Earlier today, bond analysts at S&P downgraded to junk status $33 million worth of mortgage debt issued nine years ago by the Dormitory Authority of the State of New York (DASNY). DASNY had raised the debt to complete hospital construction projects.
The episode shows that beyond the headline mortgage meltdowns of the past two years, many of the more arcane structured-finance deals that also helped define the credit boom, although they are headaches rather than disasters, weren’t worth it.
Back in 2000, DASNY and its investment-bank advisers structured this particular debt so that the rating depended on the creditworthiness of a third party, Ambac.
Ambac, then rated AAA, was a bond insurer, meaning that its main business was to promise investors in municipal bonds that if the issuer of a particular bond didn’t pay, it would make the payments on behalf of that issuer.
In exchange for this guarantee, bond issuers were happy to pay Ambac a fee, because the guarantee that the insurer provided made the bonds easier to sell.
But in this particular case, Ambac didn’t provide its simple performance guarantee. Instead, the insurer guaranteed the performance of some investments that DASNY made.
As is normally the case, DASNY set aside some of the proceeds of its bond issue in a reserve fund, enough to pay several months’ worth of principal and interest on the bonds in case it ran into cash-flow trouble. Ambac guaranteed the performance of the investments in that reserve fund.
Today, Ambac’s guarantee is worth much less than it seemed to be nine years ago — in fact, it’s virtually worthless. Ambac squandered its own good credit rating by guaranteeing the performance of mortgage-backed securities issued at the height of the housing mania.
Now, the insurer is rated CC instead of AAA, and is really just in the process of liquidating itself, since that AAA rating was its only real asset (oh, how many PowerPoint presentations by bond insurers this half of FW sat through nearly a decade ago, each with an obligatory slide explaining this exact point).
Moreover, the credibility of the ratings agencies themselves is shot, too, in the eyes of many investors who relied not only on complex guarantees but on bond analysts’ ability to parse them.
Because Ambac’s guarantee of the DASNY bonds’ reserve fund has lost its value, the bonds, too, suffered their own downgrade, and are now rated CC along with Ambac.
The downgrade isn’t the end of the world. DASNY does not seem materially more likely to default on the debt than it did a week ago (although there’s always some risk, as with any investment).
And in general, New York public authorities, while they fell into some structured-finance pitfalls like this one, have avoided real catastrophes that have hit some other municipal issuers, including Alabama’s Jefferson County as well as the many transit agencies around the country whose managers tied up the public’s assets in strange deals with AIG.
Still, though, it took time, money, and effort for DASNY to put together this complex deal — time, money, and effort that turned out to be a waste. Further, the downgrade is a problem for some investment managers, who cannot put client money in bonds rated junk status.
All in all, it’s going to be a tough slog for investment bankers to convince securities issuers and buyers that simpler isn’t better.