Thursday, 17 January 2008 05:00

As was warned in my previous monoline posts...

Back in October/November, I wrote a comical critique of MBIA and the big three ratings agencies. In it, I noted how absurd the relationship between MBIA and its reinsurer was, considering it was formed specifically to insure MBIA debt, holds a silly level of concentrated risk, and worse of all - is owned (17%) by MBIA itself. Well, finally I got someone to read my blogLaughing.

In my November writeup (from October research notes), I stated:

Relation between MBIA and Channel Re

Channel Re is a Bermuda-based reinsurance company established to provide 'AAA' rated reinsurance capacity to MBIA. Renaissance Re Holdings Ltd, Partner Reinsurance Co., Ltd, Koch Financial Re Ltd and MBIA Insurance Corp are the investors in Channel Re. MBIA has a 17.4% equity stake in Channel Re and seeded Channel Re with the majority of its business. Channel Re has a preferential relationship with MBIA.

Channel Re has entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA through June 30, 2009, and subject to renewal thereafter. Channel Re assumed an approximate of US$27 bn (par amount) portfolio of in force business from MBIA Inc and has claims paying resources of approximately US$924 mn. (source Renaissance Re 10K. Swapping Paper Losses Channel Re is insulated against huge losses because of adverse selection in terms of pricing and risk on the assumed portfolio of MBIA. The agreement between the Channel Re and MBIA protects channel Re against any major losses. This financial reinsurance scheme smells a little fishy.

Is MBIA dumping mark to market losses on Channel Re through reinsurance contracts?

The SEC and the NYS Insurance Dept. thought so. In addition, there is overlapping risk retained through the relationship - MBIA has an equity investment of 17.4% in Channel Re. Channel Re assumes 52.37% of the total par ceded by MBIA of US$74 bn. The total par ceded not covered through reinsurance contracts due to the equity investment of MBIA in Channel Re is US$6.7 bn. Thus, there is a little under $7 billion dollars of risk that many think MBIA is covered for that it really is not. Then there is the case of diversity of Channel Re's portfolio. I have a slight suspicion that MBIA's business makes up much too much of it to be considered well diversified. Rennaisance Re, the majority owner, has also come clean admitting that Channel Re has a very high exposure to CDO losses and mortgage backed securities. Uh oh! This admission came from the extreme losses Channel Re took last quarter due to mark to market issues for mortgage backed paper. Again, is MBIA doing the old financial reinsurance scheme that was outlawed not too long ago? My gut investor's feeling tells me...For those not familiar with the reinsurance game, here is a primer on financial reinsurance.

Now, today and nearly three months later) from Reuters:

Bermuda reinsurers RenaissanceRe Holdings Ltd and PartnerRe Ltd said on Wednesday they will write off 3-year-old investments in Channel Re, a reinsurer formed solely to do business with MBIA Inc , the world's largest bond insurer.

The announcement comes after Channel Re notified the companies that fourth-quarter losses stemming from its business with MBIA are expected to exceed its shareholders equity.

RenRe said its investment in Channel Re carried a value of $126.7 million at the end of September. PartnerRe said it would take a $74 million fourth-quarter charge, equal to about $1.31 per share, to write down its investment.

Reinsurers effectively insure other insurers, spreading the risk of losses among more than one party.

Channel Re expects $200 million in credit impairments from a $3.3 billion mark-to-market charge at MBIA, according to Partner Re's statement.

David Lilly, an outside spokesman for RenRe, declined to comment further on the Channel Re development. PartnerRe could not immediately be reached for comment.

Rising defaults in mortgage-related bonds have threatened to wipe out a significant amount of capital for bond insurers such as MBIA, putting ratings under threat of downgrade.

Channel Re was jointly formed in Bermuda in 2004 by MBIA, RenRe, PartnerRe and Koch Financial to do business exclusively with MBIA, which held a 17 percent stake. RenaissanceRe was the largest owner with about 33 percent, Koch owned roughly 30 percent and Partner Re, 20 percent.

