Sunday, February 03, 2008

Our negotiations will not fail!

According to various reports, the New York State Insurance Department is meeting with various banks and dealer firms, trying to broker some kind of bailout for Ambac. One proposal being floated is for banks with exposure to insured structured finance deals to infuse the insurers with new capital. The theory goes that banks and brokerages would be forced to take new write downs in the event the insurers are downgraded, and therefore they might be better off putting up cash now to avoid the write down.

On its surface, this would seem like a mere balance sheet gambit, with little economic consequence. If XYZ bank puts up $1 billion in capital to bond insurers to avoid $1 billion in write downs, it might seem like they are no different economically. Accounting wise, they'd get to record the investment as an asset, whereas a write down is just a loss.

But here is the thing. No one is claiming that the monolines are actually running out of cash today. The actual cash paid out on structured finance deals to date has been small. In fact, based on the way the insurance contracts were structured (called a pay-as-you-go credit default swap), its likely that actual cash payments would occur slowly over time.

I'm not dismissing the impairments in Ambac or MBIA's portfolio just because little cash has actually been paid out. The write downs are real. But if the AAA rating were not so key to their business, if it were merely a cash flow business, the situation would be vastly different.

And that's just the thing. If a group of banks could put enough cash into Ambac and MBIA to maintain the AAA, then it really would become a cash flow issue. The write downs today would turn into in real cash losses over many years. The banking system would have time to absorb those losses, rather than suffer large write downs right now.

No wonder regulators are pushing such a plan. The question for any bank considering involvement is how big the capital infusion has to be. I've heard numbers ranging from $3 billion to $15 billion. One of those numbers would be easy for Wall Street to take on. The other would be tough given today's capital constrained environment.

What about a government bailout? If the Fed and the Treasury really thought the failure of MBIA and Ambac were a threat to the financial system, a bailout of their insurance arms would be relatively cheap by historic standards. Consider that the government could simply take over the insurers and pay out losses over time. In any given year, the losses would be small enough to get lost in the enormity of the Federal budget. Compared to the bailout of the S&L's, it would be a drop in the bucket.

Current shareholders of MBIA and Ambac may find themselves diluted to oblivion in any bailout situation. If it winds up being a full-blown government bailout, shareholders will almost certainly be toast.


Anonymous said...

AI- two things.

1) on the conf call Thurs, MBIA said that they expect to pay out about 700mm on HELOC deals in the next two or three years. This despite the fact that the legal final maturities occur in the '35-'37 timeframe. I do not know for sure how the payout structure chnages with defaults, but I believe that because default is counted principal payment despite the fact that recovery on this type of deal is usually zero, that the payments to the certificate holders is going to be a little shorter then the average life listed in the perspectus.

2) I think that the pressure on the banks is a bit different. If the amount of capital that they needed was just economic, then the banks would have taken much of the hit to their capital base already. For example: a tranch of a CDO is rated AAA by the fact that MBIA wrapped it and might have a stand alone rating of A without. The price of this wrapped piece is say 80 as right now the wrap is not worth very much in the markets eyes, without the wrap the bond might trade for 75. On downgrade my guess is that the price of the bond drops a bit, but not all the way to 75, say to 78 or a 2 point loss.

This is not the problem as I understand it. The problem is that for regulator purposes (tier 1, tier 2 capital ratios) The amount of capital jumps dramaticly. I don't have the exact numbers in front of me, but they are something like this. If rated AAA bank must hold 10% of value as capital, if AA 20%. So the amount of regulatory capital that they would need to hold goes from 8 (80 x 10%) to 15.9 (78 x 20%). Eventhough the economic hit is only 2 (80 - 78). So the change on downgrade is the need to raise 5.9 pt more of capital then just the 2 points of eceonomic hit. Now if you can get the ratings agencies to keep them at AAA by giving a back up loan this is not drawn until losses exceed some number, then the banks can (without actually investing anything yet) stave off having to raise billions in regulatory capital as they have already in economic capital.

It depends who sets the needed amount of capital, the ratings agencies, the Office of the Comptroller of the Currency & Federal Reserve or the market. They are all looking at it a different way right now, who is right only time will tell. But I will guess that if they can put aside ego (a difficult task), the one that can put up the least money and get the most bang for the buck from the others, is the solution that will occur.

cak said...

The banks seem to be working two fronts...

