What a Rating Downgrade Really Means

Issuing bonds to finance growth is common practice for many businesses and government entities.  Companies will issue debt to fund growth as an alternative to equity financing when it is to their advantage. But in the current climate, with confusing financial instruments and the possibility of  downgraded ratings for bond insurers, things could get worse before the market can cleanse itself as it must.

During periods of cheap money -- low interest rates -- equity investors benefit when leverage is applied prudently. Even Berkshire Hathaway (NYSE: BRK-A  ) , (NYSE: BRK-B  ) , with its cash pile exceeding $40 billion, uses debt at its subsidiary companies when it makes sense to do so.

Whether the bonds are corporate or municipal, the underlying issuer will sometimes find it economical to purchase bond insurance. Bonds issued with insurance will command a higher credit and thus a lower interest rate because of the additional protection. Ratings play a crucial role in the insurance industry, and most investors rely on three rating firms: Moody's (NYSE: MCO  ) , Fitch, and McGraw-Hill's (NYSE: MHP  ) Standard and Poor's.

A hazy situation
Bond insurance companies are rated similar to the way bonds are rated: on their financial strength and their ability to cover obligations when due. Billions of dollars worth of bonds are traded and valued based on the implied ratings they carry, and, if they have bond insurance, the ratings of the bond insurer. The monopolistic business environment the rating agencies enjoy is a function of the delicate responsibility they shoulder.  

The current credit turmoil has put bond insurers and rating agencies under the microscope. Bill Ackman, head of hedge fund Pershing Square, recently sent a crucial letter to the rating agencies expressing the quality of ratings being assigned to the bond insurers, specifically, MBIA (NYSE: MBI  ) . He asks a question that should be of interest to all investors.

Recently, MBIA priced surplus notes that yielded 14%. Within days, these notes were trading at prices in the $70s, implying a yield to call of over 20%. During the initial pricing, these notes were rated AA.

Today MBIA is still rated AAA. How is it that an AA-rated, credited instrument yields 14%? A rating of AA implies very little chance of default. As an investor, if I thought these notes were nearly identical to U.S. Treasury notes in terms of risk, I would margin my portfolio and put 100% of my assets into them and beat the pants off the market by taking on very little risk.

This situation cannot be. Ackman, in his letter, says that Bank of America (NYSE: BAC  ) 5.75% bonds due in 2017 were paying 5.5% on the day he wrote -- 15% less than the MBIA surplus notes.

The domino effect
All is not well in the current situation. If most corporate insiders at major financial firms are having difficulty understanding their own financial instruments, how can the rating agencies understand them any better? These are new credit instruments that were cleverly manufactured by financial wizards who had no fluid existing market to value them. John Thain, an incredibility shrewd risk manager, is still sorting out the mess at Merrill Lynch (NYSE: MER  ) .

The effects of a rating downgrade on bond insurers could create a financial correction of great scale.

Imagine for a moment that a massive rating downgrade is assigned to the bond insurers. A consequence would be a domino effect, a downgrading of bonds on a large scale. The outcome for a company sitting on any meaningful degree of leverage would be distinctly unfavorable.

We saw what the asset write-downs did for the mighty Citigroup (NYSE: C  ) . Imagine the effect on a company with substantially less financial resources.

Let the chips fall
In the end, the market must cleanse itself of the excess. Whether this correction has occurred or is in the third or ninth inning is anyone's guess. An attempt to avoid the inevitable by ignoring the obvious will prolong the crisis. Look no further than the housing bubble for proof of that.

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