Monday, June 30, 2008

Sir, monolines coming into our sector!

It hasn't been a great year for monolines, and Pershing Square Capital's Bill Ackman has been one of the main beneficiaries. He's famously made a kings ransom shorting MBIA, betting that losses on collateralized debt obligations and other asset-backed securities would eventually drive MBIA bankrupt.

But now he's set his sights on far more conservative Financial Security Assurance (FSA). As FSA is wholy owned by European banking giant Dexia, there is no stock to short. Instead Ackman has bought credit default swap (CDS) protection against FSA defaulting on its insurance obligations. Currently FSA is rated AAA/Aaa/AAA by S&P, Moody's, and Fitch respectively with a stable outlook by all three.

Ackman's revealed his position at a conference in New York on June 18. The market paid attention. The next day CDS on FSA had moved 200bps wider to 700bps/year for protection. It rallied into the 400bps area two days later when Dexia extended a $5 billion credit line to FSA, but has since moved back into the 700 area. For context, this morning Lehman Brothers CDS was +280 offer, Washington Mutual was +585. To get into the 700 area you have to look at names like National City.

Does FSA belong in the same category as Ambac and MBIA? I'm going to explore this in two parts, first on the liability side, then on the asset side. Here are the raw facts on insurance liabilities.

The following chart details the direct residential mortgage (RMBS) exposure from MBIA and Ambac (blue bars) and FSA (red bar). Each is expressed as a percentage of the firm's total claims paying resources. So for example, Ambac has exposure to home equity lines of credit at 216%, which means that if their entire HELOC exposure went to zero, the firm would exhaust their claims paying resources two times over. The figures are from S&P and the companies themselves.

So looking at this, FSA is no better than its more troubled competitors. However, when it comes to direct RMBS exposure, the story isn't quite as dire as it would initially seem. The monolines' generally insured senior positions in RMBS deals, meaning that other securities would absorb losses first. For example, FSA states that their typical subprime RMBS transaction has 20% subordination and 7% excess spread, or excess interest collected by the trust for benefit of senior bond holders. In their first quarter earnings release, FSA estimated that more than 45% of all subprime borrowers would have to default (in a given deal) in order for FSA to pay a single dollar in claims.

Will any transaction suffer 45% defaults? Some probably will, but all of them won't. And the second lien transactions (both closed-end and HELOCs) will likely enjoy no recovery upon default, so those loss severities will be worse. On the other hand, the monolines have the luxury of making payments on RMBS losses over time, i.e., there is no large principal payment which would come due all at once. So RMBS losses will be substantial to be sure, but its probably manageable. But that's not where the really big problem is.

The big problem is in collateralized debt obligations (CDOs).

The key to the CDO creation game was to create the maximum return to the equity holder while still earning a AAA rating for the senior-most holder. In creating CDOs using RMBS as collateral, the arranger generally used subordinated securities. And by subordinated, I mean the first ones to take losses when the underlying borrowers default. Today it is widely assumed that most subordinated sub-prime securities won't receive any principal at all, and many subordinated prime RMBS will suffer significant impairments. So a CDO made up of these subordinate securities, even the senior-most piece of the CDO, is likely to incur large losses.

Which brings us to our second chart, RMBS CDO exposure, again as a percentage of claims-paying resources.

The reality is that most of these RMBS-oriented CDOs are going to take losses of 30% or more. CDOs alone will likely sap the resources of Ambac and MBIA. But FSA's exposure to this sector is nominal. Even if they were to take 100% losses on their RMBS CDO portfolio, the impact on their solvency will be minor.

Remember that FSA is a subsidiary of Dexia, and therefore Ackman's bet isn't on the common stock. In the case of MBIA, Ackman was able to short the common. Even if MBIA is somehow able to pull through as a solvent company, Ackman's gains on shorting the stock will still be substantial. With FSA, he's long CDS protection, which only pay off in the event of a default, so Ackman's bet is not on a decline in profitability or loss of AAA ratings, but on bankruptcy. In fact, FSA could lose its AAA ratings and Dexia could give up on the financial guaranty business and put FSA into run-off, and as long as FSA never runs out of cash, Ackman's CDS will expire worthless. Sure, Ackman could gain on CDS widening. Maybe he's already cashed in his gains on FSA. But given the already wide spread on FSA CDS, if FSA doesn't have liquidity problems, it will be an expensive short.

