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Our nation’s largest bond insurers are collapsing as we speak, but Wall Street’s leading rating agencies are covering it up while regulators look the other way.
Just last week, Ambac Financial Group, the parent of the second-largest bond insurer, shocked analysts with first-quarter losses of $1.66 billion — on top of $3.64 billion in the previous six months.
And the underlying facts denote a company in a death spiral:
- Even excluding non-recurring items, Ambac’s losses were $6.93 per share, more than quadruple the losses that Wall Street expected.
- Ambac’s writedowns of bad collaterized debt obligations (CDOs) and mortgage-backed securities were massive — $5.2 billion.
- Its revenues from its credit insurance plummeted by 87%.
- Its new policy business plunged to virtually zero.
- The net worth of its bond insurance unit, Ambac Assurance, fell below the minimum required to maintain a $400 million credit line — cash the company may need in pinch.
- The company’s shares, which had already lost 93% of their value last year, promptly tumbled another 43% on the news.
- And perhaps most telling of all, the cost of credit swaps on the company — derivatives designed to insure Ambac’s guaranteed bonds against default — went through the roof. Just to insure investors for $10 million for five years, it would now cost $1.1 million in upfront premiums plus an additional $500,000 per year. Total cost: a whopping $3.6 million. (Imagine a $10 million life insurance policy costing a man $3.6 million in premiums! Not exactly a vote of confidence in his life expectancy.)
With all this happening — devastating losses, its entire business model on the rocks, a cash squeeze and even questions being raised about its future solvency — you’d expect Wall Street’s rating agencies to immediately announce deep downgrades in one fell swoop.
But they did precisely the opposite. On Wednesday, Standard & Poor’s announced that Ambac’s triple-A is “solid,” and on Thursday, Moody’s also reaffirmed its Aaa rating of the company.
Meanwhile, New York insurance commissioners, while saying they’re trying to protect the public, have not only been endorsing the inflated ratings, but actively pleading with the rating agencies not to issue potentially fatal downgrades. Even as recently as last week, New York insurance superintendent Eric Dinallo echoed the mantra of the agencies that the bond insurers are “within the stress scenarios.”
How does the CEO of an S&P or a Moody’s look himself in the bathroom mirror each morning? You’d have to have a Ph.D. in both psychology and finance to figure it out. But let me at least point out some of the symptoms of the psychosis:
First, while doing absolutely nothing to alter the ratings, they find all kinds of alternate devices to communicate to the world that they’re not dumb, that they know the companies are, indeed, in trouble.
They put the company’s rating on “negative outlook,” which is supposed to send the message that, although they may not be doing anything, they’re at least “thinking about it.”
Or they try to sound like rational analysts by actually saying some pretty negative things about the company.
In fact, Reuters reports that the rating agencies have explicitly expressed concern that Ambac “did not have enough capital to cover both a bond default and the crumbling of the securities relying on mortgages.” And even S&P’s own insurance analyst, Cathy Seifert, said: “The risk is that if [Ambac] can’t regain the confidence of the marketplace. Then it’s game over.”
The rating agencies seem to attribute great import to their commentary and conditional statements surrounding their triple-A ratings. But they’re apparently not important enough to include with bond offerings to investors, who typically see only the three letters: S&P’s AAA or Moody’s Aaa.
Second, the CEOs of the rating agencies rationalize that their deceit, no matter how obvious and egregious, is actually “a public service” in disguise.
They know that the entire business model of bond insurers like Ambac is predicated on their triple-A ratings.
They know that if they take away the triple-As from the bond insurers, they could destroy their business and even possibly doom them to failure.
They know that the bond insurers cover hundreds of thousands of municipal and state governments. So if the bond insurers went under, the entire market for municipal bonds would collapse, threatening the finances of hundreds of thousands of local and state governments throughout the nation.
And they also know that their own firms — the rating agencies themselves — derive a big chunk of their revenues by rating those same local governments. So if they downgrade the bond insurers, they are, in effect, threatening the future of their own business.
