Ali’s blog

Mostly quant stuff with occasional digressions

Skullduggery behind the scenes

Posted by alifinmath on February 25, 2008

From the FT:

A group of eight banks, led by Citigroup and UBS, is preparing to inject up to $3bn into Ambac, the second-largest bond insurer. The money would be part of a plan to split Ambac’s operations into a AAA-rated municipal bond business and a structured finance business with slightly lower ratings.

A downgrade of Ambac would potentially lead to downgrades on $550bn of bonds that it guarantees. Banks could be affected because a downgrade could reduce the value of Ambac guarantees on collateralised debt obligations and derivatives trades, such as credit default swaps.

Banks have had to calculate whether costs of putting funds into Ambac would be less than the costs of writedowns associated with downgrades. Bond insurers are facing a surge in claims after guarantees on mortgage-related bonds have proved to be riskier than anticipated.

This last part isn’t clear to me. Banks will have to inject real capital into these bond insurers (which will probably be used up to pay other people for their defaulting bonds) versus writing down their own bond portfolios —  where no real capital changes hands. Why not opt for the latter?


2 Responses to “Skullduggery behind the scenes”

  1. Chris Prouty said

    Think about it in terms of the value of the enterprise. Let’s say a balance sheet for a company has $50B in assets, $4B of which is in cash and $46B in various bonds. If the firm has to take a writedown of $10B, then the asset value of the enterprise has dropped to $40B. However, if it can write a check for $3B then the asset value has only dropped to $47B. I’m no expert on this topic, but that logic makes sense to me.

    The thing that frightens me is that it will *only* take $3B to shore up the credit rating of Ambac. Given that Ambac insures a notional value much larger than $3B, it seems to me that the $3B figure is some type of expected value figure based on default probabilities…the same methodology that got us into this mess to begin with. I could easily envision a scenario in which the banks pay in the $3B and then Ambac shows up a few months later for another handout. What a mess.

  2. alifinmath said

    Sure, I understand that. Firms often make adjustments to their balance sheets. These adjustments often involve intangibles: how to price intellectual property, or “goodwill,” but can also involve tangibles — how to price machinery and buildings (e.g. after they’ve been completely written off for depreciation purposes, they’re occasionally again reassigned some value on the books)), for example. But whether tangible or intangible, these adjustments have no real bearing on the conduct of the firm’s operations (as far as I know) and don’t involve real capital going out or coming in. The difference between making a balance sheet adjustment of this sort and forking out hard cash is a real one. Given a choice between a writedown of $10bn and forking out $3bn of real money, I’d always plump for the former unless — big unless — I could unload those bonds on some other poor sucker at the initial higher value.

    I understand Ambac has insured a notional of over $500bn. As you say, $3bn won’t go far. Then what? Throw more good money after bad? Surely the captains of finance have factored in all these imponderables into their calculations?

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