Risky Paper Hammers MBIA

Thursday afternoon, Fitch Ratings responded to MBIA's news by putting the company's credit ratings on "watch for a possible downgrade." The agency notes that MBIA comes up short of a triple-A credit rating by about $1 billion of capital due to CDO downgrades, and that's including the recent $1 billion investment in MBIA by private equity firm Warburg Pincus.

Fitch essentially gives the firm four to six weeks to "obtain further capital commitments and/or put in place reinsurance or other risk mitigation measures." Fitch says it expects to downgrade the firm to double-A-plus if it cannot come up with the capital in time.

According to a Reuters report, MBIA insures the most bonds, guaranteeing $673 billion. Ambac is second, insuring $556 billion.

But the fallout of a guarantor downgrade reaches beyond forced bond sales. The guarantors also underwrite credit-default swap protection on securities like bonds, CDOs and other asset-backed debt. These firms have already taken writedowns based on widening risk premiums, or credit spreads, on their credit default swap portfolios, and analysts expect they'll take more. Credit default swaps are derivative products banks and credit investors buy to hedge against default risk in the underlying securities.

Zerbe had thought Ambac had more risky CDO exposure until MBIA's announcement Thursday. He notes that the news validates S&P's prediction that MBIA's stress-case scenario would engender losses 61% higher than Ambac's $1.5 billion.

Likewise, other financial institutions have exposure to the guarantors. Private equity firm Blackstone(BX Quote) has suffered from its investment in FGIC, according to a Wall Street Journal report. And many banks and brokerage firms are buyers of guarantors' insurance and credit default swaps as well, begging the question -- why wouldn't someone pony up cash to rescue the firms from capital shortfalls?

According to a New York Times report Wednesday, Merrill Lynch(MER Quote) and Bear Stearns(BSC Quote) were negotiating a bailout of smaller insurer ACA Financial Guaranty Corp., but they were too late. The firm's rating was slashed Wednesday deep into junk territory by Standard & Poor's, to triple-C from single-A. Last month, controlling shareholders of its French parent company invested $1.5 billion for CIFG Services in November. And, just last week, MBIA obtained a $1 billion investment from Warburg Pincus to protect its investment-grade rating.