The only thing pushing Assured Guaranty Ltd. into the red in the second quarter was its own good credit.
If that seems counter-logical, try this: just about the only bright spot for Ambac Financial Group Ltd. last year was its own bad credit.
Because of accounting standards governing how companies book the value of credit derivatives, Assured Guaranty recorded a hefty loss on the credit default swaps on its books in the second quarter.
The company attributed the loss primarily to the market's perception that Assured's credit quality had strengthened. Yes, that's right. Strengthened.
Meanwhile, Ambac last year recorded a $10.2 billion gain on its derivatives.
This during a year when structured products shoved Ambac's credit head-first toward junk and wiped out every after-dividend dollar of profit the company ever recorded plus more than $3 billion.
All this stems from a provision in a pronouncement from the Financial Accounting Standards Board that went into effect last year.
The provision, in pronouncement SFAS 157, states companies have to carry their derivative liabilities at fair market value.
The intent is simple: a company's books should carry liabilities on derivatives based on how much the company is likely to pay on them, not how much they cost at the time they were sold.
The real-time market value of a derivative theoretically provides constant updates of the probable costs of the contract to an insurer.
Ideally, as the market's verdict on future costs from derivatives varies, the insurer records gains and losses so the expected costs of the contracts would be expressed through income.
The pronouncement led to a strange consequence. When a company's credit quality improves, an existing contract with that company as insurer becomes more valuable.
This follows intuitively: if an insurer is less likely to default, you would be willing to pay more for a contract with that insurer.
If you paid $1,000 for a contract with an insurer and then the insurer's financial strength improved, you have a contract now worth more than $1,000 because of that improvement.
The insurer, meanwhile, only collected $1,000 for a contract it could charge more for if it sold today.
The difference between what the insurer collected and what it could collect today, according to the FASB, is a loss. It is a more expensive liability.
This brings us to Assured.
Credit default swaps on Assured's bonds - the prices of which reflect investors' perception of Assured's ability to meet its obligations - are doing well.
According to CDS quotes on Bloomberg LP, the cost of insuring against a default by Assured on its own bonds tumbled from $3,847 a year per $10,000 face value at the beginning of the second quarter to $1,544 per $10,000 at the end.
What that means is parties that have contracts with Assured as counterparty enjoy a bonus: those contracts are safer and more valuable.
In a sense, Assured is not charging them enough now.
Under the derivatives treatment prescribed by SFAS 157, the ascendant value of contracts held by Assured's counterparties means Assured has to record an increase in the value of its liabilities.
An increase in liabilities is a loss.
That interpretation of the improvement in Assured's credit forced the company to book a $190.2 million loss on those contracts. That was enough to push the company to a loss for the quarter.
"It's an accounting policy that doesn't make sense for our business model," said Sabra Purtill, managing director for investor relations at Assured. "We don't think that mark-to-market makes sense relative to what we're actually guaranteeing, but that's what we're required to do."
The same dynamic can credit an insurer for gains on its swaps based on a likelihood the company itself will become insolvent.
At the beginning of 2008, insuring against a default on an Ambac bond through a CDS cost $343.30 a year per $10,000. By the end of the year, it cost $2,105 per $10,000, according to Bloomberg, presumably because of the perception of greater default risk.
This made its liabilities less valuable. Any contract with Ambac was susceptible to higher default risk.
The market value of the contracts it might owe money on is lower.
SFAS 157 does not care that the reduction in liabilities stems from the risk that the company itself might go under.
The reduction in liabilities translated to a gain for Ambac.
An investor who fell asleep under a tree in 2006 and woke up this year might have trouble deciphering the following excerpt from MBIA Inc.'s first-quarter report describing losses on structured products: "These negative effects were positively offset by the impact of the deterioration in the market's perception of MBIA Corp.'s and its reinsurers' creditworthiness."
MBIA was explaining how the increase in the cost of insuring its bonds through CDS - from $3,344 per $10,000 at the beginning of the quarter to $5,312 per $10,000 at the end - implied the decay of its own credit and thus led to a reduction in liabilities to others. Under this standard, that means a gain for MBIA.
Some analysts who cover bond insurers say they ignore these variations. The companies say the gains and losses will converge over time toward zero.
The fluctuations are more than just illogical nuisances that even out over time. They create an illusory hedge.
In its 2008 annual report, Assured explained that the CDS spreads on its own bonds tend to move in tandem with the broader market.
That is, when spreads on swaps in general widen, Assured's own spread tends to widen too.
The consequence is that investors do not gain a clear glimpse into the market's judgment on the potential costs of an insurer's derivatives.
Some of the losses on MBIA's contracts that represent the market's perception of actual losses the company is likely to face are offset by gains on contracts that represent nothing more than a deterioration in the company's own credit quality.
Conversely, Assured reported a loss for the second quarter simply because investors believe it is more likely to stay in business.