Fitch Ratings said that while the near-term rating outlook for the bond insurance industry is "negative," the intermediate-term outlook is "uncertain" based on a combination of possible positive and negative trends.

The comments came in an updated outlook on the monoline financial guaranty sector released yesterday. Fitch said that "lingering uncertainty as to ultimate subprime-related losses" in addition to capitalization questions are driving the near-term negative outlook.

Fitch noted that of the seven financial guarantors rated "AAA" for financial strength in the beginning of 2007, five have been downgraded by all three rating agencies. Fitch added that it "believes each of these companies is susceptible to further ratings pressure in the future."

Fitch also said several guarantors face a risk that statutory capital levels may be depleted due to increasing losses as insured portfolios deteriorate.

It said this activity could in turn result in "both regulatory intervention and a possible termination settlement claim on various credit default swap (CDS) positions. This could result in a steep 'ratings cliff' as was most recently seen with the downgrade of CIFG."

The rating agency added that ratings will be "very difficult to stabilize" on downgraded companies until they can find ways to limit the downside risk from their structured finance collateralized debt obligations (SF CDOs).

For the intermediate term, though, Fitch said that certain factors could lead to downgrades, but other factors could possibly result in upgrades "once the near-to-intermediate term balance sheet issues related specifically to subprime losses are effectively stabilized for those financial guarantors that are ultimately able to remain viable."

Some factors that may continue to adversely affect the industry, Fitch said, are:

o Tarnished industry reputation.

o Declining municipal participation--Fitch noted that the insurers' market share for new U.S. municipal business dropped by nearly 50 percent in 2008 compared to 2007.

Financial guarantors now hold 26 percent of this market, "as many obligors have chosen to either issue new debt uninsured or seek alternate forms of credit enhancement, such as bank letters of credit," Fitch said.

The firm forecast that the industry profile will "change dramatically" in future years if the industry's market share remains at these levels.

o Uncertainties for structured finance business--Fitch said, "While structured finance risks were the cause of the industry's recent problems, structured finance has been a core source of revenues, profits and growth for the industry." Given the recent turmoil, Fitch questioned whether structured finance will be a source of revenue and profit in the future.

Factors that could have a positive impact on ratings, according to Fitch, are:

o Better underwriting risk focus--The industry, Fitch said, has indicated that it will be much more selective with respect to structured finance risks in the future.

o Improved risk management.

o Regulatory support--Fitch noted that insurance regulators have been "very proactive in the past several quarters to support stability in the financial guaranty industry." Some regulatory changes under consideration, Fitch said, such as increasing the amount of minimum capital required to conduct financial guaranty operations, may reduce the risk profile going forward.

One issue that Fitch said can have "both positive and negative ratings implications over the intermediate term" is the possibility that guarantors could split their municipal and structured finance businesses into separately capitalized and rated companies.

Fitch said, "We believe most such structures would be designed to result in an upgrade in the municipal company to 'AAA' or 'AA,' but would allow the structured finance company to remain at the current (downgraded) rating, or to be downgraded further."

But Fitch said that such a plan would be "very difficult," and added that one possible challenge to this plan could be one class of policyholders becoming subordinated to another, resulting in possible "legal obstacles in effectuating this subordination."

Special Reports /

Fitch: Bond Insurers Intermediate Outlook 'Uncertain'

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