From the March 2008 issue of Investment Advisor • Subscribe!

March 1, 2008

Mortgaging the Future

The impact of the subprime on insurance could be huge

No doubt you (and your clients) have been watching the subprime meltdown with angst as it plays havoc with clients' investments. Mortgages are defaulting all over the country, taking with them the consumer confidence that had helped fuel the market's steady rise.

Still, how does this affect insurance? In many ways. There's mortgage insurance, for one thing. When borrowers default, in some cases these days simply walking away from their homes, the mortgage insurers are on the hook for the difference between what they borrowed and what the house sells for in a foreclosure sale.

Then there's reinsurance, where much of the trouble lies. Even as the Fed substantially whacked interest rates twice at the end of January, and markets seemed to respond, William Ackman of hedge fund Pershing Square Capital Manage- ment, LP issued a report that predicted far more widespread losses--first among reinsurers and then among a broader field of institutions that may impact a wide range of investments, your clients' among them.

According to Ackman's report, Ambac Financial Group and MBIA, two of the biggest U.S. bond insurers, stand to lose $24 billion on complex mortgage investments. In fact, Ackman's report theorizes that not only will Ambac and MBIA be stressed, but there will be other reinsurance woes if other reinsurers in the chain, such as Channel Re, fail to meet their financial obligations. His hypothesis, joined with the news of another guarantor's (the Financial Guaranty Insurance Company) rating downgrade, caused the rally after the Fed's January 30 rate cut to fall short. MBIA is already under threat of losing its AAA credit rating from Moody's, despite having taken substantial steps to try to avoid such a fate. Ambac, the smaller of the two but in more critical condition, was at press time the subject of talks with banks and state regulators as the target of a bailout.

If Ackman is right, the problem with Ambac and MBIA is more far-reaching than reinsurers and could spread to other areas, affecting more investments than those in the reinsurers themselves. Calls to Fitch Ratings and NAIC were not returned by press time, and attempts to speak with a representative at Mortgage Insurance Companies of America (MICA) were unsuccessful, but Jim Peavy, the assistant VP for public relations at A.M. Best, said, "It is A.M. Bests outlook that the reinsurance market is stable and we don't see a crisis at this time." Still, investors largely have not agreed, with the shares of Ambac and MBIA having fallen hugely in market value, with the drop actually beginning in early 2007.

Ackman has provided his rationale and the spreadsheet used to make the underlying calculations (the "Open Source Model"--see the Web Extras section at www.investmentadvisor.com) so that others in the industry can make their own decisions. He is encouraging others to test his hypothesis and the Open Source Model to come to their own conclusions, "without reliance on the analytical judgment of rating agencies or the bond insurance industry." He also asks regulators to examine the figures to more accurately determine if reserves are at the proper levels and whether action is needed to prevent the distribution of dividends to shareholders. As he puts it in his accompanying letter, "If you continue to allow ordinary dividends to go to holding companies, you will be depriving the policyholders of capital that is needed to meet their obligations. In addition, we believe that by permitting regular dividends to the holding companies, you risk undermining your capital raising efforts. Stated simply: it is hard to fill a bucket with a hole at the bottom."


Marlene Y. Satter is a freelance business writer based in New Jersey. She can be reached at harpwriter@verizon.net.

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