Moody’s Investors Service on Friday downgraded the debt rating of key bond insurers MBIA Inc. (MBI) and Ambac Financial Group Inc. (ABK), increasing expectations that more write-downs are in the offing for the U.S. financial-services sector, which has already written off nearly $400 billion in losses.

Moody’s Investors Service, subsidiary of Moody’s Corp. (MCO), downgraded MBIA to A2 from Aaa, and Ambac from Aaa to Aa. The downgrade caused MBIA shares to shed more than 13% of their value, with an 86-cent decline to close at $5.59 on Friday. Ambac shares fared a bit better, gaining 2 cents to close at $2.05.

Moody’s downgrades follow similar reductions from Standard & Poor’s and Fitch Ratings Inc.

Many even question MBIA’s very survival, as it lacks the $2.6 billion in capital needed to regain its Aaa rating, according to Moody’s.

MBIA Chairman and Chief Executive Jay Brown fought off critics, saying that "despite the change in our ratings from Moody’s, our financial condition is very strong."

"We remain committed to maintaining capital strength for our policyholders and financial flexibility consistent with our goals of increasing shareholder value," Brown added in a company statement.

The downgraded ratings may have had an immediate affect on the insurers’ share prices, but also raised more questions about the more than $1 trillion in securities the firms guarantee. Those securities become riskier with the downgrade of the guaranteeing firms, making it more likely that defaults will escalate.

"The trouble for the banks is that the protection provided by the monolines becomes ‘less effective’ as the credit ratings of the monolines are downgraded," said Simon Adamson, an analyst at CreditSights, MarketWatch reported.

"In other words, the probability that the monolines will pay out on the contracts decreases," he wrote in a note to clients last week.

Some see the decline in ratings as an open door to new competitors.

"The issue really is, would they ever be able to get back to a triple A rating and I would think that would be a very heavy lift for them," billionaire investor Wilbur Ross said in an interview on Bloomberg Television on Friday. "On the other side of this credit crunch, people will be even more sensitive about ratings and the quality of the paper they’re buying."

And it’s likely that the "other side" of the credit crunch is still far off, according to analysts at the Royal Bank of Scotland Group PLC (ADR: RBS).

RBS analysts have warned clients to brace for a full-blown crash in the global stock-and-bond markets in the next three months, as the conflicting realities of slowing growth and rising inflation paralyze the world’s major central banks – causing "all the chickens [to] come home to roost," Great Britain’s Daily Telegraph newspaper reported.

The predicted swoon would cause the U.S. Standard & Poor’s 500 Index – already down 16% from its trading high of 1,576.09 reached Oct. 11 – to nosedive all the way down to 1,050 by September. For the closely watched, broad-based U.S. stock index, that would represent an additional decline of 20% from Friday’s close of 1,317.93- and a total decline of 33% from its Oct. 11 apex.

News and Related Story Links:

• MarketWatch:
  MBIA falls 7% after Moody’s cuts rating

• MarketWatch:
  Bond insurer downgrades reignite write-down fears

• Bloomberg News:
  Ambac, MBIA Unlikely to Regain Top Ratings, Ross Says

• Money Morning:
  Financial Fears Sweep the Globe After RBS Predicts Worldwide Stock-Market Crash

Year to date, shares of the largest U.S. bank by assets, Citigroup Inc. (C) have shed more than 10% of their value, but some investors still think the beleaguered bank is a smart investment.

Pacific Investment Management Co., more commonly known as PIMCO, and Calvert Asset Management Co. find the bank’s corporate bond yields attractive, Bloomberg reports. The spread on Citi’s bond compared to U.S. Treasuries reached a 272 basis point high at the end of January. Although the spread has narrowed slightly over the past weeks, it is still historically high.

"The fact that the banking sector has attracted fresh capital in the last couple of months is huge,” Mark Kiesel, an executive vice president at Pimco who oversees $158 billion of corporate bonds from Newport Beach, California, told Bloomberg. "We’ve been playing defense for the better part of two years, and the question we’ve been asking ourselves is when to go on offense. In the banking sector, we’ve started to do that."

PIMCO has been overweighting bank bonds relative to benchmark indices due to a market that is "too bearish" according to Kiesel. Renowned PIMCO Total Return Fund manager Bill Gross has also gone on record stating Citigroup, along with Bank of America Corp. (BAC) and Wachovia Corp. (WB) were "appealing".

"They’ve cheapened up to the point where there’s fair value," Gregory Habeeb, who manages $8.6 billion of fixed-income investments at Bethesda, Maryland-based Calvert. "You’re being compensated. I’m not saying there’s not risk there, but at least you’re collecting yield."

News and Related Story Links:

• Bloomberg:
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• Money Morning:
  Citigroup: Why This Turnaround Play Has Legs – Big Ones

Whenever the stock market is down, and seems destined to drop further, wise investors naturally look for a safe haven.

Municipal bonds are typically one such appealing haven, since they provide tax-free returns to individual investors in return for apparent safety of principal. Investors are soothed by the knowledge that no state has defaulted since 1841, and that smaller defaults – like that of Orange County in 1994 – are often fully repaid in the end.

Investors beware: This time around, municipal bonds may be altogether too close to the firing line for investors who are looking for a safe haven well to the rear of the action.

Bill Defeat a Sign of Trouble Ahead

The surprising defeat of California Gov. Arnold Schwarzenegger’s healthcare bill by the California state senate health committee shows that state lawmakers are becoming aware of the problem.

The bill had long been viewed as invulnerable, although there was some grumbling at its "individual mandate" feature, whereby middle-income taxpayers would be forced to buy expensive insurance.

But even with this bit of grousing, the bill was at the very top of the wish-list for California’s powerful liberal legislature, and was backed by Schwarzenegger, who retains considerable Republican support in spite of the fact that he nowadays governs primarily like a Democrat.

So what was the bill’s stumbling point? Apparently, the healthcare bill’s estimated $14.5 billion cost was deemed too great a burden for the suddenly rocky finances of California State. Since there is no sign, yet, of similar worries in Washington – it’s just the opposite, in fact – it’s worth looking very closely at just why California has suddenly become cautious.

How Taxing are These Taxes?

Property taxes are a major revenue source for both state and local governments. Thus, a serious real estate decline has a major effect on both, whereas at the national level it may have little revenue effect unless it is accompanied by a general recession.

In California, property taxes generally accrue at the local – and not the state – level, making it theoretically possible for only selected localities to default in a downturn. But in practice, the great majority of the state budget is used to prop up local tax bases, and resources are thus equalized across the state. After all, the principal use of property taxes is to fund local school systems, which most voters would put at the top of their priority list to be preserved in a downturn.

In California, property taxes fund about 22% of state revenue, including both state and local government. In addition, the state is protected to some extent in a downturn by "Proposition 13" of 1978, which capped the annual increase in the taxable value of a house while the resident remains in it. Thus, a house bought in 1980 may have half the tax valuation of an identical house next door, if that neighboring dwelling changed hands in 2006.

This has the effect of protecting the tax base from immediate downturn: Even if prices decline, some old houses will always be sold, unlocking their elevated valuations for taxation purposes.

Nevertheless, California local governments got used to their property tax base increasing by more than 10% each year from 2000 – including a 12.3% boost in 2006 – so the housing downturn will quickly affect the provision of local services, which inevitably have become bloated during the boom.

Add to that the effect of downturns in both corporate income taxes [because corporate incomes do actually decline in a downturn] and state income taxes [as residents, particularly in mortgage-banking and other real-estate-related industries, lose their jobs and no longer receive outsized bonuses], and you can see why the California legislature is worried that hard times may be ahead.

The State of These States

 There hasn’t been a state bankruptcy since 1841 [a year in which no fewer than eight states defaulted, including the supposedly prime quality "Keystone State" of Pennsylvania], but we haven’t had this significant a real-estate downturn since World War II.

The odds are that the places most affected will be the areas that had the largest price run-ups and that, conversely, can expect the greatest declines in the future. In addition, states that spend more lavishly than average, or that depend heavily on the troubled financial services industry, may be in particular trouble.

 In a November special issue, Fortune magazine calculated the amount that housing prices would have to decline in 54 major U.S. metropolitan areas to bring them back to an approximate equivalency with local rental levels. The article demonstrates that, in a number of metropolitan areas, prices are likely to decline by 30% or more in the next few years, whereas in others, the decline may be limited, or prices may even advance by a modest amount.

 The bottom line from Fortune’s analysis is that California [rated A+ by Standard & Poor's and A1 by Moody's Investors Service (MCO)], Florida (AAA/AA1) and Nevada (AA+/AA2) may be especially exposed to real-estate-price declines and consequent property-tax-revenue shortfalls.

 In addition, Maryland (AAA/Aaa), the District of Columbia (A+/A1), and to a lesser extent, Virginia (AAA/Aaa), are all vulnerable. On the other hand, Connecticut (AA/Aa3), Massachusetts (AA/Aa2), and Texas (AA+/Aa1), which suffered badly from the real estate downturn of the late 1980s, are much less vulnerable, and may even see modest price rises.

 New York (AA/Aa3) is only moderately vulnerable, but New York City (AA/A1) is especially in danger because of its very high exposure to the beleaguered financial services industry and its tradition of government waste.

 Of course, it’s likely that few – if any – of these municipal bond issuers will default. But if their ratings are substantially downgraded, municipal bond yields will increase and the bond prices will correspondingly decline. The issuers most vulnerable to housing woes should thus be avoided.

 News and Related Story Links: 

• Fortune:
  Real estate: Buy, sell, or hold?

• Money Morning News:
  Banks Step In to Shore Up Bond Insurers’ Shaky Ratings

• SacBee.com:
  California Health Plan Defeated

By Martin Hutchinson
Contributing Editor

It’s always difficult to predict a market’s performance over 12 months, but this year in the bond markets it’s simply impossible. The U.S. Federal Reserve will almost certainly change its monetary policy during the year, possibly more than once, and those changes will cause bond prices and yields to gyrate. Since success in the bond market in 2008 will require careful Fed-watching, I thought I’d set out some tips on what to look for.

In dropping the benchmark Federal Funds Rate from 5.25% to 4.25% in three moves since August, the Fed has backed itself into a corner. Central bank policymakers believed they had to drop interest rates because the subprime mortgage crisis had caused the global credit system to seize [although dropping rates hasn't made really fixed that problem], but the Fed didn’t wait until inflation was clearly down for the count before doing so. The result: Inflation is clearly up off the canvas, and is making a nuisance of itself by doing the "Ali shuffle" as it traverses the U.S. economy.

Inflationary Fuels Abound

Since August, oil prices have soared from around $70 a barrel to a just under the $100 a barrel level. That hasn’t happened because members of the Organization of Petroleum Exporting Countries (OPEC) are a bunch of global meanies [though they are], but rather because the soaring worldwide demand for oil has is pushed right up against supply, capacity is stretched very thin, and lower interest rates further stoke world demand and make the shortfall even worse.

That means the Fed may have to take some pretty nasty actions, and probably quite early this year. If oil prices continue increasing moderately – and do not feed through into "core inflation" [which excludes volatile food and energy prices, and which also is the statistic that the Fed looks at] – then all will be well. The central bank will be able to keep short-term interest rates low, which will probably keep long-term bond yields low and bond prices high.

Probably, in that case, the U.S. economy would continue to muddle forward with slow growth, but no outright recession.

That’s the scenario most observers are expecting, and indeed that hope may cause the Fed to drop the Federal Funds Rate one more time, at the close of the Jan. 29-30 policymaking Federal Open Market Committee (FOMC) meeting.

The Inflation Scenario to Watch For

Even so, I have to say that this isn’t the scenario I’d bet on. More likely, at some point in the year, oil and commodity prices – which already have pushed inflation well above the 4% level – will force up "core" inflation, too. At that point, two things will happen:

• The Fed will be forced to raise short-term interest rates, to fight inflation.
• And the long-term Treasury bond market will panic, as investors realize that – as in the 1970s – Treasury bonds suffer from their principal being eaten away by inflation, giving you the double insult of receiving interest payments that boost your tax liability, while suffering capital losses that can only be used to offset capital-gains taxes.

The bond bull’s scenario – where inflation comes down naturally, and the U.S. economy suffers through only a moderate recession – seems very unlikely to me. The Fed has already eased too much for that to happen; long-term interest rates are already below the rate of inflation, and are most unlikely to go lower.

The $500 billion injected into the banking markets by the European Central Bank in mid December makes the inflationary scenario more likely. Essentially, half a year’s European money supply growth has been dumped into the market in one operation. Unless the ECB forces the banks to repay all, or almost all, of that money in January, all that additional capital sloshing around in the world capital markets can do nothing but cause yet more inflation.

Most of those inflationary pressures will reach the U.S. shores, because the U.S. trade deficit is financed by the foreign purchases of bonds, transmitting much of the world money supply growth into the U.S. domestic market.

You therefore need to look at two things:

• The monthly inflation figures – particularly the "core" figures that the Fed watches.
• And the speeches coming out of the Fed.

If the Fed thinks an interest rate rise is necessary, it will try to prepare the market by issuing dark warnings for several weeks before it does anything. So a change in tone in Fed speeches – to one that’s much more worried about inflation – is a pretty good signal that the central bank is preparing the market for a reversal in monetary policy.

The Way to Play Bonds This Year

How should you play this? Well, the downside risk for Treasury bond prices is currently much greater than the upside potential, but yields in the short (2 year to 5 year) range, the usual protection against price drops are truly lousy at around 3%. In any case, if inflation takes off, it is likely that further weakness in the dollar will result.

Thus, you should look seriously at the as the no-load T. Rowe Price International Bond Fund (RPIBX), which invests in high-quality bonds that are not denominated in U.S. dollars.

You also want to find a good way to take a "short" position in Treasury bonds, an investment that will profit when bond yields rise and prices decline. There are currently no inverse bond exchange-traded funds (ETFs), but the Rydex Juno Inverse Government Long Bond Strategy C Fund  (RYJCX) offers the same position in the form of a mutual fund. Rydex Juno is well established, having been founded in 1995, and has over $1 billion in assets; its main disadvantage is that it has a relatively high 1.3% expense ratio.

Editor’s Note: Money Morning’s "Outlook 2008" series last covered Alternative Energy Investments. Next up: India.

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From Staff Reports

Deutsche Bank AG (NYSE:DB), Germany’s largest bank, announced Friday the launch of an anticipated $1.27 billion "Samurai" bond issue in Japan.

The new bond issues consists of five-year fixed (2.3% rate) and floating-rate tranches and a 10-year fixed-rate (1.77%) tranche.

Deutsche Bank tapped into the capital markets with bonds and swap instruments for more than 4 billion euro in the second half of August to provide liquidity for off-balance-sheet financing conduits, Thomson Financial reported.

Samurai bonds are yen-dominated bonds offered to Japanese investors from non-Japanese companies. Bloomberg News reported that sales of yen-dominated Samurai bonds have more than doubled this year, notably because U.S. authorities said that investors wouldn’t have to pay taxes of on the gains made on them.