Bond Insurance:MBIA

Insurance Risk
Last year, over 60% of all Muni Bond issuance was credit enhanced by either insurance or bank LOC’s. Since a guarantee is only as good as the one who guarantees it, the credit-worthiness of an insurer is very important. Last month, Barron’s ran an article about MBIA insurance. In the article, Pershing Square Capital Management justified their short stock position in MBIA by saying the insurer has significant exposure to the sub-prime mortgage market, delinquencies are on the rise for these loans, and MBIA’s insurance exposure is much greater than the rating agencies would like for you to believe. As fixed income money managers, we are less concerned about how well the firm’s stock does. What matters to us is the company’s ability to pay claims as well as the likelihood they would be required to pay these claims.

Breakdown of Insurance In Force

Insurance exposure can be broken down into the following categories:

U.S. and Non-U.S. Public Finance
U.S. and Non-U.S. Structured Finance

The chart below shows the amount and the relationship of this exposure. Default studies would suggest that the exposure to Public Finance is quite manageable. Total Public Finance insurance in force was $706.3 billion at the end of 2006.

The insurance in force for Structured Finance was $254.5 billion for the same period. This includes:

Collateralized Debt Obligations (CDO's)
Mortgage-backed Home Equity
Mortgage-backed Other
Mortgage-backed First Mortgage

The next chart shows the breakdown percentages for Structured Finance. According to a recent S&P report, MBIA has $5.78 billion of sub-prime exposure in Mortgage-backed securities, and about $431 million is speculative.

The chart shows 62% of their Net Insurance for Structured Finance is in CDO’s. The same S&P report said MBIA has $16.605 billion of Insurance Exposure to CDO’s with sub-prime exposure, and $2.059 billion of this is for sub-prime mortgages. If we combine this total with the $431 million of speculative Mortgage-backed, the total is $2.49 billion of sub-prime insurance written by MBIA.

Ability to Pay

S&P calculates the ability to pay this insurance exposure by looking at the following:

$13.3 billion in claims paying resources
$6.6 billion in qualified statutory capital
$819 million in earnings last year

S&P argues that any future claims are likely to be less than 1 year’s earnings. Their reasoning is that the firm’s exposure to $431 million of speculative grade sub-prime mortgages is about 6.6% of total statutory capital ($6.6 billion), and less than half of 2006 earnings. We find some problems with this analysis because:

1. None of the $2.059 billion in CDO sub-prime exposure is included in their analysis
2. Default rates for higher quality sub-prime Alt A mortgages are also rising. Currently, 2.9% of these mortgages in CDO’s are 60+ days delinquent and 1.08% are foreclosed.

Conclusion
It is easy to see how MBIA’s earnings may be negatively affected in the future due to increasing default rates in the sub-prime area. However, as bond holders we are more concerned about the firm’s ability to pay and maintain their AAA rating. We still have confidence in MBIA’s ability to pay, but feel deteriorating credit conditions are much worse than S&P’s report would suggest. The rating does not appear to be in danger at this point, but we would rather invest in underlying securities unlikely to ever need the insurance. We feel bond insurance is good when there is a localized event, such as Hurricane Katrina. Investing in junk and relying on insurance to bail you out if something goes wrong is not a formula for success. Insurance is no substitute for research if global credit conditions worsen.