Friday, February 15, 2008

When $800 billion you reinsure, look as good you will not!

This just in: Warren Buffett is pretty smart. Wednesday, the Oracle of Omaha offered to reinsure the entire municipal book of FGIC, Ambac, and MBIA, some $800 billion in bonds, in exchange for 150% of the "unearned" premium on those insurance policies. No word on whether he also asked for a pound of flesh or any one's first born.

Anyway, it was pretty obvious from the beginning that none of the monolines would be very keen to such a plan. By accepting, the monolines would be ceding the best part of their business, leaving only the shaky structured finance business remaining. On CNBC yesterday, Buffett tried to explain that the plan would be a net increase in capital for the monolines, so in theory the monolines would be able to keep their gilt-edged rating. Somehow he managed to keep a straight face. While technically the monolines may have more free capital after ceding the munis, the remaining portfolio would be substantially more risky, and I doubt the new capital ratios would please the ratings agencies. For what its worth, Ambac has already told Buffett thanks but no thanks.

But political pressure is growing. Wednesday, the Port Authority of New York and New Jersey, which owns the World Trade Center site as well as operates the PATH train system, had $100 million in Auction Rate Securities fail at auction. This resulted in a 20% coupon for the coming week. In the scheme of things, having to pay an annualized rate of 20% for one week isn't the end of the world, but its an unnecessary expense for the Authority, not to mention embarrassing. I note that the Authority has an A1 ratings from Moody's and a AA- rating from S&P, so it isn't as though there is a credit problem with the Authority. Its that the monoline insurer problem has holders of ARS panicking. The New York Metropolitan Transportation Authority, which operates New York City's subway and bus system has also suffered an auction failure.

These governmental agencies will manage the current problem easily enough. ARS are generally callable on any auction date, so relatively strong credits like the Port Authority will be able to just call the ARS and issue new bonds with some other structure. But the refinancing won't erase the embarrassment of having an auction failure. Governmental agencies, including the Port Authority, will start putting increasing pressure on the New York insurance regulators to resolve this matter once and for all.

So Buffett becomes the bird in hand, something these governmental agencies can point to and ask "why aren't you making that happen?" Perhaps it won't be his specific plan, maybe it will be something along the same lines worked out by the group of bankers that the Insurance Department has been talking to in recent weeks. But the combination of heavy political pressure and a viable private sector solution will be too difficult to ignore. A deal will be worked out to insulate the municipal bond market.


Anonymous said...

Given the FGIC news today, what are the chances that some type of split happens instead of reinsuring the muni part of the business? I heard people making lots of arguments.

-FGIC CDS traded much tighter initially as some people expected the muni business to get moved into a successor entity; now you own protection on one entity that is money good and one that is junk whereas before there was just one that was all junk.

-On the other hand, some people said it was just short covering (which I suspect is partly true since it closed well off the tights).

-Some lawyer types were saying that regulators would never split the businesses since that would take claims paying capital away from the CDO policyholders. This is clearly true, but in this type of environment anything is possible. On the other hand, forcing them to accept a Buffett-like offer kills the equity holders. If I had to guess, I would think the equity holders should get hurt before the CDO policyholders.

-I heard one person speculate that that they might try the split with FGIC as a test case and use the same for MBI/ABK if it goes well.

Any thoughts about this? I know it's all wild speculation at this point.

muni investor said...

AI, curious - what sort of premiums do insurance agencies charge on muni's to provide them rating ? In exchange what are the terms of the contract provided by the insurance cos ? Also, is there a place where one can publicly see information about ratings of underlying municipalities which are issuing debt ?

Accrued Interest said...


Dinallo says he has the legal authority to favor muni policy holders over other policy holders. He wouldn't be so public about that distinction unless he thought a split was a legitimate possibility.

One thought on FGIC: its owned by Blackstone and PMI. They aren't doing this split for the hell of it. They think that's the way to maximize their investment. The thinking might be that they have two businesses, one is good and the other is bad. Why not save the good business?

Muni Investor: I don't know off the top of my head how much the insurance costs, but I can find out. Bond insurance is paid for up front, and the insurer will paid "timely principal and interest" if the issuer cannot.

You can usually find ratings by finding the official statement. Try

Andre said...

One thing I don't understand is why mutual and hedge funds aren't jumping into the ARS market. Bidding 15% sounds like a great way for a long-term muni fund to juice returns for a few months, AND saves the Authority 500 basis points. If restricted to a small chunk of the portfolio liquidity shouldn't be an issue.

the cds trader said...

Andre, don't be fooled by the 15%. Think of it like lending to subprime borrowers...yeah they'll pay you a higher interest rate, but there's a decent chance you won't get your money back. Risking principal in return for a higher yield is probably not the play to do in today's market.

AI, I'm only slightly familiar with the ARS market, is there secondary trading in the stuff? Like, could you bid someone 95 for one of these bonds that they couldn't sell at auction? Would be interesting to know the market prices on some of the stuff.

Also, I think the bond insurers should take Buffett's offer. Only having to pay 50% extra premium to get rid of all that muni exposure? Bargain. Just think how much the credit markets have moved since a lot of those deals would have been underwritten. Sounds to me like Buffett has mis-priced it.

And yes you can tell me that only a handful of muni's have ever defaulted, and even Orange County paid you back, but times they are a changin'. Tax revenues are going to be dropping across the country. That could pressure many issuers. Remember, many folk said housing couldn't go down...we are now in the "fat tail"...anything can happen.

Brian said...

I think you may give Buffett too much credit and Dinallo not enough. I think the decision to make Buffett's bid public was Dinallo's and it was done to demonstrate that he had a credible alternative to the banks and the monolines staring each other down for the next month.

