Downgrades of MBIA Inc and Ambac Financial Group may leave managers of some structured credit products exposed to the bond insurers with a difficult decision to either see the deals get downgraded or trade out of the names and post large losses.
Moody's Investors Service late on Thursday cut its top ratings MBIA and its bond insurance arm by a surprising five notches each, sending MBIA Inc's ratings to "Baa2," the second lowest investment grade, from "Aa3," while Moody's cut Ambac and its insurance arm by three notches each.
The downgrades follow a similar but less aggressive move by Standard & Poor's on June 5, which cut MBIA Inc three notches to "A-minus," four steps above junk grade, and left the company on review for further downgrade.
"The downgrade of the "Aa" to "Baa" area is huge - this is a very big downgrade as the default risk rises dramatically and so bespoke CDO holders face further downgrades of their notes," said Tim Backshall, chief strategist at Credit Derivatives Research in Walnut Creek, California.
In bespoke Collateralized Debt Obligations (CDOs), investors sell default protection on a pool of corporate borrowers, taking varying degrees of risk depending on the position of the tranche in the capital structure. The deals are customised portfolios for individual investors. Credit default swaps on Ambac and MBIA, and their insurance arms, were popular in bespoke deals created before concerns were raised about their ratings.
Downgrades of companies included in the deal portfolios can result in downgrades of the deals and, in some cases, lead to forced selling by investors with rating restrictions on their investments. "Its not necessarily the one thing that will push a bespoke over to the next ratings level, but it doesn't help," said Sivan Mahadevan, head of credit derivatives and structured credit research at Morgan Stanley in New York.
Credit downgrades of companies that were acquired in leveraged buyouts of Residential Capital LLC, which was cut into junk territory last November, and was common in bespoke CDOs, had a more significant impact on CDO ratings.