Result: While their own ratings analysts scream internally for immediate downgrades, the CEOs jury-rig the process, override the analysts’ conclusions and force-feed the triple-A.
Needless to say, calling this a “public service” is a futile rationalization. The truth will come out no matter what and it’s only a matter of time before the rating agencies must cave in to reality, downgrade the bond insurers, and finally face the day of reckoning they’ve tried so hard to postpone.
The only lasting consequence of the rating agencies’ delay tactics is to allow time for more people to get trapped in bad investments and more local governments to borrow money they can’t repay. End result: Bigger shock waves on Wall Street and more damage to our economy than it would have suffered otherwise.
Investors Like You and Me Are a Lot
Smarter Than They Give Us Credit for!
We’ve been around the block a few times, and we can take the bad news like adults — when it happens and as it happens.
It’s when they cover it up, let it fester and then compulsively lie until their noses are longer than Pinocchio’s that they create conditions ripe for panic.
But Ambac’s triple-A is just one example of this pattern. We also see very similar circumstances at MBIA, FGIC and every major bond insurer in the country.
With minor variations, it’s a similar pattern with S&P, Moody’s and even Fitch. (Fitch did downgrade Ambac and MBIA, but has kept their ratings at a still-lofty double-A.)
Nor is this the first time America’s top rating agencies deliberately hid the truth, inflated ratings and trashed the savings of Americans …
How Wall Street Rating Agencies
Helped Trap Six Million Americans in
Failed Life Insurance Companies
In the late 1980s and early 1990s, every one of Wall Street’s leading rating agencies consistently gave large life and health insurers their top ratings — even as they themselves recognized the companies were taking on huge risks.
The end result was a catastrophe that should have forever taught them a lesson … but, unfortunately, has long been forgotten.
I’ve told this story in my book, The Ultimate Safe Money Guide. But to make sure you’re not among those who forget it, let me tell it again now — this time in juxtaposition to today’s bond insurance cover-up.
The problems began with three, initially small life insurers that based their entire business plan on junk bonds — Executive Life of California, Fidelity Bankers Life and First Capital Life.
With Executive Life in the lead, all three invested heavily in junk bonds to pay super-high, guaranteed yields on fixed annuities and other policies. They contracted with large Wall Street brokerage firms to sell their policies through their extensive branch networks. They lured in millions of investors. And they transformed themselves into giant junk bond insurance companies.
The keys to their rapid growth was twofold: First, they had to hide the dangers of junk bonds from their customers. And second, they had to play on the faith people still had in the inherent safety of insurance.
But to make the scheme work, they needed two more elements: the cooperation of the Wall Street rating agencies and the blessing of the state insurance commissioners.
The cooperation of the rating agencies was relatively easy. Indeed, for years, the standard operating procedure of the leading insurance company rating agency, A.M. Best & Co., was to “work closely” with the insurers.
If you ran an insurance company and wanted a rating, the deal that Best offered you was very favorable indeed. Best said, in effect: “We give you a rating. If you don’t like it, we won’t publish it. If you like it, you pay us to print up thousands of rating cards and reports that your salespeople can use to sell insurance. And subsequently, if we downgrade your rating or you change your mind, we’ll take the rating out of circulation, hiding it in one of our ‘non-published’ categories. Tails you win; heads they (your customers) lose.”
Three newer entrants to the business of rating insurance companies — Moody’s, Standard & Poor’s and Duff & Phelps (later bought by Fitch) — offered essentially the same deal. But instead of earning their money from reprints of ratings reports, they simply charged a large flat fee for each rating — anywhere from $20,000 to $40,000 per insurance company subsidiary, per year. And later, A.M. Best decided to change its price structure to match the other three, charging the rated companies similar upfront fees.1
Not surprisingly, the rating agencies gave out good grades to almost all comers, especially if they were big and willing to pay the fattest fees. At A.M. Best, the grade inflation got so far out of hand that no one in the industry would be caught alive buying insurance from a company rated “good” by Best. Everyone (except the customers) knew that Best’s “good” actually meant bad.
