Moody's Investors Service said yesterday that bond insurers' recent mark-to-market losses on credit default swaps "may not represent a true indicator of actual credit deterioration," providing some support to the insurers' claims that unrealized losses from CDS on their balance sheets are likely higher than losses could be from actual claims.

However, Moody's warned that the unrealized losses represent more than just accounting "noise" because they show insurance on the same risk exposure would require a bigger premium today, and that weakened balance sheets could reduce insurers' ability to gain business and raise capital.

"In public disclosures, the guarantors have indicated they believe expected actual credit losses on their insured CDS portfolios will be materially lower than implied by estimated market values ascribed," wrote Moody's vice president Wallace Enman in the report. "This view is broadly consistent with the analysis performed by Moody's in our modeling of the guarantors' portfolios, as disclosed in our research."

Because most credit default swaps are treated as derivatives, they must be marked-to-market on insurers' balance sheets even if they are designed to be held to maturity and have no requirements for collateral posting or early termination. Declines in swap values do not necessarily impact the insurers' actual claims-paying resources, appearing as unrealized losses on the balance sheet that will reverse over time if the insurer never has to pay a claim.

But the unrealized losses have battered the balance sheets of many insurers, the report showed. MBIA Inc., for instance, has taken mark-to-market losses of $5.8 billion over the last three quarters excluding impairments. Its equity according to generally accepted accounting principles fell to $1.3 billion from $6 billion over that time.

The balance sheet losses could scare off potential customers and make investors weary of injecting capital into the firms, Moody's said. The losses could also trigger debt covenants that would cut off insurers from their credit facilities.

"Despite the fact that non-economic mark-to-market losses do not directly affect the guarantors' claims paying resources of the guarantors, the marks can significantly inhibit the financial flexibility of the industry in several ways," the report said.

In addition, some CDS allow a holder to demand a market-value termination when the counterparty becomes insolvent. Although Moody's said a majority of insurers' have a low risk of insolvency, these provisions "represent another way in which mark-to-market valuations could have real consequences."

"Such terminations could result in significant cash payments being required," the report said. "In such extreme cases, and assuming market values remained depressed, the guarantor would be forced to realize losses that might otherwise reverse over a longer time horizon."

The holding company of a bond insurer usually sells a swap through another subsidiary before having the insurer insure the swap. This eliminates the impact of mark-to-markets on the statutory capital of the bond insurers unless default occurs.

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