From Bloomberg 2/1 (via blogger SIV)

Reinsurance Plan

One of Dinallo's proposals to rescue the company would have banks and securities firms act as reinsurers of bonds and securities that Ambac guarantees, one of the people said. Ambac would pay an upfront fee in return for a promise that the banks would reimburse it if insurance-related losses exceeded an agreed-upon limit, the person said.

Another option would be for banks to provide the bond insurer with capital to help it pay claims. The banks discussing a possible Ambac rescue also include Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, one of the people said.

``Wachovia recognizes the importance of the monoline insurance industry to the financial services sector,'' said spokeswoman Christy Phillips-Brown. ``We would be supportive of efforts to add stability to the system.''

``The likelihood of getting an industry solution is not very high,'' said Merrill Lynch & Co. Chief Executive Officer John Thain during a conference call earlier this week. ``It's quite likely that we get recapitalization or restructuring type of solutions for the individual companies.''

Anonymous said...

Um Soc Gen is part of the bailout plan?!?!?! They have some other problems at the moment I think.

Anonymous said...


As you say, the goal of a rescue is to avoid bank write downs. These would consume bank capital and constrain lending.

Is there an alternative for regulators to pursue?

Of course. Bank capital is not a constant. What's really at issue is the ownership of that capital. Highly dilutive rights offerings are a staple of credit crises. They happened in Mexico in '95/'96 and Japan in the late nineties, to name just two examples.

So another way of looking at these government efforts is that they are a delaying tactic for bank dilution. What is the public interest in delaying this event? The longer you wait, the higher the probability the the rights offerings come in undersubscribed despite massive discounts. That is truly the worse case scenario, as bank capital availability becomes price inelastic.

Unsympathetic said...
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Unsympathetic said...

AI - On Friday, Sean Egan of Egan-Jones was on CNBC. He said quite explicitly that both MBIA and Ambac need over $30B each, and rated them both well into junk territory due to the lack of those funds.



Accrued Interest said...

Wagner: I think (not 100% sure, so please someone chime in) that MBIA has a choice about whether to pay the principal at default or keep paying interest.

You make a great point on Tier1/2 capital sitation. Should have thought about that and included it more in my piece. To follow your logic: if there was a real bailout of the monolines and suddenly the AAA was secure wouldn't those $80 bonds trade up to like $95? Improving capital considerably?

Cak: Good stuff. Thanks.

Anonymous said...

Specifically, Sean Egan gave ratings of B+ for MBIA and BB- for Ambac (at about 03:10 into the video). So much for "AAA".

Anonymous said...


Here is why I don't believe that the losses can just be paid at the end of the legal final on SF:

1) I took at look at one perspectus: CWHEQ-07-2 and it was clear that for cash flow purposes, when default occurs the underlying note is sold (or attempted to be sold) and the value is as if principal was paid. I believe that if we take this to an extreme and say that all of the underlying HELOC's default with 100% severity at once, then it is as if all the principal comes back at once and the whole capital structure comes due for payment immediately.

2) While MBIA did not say so directly, in the conf call they said that the reserves that they have take (614mm) are expected to be paid over the next two years, well short of the ~30yr legal final. Why would they raise capital at 14% then pay it out in a short time frame, if they could just pay the interest on these certificates ~5%. There is 9pts of arbitrage in that.

3)Finally, take a look at pg 8 of the presentation to the surplus note holders. (Found in the MBIA 8k dated 1/09/08) They say that 40% of some types of SF products are due one credit event and not on final maturity.

Accrued Interest said...


Well something is up with that then, because I've read several places that principal can be delayed. Maybe that's on CDOs? You are referencing a HELOC deal right?

I've read Egan Jones' reports. I'll say that I think they generally do good work. But in this case, their reports on the bond insurers don't make clear what their assumptions are. Maybe this isn't the case, but when I read the report, it sure seemed like the loss calculations were sort of back of the envelope.

Is it me or is this whole bond insurer episode exposing how subjective bond ratings are? I mean, if Egan Jones can conclude MBIA deserves a B+ but Moody's still thinks they deserve a Aaa... something is amiss. I'm working on a post about how bond ratings are too engrained in our financial system. If you have any ideas on that end, please post them.

Anonymous said...

On the ratings agencies. Some random and less then fully thoughtful ideas.

1) In essence, ratings are outsourced credit work, yet are paid for by the non-insured party (except egan jones), this is at its very core a bad idea.

2) The government has basically created an ologopoly (sp?). They have only added EJ recntly to their list of NRSROs. This is also bad as it limits the range of ideas/viewpoints on a credit.