Soon, the grade inflation even began to infect Best’s “excellent” grades. The decision makers at Best were so committed to working with the companies, and so afraid to hurt their business with a downgrade, that they continually reaffirmed their top ratings even when it was obvious that the insurers’ junk bond portfolios were sinking.
The executives at Best faced exactly the same dilemma as the CEOs of Wall Street’s rating agencies face today: If they downgraded the companies, they would destroy their customers’ business model. But if they didn’t do or say something to reflect the obvious reality, they’d look like dumb fools.
So instead of downgrading, Best’s executives told their analysts to start using small, lower case letters next to their “A” grades — cryptic “moderators” that only Best could fully understand. They had “w” for “watchlist,” “c” for “conditional” and others.2
Best insisted that these footnotes were “very important.” But at the same time, Best allowed the insurance companies to continue advertising the “Excellent” ratings to the public without the footnotes. In effect, Best had two sets of ratings — one for the customers and one as a butt-covering device for professionals.
Pinocchio would be proud.
Over at S&P, however, the noses were even longer. Fred Carr, the head of Executive Life, was not satisfied with his rating from Best and went to Standard & Poor’s to get an even better rating.
Typically, S&P charged a large insurance company about $40,000 per year to give it a rating. And just like the deal with Best, if the insurance company didn’t like the rating, S&P wouldn’t publish it.
But along with junk bond king Michael Milken, Fred Carr cut an even better deal. Milken paid an extra $1 million under the table and, in exchange, got a guaranteed AAA for his junk bonds and for Fred Carr’s insurance company. And all this despite a business model that was predicated largely on junk bond investing!3
Moody’s, the least liberal of the established rating agencies, was shell-shocked and a bit pissed. They couldn’t believe Executive Life’s Carr got an AAA from S&P. So they did something they rarely do. They decided to go ahead and rate Executive Life with no request from Carr and no payment, giving them a grade of “A1,” which was still OK, but not superlative.
Carr couldn’t care less. By that time, he had gotten everything he needed from the insurance ratings agencies. He knew he could leverage the AAA rating from S&P — combined with his high guaranteed yields — to get filthy rich. And he did just that.
Initially, getting the blessing of insurance regulators was not quite as easy. In fact, the state insurance commissioners around the country were getting so concerned with the industry’s growing investments in junk bonds — and unrated bonds — they decided to set up a special office in New York, called the Securities Valuation Office, to monitor the situation.
What was the definition of a junk bond? It should have been the same standard definition that the rating agencies themselves had already established — any bond with a rating from S&P and Moody’s of double-B or lower.
But the insurance companies didn’t like that definition. “You can’t do that to us,” they told the insurance commissioners. “If you use that definition, everybody will see how much junk we actually have.” The commissioners struggled with this, but amazingly, they finally obliged.
It was like rewriting history to suit the new king. Rather than use the widely accepted standards, the insurance commissioners actually invented a brand new, cockamamie bond rating system of their own that conveniently misclassified the bulk of the junk bonds as “secure bonds.”4
Result: The insurance companies kept buying more and more junk, more investors got trapped into shaky annuities, and no one had any way of knowing how bad the situation really was — not even the regulators.
Pinocchio would be green with envy.
This went on for several years. Finally, however, after a few of us screamed and hollered about the sham, the insurance commissioners realized they simply could not be a party to the cover-up any longer.
They decided to bite the bullet. They adopted the standard double-B definition and reclassified more than $30 billion in “secure” bonds as junk bonds. It was the beginning of the first scene in the final act for the junk bond giants.5
The New York Times was one of the first to pick up the story. Newspapers ran it all over the country. And the cover-up was over. But unfortunately, for millions of investors, the fire had barely begun.6
Large junk bond insurance companies were falling like dominoes — Executive Life of California with 452,000 policyholders, Executive Life of New York with 102,000 policyholders, Fidelity Bankers Life with 373,000, First Capital Life with 268,000 — each and every one dragged down by large junk bond holdings.7
These were the same junk bonds that were bought with people’s keep-safe insurance money, hidden away by the deceptive insurance companies, covered up by the rating agencies and blessed by the state insurance commissioners.