The facts on the insured side just don't support FSA going the way of MBIA or Ambac, particularly when you limit the discussion purely to solvency. Next up, a look at FSA's investment portfolio. (Hint, that doesn't look as rosy.)


Gringcorp said...

Ackman's gains on his long FSA CDS position probably depended in part on how good his reading of Dexia's willingness to support FSA was. I don't think he needed a default to make some pretty good gains, though. Presumably this is what people are talking about when they complain about the CDS market being illiquid and less-than-transparent, though it's hardly Ackman's fault that monolines' books are not that well understood, and that he has such an ability to move his targets. I'm not sure whether anyone this side of Boone Pickens gets so much bang from talking their book.

Sivaram Velauthapillai said...

Ackman's real argument is against the invesment portfolio... let's wait and see what your results are...

I still think Ackman is going to be wrong on his assertion (i.e. FSA going to default) but he'll make money (likely by exiting after spreads widen--assuming that's possible)...

Dave M. said...

Ticker symbol on one of FSA's bonds is FSB.

mack said...

A position against FSA CDS is analogous to a bet against Dexia, albeit tangentially so (and much simpler).

Ultimately, that's the analysis that determines this trade.

Whether Ackman took this perspective or simply wanted to 'flex' his new found muscles in market credibilty for a quick 200 basis points, no idea.

Accrued Interest said...

If he wanted to bet against Dexia, why not bet against Dexia? CDS there is around 500bps tighter, so the bet is much cheaper.

He is implicitly betting that Dexia won't support FSA, because if they do, then obviously FSA and Dexia CDS should converge.

Anonymous said...

In addition to FSB, other FSA debentures are FSE and FSF. All are rated AA by S&P and Aa2 by Moody's.

Anonymous said...

As Ackbar... err, I mean Ackman would undoubtedly say, "It's a trap!"

mack said...


That's a good point. But "cheaper" may not equal more profitable.

It's hard to discern why someone makes a trade, but I suspect it was "simpler" to have a go at FSA, even though it costs more.

Bill Ackman had to carry his shorts against Ambac/ MBIA for what, years?

He might be getting tired of that nonsense.

The point about FSA being a proxy for Dexia pivots not on whether Dex "will" support FSA, but "can" it do so, in my mind. To the extent he made an up and down analysis, that would be the critical point (to me).

Truly, it may have been cheaper and ultimately more profitable to go w/ Dexia, it just seems more complicated and drawn out.

FSA=Dexia is probably just a semantic argument that popped in my head, but, glad you challenged me on it b/c it forced me to think about why it was there in the first place.


Accrued Interest said...

Actually thinking more about the Dexia vs. FSA argument... I can imagine a progression of logic like this...

1) I think Dexia is weak, but not close to failing.

2) The market may perceive Dexia as too big to fail, putting a limit on how far the CDS will widen.

3) Subsidiary FSA benefits from an implied backing from Dexia, which in reality is not absolute.

4) If Dexia were to sell FSA (to help raise capital) or else allow it to fall below AAA, the CDS would widen.

5) Therefore long FSA CDS is a better bet than long Dexia.

Now I don't follow Dexia closely, so I don't have an opinion about Dexia being weak or not. But if I did have that view, the short FSA starts making more sense.

My strong suspicion is that Ackman is really just talking his position, knowing that if he advances a half-way reasonable case against FSA the CDS will widen no matter what. That's why long FSA CDS makes more sense than long Dexia.

Gringcorp said...

I'm with you on the "FSA failing" versus "talking his way to a quick profit" front. I'm faily certain that Dexia neither implicitly nor implicitly guarantees FSA, and the ratings agencies probably demanded a very rigid separation beteen the FSA and Dexia credit. That said, Dexia is the banker to much of local government in France and Belgium, the monoline is an extension of this franchise (though FSA's European book is much smaller than its US one), and its failure strikes me, at least, as unlikely.

Tony Towers said...

You stated that FSA’s investment portfolio doesn’t look rosy. Now that Dexia is providing FSA with a $5 billion line of credit shouldn’t that offset the weakness in the investment portfolio? Wouldn’t the line of credit ensure that FSA’s capital exceeds the amount necessary to maintain the rating agencies' AAA for now.

Accrued Interest said...

Yeah I wanted to get to the FSA investment portfolio and haven't gotten to it. Obviously Dexia is trying to show they will fully support FSA without pledging any capital immediately.