3) People doing the credit work at the agencies cannot make even a fraction of the amount that people at hedge funds or banks doing the same work can. This generally means that if someone is good, they don't stay at the agencies. Not to say that certain people are not good, but I think that the average quality is not as high as other places.

4) In the financials especially, the ablity to access capital is crucial. The ratings therefore influence the underlying business. There is an inherent conflict of interest when maintaining the rating means that the credit should get a higher rating.

5) I am not at all sure what to do about these. And yes, the market has gotten lazy in so many ways in doing credit work.

These are just disjointed and incomplete thoughts, please treat as such. Look fwd to your post.

Anonymous said...

FWIW Tom Brown on Egan Jones

The Bond Guarantors Need $200 Billion? No Way. Egan Jones’s headline-grabbing estimate is off by several ballparks

Accrued Interest said...

My problem is that the ratings agencies get to decide what constitutes AAA (or AA or A etc). But reasonable people could disagree. I mean, I could make a case that since M2M losses haven't historically correlated with real cash losses, that the Accrued Interest Ratings Agency was going to ignore M2M losses.

Conversely I could argue that a AAA rating required a certain ratio of capital to insured exposure. In that case, M2M losses are all that matters! The insurer could be insolvent before they've paid out a dime in cash losses.

I think readers would agree that neither seems quite right, but guess what? That's how we get the divergence between EJ and S&P.

FWIW, I saw that DePaul University is doing a new deal with XLCA insurance. Boggles the mind. I sure hope there is some funky legal reason why they are doing this. Otherwise, I can only imagine how the call from the investment bankers (Lehman) to XLCA must have gone.

Lehman: Hello? Is this the municipal bond insurance deparment.

XLCA: Uh... yeah. What can I do for you?

Lehman: We'd like you to bid on insuring a new DePaul University deal.

XLCA: (Long Pause) Very funny. Who is this really?

Lehman: Its Lehman Brothers. We're doing a new deal for DePaul...

XLCA: And you want us to bid?

Lehman: If you would be so kind.

XLCA: You know this is XLCA. Our parent is Security Capital?

Lehman: Yes. And we'd like you to bid on insuring ...

XLCA: Yeah, I got that part. Alright. How about 15bps.

Lehman: Great.

XLCA: I meant 150bps.

Lehman: Great. I'll call you when the deal is done.

Anonymous said...

In response to the comment from Egan:

You imply that Egan said that the industry needs 200bn to remain solvent, which is not what he said, at least not on the CNBC video (link: He said that 1) MBIA needs $10bn of capital to cover losses 2) that MBIA needs $30bn to have the cushion to remain AAA 3) that the simple math was MBIA is one of 7 bond insurers therefore the industry needs $200bn.

So before we even begin a discussion, let just get what he said straight. Now we can attack what he said. 1) That they need 10bn to remain solvent. That seems large. I believe that the heloc, 2nds and cdo^2 will have very high severity on underlying default, but don't believe that the losses will exceed the CPR of the company by 10bn. The CPR as of 12/31/07 was 14bn. I would put a small discount on this as some of these funds are not immediately available and are based on payments in the future that may or may not get paid. Lets just say that I think real CPR is about 12bn. Adding his $10 bn gets to 22bn. The net par insured on MBIA in SF is about 290bn. So there has to be about 7% loss versus NPI. Given the general attachment points, I think that this is unlikely.

The $30bn that he says that they need to be AAA. This one is a bit hard to argue with as he is the one handing out the rating. But in essence, he is saying that the losses are not only large, but highly variable. If we could all agree that the losses were $10bn not one penny more or one penny less, then the amount of capital to be AAA should not be higher then this. By saying that they need 30bn, he is saying that the variablity of losses is large. Given that I think that the 22bn of osses is already on the high end, an additional amount of 20bn is excessive. On the other hand, this is a business that as recently as the 3Q '06 conf call management was still calling a "zero loss underwriting." And they have raised $1.5bn of capital with at least anoth 0.5bn coming since then.

Finally the 200bn number. Really, if he was not speaking off the cuff, Mr Egan would have done a bottom up analysis on all of the monolines. At least he could have taken the market share that MBIA had and multiplied by the inverse. Market share can be defined in various ways (GPW, NPW, GPI....) but I think that roughly MBIA and AMBAC had about 50% between them and the rest the other 50%. Lets just say that MBIA had 25%. So the amount to get the industry to AAA should not have been over 200bn, but more like 120bn. Again, I think all of his numbers are high.

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