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
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.