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What a Rating Downgrade Really Means

Sham Gad
January 25, 2008

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 identica