Muni Bond Insurers Get a Lease on Life

It was a big day for municipal bond insurers Ambac (ABK - commentary - Cramer's Take) and FSA. Muni investors may be seeing some light at the end of the monoline tunnel. Stock investors in Ambac should be careful.

FSA announced a net loss of $330 million in the second quarter after increasing its estimated claims on residential transactions by $603 million. But the bigger news was that its parent, Dexia, has contributed $300 million in fresh capital to FSA and has assumed all risk in FSA's guaranteed investment contracts. In response, Standard & Poor's affirmed FSA's AAA rating, although the outlook was revised to negative. Fitch affirmed FSA's rating at AAA with a stable outlook.

There is no word yet from Moody's, which had put FSA's Aaa rating on negative watch in July. However, Moody's did release a very telling FAQ on its ratings methodology for the monoline insurers. Moody's claims that its ratings methodology has not changed, but a simple read of ratings reports from late 2007 indicated a focus on excess capital beyond "stress case" losses.

In putting FSA on negative watch in July, Moody's emphasis has clearly shifted to financial flexibility. One might conclude that Moody's now views losses on structured finance products as too uncertain to estimate, and therefore has shifted its focus to an insurer's ability to raise new capital no matter the loss level.

Nothing in the Moody's FAQ says this in so many words, but it contains statements that hint at this sort of thinking: "Moody's believes that both FSA and Assured [Guaranty] will be able to meet claim payments with a very high degree of reliability. However, the compositions of their insured portfolios ... may leave them vulnerable to a higher degree of volatility than their existing business models can sustain at the current Aaa ratings."

Ambac Retrenches

Meanwhile, Ambac reported a first-quarter profit of $823 million. Unfortunately, that figure reflects a $976 million gain due to deterioration in Ambac's own credit default swaps spread. It's a frustrating quirk of the mark-to-market accounting rules, and it really renders Ambac's reported income statement irrelevant. But the rationale is quite simple. If a CDS contract with Ambac as the counter-party were traded on the open market, there would certainly be a discount for Ambac's creditworthiness.

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At the time of publication, Graff had no positions in 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.