Channel Re had a triple-A rating, with a stable outlook, from McGraw-Hill Co's rating firm Standard & Poor's.


and then...


Now, back to the news release...

Bermuda, an offshore reinsurance center, is home to more than 1,500 insurers and about half a dozen bond reinsurers, including another that counted MBIA as a large customer, Ram Reinsurance Holdings .

Separately, RenaissanceRe said it will also take a $55 million charge in the fourth quarter to increase its incurred, but not realized, reserves for subprime-related exposures in its casualty clash reinsurance business....

RenRe said it expects to post a profit in the fourth quarter and for the full year despite the charges. It is due to report quarterly earnings on Feb. 5.

Sepearately, as reported in :

The FINANCIAL -- According to Dow Jones, RenaissanceRe Holdings and PartnerRe Ltd. said late on January 16 that their investments in Bermuda reinsurer ChannelRe are now worthless amid turmoil in the bond insurance industry. RenaissanceRe owns 32.7% of ChannelRe, a financial guaranty reinsurer that provides back-up coverage exclusively to bond insurer MBIA Inc. (MBI). PartnerRe (PRE) owns 20%, Koch Financial owns 29.9% and MBIA owns 17.4%. RenaissanceRe's stake in ChannelRe was valued at $126.7 million at the end of the third quarter. The company said late on January 16 that this will now be cut to zero. PartnerRe, which valued its stake in ChannelRe at $74 million at the end of September, said the same thing. BIA said recently that it will take a $3.3 billion charges in the fourth quarter to cut the fair market value of some of its exposures to mortgage-related securities. Because ChannelRe reinsures some of MBIA's risks, it will also take write-downs. Those charges will exceed its shareholder equity, or net worth, under generally accepted accounting principals, RenaissanceRe (RNR) and PartnerRe explained. RenRe said it expects to post a profit in the fourth quarter and for the full year despite the charges. It is due to report quarterly earnings on Feb. 5.

Now, recently I've been moaning and complaining about another poisonous monoline insurer/reinsurer relationship, that of Assured Guaranty and Ambac, in Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibilty They May Have Had Left on December 15th.

MBIA takes nearly a billion dollars in value losses on its portfolio in one month, gets a 500 million dollar equity investment below current market price, and an offer for another $500 million through a discounted right's offering, which brings it back to where it was before it lost the $1 billion last month (which was in trouble) and it gets its AAA rating confirmed??? Ambac buys reinsurance from Assured Guarantee, a company in the same business as Ambac taking very similar losses, and it gets to retain its AAA rating??? Doesn't anyone see concentration risk and an uncomfortable amount of correlation here, or is it just me?

Assured Guaranty reported a net loss of $115.0 million, or $1.70 per diluted share, for the quarter ended September 30, 2007 compared to net income of $37.9 million, or $0.51 per diluted share, for the third quarter of 2006. The decline in net income was primarily due to an after-tax unrealized mark-to-market loss on derivatives (hey, isn't that what Ambac and MBIA said as well?) that was announced by the Company on October 22, 2007 of $162.9 million, or $2.40 per diluted share, on financial guaranties written in credit default swap ("CDS") contract form. As of November 30th (38 days later), it reported that it has after tax mark to market losses of $220 million. They are averaging one and a half million dollars per day in value loss, with this rate bound to accelerate in the very near future (they only had $1.6 million in 9/06 - that's a 200x increase). The macro conditions that brought upon the CDS (paper) loss are getting much worse, not better as the trend clearly indicates. About 70% of the unrealized CDS loss stems from RMBS and CMBS swaps. Well, you know how I feel about the residential market. Here is how I feel about the commercial market. Things are about to get much worse. Despite all of this, AGO now accepts $29 billion of additional ceded risk from one of the most dangerous monoline portfolios in the business. I am appalled!

