Saturday, June 21, 2008

Monoline downgrade fallout

(Naked Capitalism) In the anxious January/February period, when New York Insurance Superintendent Eric Dinallo made Herculean efforts to come up with $15 billion for MBIA and Ambac, it was a high-stakes drama, since it was assumed that the loss of the AAA ratings would End the World of Finance As We Know It.

Now that the once-unthinkable has come to pass and the two big bond guarantors are no longer AAA rated, the reaction is more muted. Hey, when you've got the Fed backstopping the financial system, why worry? But the monolines have been on the ropes for months; the rating agencies have given plenty of warning of the likelihood of downgrades (although Moody's cutting MBIA from Aaa to A2 on its insurance sub was a big surprise), so investors have had time to arrange their affairs accordingly. While we'll no doubt see knock-on effects for some time, perhaps we'll escape worst-case scenario of cascading forced sales.

But don't kid yourself that there won't be dislocations, particularly since they've already started, Indeed, the generally positive Wall Street Journal is chastened:
The long-anticipated credit-rating downgrades of the nation's big bond insurers are pressuring financial markets, perhaps worse than expected.

The Journal describes another shoe that is dropping:
Financial firms like Bank of America Corp., J.P. Morgan Chase & Co., Depfa Bank of Dublin, Citigroup and several other European banks are involved in the business of backstopping municipal-bond issuers, whose debt often is also insured by bond insurers. If Wall Street can't sell the bonds, called variable-rate demand notes, in weekly or daily scheduled sales, they or the investors can exercise their right to sell it to banks that have agreed to be buyers of last resort.

Those obligations are coming home to roost as money-market-fund managers sell out their positions on bonds insured by Ambac or MBIA. In some cases, the bonds must be sold by the funds to these backstop banks if the ratings of the insurance company reach a certain threshold.

Of the approximately $420 billion market for variable-rate demand notes, about $70 billion is insured by Ambac or MBIA, according to industry estimates. Of that $70 billion, bankers said as much as $35 billion is likely to be sold back to these banks, further straining their balance sheets.

When these banks do step in, the interest rate on the bonds typically rises, hurting issuers. Issuers are also forced to repay the full principal on their debt sooner than their original 30- or 10-year maturity.

Bloomberg reports that the muni bond market was hard hit, since it already had a fairly heavy calendar of new issues:
U.S. municipal bonds dropped, driving benchmark 30-year yields to the highest since July 2004...

The municipal market sagged for two weeks amid above- average issuance, selling related to bond-insurer downgrades and property-and-casualty companies liquidating to meet flood- related claims in the Midwest, according to David Thompson, president of Chicago-based bond dealer Griffin, Kubik, Stephens & Thompson Inc.

``A `perfect storm' of supply'' has been driving declines, Thompson said in market commentary today...

Most benchmark yields rose this week to levels last seen after the collapse of the auction-rate securities market and liquidations by some municipal-bond hedge funds in late February...

``There's virtually no bid out there right now,'' said Michael McKenna, a trader with Livingston, New Jersey-based GMS Group LLC. ``There's such a huge liquidity issue in municipals again. We're getting hit.''

The Financial Times tells us that banks and investment banks have $125 billion of guarantees from Ambac and MBIA, which support various structured credits and other assets. The only recent estimate we've seen of possible losses from them is $10 billion for Citi, Merrill, and UBS, the firms with the greatest exposure.

We had commented yesterday on MBIA's need to provide extra collateral on its guaranteed investment contracts as a result of the downgrade (and corrected an erroneous surmise of its impact on claims paying resources). MBIA announced that will have to post $4.5 billion in collateral on its GICs and may also face $2.9 billion in termination expenses on GICs. The insurer said it has $15.2 billion available to satisfy these needs. This is consistent with the estimates in their latest 10-Q.

The Financial Times provided further detail:
The ratings cuts are not expected to have a significant impact on the need for the bond insurers to post collateral on derivatives and other contracts. According to analysts, only further downgrades to the triple B category would likely trigger demands from banks for collateral payments.

