Insurer Risk: What Kind of Damage Would Banks Sustain From An Ambac Down Grade?

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One of the things that is very apparent from Merrill's earning's statement is that the banks face serious counter-party risk now that bond insurers have run into trouble. Merrill took "credit valuation adjustments" of $2.6 billion related to hedges with financial guarantors on US ABS CDOs.
"These amounts reflect the write down of the firm’s current exposure to a non-investment grade counterparty from which the firm had purchased hedges covering a range of asset classes including U.S. super senior ABS CDOs," Merrill stated.
But this could only be the tip of the iceberg. The downgraded counterparty is said to be ACA. But other bond insurers, including the giant Ambac, are facing write-down risk. Last night Moody's told the market that Ambac is in serious risk of a downgrade.
According the FT Alphaville, the bank’s total exposure via credit default swaps purchased from the bond insurers for super senior CDOs is $19.9 billion, so if there are more downgrades there is a potential for even larger "credit valuation" write-downs. And that's just Merrill.

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