Saturday, February 23, 2008

Monolines: Now witness the destructive power!

New CEO Jay Brown at MBIA is considering a good bank/bad bank split. We talked about this idea a bit with Ambac on Wednesday. Now let's talk a bit about the bigger picture. My view is that a split is a good idea for both shareholders and the economy. For shareholders, it preserves the part of their business which remains viable (muni insurance). As it is, neither Ambac nor MBIA will be able to write new business of any kind until their AAA/Aaa rating is stable, and that ain't happening without a ton of new capital or a split.

For the economy it would also be beneficial, in my estimation, because it would turn an unknown into a known. See, the market can deal with banks needing more capital, particularly if the new capital required is a known quantity. The market can't deal with capital needs being some wild unknown. Right now write downs and/or new capital needs related to monoline wrapped ABS is a wild unknown. Plus its a wild unknown how the contagion may spread to the municipal market. If the businesses were split, the capital situation for banks would come more into focus. Plus the problems in municipals would be all but eliminated. We'd turn a big unknown into a known, which is always good for markets, even if the known isn't good.

Which brings us to another question: how bad would it be for banks if all the monolines split their municipal and structured finance businesses?

To get to the bottom of this, let's look at Ambac and MBIA's "problem" bonds. These are the bonds trading at large discounts to their original value, and not just because of generalized weaker liquidity: closed-end second liens, home equity, sub-prime first liens, and ABS CDOs. Here is Ambac's exposure to "problem" bonds: (from Ambac's investment relations site)

  • Closed-end second liens: $5.3 billion
  • HELOC: $12 billion
  • Sub-prime first liens: $8.4 billion
  • ABS CDO: $32.2 billion
  • Closed-end second liens: $11.1 billion
  • HELOC: $11.7 billion
  • Sub-prime first liens: $4.7 billion
  • ABS CDO: $30.6 billion
That's a total of $116.1 billion.

So here are some of the questions that remain to be answered.
  • To what degree have banks already written down the value of these bonds? All indications are that structured finance bonds have been trading like there is no insurance for a while. So if the banks have truly been marking to market, there should be little actual write downs. We'll have to see whether that's actually been the case or not. If I had to bet, I'd bet that the brokerages did a better job than banks in handling write downs.
  • How much of this paper is held by U.S. banks vs. foreign banks? It was widely believed that European banks were big buyers of AAA-rated ABS CDO paper, and that they loved to get wraps on top of that. So it stands to reason that the CDO exposure may be heavily European.
  • How much of a downgrade would the wrapped paper suffer? The banks that hold this paper probably know the answer, since some of the CDS contracts were done privately. That means that the bond's public rating is a uninsured rating. It gets its "insured" treatment by virtue of a separately negotiated CDS contract. Other paper was wrapped when the bond was issued, and may or may not have an underlying rating.

As long as these questions linger, the credit market is going to continue to discount brokerage and bank bonds, which are currently at or near all-time wides. In addition, if banks are uncertain about their capital position, their willingness to lend will be compromised. In other words, we need come to some conclusion with the monolines before the economy can start moving forward.


steve said...

AI, in attempting to dumb this down to a level that i might understand -- split or good bank/bad bank may help the muni biz but to be honest, who ever thought the muni biz was gonna be a problem? in that they have the ultimate taxing authority, well, there's never been doubt in my mind they'd eventually slug through this hurdle and well, get back on with life. the bad bank though, still presents more questions of liability and losses to be accounted for. sure investment banks might have done a better job of writing securities down but then again, they may still be problems out there. what good is throwing additional capital at the 'good bank' part if we're still not addressing the problems created by the bad banks.

HOW would this be good for the economy? simply segregating the 'bad bank' doesn't give IT capital or help those exposed ease pain of writedowns. heck we still dont know who's got what in terms of exposure.

more importantly if the investment banks who've been 'diligent' (?) about writing down their bad paper have been so good about doing it -- well so what? they've NOW not had enough capital to support Auction Rate Securities markets and they stand to lose more by walking away from that market and allowing fails, dont they? Reputational risk as well as litigation risk?

not sure i'd go with split as good as it just denotes who's wearing the white hats and who's wearing the black ones. doesn't help catch the bad guys. THEY've still got some writing down to do ... as far as we know right now there have been somewhere in the neighborhood of what, $150Bil written down? JPMorgan's estimate was for something closer to $300-400Bil of charges to be taken and that seems to be fairly widely accepted figure.

throw some more capital over at Ambac. Great for them, really. Heck, even Ackman probably likes the plan (?).

