Moody’s comments on financial guarantors’ exposure to California utilities

New York, NY, Jan. 17, 2001 à‚– Moody’s Investors Service said today that California’s escalating energy crisis has increased the probability of bankruptcy for both Southern California Edison (SoCal Edison) and Pacific Gas & Electric (PG&E) which, in turn, places the financial guaranty industry’s exposure to these utilities at greater risk.

Following SoCal Edison’s 8-K filing with the SEC yesterday, Moody’s cut the utility’s senior unsecured debt rating to Caa2 from Baa3, keeping the rating on review for further downgrade. PG&E was also downgraded by Moody’s to Caa2 from Baa3 and remains on review. Moody’s rating outlook for the financial guarantors with exposure to these two utilities remains stable.

Among the primary guarantors, MBIA’s exposure is by far the largest, with approximately $445 million in net par outstanding to SoCal Edison and another $590 million to PG&E as of Dec. 31, 2000. Roughly one-third of MBIA’s exposure is unsecured, with the remainder secured by first mortgage liens. Ambac’s exposure totals $75 million to SoCal Edison and $73 million to PG&E, all of which is fully secured by first mortgage liens.

FSA’s exposure is significantly smaller at $6 million to SoCal Edison and $13 million to PG&E, while FGIC has only $15 million in exposure to SoCal Edison and no exposure to PG&E. The guarantors’ aggregate net exposure to these two troubled California utilities as a percent of Sept. 30, 2000 capital levels (consisting of statutory capital, loss reserves, unearned premium reserves and the present value of installment premiums) was 13% for MBIA, 3% for Ambac, and less than 1% each for FSA and FGIC.

The rising level of uncertainty in California’s power market has increased both the probability of bankruptcy for SoCal Edison and PG&E, and the level of risk relating to the guarantors’ insured exposure. The utility rating downgrades in California reflect the financial default of SoCal Edison and the technical default of PG&E. If the guarantors pay claims under their insurance policies, the secured portion of their exposure may well benefit from high recovery rates if historical experience is any guide.

However, the level of uncertainty clearly rises under a bankruptcy scenario, and it’s difficult at this time to determine what the likely recovery rates would be, particularly on the unsecured portion of the guarantors’ exposure. Despite sizable exposures to these troubled utilities for some of the guarantors, no immediate impact on financial strength is foreseen.

Because the obligation under a financial guaranty insurance policy is to pay principal and interest when due (i.e., payments cannot be accelerated without the guarantor’s consent), the guarantors will have time to prepare for making any payments to bondholders that might be required. Current capital and liquidity positions among the guarantors are strong, and the incentive to maintain Aaa ratings over time remains high.

Nevertheless, aggregate exposure levels for MBIA in particular are sizable, which potentially exposes the company to material claims payments relating to these transactions and reinforces the negative impact that large single or correlated risks can have on the portfolio.

If MBIA’s actual losses net of recoveries turn out to be substantial, there would be pressure on the claims paying resources of the company. Among the monoline financial guaranty reinsurers, only ACE Guaranty Re (AGR) has significant exposure to these electric utilities. AGR’s total par exposure to SoCal Edison is $38 million. It is comprised of $8 million in bond reinsurance ceded from primary insurers and $30 million in unsecured exposure assumed through credit default swaps.

AGR’s total exposure to PG&E is $101 million, which is comprised of $6 million ceded from primary insurers and $95 million in unsecured exposure assumed through credit default swaps. AGR’s total exposure to these two utilities at $138 million, represents about 15% of its Dec. 31, 2000 capital base, which consists of statutory capital, loss reserves, unearned premium reserves, and the present value of installment premiums.

Because most of its exposure has been assumed through credit default swaps, AGR may experience higher loss severity on that exposure than the primary guarantors will on their non-credit default swap exposure. All of AGR’s credit default swap exposure is unsecured. Moreover, under the terms of its agreements, AGR may be required to settle these positions within thirty business days after the occurrence of certain credit events.

The method of settlement may vary: under some transactions, AGR may be required to purchase the defaulted instruments at their notional value, while under other agreements AGR may be required to make a cash payment in an amount approximately equal to the difference between the instrument’s notional value and its average market value over a period of approximately 30 business days following the occurrence of the credit event.

Despite the large magnitude of these potential losses relative to the company’s size, Moody’s believes it is unlikely that defaults by SoCal Edison and PG&E would prompt a negative rating action. AGR has more than adequate liquidity to meet its potential obligations.

Moreover, it has been operating with a modest capital cushion relative to its current rating level, in part because it has $25 million in unrealized statutory capital gains. The company has a healthy operating business as well and a powerful economic incentive to maintain its Aa2 financial strength rating. Furthermore, its parent company, ACE Limited, has substantial capital resources, which could be made available if necessary to preserve AGR’s franchise.

Assuming that loss levels are within current expectations, the guarantors’ exposure to SoCal Edison and PG&E should be manageable without requiring additional capital to support their ratings. Nevertheless, these exposures highlight the vulnerability that large single risks impose on a financial guarantor’s financial strength.

They also highlight the risk for a guarantor of providing financial guaranty protection through the credit default swap market, which can result in the acceleration of loss payments and higher loss severities. Moody’s will continue to monitor the situation in California closely, as well as the implications for the guarantors.

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