I hear a lot of people crooning about this being only paper losses, and not actual claims until payment is defaulted or missed or principal is actually and materially impaired before maturity. Well, it is happening now, and in droves. AGO's management laments on how they have minimal exposure and losses to direct subprime liabilities, which appears to be true with a casual glance at their reporting, but the devil is again, in the details. Aside from 75% of AGO's mortgage portfolio being in the most toxic vintages of 2006 and 2007 (which most likely will lead to problems down the line), they have a strong correlation in product mix with Ambac, the company they just reinsured $29 billion of exposure. Ambac's loss exposure is stemming primarily from their structure product and consumer finance guarantees, not their residential mortgages, per se. Structured finance in particular is what got them in trouble. There is no real loss history on this stuff, because it is brand new and the losses that are being witnessed now are tremendous. Well, hazard a guess as to where the majority of Assured's earned premium comes from? That's right, structured finance. As of 9/30/07, it was 58%. Now, with the acquisition of Ambac's risk, and of course depending on exactly what it was that was actually reinsured (we don't really know yet, do we?) it will/can definitely shoot upwards, significantly upwards. No matter which way you look at it, there is a VERY high concentration of risk, especially in an area with no real discernible loss history and the only real discernible losses being significant. Compare and contrast to the actuarial loss histories used in life, vanilla P&C, and health lines - we're talking multiples of decades (like 50 - 60 years+), not just a few years as in CDOs. That is REAL insurance. This new fangled, financially (not so)engineered, structured product guarantee business is gambling with shareholders capital, pure and simple - slot machines - Vegas style!

I'm not trying to make it seem like AGO foolishly reinsured ABK's book. On the contrary, AGO probably just took the best stuff from Ambac (they apparently refused to insure CDOs), which really leaves the ABK shareholders worse off. They also only insured $29 billion out of a much, much larger portfolio of exposure. I am trying to point out the reduced value of reinsurance when there is a high correlation of risk between the two parties. If I am sick and you have the same disease, it may not be prudent for me to give you a blood transfusion! Some risk will be retained through counterparty credit risk, or put in simpler terms - two sick people sharing the same blood and calling it a cure. Thus, in my opinion, the number $29 billion is misleading as to the actual amount of risk transferred. Another example of this correlation is MBIA, who actually owns 17% of their main reinsurer. Now, how is that truly transferring risk? They are only transferring 83 cents on the dollar, and that 83% is further reduced by the amount of correlation in the insured portfolios and losses - and there definitely is correlation, for their reinsurer took losses for derivative mark downs the same quarter that MBIA did, and passed them on to its parent companies, of which MBIA is one, along with General Re. This monoline business model stinks, pure and simple.

AGO used capital to buy back shares in lieu of reserving for future losses through '06 and announced a new buy back program going forward last month in November to buy back more shares. Hey, why provision for losses when we can buy back shares. That's what MBIA & Ambac did and look where it got them (this is how I feel about buybacks). If you get a chance, look at these two cos. charts at about the time they borrowed money to buy back stock. Look out below!!! But wait!!! Just a few weeks ago, Assured then announces its intention to sell $300 million in shares to shore up its capital in its reinsurance division to go huntin' for new business. Like Moody's, these guys are a fickle bunch. So, my astute readers should ask, why didn't they just take the money that they used to buy back the stock and simply reinvest it in their business to begin with??? Hmmm! Good question. Could it be that management did not have the foresight to see this opportunity coming just last month. If so, what else did they "not see"? I would suggest you look into the risk profile of their newest addition to their portfolio.

Thanks to Moody's, the AAA rating moniker is now close to worthless.

Now, the pundits swear that AGO is one of the safest or monoline reinsurers. I am stretch thin as it is, but I think I will take an even closer look at AGO. I'm bearish on the company as it is, being that I took a very cursory look and definitely didn't like what I saw. Let's see what we can dig up of I pull out the forensic spyglass... For the record, I am obviously short any company that I post bearishly on, and long any company that I am enthusiastic about. I invest for a living, and am not a writer, so I believe it is not necessary to include the normal disclaimers. I will put in a general disclaimer for all of my written opinions - I put my money where my mouth is, or at least I try toLaughing.

Last modified on Thursday, 17 January 2008 05:00