa1/CCC
Syncora — Aaa/AAA to default
Triad Guaranty — A- to default.

Let me make a modest suggestion: financial and mortgage insurance does not work in times of extreme financial stress. Aside from Assured Guaranty every insurer offering coverage from financial/mortgage risks got smashed. Aside from AGO, all are at junk credit levels.

What this says to me is that the method of regulating financial and mortgage insurers is wrong. Financial risks are more severe than other risks, and a greater amount of capital must be held for solvency. When financial risks go bad, many risks go bad.

But wait, you say, at the greater level of capital, no one will buy the insurance. That might be true in the short run, but in the long run pricing levels will adjust. Insurance for mortgages will be bought, if the credit is secure.

Back to investment banks. They must be fundamentally sound institutions, given the high degree of leverage employed. Once they have a junk rating, fewer will do business with them, much like the financial insurers.

As a result my answer is no, no credit-sensitive institution can be junk-rated. Even a low-investment-grade rating is a stretch. During the boom phase, any investment grade rating can work; in the bust phase only the best market practices maintain a credit rating. and few credit sensitive entities maintain an investment grade rating.

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And now the score is:

Ambac Financial Group [ABK] — Aaa/AAA to default
ACA Holdings — A to default
Assured Guaranty — Aa3/A+ to A3/A-
MBIA Inc — Aa2/AA to B2/B-
MGIC — A1/A to Caa2/B-
PMI — A1/A to default
Primus Guaranty — Baa1/BBB+ to WD/WD (withdrawn, though still solvent)
RAM Re — Aaa/AAA — NR/NR
Radian — A2/A to Caa2/CCC
Syncora — Aaa/AAA to default
Triad Guaranty — A- to default.

With one small exception on MGIC, all of these have languished from my original article. My main point still stands: You can’t run a credit sensitive institution with a junk rating, you will eventually go bust, with high probability.

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David Merkel

2010-present, David is working on setting up his own equity asset management shop, tentatively called Aleph Investments. From 2008-2010, he was the Chief Economist and Director of Research of Finacorp Securities. He did many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, he was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, he was a leading commentator at the investment website RealMoney.com. His background as a life actuary has given him a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that he deals with in this blog. All of these goals rely on the help of Jesus Christ and his readers.