Like today’s rating agencies and regulators, they knew they were hiding the truth, but they rationalized it as a “public service” to prevent a negative reaction by investors. In reality, they were merely helping to create the conditions for the very panic they sought to avoid.
One day, everything seemed to be just fine. Then the truth came out and all hell broke loose. Junk bonds went sour. Institutional investors in the insurers immediately demanded their money back. Insurance companies ran out of cash to meet their demands. And their house of cards came crashing down.
At one company after another, the insurance commissioners marched into the headquarters, took over the operations and declared a moratorium on all cash withdrawals by policyholders. How many policyholders?
We checked the records. The failed companies (including Mutual Benefit Life, which was caused primarily by real estate speculation) had exactly 5,950,422 policyholders, including individuals and groups. Among these, 1.9 million involved a cash value.8
If you were among these 1.9 million policyholders, your money was frozen. They wouldn’t let you cancel your policy. They wouldn’t even let you borrow on your policy. If you had a life-and-death emergency and you needed your money immediately for medicine or surgery, you had to beg and grovel before a state bureaucrat to prove that your emergency was more desperate than everyone else’s “emergency.”
The state insurance guarantee associations, which were supposed to make policyholders whole in case of an insurance company failure, choked and then went limp. Reason: They had no money. Unlike the FDIC, the insurance guarantee association in your state usually doesn’t have money in the kitty ahead of time; it raises the money from surviving insurance companies after a failure. That works when just a few small companies fail. But when the failures are large, where are they going to get the money? The guarantee system itself fails.9
The authorities put their heads together and came up with a “creative” solution. To avoid invoking the guarantee system, they just decided to change the definition of “when a failed company fails.” Instead of declaring the bankrupt companies “failed,” they decided to call them “financially impaired” or “in rehabilitation.” That way, the guarantee mechanism was not triggered and the cashless state guarantee associations saved face, while the freeze on all policyholder assets continued — for months.
Finally, the authorities created new companies with new, reformed annuities yielding far less than the original annuities.
They offered policyholders two choices: Either you “opt in” to the new company and accept a loss of yield for years to come. Or you “opt out” and we give you your share of the cash we have available for you right now. How much? In most cases, policyholders got back no more than 50 cents on the dollar. It was the greatest disaster in the history of insurance.
History Repeats Itself
As with the bond insurers of today, the life insurers of the 1990s took excessive risks. Then it was in junk bonds. This time it’s in mortgage-backed securities.
Like then, the rating agencies covered up the risks and were paid handsomely to do so. Then it was A.M. Best, S&P, Duff & Phelps and, sometimes, Moody’s. Now, it’s S&P, Moody’s and, to a lesser extent, Fitch.
Both then and now, the rating agencies devised various gimmicks to forestall downgrades while still giving their analysts some vehicle for covering their butts. Then it was ratings footnotes that the companies said were important for professionals but not needed when presenting the ratings to the public. Now, they’ve dropped that particular practice but use other descriptive devices like “negative outlook” that’s maintained for months, keeps getting more and more negative, but is still not reflected in the grades that the public sees.
And in both cases, the primary agenda of the regulators, at least initially, is to “protect the public from the truth” and effectively give their blessing to the cover-up.
The biggest problem of all: This time, the damage could be far greater.
How many retirees have placed their faith in the ratings of hundreds of thousands of tax-exempt bonds that could collapse in value?
How many municipal employees and their families are counting on the ability of local governments to roll over their debts in a muni bond market that could be largely obliterated?
How many more Americans, already hurting from the housing bust, mortgage meltdown, credit crunch and recession, will be impacted by the shock waves emanating from a muni bond disaster?
