Expand Your Time Horizon on Bond Insurers

Sometimes life is unfair. Take, for example, Moody's Investor Service's ever changing criteria for their Aaa rating. On Monday, Moody's put both Assured Guaranty (AGO - commentary - Cramer's Take) and FSA's Aaa rating on negative watch. This despite Assured Guaranty having excess capital, defined as 1.3 times Moody's assumed losses given a "stress" scenario, and FSA falling short by only $140 million. Plus, FSA, it should be noted, just secured a $5 billion line of credit with parent Dexia.

In both cases, Moody's cited declining use of bond insurance in general: "Bond insurance volumes in the municipal segment have also declined significantly, with insurance penetration rates dropping by a third or more." It seems Moody's has concerns that the decline of muni insurance in general is a negative for FSA and Assured Guaranty's long-term business models. This is interesting, since FSA and Assured Guaranty have both increased their market share considerably. In Assured's case, they are writing substantially more business now than last year, and for FSA, it's at least close.

It still looks to me like FSA and Assured Guaranty have plenty of capital, especially given their lack of ABS CDO exposure. But it isn't my opinion that matters. So what should municipal investors do with their FSA and Assured Guaranty paper? And would a downgrade of either lead to an investment opportunity?

First, consider what "negative watch" means. In most cases, negative watch turns into a downgrade, unless some intervening event occurs. For FSA, it's possible that Dexia contributes capital to bring FSA above Moody's target levels. But given that Assured is already above those levels, it's not certain that a capital infusion would make any difference. So investors should assume that FSA and Assured Guaranty will be downgraded. I would also assume that S&P will eventually follow suit.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.