Now, to continuing debates about the endgame, which (let us stress) is not imminent. However, the monolines having nada in the way of a viable long-term business strategy (limited credit enhancement opportunities to begin with due to absence of AAA; bona fide risk assumption now required due to changes in muni bond rating practices thanks to Congressional pressure, something they've never done intentionally; and generally bad outlook for municipal creditworthiness). So while they may find the occasional bit of viable business, they are effectively moving towards a run-off, whether they have admitted it to themselves yet or not.

Felix Salmon had a interesting conversation with Josh Rosner, who (like Felix) has been talking to the NYSID. Rosner said that the regulator would block the credit default swaps holders right to accelerate (demand immediate payment) in the event of insolvency or custodianship (which we indicated was unlikely). Felix quoted Rosner:
I expect that the NYSID would ultimately attempt to abrogate any attempts by counterparties to use the acceleration clause. That is not to say I agree that it is right to violate contracts that the NYSID knew existed nor is it to say that I believe they could do so without it leading to protracted court challenges, rather it is to say that is my expectation of what they would likely do to protect claims paying resources for muni policyholders.

Felix also asked if Rosner thought the monolines would make good on their commitments:
If policies were all to pay over time, assuming no further degradation in the macro economy and thus deterioration of CMBS and other commercial asset classes they should be close to being able to meet their obligations at maturity. I do, however, expect further deterioration so, at this point, I am comfortable saying that no one can honestly tell you whether they will ultimately have enough $.

Finally, the GIC misque led me to dig deeper into MBIA's statement that it has $16 billion in "claims paying resources". It appears that MBIA defines the term in a way that departs from that used by the industry association, the Association of Financial Guarantee Insurers. Since this figure, although mentioned in SEC filings, is published and computed in an operating supplement that is subject to neither GAAP nor SAAP, this deviation no doubt is permissible.

I'd be curious to get reader input. I'm disturbed by MBIA's propensity to stretch the truth to near the breaking point, and the differences to me look significant. One item, flagged in the discussion below lifted from the revised version of the post, seems particularly aggressive. There are other disparities, but it isn't clear whether other financial guarantors take similar liberties.
However, the reader input on the GIC question led me to look deeper into the definition of claims paying resources, and I am troubled by what I see. MBIA's statutory surplus, as shown for its combined insurance companies at the end of 2007, was $3.7 billion (versus $4.1 billion the prior year end). That is a lot less than the so-called claims paying resources. This concept is used by bond insurers (my impression is not by the insurance industry generally; "claims paying ability" which is usually a rating, is a different concept).

CPR is equal to capital (which in insurance lingo is surplus) PLUS the unearned premiums (this definition comes from the financial guarantors' industry association, the AFGI). Yet in MBIA's case (per its statutory filings) the unearned premiums (year end 2007) show $3.5 billion of unearned premiums (see the liablity side of the balance sheet) while the asset side shows $7.3 billion of uncollected premiums. Query how you get to $16 billion if the definition of claims paying resources is surplus + unearned premiums.

Aha, but it's in the operating supplement, page 7, which as our former general counsel points out, is prepared in accordance neither with GAAP nor SAAP and "should be treated with due caution". Using the year end figures to make it comparable to the statutory report, they add a $2.7 billion contingency reserve to the surplus and $2.6 billion of present value of installment premiums (I have serious problems with that concept; if you are a bank, you don't get to discount your future interest spread and count its as some sort of capital). They also show $900 million in "Loss and LAE reserves" and "soft capital" of $850 million.

What raises my eyebrows (aside from the notion of the present value of installment premiums) is that the operating supplement shows that their claims paying resources increased by $1.5 billion by the end of the first quarter versus year end The change is largely explained by the change in "Loss and LAE reserves" which increased by $1.2 billion since year end (note that "Loss and LAE reserve" corresponds to the total shown for "Loss" on the year end statutory balance sheet).

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