Fantasy Land

In the streets there's no wrong and no right
So forget all that you see
It's not reality
It's just a fantasy
--Aldo Nova

The debt markets largely depend on two rating agencies, Moody's and S&P, to rate the creditworthiness of borrowers. Ratings range from AAA (excellent ability to pay back lenders) to junk (very questionable capacity for payback).

Bond issuers (i.e., borrowers) want to score higher ratings, because higher ratings mean borrowers pay less to borrow funds. Moreover, many institutions (e.g., pensions funds) are by charter only permitted to invest in 'investment' grade debt; they can't buy the riskier 'speculative' grade stuff.

Recently, eyes have focused on the credit ratings of MBIA (MBI), the largest insurer of municipal bonds. Oddly, MBI has historically enjoyed the top AAA rating, despite being a highly leveraged entity. For comparison, the other half dozen companies garnering the AAA rating include some of the most hisorically solid large companies out there including General Electric (GE), Johnson & Johnson (JNJ), and Berkshire Hathaway (BRK.A).

MBI's AAA rating has been vital to its success on a number of fronts. Since they borrow so much money, their top shelf credit rating drastically reduces their cost of borrowing. Morever, those insured by MBI, primarily cities and other locales issuing 'municipal bonds', enjoy lower costs of borrowing because MBI guarantees payback of the debt that they insure. Buyers of the debt are willing to settle for a lower interest rate in exchange for the guaranteed payback.

The concern right now is that, due to the credit crunch and general economic slowdown, many municipalities are closer to defaulting on their positions than they have been in years. If they default enmasse, there is no way MBI will be able to cover all claims by muni bond holders. Some folks think that MBI is currently insolvent. In these types of situations, the bond rating agencies would typically look at the numbers and downgrade MBI's ratings. The consequences of doing so, however, would be significant. Muni bond markets might freeze up, and MBI would be rendered insolvent as municipalities defaulted.

So, lo and behold, the rating agencies came out this week and reaffirmed MBI's AAA credit rating. MBI just closed their FY2007 books with $3.1B in revenues, a -61% profit margin, and about $3 in debt for each $1 in cash. For comparison, Pfizer (PFE), a company that just LOST their AAA rating a couple months back, sported FY2007 results $48.6B in revs, 17% profit margin, and $22B in cash on the balance sheet (about $3 cash for each $1 debt).

Does something seem out of whack to you?

Why MBI ever earned the AAA rating to start with is easy to speculate about. Pessimists suggest that below-board deals were struck (and continue to be struck) to preserve MBI's rating.

The question, of course, is whether any rating shennanigans will continue to be effective, or whether the market ultimately wakes up, and finally recognizes that the emperor wears no clothes.

position in PFE