We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.  Wait, why I am I mentioning the holding companies?  Isn’t it the operating subsidiaries that matter?

Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.  But let me tell a story first.

Failure improves markets by introducing risk-based pricing.  In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.  Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts (GICs) to institutions for their Defined Benefit and Defined Contribution pension plans.  The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.  (These were the days prior to risk-based capital.)

After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.  It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.

The rating agencies are ratchets. (or, do I mean rackets? )  Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.  But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises.