Deus Ex Macchiato

Rather like Lost, the Monoline Death Watch has been going on so long that one can neither remember all the twists and turns, nor rouse much enthusiasm for the final denouement. Still, the news from Bloomberg that Wisconsin Insurance Commissioner Sean Dilweg

is taking over a portion of Ambac’s policies to protect municipal bondholders who count on the company’s guarantees. He halted payments on the $35 billion of mortgage bond policies and other contracts

The press release is here: comment from Rolfe Winkler (who seems to be a rather less hysterical and better informed Reuters blogger than Felix Salmon) is here.

Basically Dilweg is segregating the muni insurance business written by Ambac Assurance Corp from the bad stuff, primarily CDS on ABS. The CDS counterparties will get 25 cents on the dollar or so, plus a share in any eventual upside from there. This is an event of default for credit derivatives referencing Ambac.

Update. There is a provocative post on the legal implications of the segregated account approach Ambac has taken by Stephen Lubben at Credit Slips here. I’m not up to speed with the details here, but it certainly seems that the possibility of being forcibly novated into a position with less access to liquidity and much less capital might be troubling to a counterparty…

Posted in: CDS and Negative Basis, Monoline by David /
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I always thought that of the monoline insurer’s two businesses, writing wraps on muni bonds was safe, while writing wraps on structured finance instruments was dodgy. It seems I was wrong about the first part. From Bloomberg:

Ambac Financial Group Inc., the second biggest bond insurer, faces as much as $1.2 billion in claims if a judge in Nevada allows Las Vegas Monorail Co., which runs a train connecting the city’s casinos, to reorganize in Chapter 11 bankruptcy… The City Council of Pennsylvania’s state capital shelved a plan to sell taxpayer-owned assets to meet payments on $288 million of debt used for an incinerator funded in part with bonds insured by a unit of Bermuda-based Assured Guaranty Ltd. Harrisburg is weighing a possible bankruptcy filing.

With state tax collections last year through September showing the biggest drop since at least 1963, as measured by the Nelson A. Rockefeller Institute of Government in Albany, New York, local governments are seeking concessions from creditors of public projects, including bond insurers.

Ooops.

Update. A correspondent of Felix Salmon’s points out that the total claims-paying resources at National Public Finance Guarantee, the muni arm of MBIA, are $5.5B. That’s about 1.1% of its insured bonds. Hmmm, seems a bit light to me…

Posted in: Credit, Monoline by David /
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MBIA, once one of the most important monoline insurers, is sueing Credit Suisse for pervasive and material misrepresentation of the risk that they insured on RMBS. From Bloomberg via FT alphaville:

A Credit Suisse Group AG unit was accused in a lawsuit by MBIA Insurance Corp. of making fraudulent misrepresentations about mortgage-backed securities… [in a] transaction that was sponsored, marketed and serviced by the Credit Suisse units…

“CS Securities fraudulently induced MBIA to participate in the transaction,” MBIA said in the complaint. MBIA said the bank claimed it had “used certain strict underwriting guidelines to select the loans sold into the transaction when in fact it did not.”

So far, so ordinary. Insurers takes risk, insurer takes hit, insurer claims it did not know what it was doing because the client did not tell them everything, insurer sues is a sadly common story. But this one gets better:

Since the transaction closed, the securitized loans have defaulted “at a remarkable rate,” MBIA said.

“Through Oct. 31, 2009, loans representing more than 51 percent of the original loan balance, or approximately $464 million, have defaulted and been charged-off, requiring MBIA to make over $296 million in claim payments,” MBIA said.

MBIA said that a review of the defects of the loans included in the transaction show they were “systematically originated with virtually no regard for the borrowers’ ability or willingness to repay their obligations.”

One might wonder why MBIA did not notice this before they agreed to take the risk. So (as FT alphaville puts it) in order for MBIA to succeed, it will have to convince a court that its much-vaunted underwriting and due diligence weren’t actually all that great. Mind you, given that MBIA have gone from being AAA-rated to BB-, that might not be too much of a surprise to some people.

Posted in: ABS, Legal Risk and Trade Documentation, Monoline, Mortgages by David /
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Felix Salmon discusses some recent JPM research on MBIA:

in a note issued this morning they said that MBIA’s tangible book value is actually negative, to the tune of about -$40 per share.

OK, the full article has some caveats. But the mere fact that a reputable investment bank (if that is not an oxymoron) can suggest that MBIA is insolvent should raise some warning signs about the extended historical fiction that is insurance accounting.

Posted in: Accounting, Insurance and Actuarial Practice, Monoline by David /
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(The fate of the monolines was sealed by the risk they wrote in 2005-2007, so day 1000 is if anything conservative – it takes insurers a long time to die thanks to their accounting and the pay as you go nature of the claims against them.)

In a move so predictable it hardly raises a yawn, Bank of America, Citigroup, JPMorgan and 15 other large financial institutions filed suit on Wednesday against MBIA, claiming the bond insurer reduced its ability to pay policyholders by splitting its business in two.

It is difficult to think of how a monoline could split without generating lawsuits. If x of capital and y of investments support z of risk, and you split z into to pieces, how do you divide x and y? There is not widely agreed answer, so someone is going to think that the credit quality of the piece they end up with a claim against is lower that it should be – and they will sue. Moreover since there are clearly diversification benefits between risks, even if the split is entirely fair, the capital needed for the two pieces is larger than that for the original whole.

The lesson? Agree collateral upfront, based on your marks.

Posted in: Capital and Contingent Instruments, Insurance and Actuarial Practice, Monoline by David /
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Watching the monolines die is a bit like listening to Fidelio. Intellectually you know that it going to end, but there are times when it feels like it cannot happen fast enough. Now we seem to have moved past the Komm, Hoffnung of Act 1 – there is no hope – and the protagonists are in chains. Specifically Syncora (which used to be called SCA – the name swapping in monoline land is as bad as that in a Shakespearean comedy, and a lot less funny) has stopped paying claims. This is of course a default event for CDS written on it. The FT story is here.

Posted in: Monoline by David /
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From Bloomberg:

MBIA Inc. was sued by Third Avenue Management LLC… over claims the insurer’s split of its bond-insurance businesses hurts debt holders.

Three mutual funds managed by Third Avenue bought notes issued by MBIA Insurance Corp. in February 2008 based on assurances that the company was recapitalizing following losses in its structured finance insurance business…

MBIA, the largest bond insurer by outstanding guarantees, said in February it was transferring $5 billion in cash and its public finance business to another entity that has no obligation to the notes, Third Avenue said in its statement.

Posted in: Legal Risk and Trade Documentation, Monoline by David /
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The slow slide continues. Following S&P and in response to MBIA’s restructuring plan, Moody’s downgraded MBIA to B- from BBB+ on Wednesday. The best bit is on Bloomberg:

Credit-default swaps tied to MBIA Insurance Corp. jumped 7 percentage points to 60.5 percent upfront, according to CMA DataVision in London. That’s in addition to 5 percent a year. It means it would cost $6.05 million initially and $500,000 a year to protect $10 million for five years.

Given more than half a chance of failing within five years, according to the CDS market, you would have thought it wasn’t worth printing stationary for the new company. Maybe they could just cross out MBIS and write in National Public Finance Guarantee Corporation by hand.

Posted in: Monoline by David /
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From Bloomberg:

XL Capital Ltd., the biggest Bermuda- based insurer by assets, is seeking a buyer after reporting investment losses larger than its market value, four people with knowledge of the matter said.

Big oops. I could be mean about actuaries. I could be mean about monoline-type business models. But for now I just want to raise a glass to a company that was mostly a sophisticated risk taker. Sadly `mostly’ and `not enormously hugely massively well-capitalised – more capital than you can shake a stick at’ can be a toxic mixture.

Posted in: Monoline, Writedown by David /
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Accrued Interest picked up something that I had missed, namely the continuing long slow death of the monolines. In particular Moody’s downgraded the last of the AAAs, FSA and Assured Guaranty, on Friday. Read about it here. This is rather like that poignant moment when the last of bottle of 1970 Lafite is drunk – although the smiles are a little less broad.

Posted in: Monoline by David /
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Confirming the insurance industry habit of substituting claims adjustment for underwriting diligence, MBIA is suing Countrywide according to Housing Wire:

The breach-of-contract lawsuit, filed in New York State’s Supreme Court, suggested that Countrywide developed a “systematic pattern and practice of abandoning its own guidelines for loan origination,” in effort to inflate its market share during the mortgage-lending boom. MBIA accused Countrywide of knowingly negotiating riskier loans “no matter the cost to borrowers, investors or guarantors like MBIA.”…

Overall, the case involves 10 residential mortgage-backed securitizations of more than $14B in mortgage loans.

This is going to be interesting. On the one hand, it seems obvious that mortgage quality did decline in the last years of the Greenspan boom. But can MBIA really prove that Countrywide abandoned its own loan underwriting standards – rather than simply changing them to adjust to `market conditions’ – and that that was a breach of contract of the financial guarantees? If it can, we are going to see a lot more wriggling from the wrappers, and the lesson from Hollywood Funding – that insurers can’t always be trusted to pay when you think they have written protection – will be driven home to a lot more people.

Posted in: Insurance and Actuarial Practice, Legal Risk and Trade Documentation, Monoline by David /
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Some morning reading:

On the duty of auditors. A taxing matter addresses the inherent conflict of interest and suggests that it might be a good idea for auditors to be hired by the SEC rather than the company.

Ultimate loss projections are increased by Moody’s. MBIA and Ambac have not been in a train wreck for weeks and they are getting jealous of all the attention Fannie, Freddie, AIG, Lehman, Merrill and so on are getting. The FT has the details.

One aspect of a run on a broker/dealer. Dealbreaker points out how a B/D share price fall can push clients into moving money from non-seg’d to seg’d accounts. The result is akin to a run on a bank.

And finally, given that Cristiano Ronaldo is on a lot of people’s lists as `worst role model in sport’, please will the Treasury drop AIG’s sponsorship of Man U as a matter of urgency, or at very least demand that Ronaldo’s legs are pledged as long term collateral and lodged permanently in a vault at the New York FED?

Posted in: Accounting, Broker/dealers, Monoline, Taxation by David /
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Lawyers to your keyboards. Ambac is pushing ahead with the good insurer/bad insurer model. From Bloomberg:

Ambac rose as much as 15 percent in late trading as Wisconsin regulators, which have jurisdiction over the New York-based company, approved a plan to move $850M out of Ambac Assurance Corp. into the new business, according to a statement today. Ambac is seeking to obtain an AAA credit rating … for Connie Lee.

Apart from the obvious questions — who gets the capital, who gets the muni derivatives, and why anyone thinks structured finance counterparties might be remotely comfortable with all this — don’t we have a bad enough history with two syllable first name one syllable second name companies? I mean, Indy Mac, Fannie Mae, Freddie Mac, … Connie Lee — it is not encouraging, is it?

Posted in: Legal Risk and Trade Documentation, Monoline by David /
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In what is either a strong buy signal for the market or a strong sell signal on the stock, MBIA has announcing that it was not changing its projection of losses on its mortgage-related exposures. The FT story is here. Yes, they had some bizarre FAS 159 gains (CNN is here and my take on the rules is here): yes, they resumed a share buy-back programme. But ignoring all that, if their actuarial loss estimates for RMBS have not changed, either that is a very useful datapoint on where realised default losses actually will be, or their actuaries are fools and it is time to short the stock again. It will be interesting to see which.

Update. John Dizard has pointed out the possible value in the monolines as a vulture play on the eventual losses on RMBS. I can see the idea, but I’d like to know more about the implied residual value of the monolines given the current equity price. Are they really cheap yet?

Posted in: Fair Value, Insurance and Actuarial Practice, Monoline, Mortgages by David /
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This was my favourite blog title of the day: And now young monoline… you will die. Accrued Interest makes some good points, and indeed it must be frustrating trying to run a monoline when one’s de facto regulator, the ratings agencies, keep changing the capital model. However:

• It was clear that the capital models used up to mid 2008 were flawed, and so volatility in capital required for a AAA was to be expected.
• One of the key parts of an insurer’s business model is time diversification. Business underwritten in one year diversifies that written in another, and losses in one year – subject to enough capital being available to continue – can be offset by higher premiums the next year. For the monolines though this does not work any more as there is much lower demand for muni wraps and those that are getting done are mostly being written by Berkshire. So the agencies are right to account for this change in their re-rating of the monolines.

Anyway, Bill Ackman might fancy being able to buy another small country, so it is about time for another wave of monoline downgrades.

Posted in: Capital and Contingent Instruments, Monoline, Photography, Ratings, Regulation by David /
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Yet another story about the travails of the monolines – this time on guaranteed investment contracts – made me think about who is really to blame for the mess these companies are in. It’s the people who made their underwriting decisions: their actuaries. They decided that there was little risk in guaranteeing investment returns for extended periods. They decided writing hundreds of billions of dollars of financial guarantees on ABS was a good risk return tradeoff. For that matter their colleagues in the life companies decided that variable annuity life policies were a good idea. (These policies, like a GIC, guarantee a return on a risky investments so they act a lot like long dated written puts: needless to say, the actuaries did not price them that way. Now that the equity markets are tumbling you can expect to see some life companies getting into distress…)

So perhaps one lesson that shines out of this mess is do not let an actuary price or risk manage a financial contract without help from a professional. They are not certain to screw it up. But the evidence of the last few years suggests that there is a real risk that they might get it very wrong indeed.

Posted in: Insurance and Actuarial Practice, Monoline by David /
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Recent articles (see for instance here, here, here, and here) have spurred a concern that I confess should have occurred to me earlier. What can cause an event of default by a monoline, and what happens next.

The first issue concerns the effective recovery for ISDA claims against a monoline. Here the crux is the relationship between the holding company and the insurer. As I understand it, most monolines are structured with a listed holding company and a regulated insurance sub. Obviously insurance contracts, including financial guarantee policies (whether transformed into CDS or not), are written by the insurance company, and so the insurance company has most (but not all) of the group’s capital to support this risk.

Which group company writes CDS? My suspicion is that it has often been the holding company. If the regulator seizes the insurer, it is almost certainly (but check your docs) an event of default on the CDS. But in that case the regulator will almost certainly not permit CDS counterparties to be paid at the expense of claims paying ability for the insurance business – they won’t let the money out of the insurer. The holding company will be left with a whole lot of liabilities and essentially no assets beyond a worthless stake in an insurer the regulator has taken over.

This is of course also an issue if you have debt issued by the holding company, or if you have transacted CDS referencing that debt. As Linklaters pointed out a few months ago, credit events can include quite minor regulatory intervention. I suspect that after such an event recoveries might be very low even if the operating sub is still perfectly capable of paying insurance claims.

Update. FT alphaville has additional reporting on FSA, CIFG and FGIC here, following their earlier story on MBIA. What I can’t see in the material I have read so far is whether a breach of regulatory capital requirement of the insurance sub is likely to be credit event on (a) CDS written by the parent and/or (b) CDS referencing the parent.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Monoline, Regulation by David /
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… or perhaps not if you are a monoline. Especially a press officer at a monoline. There’s lot’s of steam to generate as this list of current press releases from Bloomberg admirably demonstrates. Oh yes. Long coal, short insurers.

Posted in: Monoline, Ratings by David /
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S&P lowered Ambac and MBIA to AA today. They are under review from Moody’s. Fitch, only six months late rather than the year or so of the other two agencies, downgraded them in January. Bill Ackman made another big pot of money. And there’s a nice opportunity opening in zombie monoline runoff…

Posted in: Insurance and Actuarial Practice, Monoline, Ratings by David /
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From the FASB:

Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation.

Specifically, from the standard itself:

The recognition approach for a claim liability relating to a financial guarantee insurance contract requires that an insurance enterprise recognize a claim liability when the insurance enterprise expects, based on the present value of expected net cash outflows to be paid under the insurance contract discounted using a risk-free rate, that a claim loss will exceed the unearned premium revenue.

For the monolines, of course, that means a realistic assessment of eventual credit losses. Now that isn’t an easy thing to do, and there is still a lot of wriggle room in how that standard is applied, but at least sticking their heads in the sand is no longer a sanctioned accounting standard.

Posted in: Accounting, Monoline by David /
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Bloomberg reports MBIA had a substantial first quarter loss yet the stock went up:

MBIA Inc., the ailing bond insurer, rose in New York Stock Exchange trading after saying it will pump $900 million into its insurance unit and reporting a first-quarter loss that was narrower than some analysts’ estimates.

(The $900M is a downstreaming of cash from the parent into the insurer. That money cannot now be dividended to shareholders unless regulators are comfortable with the capital adequacy of the insurer: the funds came from a $1.1B capital raising in February.)

MBIA, whose market value has slumped 87 percent in the past year, gained as much as 9.8 percent as the company reported a net loss of $2.4 billion and an operating loss of $3.01 a share.

It seems that anything less than a cataclysm is a cause for celebration with the monolines at the moment.

Update. Bloomberg now reports:

MBIA Inc. and Ambac Financial Group Inc. had “meaningfully” higher losses on home-equity loans and collateralized debt obligations than anticipated, raising concern about their Aaa status, Moody’s Investors Service said.

The losses elevate “existing concerns about capitalization levels relative to the Aaa benchmark,” Moody’s said in a statement today.

So instead of being, say, $10B short of AAA they are now $12 1/2 ? Big deal. Sabre rattling won’t make up for the downgrade that should have come months ago.

Posted in: Monoline by David /
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Warren Buffett’s new monoline is doing well, partly through writing wraps on already wrapped paper. From the FT:

Berkshire Hathaway’s fledging bond insurer generated $400m in premiums during the first quarter, outstripping all the established, but troubled, operators in the so-called US monoline insurance market.

Many of the 278 contracts the unit wrote were for clients who already held policies from other triple-A rated insurers, Berkshire’s Warren Buffett said at the annual shareholder meeting in Omaha on Saturday. “They’re paying us a [higher] fee to write insurance that will only be paid if the principal [insured party] and insurer didn’t pay,” Mr Buffett said. “It tells you something about the meaning of triple-A in the bond-insurance field.”

I guess if you need a real AAA BHAC is one of the few places you can go. The interesting question is why people want that degree of credit protection on muni risk given the low underlying default probability.

Posted in: Monoline by David /
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From Bloomberg:

The first-quarter net loss was $1.66 billion, or $11.69 a share, New York-based Ambac said today in a statement.

That is over 10% of their claims paying ability (as stated in the 2007 annual report) in one hit.

Ambac fell as much as 22 percent in early New York Stock Exchange trading as new business slumped 87 percent after states and municipalities shunned its insurance and the market for mortgage securities dried up.

Looking into the detail, we find two major components of the loss: $1.7B mark to market loss on written credit derivatives held at fair value (primarily CDOs of ABS), and a $1B increase in reserving for written financial guarantees on RMBS accounted for as insurance. What I would really like to know is the balance of Ambac’s subprime risk taken via CDS vs. that taken financial guarantees. In other words, how does Ambac’s fair value write-down compare with its reserves? If $100M of ‘average’ (whatever that means) exposure taken via CDS generated $20M of write-down, say, how much did Ambac increase its reserves for $100M of average exposure taken via writing financial guarantees?

If things keep on going down like this it is going to get very messy. Still, at least Bill Ackman had a good day.

Update. Meanwhile other market participants old (FSA) and new are queueing to eat Ambac and MBIA’s lunch. The FT reports:

Two companies are considering opening new bond insurance firms – a large US bank and a large private equity firm – according to New York’s insurance industry regulator.

Finally, Calculated Risk has a post on adverse selection in the monoline’s portfolio: see also slides 31 & 32 of Ambac’s Q1 presentation. I’m not sure what exactly if anything one can conclude from the information, but it is interesting.

Posted in: Monoline, Photography by David /
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I have held off for a couple of days on commenting on this document not least because it is large, dense, and worth reading carefully. There is an awful lot of information in the full text here — the executive summary is here. In this post I will comment on chapter 1: posts on subsequent chapters will follow later in the week.

My tuppence ha’penny:

• The headline credit crunch loss predicted by the IMF of $1T has received a lot of press, not least because it is rather larger than the $460B some other commentators have been focussed on. Firstly no one really has any idea at this stage, and secondly it is half the estimated value destruction in the 1994 bond market crisis; so while it is a large number, we should not be too freaked by it.

• There is a lot of good information in the report. For instance this table showing the dependence of a number of European banks on wholesale funding, may be of use in selecting your next short. Just remember it is hard to make money shorting the Republic of France or its wholly controlled subsidiaries.

  

• According to the IMF there has been a massive rise in leverage of global banks. The report has this picture showing the growth of Bank assets and Basel 1 risk weighted assets, which I don’t understand.

  

  Here’s my problem. Consider the Basel 1 risk weights:
  

  Asset Class	Risk Weight
  Cash, Good quality sovereigns, Insured residential mortgages, short term commitments	0%
  Loans to banks and muni risk	20%
  Uninsured residential mortgages	50%
  Loans to banks and muni risk	20%
  All other loans	100%

  If assets are above 15T and RWA are at 5T the average risk weight is roughly 35%. How can that be given the preponderance of corporate and retail risk in the system? Remember RWA also includes derivatives risk which is off balance sheet and not included as an asset, so this number makes even less sense. If anyone can explain how the average Basel 1 risk weight for the banking system comes out at less than 50%, I should be very grateful. Certainly if the data above is correct, the IMF’s conclusion makes a lot of sense:

  Bank supervisors need to take more account of balance sheet leverage as they assess capital adequacy.

• The IMF seems to take a rather optimistic view of the effect of the credit crunch on the availability of credit. They forecast a slowing of the rate of growth of credit but not an outright contraction:
  

  The pace of credit growth in a squeeze would be reduced to a little over 4 percent of the outstanding private sector debt stock in the United States.

  I think that is wildly optimistic. Everything we are seeing from the retail and commercial mortgage markets, for instance, suggests that credit growth will be negative for the next half year at least.

• The IMF administers a richly deserved kicking to the monolines and their system of regulation:
  

  In the United States, the experience of the financial guarantors argues for reforms to U.S. insurance regulation.

  Responsibility currently resides with the states, which has impeded coordination of regulatory efforts across states and with federal bank and securities regulators where spillovers are now evident. A new strategy for regulation of the financial guarantor sector needs to be implemented, including a coherent approach to capital adequacy and new limits on financial guarantors’ activities.

Posted in: Basel, Economic Theory, Monoline, Regulation by David /
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From Bloomberg:

Fitch Ratings cut MBIA Inc.’s insurance unit to AA from AAA, saying the bond insurer no longer has enough capital to warrant the top ranking.

MBIA, the world’s largest financial guarantor, would need as much as $3.8 billion more in capital to deserve an AAA, New York-based Fitch said today in a report. The outlook is negative, Fitch said.

Fitch issued the new, lower rating even though Armonk, New York-based MBIA asked the ratings company last month to stop assessing its credit worthiness.

My guess would be that Moody’s and S&P won’t crack under this news despite the evident fillip to Fitch’s reputation. Which is a shame.

Posted in: Monoline, Ratings, Reputational Risk by David /
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An easy winner, this. From the FT:

The Federal Home Loan Banking system, a government-sponsored network of US banks, is seeking to enter the so-called “monoline” insurance market to help local governments that have been hurt by the credit market storm.

In particular, some banks in the network want to offer their top-notch credit ratings to municipal infrastructure projects – and thus fulfil the role traditionally taken by monoline insurance groups such as MBIA.

Why not have them wrap structured finance too? I mean, what could possibly go wrong with pseudo public sector entities backed by taxpayers getting into an area of finance they have never been involved with before?

Posted in: Monoline by David /
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The FT reports:

The dark cloud of uncertainty over the credit ratings of bond insurers Ambac and MBIA is slowly lifting, and sentiment in the credit markets and stock markets is improving as a result.

Moody’s Investors Service and Standard and Poor’s this week reconfirmed the triple-A ratings for MBIA. Standard and Poor’s had also confirmed its top rating for Ambac, where discussions continue about a deal with banks to inject fresh funds and restructure its business.

That may well be true, but the share prices don’t reflect it. Courtesy of Bloomberg, the picture to the right illustrates the equity prices for MBIA and Ambac.

This is turning into a complicated and difficult to navigate mixture of politics and economics. On a mark-to-market basis the largest monolines are almost certainly not AAA — but they are not mark-to-market players. Their leverage is terrifying. But they have powerful friends, and it is increasingly being seen to be in the industry’s interests that they survive at least in run-off if not as fully fledged players. Muni insurance is getting tougher with some states opting out entirely and Buffett soaking up much of the other business.

Posted in: Monoline by David /
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What does AAA mean? Almost nothing it seems. Hot on the heals of the agencies’ failure to downgrade MBIA and Ambac there is a lovely interactive graph from Bloomberg showing the collateral support for the AAA bonds in the ABX: Bloomberg concludes only 6 of the 80 deserve the rating.

Barney Frank has noticed that the disconnection of ratings from default probability is an issue for municipalities, who have been given a rating far below their PD, then charged for insuring their debt on that basis. And he wants to see some changes. According to Bloomberg:

Barney Frank gave ratings companies a month to fix “ridiculous” standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

“I am going to say to the rating agencies and to the insurers: they have about a month to fix this,” Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. “We’re going to tell them they have to straighten it out.”

I think I like this guy…

Let’s look at the prospects for the monolines then. Barney is going to ensure the good quality states and other munis are rated AAA. A lot of muni insurance business goes away because of that. Buffett will eat much of the rest. And the structured finance market has disappeared too. Hmmm, business model, what business model?

Posted in: ABS, Monoline, Ratings by David /
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Will one and a half be enough? Ambac tumbled yesterday on news that instead of an expected bank-based recapitalisation in excess of $2B, the monoline would instead do a $1B rights issue and sell $500M of hybrid securities. This is really calling S&P and Moody’s bluff. If Ambac’s judgment is that that they do not have the bottle to downgrade it, only a billion of new equity feels like a reraise on the river after flat calling the turn.

Ambac has also decided not to split. Presumably given Dinallo has no authority to force them to, and the legal risk of good insurer/bad insurer is great, this at least counts as rational.

Posted in: Monoline by David /
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Yes, S&P’s fantasy world where the bond insurers are AAA is developing nicely. Bloomberg reports:

MBIA Inc., battling to stave off the crippling loss of its AAA credit rating, soared in New York Stock Exchange trading after Standard & Poor’s said no downgrade of the bond insurer is imminent.

The insurer remains on negative outlook, meaning that any ratings move may be lower, though not any time soon, New York- based S&P said today in a statement. Ambac Financial Group Inc., which ranks second to MBIA among bond insurers, is still being reviewed for a possible downgrade pending the company’s ability to raise new capital, S&P said.

This must be so frustrating for Bill Ackman. He’s basically right, but the world keeps on being irrational. And this, of course, takes the pressure off Moody’s to do anything about MBIA either.

Posted in: Monoline, Ratings by David /
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Oh to be a litigator today. There are so many delicious cases to sate yourself on. Should you take on one of the ‘significant legal challenges which will hold up the resolution of the monoline issues for years‘? Sue the State of New York perhaps, or something in Wisconsin? Or maybe you want to represent CPDO investors in a suit against the banks who ran them, the ratings agencies who rated them, or both? With the current deleveraging, these cases may well be filed soon. Or perhaps you fancy having a go at Citigroup over their suspension of hedge fund redemptions? Then of course there are the hedge funds who own significant positions in Northern Rock. And that’s just one day’s news.

Update. A nice take on subprime-related litigation is here.

Posted in: Bank Run, CPDO, Monoline by David /
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It’s a make your own posting for the weekend: just a few random facts which you can cook up, or not, as you see fit.

• FGIC wants to be split into two, leaving a muni insurer and the rest, primarily structured finance (of which much is U.S. RMBS, prime and subprime).

• There is no word as yet as to how they will work out how much capital goes to each piece, nor how the evident contractual law implications of this will be worked out.
• Ambac is domiciled in the state of Wisconsin. Insurance regulation is a state by state matter and so Dinallo has no authority there. The man who does, Sean Dilweg, is keeping quiet.
• Moody’s downgrade of FGIC was Moody’s from Aaa to A3, six notches. That’s quite a big fall.
• The text of MBIA’s response to Ackman’s ‘Dear Regulator’ letter is here. Note in particular pace my earlier post about the structure of the contracts written, our reserves are based on reasonable estimates of probable losses, in accordance with the guidance [in FAS 5], i.e. insurance accounting.
• The text of Dinallo’s testimony is here. Am I alone is detecting a note of self criticism in:
  

  “The primary goal of insurance regulation with respect to financial oversight is to ensure that the insurer maintains an adequate level of solvency and is able to honour policyholders’ claims. The business model for the financial guaranty insurance companies, however, requires that they hold levels of capital that will allow them to maintain the AAA rating necessary to write new business.

  “It has become clear that the loss of the AAA rating essentially cripples the company’s ability to do business as a going concern and puts the insurer in a “run-off’ mode. We now are considering whether the sustainability of the business model should be the regulatory standard going forward. While we of course consider claims paying ability as the benchmark, our goal for the future, for all insurers, is to do higher level risk-based examinations.

• Eliot Spitzer’s position — that reverberations from the crisis facing the bond insurers could cause “substantial damage” to the US economy — certainly seems reasonable considering the write offs at UBS. And on Friday Citi estimated that there are another $18B to come. More generally bank default swap spreads have gone out in response to the monoline break up plan.
• On the bright side, though, there is at least a credible new ratings system proposal here.

Posted in: Monoline, Ratings, Regulation by David /
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This is a valid question as we go into any restructuring of the bond insurers, and the answer is more complicated than it appears at first sight. Here are some of the issues.

Many corporate bonds pay interest and final principal – you get coupons for some period, then a return of principal.

A standard CDS on a corporate bond uses a notion of credit event which typically includes default, failure to pay and bankruptcy. If the bond displays a credit event, then the CDS protection buyer stops paying the premium on the CDS and has the right to receive recompense in a short period, perhaps 3 or 5 days. This recompense is either through the right to deliver a bond and receive par (physical settlement) or through the right to receive an estimate of par minus recovery as a cash payment (cash settlement). Some key features include rapid payment, the ability to go short – by purchasing cash settled CDS without owning the bond – and the derivatives (i.e. mark to market) nature of the instrument. Note too that the premium is risky in a standard CDS: if default happens, you stop paying it.

There are insurance policies which behave much like CDS. These are part of a wider class of insurance known as financial guarantee policies. The difference here is that they are legally insurance (and hence have a different legal, accounting, regulatory and tax framework). In particular this is not a mark to market instrument, and in most jurisdictions you have to be an insurance company to write insurance. Note also that insurance typically requires an insurable interest – I cannot profit from buying fire insurance on your house even if it burns down – so if you purchase a financial guarantee policy directly it might not allow you to go short.

The fact that there are two instruments, CDS and financial guarantee policies, which can act much the same way yet have very different accounting should be a matter of shame to the FASB and the IASC.

Another possibility for obtaining protection is a bond wrap. Bond wraps are part of a wider class of insurance policies known as financial guarantee policies. In a bond wrap the policy runs to maturity of the bond, you have to keep paying premium until that date (so the premium is not risky), and the policy writer agrees to make good the scheduled cashflows of the bond should the original bond issuer suffer a credit event. Thus here you get paid on the original schedule, and if there is a credit event you substitute the risk of the issuer for that of the policy writer. Most of the muni policies the monolines have written are in this form. The advantage from their perspective are not only insurance accounting, but also lack of cashflow stress: unlike a CDS you typically have plenty of time to find the cash to make the principal repayment.

With amortising securities the issues become more complex since there is the possibility of a principal and interest payment at each coupon date. You can write standard CDS on amortising securities, but it is also possible to write a pay as you go CDS. This imports bond wrap technology into derivatives, and gives the protection holder the right to demand payments on the original schedule from the CDS writer.

For corporate bonds, amortising or not, matters are fairly straightforward since the failure to receive any cashflow (or at least a material one) is an event of default. For ABS you might not want that feature though: in a typical credit card deal, for instance, there will be a certain level of delinquencies which all parties expect, and if you have a credit event which triggers cash settlement based on default, then many junior ABS would suffer that event in the first month. Moreover in many ABS the collateral prepays, so you do not know when you will get your principal back. This means that to define a CDS or financial guarantee you need to tease out the cashflows each security should get in a given month given the level of prepayments, see what cashflow it actually gets, and define protection based on the difference.

Matters get even more difficult when you have amortising collateral in a CDO but some of the tranches have bullet maturities. Remember too that in some cases the CDO issuance SPV can be technically unable to pay without the CDO collateral having lost value: this can happen in particular due to liquidity risk. Figuring out exactly who pays whom what when something bad happens in a CDO of ABS is sufficiently complex that standard documentation has not been available until recently. Most transactions historically used bespoke documentation, and figuring out exactly which risks were transferred was not a trivial business.

Finally, note that the legal final maturity of ABS is often well beyond the last cashflow date. For a mortgage deal, for instance, it might be 35 years. So a contract which only gives you the right to claim ultimate principal at legal final maturity is like buying protection on a long dated zero coupon bond.

My guess is that most but not all of the monoline’s structured finance business involved taking middle or upper tranche ABS and writing pay as you go style protection on it in the form of a financial guarantee. This has considerable accounting advantages over writing standard bullet CDS, as well as the advantages the monolines enjoy as a result of insurance rather than banking capital. Finally it means that the monolines have relatively little immediate cashflow stress even though their structured finance portfolio would be, on a mark to market basis, highly underwater. None of that means that there is no problem with their business — just that if this is going to be a train wreck, it will be a slow motion one.

In any event we do need to know the answer to this question as it determines the capital needs. If they have written CDS with collateral agreements then the monolines need enough capital to support the mark to market volatility of the trades. If they have just written insurance then they only need enough to support the ultimate realised losses on the portfolio. Those numbers are very different (and it impacts how right Bill Ackman is).

Some people have suggested that one of the villains of the current crisis is mark to market. I don’t agree: mark to market gives one view of the value of a portfolio; insurance accounting another. But certainly having a portfolio of similar risks subject to wildly differing accounting principles in the same legal entity is unhelpful.

Posted in: Accounting, CDS and Negative Basis, Insurance and Actuarial Practice, Monoline by David /
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Eric Dinallo, New York’s insurance superintendent, testified today at a hearing of the House Financial Services subcommittee. Both the FT and Bloomberg report various parts of his evidence. The FT first:

[Dinallo] said on Thursday that a government bail-out of troubled bond insurers ”is not planned”. [...]

Mr Dinallo, told lawmakers that finding a solution to allow Ambac, MBIA and others to maintain triple-A credit ratings on which their guarantee business depends was an ”extraordinarily difficult problem”.

Certainly he wins marks for honesty on the latter point. But according to Bloomberg matters got more interesting:

New York regulators may consider splitting bond insurance companies into two businesses to protect municipal debt from losses on subprime mortgage securities.

How could this possibly work? It does not suffice simply to split the liabilities: you have to split the assets too. Presumably any split would have to be equitable to equity holders (and to senior debt holders), so equity would have to be split pari passu with risk. But estimating the economic capital required for a large monoline is about as difficult a problem as we have in financial modeling at the moment, especially given that the muni business diversifies the structured finance business so the standalone capital requirements of the two pieces are more than those of the original whole. Moreover does Dinallo really have the power to do this if shareholders are hostile?

Update. Eliot Spitzer has upped the anti. According to the FT, he has given the bond insurers three to five business days to find fresh capital, or face a potential break-up by state regulators who want to safeguard the municipal bond markets. Oh, and Moody’s has downgraded FGIC. So no pressure then. At least we can watch the auction market fall apart while we wait. And join Paul Krugman in speculating on what’s next.

Posted in: Capital and Contingent Instruments, Monoline, Regulation by David /
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The offer from Berkshire Hathaway to take the monolines’ stable profitable business – muni wraps – and leave the unstable loss-making part – structured finance – reminds me of LTCM. It is a little discussed part of the LTCM saga that Buffett made an offer to acquire the assets (but not of course the liabilities) of LTCM just before the 11 bank FED-sponsored bail out that eventually rescued the fund. (More details of the LTCM farrago are here and here while Naked Capitalism has more on Warren’s offer to the monolines here.) Then as now the question is why on earth anyone would accept the Buffett proposal.

For the monolines it does not seem as if Dinallo can force them to, and provided they can carry on paying claims, they can operate at least in semi run off for some years. Who knows, the CDO market might even have recovered by then. Even after a downgrade I do not see what would persuade the monolines to do a cash negative deal such as Buffett is offering: they would just bleed to death faster. Which does rather beg the question as to why he proposed something that they are palpably so far from being able to accept.

Posted in: Monoline, Worst case scenarios by David /
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The FT recently discussed negative basis trades. Here is the basic idea.

• A bank buys a bond, typically a long dated one.
• The bank buys a CDS or a financial guarantee policy to maturity of the bond from a counterparty, often a monoline.
• The bank would then hedge against the risk that the protection it had bought was ineffective often with another monoline.

This was profitable despite the multiple layers of protection since the credit spread of the bond was bigger than the cost of the first and second hedges combined. Remember a bond spread includes compensation for much more than the risk of default: it includes compensation for illiquidity, for the volatility of the value of the bond, and so on. The bank is basically monetising those premiums.

Most of these trades were done in the trading book so the banks concerned booked the PV of the difference between the credit spread of the bond and the cost of the protection up front.

With the monolines at AAA and monoline protection some tens of basis points, this approach was not a huge issue. But now monoline protection is hundreds of basis points and the AAA ratings might not be with us very long. Also, the bonds used were often either the supersenior tranches of CDOs or long dated inflation linked debt. The latter isn’t a problem: the former is, since the underlying credit quality of these bonds has gone South for the winter too. And negative basis trades are out there in size. The FT says:

Bob McKee, an analyst at Independent Strategy, a London research house, believes that up to $150bn worth of CDO business done by the monolines could be negative basis trades.

Doubtless there are some who will use these trades as another stick to beat the already bloodied body of structured finance. I would suggest the reality is somewhat different. The problem isn’t the trades themselves: it is the selective use of mark to market. Marking the trades up front is fine providing you do it properly. That means:

• Credit adjusting the pricing of all derivatives. The details are complex here but basically you PV the value of net cashflows from a counterparty back along their risky credit curve rather than along the Libor curve. This has the effect as a counterparties’ credit quality decreases of automatically marking down your trades.
• In particular valuing trades with realistic default correlation assumptions. In particular the only time that you need written protection on supersenior ABS is when the ABS market is in trouble – and that is just when the monolines are in trouble. Therefore the probability of joint default of the bond and the protection seller is not
  
  PD(bond defaults) x PD(monoline defaults)
  
  As it would be if they were independent. Instead it is something a lot closer to
  
  min(PD(bond defaults), PD(monoline defaults))
  
  Since the default correlation is so high. For the full negative basis trade it is reasonably close to
  
  min(PD(bond defaults), PD(monoline1 defaults), PD(monoline2 defaults))
  
  The real problem, then, is that some banks may have used naive default correlation assumptions in marking these trades and hence they are carrying them at an inflated value.
• Using realistic funding assumptions in valuing the position. I shudder to think about this, but it would not be massively surprising to discover that some of these trades were also valued under the assumption that the bank could fund the bond at Libor flat forever. That means in effect that the position has again be overvalued up front and will show a net carry loss over time.

Of course none of these issues would have seen the light of day without the declining credit quality of the monolines. But it does highlight the fact that those banks which have prudent P/L recognition and state of the art valuation policies are much better placed to withstand market turmoil than those who don’t.

Posted in: CDS and Negative Basis, Model risk, Monoline by David /
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The ratings agencies are starting to notice how high the water has risen around the monolines. Today XL Capital reported a billion dollar loss for the 4th quarter and Moody’s cut them from AAA to A-. In one step.

Can MBIA and Ambac be far off? Given mounting regulatory pressure the agencies surely cannot delay long. Admittedly the monolines are scrambling to raise new capital but the WSJ thinks that the rescue plans won’t prevent downgrades. One hopes for the sake of the credibility of the whole system, that they are right.

Posted in: Monoline, Writedown by David /
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Accrued interest explains. It’s interesting.

Update. Bloomberg has an article here on recent auction market failures. Another factor they mention is the unwillingness of banks to support the market by underwriting the bonds. Given some of the yields available and the good credit quality of the (mostly muni) issuers, I’m surprised the hedge funds have not stepped up to the plate. Anyone fancy a revolving CDO of auction market securities structured like a credit card deal with early am and such like?

Posted in: Markets, Monoline by David /
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There’s a rumour of one, certainly, with some big names according to CNBC: RBS, Wachovia, Barclays, UBS, Societe Generale, BNP Paribas, Dresdner and Citigroup.

This is a curious list. Firstly it is mostly European, with no U.S. broker/dealers involved. Some of the banks on the list – notably Soc Gen – might be assumed to have bigger problems themselves right now without supporting Ambac. RBS and Barclays have recently been identified as having relatively low capitalisation given their tangible equity to asset ratio so it would be curious if they are willing to put up cash for an investment that will be a straight deduction from capital.

It is impossible to opine on how good an idea any rescue will turn out to be until we have seen the structure – some people are talking about a reinsurance sidecar as an alternative to a pure equity injection – but certainly it hard to see that the banks would leave much for existing shareholders. The equity bounce (ABK was up 16% on Friday) therefore feels overdone.

Elsewhere in the forest FGIC has been downgraded so presumably it is too late for them. And Bill Ackman is still gunning for MBIA and Ambac. His latest letter is here: in it he sets out an estimate of $11.6B for the capital necessary for each of the two big monolines. So, boys, get your cheque books out. Well, most of you. We’ll need cash from you, Soc Gen…

Posted in: Monoline by David /
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The FT asks a question:

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope?

Roger Ehrenberg has an answer:

Is the financial system somewhat broken and in need of reform? Absolutely. But is the increasingly liberalized system in place today an essential element of a healthy, integrated and global financial marketplace? I think the answer is also a resounding yes. So where have things broken down, and what can we do to fix them? Here are some ideas:
1. Increase transparency among regulated institutions
2. Homogenize global accounting standards
3. Homogenize global regulatory frameworks
4. Aggressively strip conflicts of interest out of the system
5. Clarify the roles and responsibilities of fiduciaries
6. Develop common sense compensation policies and practices

Let’s examine these one by one.

1. Increase transparency among regulated institutions
Accounting disclosure of derivatives is pretty much useless. Even with Basel 2 the disclosures on market risk in general are only marginally more useful: the VAR typically tells you little. We need more useful disclosure on market risk, liquidity risk, off balance sheet risk and credit risk mitigation.

2. Homogenize global accounting standards
I don’t see this as pressing. Standards are coming together already and while significant differences remain, they are not nearly as important as the things you get no information about from financial statements. See 1. above.

3. Homogenize global regulatory frameworks
Yes, but the issues are mostly not between banks in different countries but rather between banks and non-banks in the same country, notably between banks and insurers but also between banks and broker/dealers. The monolines would never have been able to get into their current state if they had been regulated under Basel 2.

We also desperately need to fix the market risk capital regime. I have talked about this before so I won’t go over old ground: suffice it to say, VAR is no longer a useful measure of market risk capital (if it ever was).

4. Aggressively strip conflicts of interest out of the system
This is definitely right. Legal and regulatory steps to align interests are necessary as clearly the buyers of securities either couldn’t or wouldn’t do the job.

5. Clarify the roles and responsibilities of fiduciaries
What Ehrenberg means is that if you give your cash to someone with the mandate to manage it conservatively and preserve capital, and they buy a Libor + 40 AAA floater that subsequently defaults, you should have someone you can sue. Certainly the idea that a rating substitutes for due diligence is bizarre and it should not be defensible in court. But right now it probably is.

6. Develop common sense compensation policies and practices
This is just a variant of 4. The way people are paid should not set up a conflict of interest between shareholders and the risk takers they pay, nor between those risk takers and the broader financial system.

Conclusion
I do not believe that the credit crunch was brought about chiefly by malevolence or bad faith. Of course there was some of that, but mostly it was a series of small incentive structures combining to produce a systemically disastrous result. Hence we need to fix the rules of the game to produce better incentives.

Posted in: Accounting, Basel, Monoline, Ratings, Regulation by David /
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A panoply of drama today.

First UBS. $14B. That’s quite a lot. As Bloomberg reports:

The Zurich-based bank announced today a net loss of 12.5 billion Swiss francs ($11.4 billion) for the fourth quarter [...]

The bank increased markdowns directly linked to the subprime market to about $12 billion from the $10 billion it forecast in December and said an additional $2 billion of writedowns are for other U.S. residential mortgage securities.

This is in marked contrast to their prediction of a profit for Q4 made at the time of the Q3 writedown. Perhaps more significantly, as Naked Capitalism points out, this suggests more pain to come from the other players before this sorry farrago is over.

Next the bitter suspense of the bond insurers. Will they be downgraded today? Tomorrow? Sometime, never? The agencies are walking the line. If they wait for the man, Mr. Dinallo, they risk losing even more credibility. If they move too fast too soon they risk a shareholder lawsuit. (CNBC has some further insight here while the FT points out the size of the short interest in the monolines — about 40% apparently.)

Meanwhile opinions continue to differ on how much the monolines need. Even the normally bullish WSJ says:

However, it quickly gets complicated, given that the banks themselves have differing levels of risk exposure to the bonds in question and also have differing abilities to provide cash. Calculating how much each should put up on a pro rata basis could be complicated and spark disagreement.

Moreover it is not just the banks’ relative share that is in doubt, but also the size of the recapitalisation. The FT has estimates of between $10B (the monolines themselves) and $140B (Independent Strategy). You certainly don’t want to low ball it and then have to go back to the market again so any plan that only puts in a couple of billion per firm has significant danger.

Update. John Thain is bullish here although he agrees that an industry wide bailout will be problematic. He said in an interview with the Financial Times on Wednesday that

He expected individual credit insurers would receive capital infusions from investors, but that it would be difficult to craft an “industry-wide” bail-out for the beleaguered guarantors.

Mr Thain said an effort by New York state regulators to help leading bond insurers maintain their credit ratings was raising interest in the sector on the part of investors including private equity groups and specialists in distressed companies.

However [...] getting banks to agree on a single approach was unlikely because they have different exposures to the credit insurers and varying opinions on what should be done.

Meanwhile Bloomberg reports:

MBIA Inc., the world’s largest bond insurer, posted its biggest-ever quarterly loss and said it is considering new ways to raise capital after a slump in the value of subprime-mortgage securities the company guaranteed.

The fourth-quarter net loss was $2.3 billion, or $18.61 a share, raising concern the Armonk, New York-based company will lose its Aaa rating at Moody’s Investors Service. The loss came a day after FGIC Corp.’s insurance unit became the third company to be stripped of its AAA credit rating.

Posted in: Capital and Contingent Instruments, Monoline, Ratings, Writedown by David /
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I have blogged before on the idiocies of PFI – how Gordon Brown has a reputation for economic prudence given he facilitated this is beyond my ken – but the latest news is even more extraordinary. Not only are we paying more for our infrastructure than we should, but now the very future of an important project, the Airbus tanker project, is under threat. According to the FT:

The turmoil in credit markets has dealt a big blow to the UK government’s defence procurement programme, putting in jeopardy plans to help fund a new fleet of Airbus tankers for the Royal Air Force with a bond issue.

The issue is that the bonds financing this project were expected to be wrapped by Ambac. This is beyond crazy: in many instances either explicitly or implicitly (because the project cannot be allowed to fail) the government backstops PFI, so there is no need for a wrap. It is only the bizarre fiction of PFI that pretends that there is any risk transfer, and hence any need for an insurer to be involved. PFI is a waste of public funds on an extraordinary scale: it is time we held Gordon accountable for it.

Posted in: Monoline, PFI by David /
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Following on from my musings earlier in the week that it was the (perhaps false) hope of a monoline bailout that caused the market recovery, possibly together with a bounce back after the negative price impact of Soc Gen’s liquidation of its rogue trader position, let us turn to the result of a downgrade of Ambac and MBIA. Bloomberg has an item about a recent research piece:

Banks may need to raise as much as $143 billion to meet regulators’ requirements should rating firms downgrade bond insurers, Barclays Capital analysts said.

Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Financial Group Inc. are cut one level from AAA, and six times more for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today.

If that is even within spitting distance of the truth, it explains why the markets reacted so positively to the news of a possible bail-out, and why if permabears like Pershing Square’s Bill Ackman are correct the bounce in MBIA and Ambac is both purely temporary and very troubling for the banks.

The problem with the proposed rescue is knowing how big it might need to be – Dinallo thinks $20B, but Egan Jones’ estimates are an order of magnitude higher – and who stands most to gain and hence who should put the most in. Without reliable mark to markets on the wraps the monolines have written (which remember are mostly insurance and hence not MTM), how can Dinallo determine who contributes what? Without FED involvement it is hard to see how this can work, and even if they do ‘persuade’ banks to contribute – as they were signally unable to do with the MLEC – figuring out the flows will be a difficult business.

Posted in: Monoline, Ratings by David /
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Did the rate cut work? No.

Did the bailout of the monolines work? Yes.

The week so far in pictures (respectively the Dow, Dax and FTSE).



It seems that worries about losses to banks on wrapped bonds, the closure of the muni market, and yet more structured finance write downs were more pressing than rates.

Update. Fixing the monolines will take time, according to the New York State Insurance Department. I wonder how the markets will react if this bailout goes the way of the MLEC. Naked Capitalism certainly thinks the signs are not encouraging and Gillian Tett has some further comment on the balance between moral hazard and systemic risk.

Posted in: Markets, Monoline by David /
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The headline is Merrill Posts Record Loss on $16.7 Billion Writedown. Let’s take the Merrill earnings release and pull it apart a bit. Specifically, consider the CDO positions.

A first glance, the position seems fairly benign.

But now consider the footnotes:

(2) Primarily consists of principal amortization for U.S. super senior ABS CDO net exposures, as well as changes in hedges and increases due to ineffective hedges.

Now, amortisation reduces exposure. But the high grade number is up. So the increase must be due to ineffective hedges. This emphasises that these are net numbers.

(3) For total U.S. super senior ABS CDOs, long exposures (including associated gains and losses reported in income and other net changes in net exposures) were $46.1 billion and $30.4 billion at September 28, 2007 and December 28, 2007, respectively. Short exposures (including associated gains and losses reported in income and other net changes in net exposures) were $31.3 billion and $23.6 billion at September 28, 2007 and December 28, 2007. Short exposures primarily consist of purchases of credit default swap protection from various third parties, including monoline financial guarantors, insurers and other market participants.

Ah. Those would be the monolines that are doing so well at the moment. I don’t want to rain on Merrill’s parade, but if I were an investor, I might want to know a bit more about those hedge counterparties other than their ratings. The weighted average spread they trade at in the CDS market perhaps. That would give some idea of where between a net $4.8B and a gross $30.4B the exposure really lies.

Posted in: ABS, Broker/dealers, Credit, Monoline, Writedown by David /
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From Naked Capitalism:

Annual Premium as a Percent of Exposure:

MBIA 18 basis points
Ambac 21 basis points

Leverage (Net Debt Service Outstanding/Statutory Capital)

MBIA 147X
Ambac 143X

That speaks for itself I think.

Update. The testing times continue for the monolines. From Bloomberg:

New York-based Ambac dropped as much as 65 percent and Armonk, New York-based MBIA fell 38 percent after Moody’s and S&P said late yesterday they are reviewing the rankings the companies depend on to sell bond insurance. Credit-default swaps on both guarantors rose to records, signifying investors see a growing chance that the companies won’t be able to pay their debt.

Ambac, which yesterday cut its dividend and ousted its chief executive officer after reporting greater-than-expected write downs on the bonds it insures, said Moody’s decision was “surprising.”

Surprising as in we are surprised you finally worked out that we are leveraged up the kazoo? MBIA’s surplus notes, despite their 14% coupon, are now trading at 84 cents on the dollar. And Bill Ackman thinks they will never pay a penny.

Posted in: Monoline by David /
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The FT has an article on the failure of SCC, a Dublin-based credit derivatives product company or CDPC. SCC was only twenty five times leveraged, a relatively low level compared with some of the other CDPCs. But it did have a small absolute level of capital, $200M, and no rating.

What is interesting is why SCC collapsed. It wasn’t that it had written CDS on underlyings that defaults. No, as with ACA, it defaulted because it could not post sufficient collateral. Let’s pick up the story with the FT:

Court documents from Nomura’s attempts to liquidate the company and SCC’s successful response to secure a Chapter 11-style restructuring show that between the end of June and August 16 last year, collateral demands rose from $55m to $438m. SCC managed to put up $175m worth before running out of funds and sparking Nomura’s High Court petition to have the firm liquidated.

The ravages wrought by mark-to-market accounting are visible in the tens of billions of losses among investment banks, the collapse of the structured investment vehicle industry and in the ever-more precarious position of the bond insurers.

And yet, credit losses from actual defaults outside of the US subprime mortgage market remain minimal. SCC told the High Court that expected losses over the life of its contracts would be a fraction of the collateral it had to post.

Now of course we have no idea whether SCC is right about that claim or not, but the key point is that credit support default is a real honest to goodness game over default. The relevant question for a CDS counterparty is therefore not only whether they are sufficiently well capitalised to remain solvent under a claim: it is also whether they are sufficiently liquid to be able to adhere to the terms of their CSA. It’s the volatility of the mark to market of their portfolio that matters, not only the ultimate loss. Did the prime brokers think about when they were buying protection I wonder?

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Monoline by David /
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14%, according to Reuters.

Posted in: Capital and Contingent Instruments, Markets, Monoline by David /
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Bloomberg reports that MBIA is falling again:

MBIA Inc., the giant bond insurer hobbled by the collapse of the subprime market, will cut its dividend 62 percent and raise $1 billion in a sale of notes to boost capital and preserve its AAA credit rating.

The Armonk, New York-based company has declined 81 percent on the New York Stock Exchange in the past 12 months and fell 4.2 percent today after it reported fourth-quarter writedowns and expenses of about $4 billion related to mortgage securities.

Bizarrely Buffett may be willing to help, despite his interest in setting up a competitor:

“We’re looking at multiple ways to participate in the industry,” Ajit Jain, head of Berkshire’s new bond insurer, said today in an interview. Berkshire, based in Omaha, Nebraska, is “looking at ways to support the existing insurers in terms of reinsurance and capital,” he said.

Part of the reason the monolines are in focus is, as Naked Capitalism reports, that Countrywide is rumoured to be close to bankruptcy. If it were to go down, it would trigger a wave of claims on the wraps the monolines have written that they likely could not pay. In this context, why doesn’t Buffett just let his competitors go down? Or has it been gently suggested to him that it would be in the U.S. national interest if he used that spare cash to support the industry? Certainly the NYT’s account of the support Buffett got for setting up his new monoline is bizarre. To pick some of the juicier bits:

Shortly before Thanksgiving, Eric R. Dinallo, the insurance regulator for New York State, did something unusual. He called Warren E. Buffett’s right-hand man on insurance, Ajit Jain, and suggested that he start a new company to insure municipal bonds in New York….

To be a New York company, Berkshire, with its main insurance offices in Stamford, Conn., would technically need to run its new business from offices in New York. But Mr. Dinallo agreed that Berkshire could set up a token office in New York and do most of its work in Connecticut…

For its part, Berkshire agreed to put up $105 million in capital to start, $30 million more than the minimum required by New York. But “to minimize the amount of capital trapped in the entity,” Mr. Jain said, Mr. Dinallo worked out a way for Berkshire to increase its leverage by permitting it to exceed the usual limits on reinsurance, or insurance on the risk the new company acquired.

Posted in: ABS, Insurance and Actuarial Practice, Monoline, Mortgages by David /
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There is a very nice article on Accrued Interest summarising the muni market. It helpfully discusses who the muni issuers are, the difference between general obligations and revenue bonds, muni default rates, and the role of the monolines in wrapping muni bonds. What we need next would be a summary of the tax games in muni land…

Posted in: Insurance and Actuarial Practice, Monoline by David /
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…is pretty near perfect as usual, or so it appears. The FT reports:

Shares in bond insurers MBIA and Ambac fell sharply on Friday amid concerns that a rival US bond insurer planned by billionaire Warren Buffett will eat into their ability to win new business and further damage efforts to boost their flagging capital bases.

If Berkshire Hathaway Assurance sticks to wrapping muni debt it will doubtless make a lot of money. Whether it makes a decent ROE is less clear as (one would hope anyway) the ratings agency criteria for the amount of capital needed to be a AAA bond wrapper will have changed. On the other hand if Buffett just keeps 1.1 times the amount of capital MBIA, AMBAC etc. would have for his book, he will probably do fairly well.

Meanwhile Fitch has given MBIA and Ambac four weeks to raise the billion or so of extra capital they need to retain their AAAs. It will be an interesting month for the monolines.

Update.A nice post from Accrued Interest points out that BHAC is basically a punt on muni investors not waking from their lethargy and actually doing some credit research.

The only risk AGO [but more broadly monolines without structured finance exposure] stock holders face is the possibility that municipal bond insurance declines as a concept. That bond buyers are no longer willing to pay for extra protection on AA-rated school districts and A-rated sewer systems. The fact is that the history of defaults on these types of credits is slim indeed, which is exactly why the municipal insurance business is so profitable. Classically, muni buyers liked insurance because it prevented them from having to do any credit research. So the question is, will investor laziness trump the fear created by current insurer troubles?

Put in those terms, I’m a buyer of OTM calls on laziness…

Posted in: Monoline by David /
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Bloomberg reports that Ambac is doing something to try to stave off the loss of its AAA:

Ambac Financial Group Inc., struggling to avoid the crippling loss of its AAA credit rating, took out insurance on $29 billion in securities it guarantees.

The world’s second-biggest bond insurer agreed to transfer the risk that the securities will default to Assured Guaranty Ltd., according to a statement today. Reinsuring the debt will free up capital backing those bonds, Ambac said. Ambac fell as much as 7.6 percent in New York Stock Exchange trading on concern the deal alone won’t be enough to save its credit rating.

The market reaction is understandable: to be safe, Ambac needs $2-4B of new capital, and this deal won’t free up nearly that much. To put it into context, it guarantees about $550B of securities, so this deal covers around 5% of its portfolio. With the ratings agencies on the prowl and considering downgrades, it is crunch time for the monolines.

“We’re heading into maybe the most turbulent few weeks the bond insurers have ever seen,” said Matt Fabian, a senior analyst and managing director at Municipal Market Advisors, an independent research firm in Concord, Massachusetts. “There could be some very serious numbers floating around before Christmas.”

Ambac’s agreement probably freed up $1 billion or less of capital, Fabian said. The ratings companies are likely to demand more, he said.

What is interesting, though, is the following comments from Robert Genader, Ambac CEO:

“Reinsurance is a valuable, capital-efficient and shareholder-friendly tool for managing risk and capital”.

He’s right. You always have an alternative to increasing capital (as MBIA did with its share placing last week): you can decrease risk. Hedging and (re)insurance both achieve that: if you can reduce risk using either of them more cheaply than you can raise new capital, it makes sense to transform your capital requirement rather than your capital base. Anybody want another $100B of bond risk on a reinsurance basis?

Posted in: Monoline by David /
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According to Bloomberg:

Security Capital Assurance Ltd. may lose its AAA credit rating at Fitch Ratings, the first top-ranked bond insurer put on notice since the industry came under scrutiny last month because of rising defaults on subprime mortgages that back securities they guaranteed.

Short munis, long treasuries.

Update. The tail end of the field is starting to fall behind:

FGIC Corp. and XL Capital Assurance Inc., two bond insurers, may lose their Aaa credit ratings at Moody’s Investors Service after a slump in the value of the debt they guarantee.

MBIA Inc., the largest bond insurer, and CIFG Guaranty had their outlooks lowered to “negative” by the New York-based ratings company today. The Aaa rankings of Ambac Financial Group Inc., Assured Guaranty Corp., and Financial Security Assurance Inc. were all affirmed, signaling no plans to change them, Moody’s said. Radian Group Inc. was also affirmed.

Remember that the wrapped bond market is over $1T: this warning puts over 80,000 separate bond issues on negative watch according to Calculated Risk. If the ratings agencies hold their nerve and do actually downgrade a major monoline, the market impact will be enormous.

Posted in: Monoline, Ratings by David /
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The crunch is getting crisper if not more chocolatey. Currently suffering are:

• The monolines. CIFG for instance is about to get a capital injection according to the WSJ. Now would be a great time to set up a new monoline, writing pure muni business. Perhaps Warren will help?
• Any bank relying on the securitisation market for part of its funding, according to FT alphaville.
• The ratings agencies, who many people (including David Einborn) think screwed up big time.
• Fannie and Freddie, who need more capital, according to CNN.
• Anyone who was long equity: the markets have been falling, wiping out the gains so far this year on the S&P according to Bloomberg.
• RMBS, CMBS, CDO and even covered bond holders.
• As we said yesterday, the writers of liquidity lines and anyone who wants to issue ABCP:
  
  (This figure and the next one come from an article by Charles Calomiris.)
• And just to end on a cheery note, Hank Paulson says 2008 will be worse than 2007 for the U.S. housing market according to the Guardian. Not that 2007 was so wonderful:
  

I’m personally not in the the-world-is-coming-to-an-end school but these signals are undoubtedly strongly negative. Let’s be careful out there.

Posted in: Federal Agency, Markets, Monoline, Mortgages, Ratings by David /
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Friday market update: from Bloomberg, we learn that

Merrill’s 6.4 percent notes due in 2017 pay a spread of 2.24 percentage points, almost double the premium of 1.21 percentage points a month earlier

Meanwhile

Citigroup paid 1.90 percentage points more than Treasuries of similar maturity to sell $4 billion of 10-year notes on Nov. 14

That’s nothing compared with the monolines in the CDS market. According to FT alphaville there is a one in three chance of monoline default, while Bloomberg gives more detail:

Credit-default swaps on MBIA more than tripled to 410 basis points since Oct. 15, according to CMA Datavision in New York. The price suggests that investors see a 28 percent chance MBIA will default, according to JPMorgan Chase & Co. valuation models. Contracts on Ambac have climbed to 620 basis points, CMA data show. They imply a 40 percent chance of default.

Things are interesting out there. Have a good weekend folks.

Update.Naked Capitalism estimates the likely cost of a monoline downgrade as $200B. (Is that all of them or just a big one?) Anyway, with the kind of impact, we had better hope someone at the FED plays golf with someone at the New York State Insurance department this weekend.

Posted in: Bonds and CBs, Broker/dealers, Monoline by David /
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Most OTC derivatives are done under ISDA documentation. Included in the typical package (master, confirm, definitions, schedule) is the CSA or credit support annex. This specifies what kinds of credit support, if any, each party to the contract has to give to the other. Commonly, for instance, the CSA might say (lawyerese for) ‘each of us will post collateral monthly to the other if the net value of the exposure is more than $10M. Acceptable collateral is cash or G4 government bonds, and the party has three days to post the collateral after it has been requested.’

Failure to adhere to the terms of a CSA is typically a default event for the contract, resulting in the whole amount becoming due and payable.

The FT has an interesting story here in regard of one of the smaller financial guarantee insurers, ACA. Apparently ACA has written protection on the senior tranches of CDOs in the form of credit default swaps where the CSAs specify collateral in the event that the tranches are downgraded:

Such provisions require ACA to post cash equivalent to the mark-to-market loss of the CDS contract pursuant to a ratings cut.

That collateral could be substantial if ACA’s CDOs have much subprime in them. Again according to the FT:

AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches.

If ACA can’t find the collateral then presumably the whole MTM of the contracts become due and payable. Given that

ACA has only USD 1.1bn in claims paying resources, according to research by Credit Suisse

At that point the holders of the wrapped tranches will really have a problem.

Posted in: CDS and Negative Basis, Monoline by David /
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One of the many threats to the ABS market at the moment is the perceived decline in the credit worthiness of the large bond insurers, aka the monolines. There are a small number of these firms, and most of them carry either a AAA or AA credit rating. They are vital to the functioning of the ABS market in that they wrap bonds, providing a guarantee that if the underlying collateral does not pay timely interest and ultimate principal, then the monoline will. This solves the information problem on less well understood ABS collateral, and lowers funding costs for pools with non-standard characteristics.

Unfortunately the monolines have wrapped a significant amount of subprime collateral. This is causing a drag on earnings with both AMBAC and MBIA reporting losses last week. Investors are concerned that this is only the beginning and have bid up default protection on the monolines. Five year CDS spreads have gone from a few tens of basis points to 300 for AMBAC and 200 for MBIA.

The monolines typically have very diverse pools of risk that they have wrapped, considerable claims paying ability, and fairly large capital bases. However they are also highly leveraged and, since much of their protection is legally insurance, they do not mark all of it to market, and even where they do have MTM instruments, these are often sufficiently illiquid that they are marked to model. They also engage in transactions other than public bond insurance, wrapping risk in private transactions and, in MBIA’s case, managing a SIV. Given rising default and rising default correlations across ABS, then, investors are concerned that the monolines’ capital models might not be robust and hence that their AAA status is questionable. Certainly were a monoline to fail the impact on the market would be very considerable. MBIA alone, for instance, from 2005 to mid 2007 insured $35B of bonds, their RMBS portfolio is over $45B, and their CDO book over $100B. The muni market would also suffer a massive case of illiquidity as investors scramble to understand bonds that previously had traded on the strength of their wraps.

Note finally that since the monolines are insurers, they are not regulated by the FED or the SEC. Any bail out would have to be coordinated between the insurance commissioners and the capital markets regulators. The threshold for ‘default’ is also higher, since a monoline cannot operate unless rated at least AA: a downgrade below that level would probably be taken by the market as more or less equivalent to failure. Meanwhile 300 over isn’t a typical AA credit spread: the market evidently views a monoline failure as a real possibility.

Update. As at the 1st of November, according to the FT, the (AAA-rated) debt of Ambac and MBIA costs 345 bps and 310bps respectively to protect in the CDS market. XL Capital is trading at 445bp.

Posted in: ABS, Monoline, Ratings, Regulation by David /
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