I’m afraid it could be many more than the six million with policies in the failed insurers of the 1990s. And I’m afraid that the great bond insurance cover-up, although temporarily postponing the inevitable, will just compound their woes.
Our recommendation: Build a wall of protection around your investment portfolio. Seek alternative markets that are far away from the turmoil of the U.S. credit crisis. And above all, stay safe.
Good luck and God bless!
Martin
1For a discussion of the amounts that each rating agency charged companies they rate, see “An Expanded Watch List of Life-Health Insurance Companies,” Insurance Forum, November 1994, pp. 110- 111. Insurance Forum, Inc., Box 245 Ellettsville, IN 47429 or www.insuranceforum.com.
2 Eric Berg, “New Ratings For Insurers Are Disputed,” New York Times, April 30, 1991.
3 In 1986, Michael Miken of Drexel Burnham Lambert, the leading proponent of junk bonds on Wall Street, persuaded several local governments around the country to issue municipal bonds for purported public purposes, raising $1.85 billion from investors. The investors, based on the disclosures furnished, thought they were buying municipal bonds for use in public projects. But they were really buying junk bonds in disguise: Their money was invested in Guaranteed Investment Contracts (GICs) with Executive Life Insurance Company. Executive Life, in turn, put most of the money into junk bonds. Except for one isolated transaction, none of the $1.85 billion was used for any announced public purpose. Fred Carr and Executive Life made out like a bandit, paying 8% to 9 1/2% for funds and earning 15% from the junk bonds they bought through Milken. In at least one documented case (the Memphis Housing Authority), it was agreed that S&P would be paid a $1 million fee to rate each of the municipal bond issues involved in the deal — apparently a lot more than their normal fee. S&P rated the bond in Tennessee, plus two issues in Louisiana, two in Texas, one in Nebraska and one in Colorado. They all received an AAA rating. Because of the way the deals were structured, it appears that the AAA rating was a precondition to the underwriters completing the transaction. If S&P failed to rate them AAA, it would have killed the deal. Second, it was agreed ahead of time that S&P would also give Executive Life an AAA. Documents in the case indicate that, when the S&P analysts asked Executive Life President Fred Carr what he intended to do with the money, he simply refused to answer them. That alone should have set off alarm bells and whistles. But it didn’t. S&P went ahead and gave Executive Life the AAA rating anyhow.
4 The Securities Valuation Office established the following four bond classes: “YES,” “NO*,” “NO**,” and “NO.” The first category, “YES,” was the one considered to be investment grade, while the three “NO” categories were considered junk bonds. However, the “YES” category actually included billions of dollars of bonds rated BB or lower (junk) by the leading rating agencies.
5 Based on the faulty definition of junk bonds used until 1989, the insurance commissioners reported that First Capital Life had $842 million, or 20.2% of its invested assets, in junk bonds at year-end 1989. However, based on the correct, standard definition of junk bonds which the commissioners finally began using in 1990, it turned out that First Capital actually had $1.6 billion in junk bonds, or 40.7% of its invested assets. Fidelity Bankers Life’s junk bond holdings, previously reported at $639 million or 18.3% of invested assets, jumped to $1.5 billion or 37.6% of invested assets. All told, the industry’s junk bond holdings surged from $51 billion at December 31, 1998 to $84 billion on December 31, 1990, with virtually the entire increase attributable to the change in definition.
6 Eric Berg, “Insurers Forced to Report More Investments As ‘Junk’,” New York Times, April 30, 1991.
7 Martin D. Weiss, “Toward A Full Disclosure Environment In The Insurance Industry,” testimony before the U.S. Senate Committee on Banking, Housing & Urban Affairs. See especially Chart 1.
9 For more on the failure of the guaranty association system following the large insurance company failures of the early ’90s, see “G.A.O. Finds Pension Risk in Funds Shifted to Insurers,” New York Times, April 22, 1993 and “GAO Hits Guaranty Funds’ Gaps,” National Underwriter, May 3, 1993.
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