Again, please try and dumb this down though to my level as i dont see how this stops the price of homes from declining and the positive feedback loop everyone keeps talking about from happening ... does it?

Sorry for excessive rant this evening ... any/all input, though, would be greatly appreciated.

W.C. Varones said...

Banks to Ambac:

You've got me? Who's got you?

eTrader said...


Although muni are very safe, investors could get great benefits by insuring them. It was called "Negative Basis Trade".

By using NBT, investors could *accelerate* the profit at the front, that means they didn't need to wait for maturity of the bonds.

steve said...

etrader ... negative basis trade ... throwing something MORE technical doesn't exlpain or backstop the value of housing, does it? might help you in a punt, but how is negative basis trade relevant to good bank/bad bank and resolving losses that STILL EXIST, do they NOT ... good bank/bad bank, negative basis trade or NOT ... protecting shareholders for insurance companies to a degree BUT ... still leaves ME with more questions than answers, so again, please dumb down just how negative basis trades is a relative solution or answer to ME?

steve said...

AND ... not for nuthin, along the lines of dumbing things down, i guess my point might be illustrated by the following sentence from Page One article (Feb 23rd) on hedge funds -- kings of complexity ...

"The most mundane bonds are in heavy demand: Ten-year U.S. Treasury securities have gained
12.3% over the past year, and are up 2.5% since the start of 2008."

Plain OLE Treasuries +2.5% ytd ... hmmm ... how bout yer negative basis trades ...

back ON POINT, though .. good bank/bad bank and house prices ... not seeing it ...

the cds trader said...

i don't see how the "good bank/bank bad" can be set up, it sounds like fraud, dumping all the good assets into one concern and all the bad assets into another.

so sounds like the idea won't work.

And another thing, why is everyone assuming muni's are safe? I don't know much about the sector, but everything I am reading, particularly over at Mish's blog, points to tax revenues falling everywhere and a clear funding crisis in a lot of states. Muni defaults anyone?

Accrued Interest said...


My point is that losses can be dealt with. Ever spreading contagion cannot be dealt with. So by splitting the businesses you are creating a firewall around the muni business, basically saying that this is one place the contagion won't go. It doesn't matter a hill of beans for home prices. But it does help the economy start sorting things out.

I also think you need to consider the following fact: the banks want to do this. Citigroup and a bunch of mainly European banks are supposedly close to something, and it will involve splitting the business. If the split is so disasterous to banks, why do they want the split?

I think this is the answer. They are going to get equity in the muni business in exchange for a credit line for the structured finance business. The credit line will allow the SF to keep a rating of A or BBB, while the muni business gets a AAA and remains a viable going concern.

Just a guess.

steve said...

cdstrader -- thank you. 'nuff said, then ... suppose i'm NOT missing anything and do feel somewhat better ... by sounds of yer name you are someone who is tasked with understanding and probably trading in a very complex marketplace ... problems are still problems no matter WHERE they are ... in my first rant (above) i'd stated so far there have been $150Bil of writedowns ...

just finished reading Lehman's weekly rel val and they've got running tally UP OVER $200Bil ... and with capital infusions of ONLY $93Bil so far ... well even I'm capable of doing THAT math -- withOUT Monroe ...

SO, throw another $3Bil @ Ambac -- stock mkt rallies smartly on THAT news -- isn't it to be SOLD?

steve said...

AI -- i do get what yer suggesting as to WHY banks want it .. need it. Isn't it sort of ironic that they'll support THIS but not some of these failed auctions of past couple weeks, though? All of a sudden they've got capital to put to work -- UNKOWNs, though is reputation damage that has already occured as well as litigation that may already be IN the works, no? Banks with balance sheets like swiss cheese NEED to do this to save themselves -- am all for these guys getting something outta the deal, as opposed to Buffet, though ... i donno. Again, sorry for rant, am just extremly frustrated at past week's overall mkt and very much looking forward to a fresh start tomorrow!

Sivaram Velauthapillai said...

(disclosure: long Ambac--and hurting)

I think this is THE move for Ambac. It massively dilutes shareholders but we have few other choices. If what they are doing doesn't succeed, things are going to fall apart...

The split is nothing like what it sounds like. I'm not a lawyer but I don't think the companies can split in the sense of spinning off one division. I don't think that's legal for insurance companies (or any other company for that matter). Instead, it is more of ring-fencing one area from the other.

My guess is that the split is similar to how Cigna, a property & casulty insurer, in the mid-90's, split one of its areas with potentially large liabilities due to asbestos and environmental clean-up insurance, from the rest. ( read the middle of this post on my blog for an idea of what may happen).