And of course, just in case the monolines couldn't read the tea leaves after the Buffett announcement, Sheriff Spitzer stood up in the town square yesterday to put them on notice that he was bringing them 5 days hence, dead or alive.

It is also pretty clear that Dinallo was the instigator behind Jain's bid (privately) on the muni book in the first place.

You are right to point out that the seize up in the muni market quickly changed the exercise from one of rating preservation to contagion avoidance. It was becoming more and more obvious that there wasn't alot of value to argue over on the structured finance side, so given a choice between the two, saving the muni piece was the clear priority.

It will be interesting to see how this gets sorted our legally. Beyond the question of whether the Samarai bond insurer (cue John Belushi) treatment will withstand legal challenge, there are the questions of how to treat the FGIC debt that is outstanding and the derivatives that reference it. There is a quote in the WSJ saying this will provoke "instant litigation" My guess is with the threat of regulatory intervention on the table, they will find a way to get past all these issues.

James I. Hymas said...

I have no objection to the monolines being split to save the municipalities at the expense of the CDO-holders ... but I want to see the entire capitalization of the company - equity, debt, petty cash, unused taxi vouchers - wiped out first.

Otherwise, I don't see how the plan is ethical.

Anonymous said...

What an extraordinarily useful post!

Accrued Interest said...

CDS Trader: I really don't know if its possible to buy ARS at $95.

Andre: I think the funds are starting to get involved. All of a sudden I'm getting very detailed information on ARS offerings from all the dealers who cover me. It used to be that bond salesmen didn't even get paid for selling ARS, so unless that's changed, it must be that customers are asking about ARS.

I think the funds are just bidding very high rates. Later today I'm going to make a post about JPM's auctions from Thursday which should shed some light.

gramps said...

AI - I would love to hear (from anyone on this blog) a true *current* risk assessment of munis. Yes, I know home prices only go up and munis have "always" paid (eventually) in the past. Great, Orange County eventually made good on bad interest rate bets by taking from a different government fund -- but what happens when its the "main" fund that has a problem? A state cannot go bankrupt (close its doors like a business) -- but it also cannot print money like Uncle Sam (and printing money isn't really paying it back anyways).

States haven't really been tested financially in over a hundred years -- and government was a lot smaller (and less important) back then.

Bethlehem Steel was a fantastic credit risk historically -- now its a cheezey line in a Billy Joel song.

Focusing on the present instead of the past... States have massive unfunded or underfunded pension obligations and OPEB (mostly health care). Many municipalities entered into strange swap or swaption agreements when they issued debt (why is a municipality making interest rate bets?). Welfare and entitlement spending is exploding. Governments all over have a labor cost problem that makes GM's look like child's play -- GM being a prime example of a "perfect" credit risk in the past that isn't anymore.

On the revenue side, its just plain stupid to say a muni can just raise taxes / fees. Some increases are possible, but taxpayers are not an unlimited source. Over the long haul, government spending cannot grow faster than the economy without causing problems -- and ours (federal, state and local) have already grown faster than the economy for years. Several high tax states (including mine) have already experienced net population declines over a 10yr period (that's before the recent housing problems). Sorry to bring this up, but fewer residents is a fancy way of saying fewer tax payers -- most of the decline was middle class.

While AI's comment (earlier post) that some property taxes adjust with a lag (assessments done every "n" years and/or phased in) -- most states and local authorities have snuck in a "stamp tax". That is, when you sell your house, you pay 2% to the government to transfer the deed (they are not all 2%). In the "flip that house" era, that has been a gigantic revenue source-- and it has dried up NOW not in 3 years. States budgeted for 5-6% YoY growth in sales tax receipts are finding that they will be lucky to be flat YoY.

The big problem with muni's is that their accounting systems share a lot in common with Enron and SIVs-- lots of liabilities are treated as "off the books", when they are very much the muni's liability. Its very difficult to get an accurate picture of a government's true economic position.

The entire country has lived well beyond its means now for many years-- government included. I find it a little amazing that anyone would try to argue that municipal authorities are somehow immune from reality.

Just as some homeowners got themselves massively over extended, its hard to imagine that at least some governments did not also. The lack of good information makes it very hard to figure out which ones are over extended.

If you want to say that "most" munis are going to pay up, one way or the other, I'd probably agree. But to suggest that there is zero credit risk with any of them?

Accrued Interest said...

I'd say it depends on what you mean by "zero credit risk." We'll probably see more downgrades than upgrades. But ultimately the kinds of general obligation credits you're talking about are extremely safe. When they run into problems, it becomes a question of budget decisions. That's what happened in California in 2002. Politicians claimed they were near bankruptcy, but of course that was silly. All they needed to do was make the hard decisions on their budget. Municipalities go through this every few years, either because of some bad budget decisions or a recession or what have you.

Ironic you mention Allentown. Allentown PA has never been bankrupt. The U.S. economy is not going to go through anything as tough as small PA steel towns have.

muni investor said...

CDS trader, as far as I know, ARS always trade at par. The premium rate is decided by a dutch auction depending on the rates placed by individual buyers/sellers. You cannot bid $95 for a par.

Also, the 15% interest rates are unlikely to last for long. The fundamental problem is liquidity - not enough buyers, too many sellers. As soon as the interest rates go up - two things happen : the vehicle attracts buyers, or the municipality calls the security to avoid having to pay ridiculous interest rates for borrowing money.

From what I've seen, I've not seen any 15% rates. I suspect the media has overblown the rate resets. I have ARS's and they've been reseting to about 5-6% tax free (which is still better than the 2-3% rates you get for ultra short term funds. I'm assuming that its very likely that several of them will end up getting called sooner or later. So, while the liquidity has been lost for the short term, there is double the interest rate coming in.