The whole point of a split is not to avoid liabilities (you can't); it is simply to keep a AAA rating for one area (muni bonds in this case), while the structured product area is possibly rated AA. In the case of Cigna (which is a P&C and has nothing to do with bond insurance), the asbestos-tained unit went into run-off right away while the untainted business operated as normal. In this case, I suspect the structured product side will try to operate with a lower rating (if it can't then it will go into run-off).

Note that I am speculating on what the monoline strategy is going to be (there are a lot of rumours floating around and we won't know until the details are released).

None of this will stop house prices from declining or avoid a recession or whatever else that may be happening. However, it should increase transparency and eliminate the uncertainty (a word investors don't like) in certain segments of the market. The muni bond business will start to improve over time if things work as I hope. Banks and others with monoline exposure will also gain some clarity. However, for the monolines, the ultimate outcome comes down to subprime losses and recoveries (we won't know this until the end of this year IMO)...

steve said...

guess your conclusion is kinda my point ... "However, for the monolines, the ultimate outcome comes down to subprime losses and recoveries (we won't know this until the end of this year IMO)..."

for the monolines -- until only a month ago, this was NEVER an issue. the subprime problem continues to morph ... who can tell us what the next buzzword is gonna be -- as it may relate to credit cards and even to commercial mortgage mkt (read Abelson from Barrons).

BACK TO AIs Blog post, though -- we're all very concnerned for the moment about The Monolines ... we're in the middle of the trees and NOT seeing the friggin forest. Maybe AI is and perhaps you are, too, Sivaram in that you are both trying to make lemonade outta lemons -- sifting thru failed auctions and trying to catch falling knives buying Ambac ... good for you both and am sure you'll be quite successful ...

Again, though, dumbing this down so as I can understand -- in the bigger picture, we've got more than $200bil in writedowns and about $93Bil in capital infusion (data from Lehman bros -- let me know if you'd like copy). SO, Ambac is gonna possibly get ANOTHER $3Bil. Terrific. This was NEVER about muni's or insurers to begin with.

Started back in August when a couple dudes over at Bear royally 'F'd UP. Cockroach theory fully in effect here -- never just one. Siv, were you long Ambac since this time last year?

AI, were you looking for failed auctions this time last year? I'm guessing here, not ... could be wrong. Be that as it may -- hopefully wind as all of our backs. Sooner we move on from ALL of this, the better we'll all be. FEAR is though, it's gonna be worse before its better.

the cds trader said...

Steve I agree this rally is to be sold. Equities living the dream while fixed income plays out the nightmare reality. Tons of downside for equities esp homebuilders, banks, reits/cre players, retailers etc. And you are right to try and "dumb down" a lot of what is going on, none of it is that complicated and its all about learning the details.

Can u send me a copy of that Lehman piece? thecdstrader AT thanks

Sivaram, re: your cigna example of putting company in runoff, it may have worked in that case but it would be interesting to see what would happen if the runoff entity's losses were more than its capital...I suspect policyholders would then go after the other split off company.

PNL4LYFE said...

Can anyone confirm whether the $116bn figure includes private CDS exposure too or just bonds that were wrapped when issued? I assume it's the latter because the former is probably even uglier.

Anonymous said...

what? i still dont understand how a split can be legal. while some of the banks may back it the other people who purchased SF protection will now be placed in the back of the line when they really bought insurance from the entire entity. how can you take from one holder and give to another willy-nilly?

PNL4LYFE said...

A 'split' could be accomplished in a couple different ways. The two broad cases are 1) Moving the muni business into a new entity and 2) creating a new entity to sell reinsurance to the muni part of the business. There a lots of other details that would be important, but I can't pretend to know how those will work out.

Case 1 would be favored by equity holders because it preserves value from the muni business; presumably the new muni entity would be able to pay dividends to the holding company. This solution is worse for structured bondholders and is probably subject to much more litigation risk

Case 2 would be much easier from a legal perspective. I think policyholders would favor this option although it's hard to say how much money the holding company would be able to extract from the new entity; if they take very much, stuctured holders would still object.

In either case, the structured business needs capital to avoid a downgrade. The banks need this to avoid writing everything down right now. My view is that banks will continue to inject capital in the future as it becomes necessary (which I think it will). This way, they will realize losses as they occur instead of having to take a huge MTM hit upfront. This is good for everyone as it keeps them from becoming undercapitalized and hopefully will allow them to help areas of the credit market that are now frozen but are still fundamentally sound (at least for now...)

CrocodileChuck said...

"How much of this paper is held by U.S. banks vs. foreign banks?"

Swiss and UK banks have the greatest exposures in Europe