Friday, June 20, 2008

On the MBIA and Ambac downgrades

(Naked Capitalism) As readers probably know by now, Moody's, the last holdout on the AAA rating for the two big monolines MBIA and Ambac, downgraded both companies earlier today, and more harshly than Standard & Poor's. And even with this downgrade, it underscored that more cuts are likely to be in the offing

Per Bloomberg:
MBIA's MBIA Insurance Corp. unit was reduced five levels to A2 from Aaa, New York-based Moody's said today in a statement. Ambac Assurance Corp. was lowered three steps to Aa3, Moody's said in a separate release. The outlook on both is negative.

Standard & Poor's now has both at AA, which is equivalent to a Moody's Aa2 (Aa3 is lower than Aa2). Note that the ratings on the insurance subs are the ones of most concern to investors. Note further that Moody's takes a dimmer view of MBIA than Ambac.

The rating agency underscored that questionable new business prospects are a major concern:
MBIA's downgrade reflects its ``limited financial flexibility and impaired franchise,'' Moody's analyst Jack Dorer said today in a statement. Ambac has ``significantly constrained new business prospects'' and likely will incur more losses, Dorer said.

This is a fairly blunt statement, and confirms the widespread view that the monoline business model has gone the way of the dodo bird. The free lunch of guaranteeing muni bonds that, were they rated on the corporate scale, in many cases wouldn't need credit enhancement, is over. Municipal guaranteed will involve real risk assumption, a skill the monolines have not mastered.

With Warren Buffett offering a true AAA, most of the business worth doing will gravitate to him. And with doubts about ratings strength in play, what government body would sign up for a guarantee, designed to boost their rating, if a future downgrade may render it moot? ACA, which had only a singe A was able to write only $7 billion of muni guarantees out of a $70 billion portfolio.

Another part of the statement from Moody's called the truthfulness of MBIA into question:
MBIA is $2.6 billion short of its target capital level for an Aaa company, Moody's said. The rating company also said MBIA's decision to retain $1.1 billion at its holding company was ``indicative of a more aggressive capital management strategy'' and contributed to the extent of the downgrade...

Ambac is $225 million below the Aaa target level, Moody's said.

Sp the depth of MBIA's downgrade is a self-inflicted wound. Had the monoline acted in accordance with its earlier promises, it would have gotten a higher mark.

But note specifically that the rating agency felt compelled to state the amount of capital MBIA needed to secure an AAA. Contrast this with the statement from MBIA on its website:
The rating agencies are now indicating that the ratings of the Insurance Company are dependent on other factors besides the amount of capital or claims-paying resources it has.

This has been the big excuse for MBIA not downstreaming the $900 million at issue to the insurance sub. They have asserted that no matter what they did, the ratings agencies will not give them an AAA. Moody's has decided to correct the record. Again, another falsehood from MBIA, and a whopper at that. Felix Salmon, in a fresh post, tells of a conversation with a Hampton Finar of the New York State Insurance Department, and the NYSID falls largely in line with the MBIA story:
MBIA "needed a capital infusion to help them ride this out at triple-A," said Finer: "they weren't hitting the rating agency ratios". This is almost exactly the same as the Jay Brown talking points. The capital-raising was done for the sake of the ratings agencies, and once the ratings agencies said that it wouldn't do any good, there was no obvious point in doing so any more.

This is debatable; MBIA could conceivably have raised enough capital, although it would have been massively dilutive. But that still isn't the same as saying it was unattainable, which is what Finer implies (in fairness, it would probably be seen as highly aggressive for a regulator to call the rating agency to verify the accuracy of the statements that MBIA made to NYSID, so it's understandable that NYSID would share MBIA's view. We hope they've wised up now).

The NYSID also seems more than a tad in denial about the viability of the bond insurer's business prospects. Again from Salmon:
Was NYSID upset that MBIA didn't send the money downstream? Not particularly. If it had really wanted MBIA to do that, it could have forced the issue, but it didn't. "We have a lot of authority over how that money gets used," said Finer. "We'd like to see what else can be done with it." If that involves sending it to a different subsidiary, that might be fine; the only thing he seemed keen not to see was the money getting sent directly back to shareholders.....

Finer was also keen to see MBIA back in the business of writing insurance again. "We don't really want companies in indefinite run-off, they're kind of poisonous," he said, since such companies have much less incentive to pay out than one which stands to lose a lot of business if it starts denying claims. "Companies should be downgraded, frankly, in indefinite runoff."

What about a corporate structure where the old insurance subsidiary was in de facto runoff while a new subsidiary was writing new policies? That could be made to work, said Finer, so long as the reputation of the new subsidiary rested to some degree on the alacrity with which the old subsidiary paid its claims.

This conversation appears to have taken place before the Moody's downgrades, and the severity of the cut on MBIA may put a different complexion on things. The NYSID may be regretting its decision to indulge MIBIA on keeping the $900 million at the parent level.

I must admit I have trouble with the logic here: things are OK at the MBIA insurance sub; we'd rather have them pursue new business. As we have discussed at length elsewhere, there does not appear for there to be any strategically viable route for them to take. Whether the insurers recognize it or not, the best economic scenario (as in maximum NPV) is for them to be in runoff mode.

Any attractive new business opportunities will be highly limited given their deteriorating outlook. The rating agencies are no doubt worried about other shoes dropping. While subprime writedowns have largely run their course, Alt-A and Option ARMs have only begun to hit in a serious way (although the monolines may not be seriously exposed here) and the housing-related deterioration in muni credits has just started. So as the Moody's negative outlook indicates, things can only get worse. Yet to keep the company from shrinking, the pressure will be high to write more business than is attractive on a risk/return basis given the external environment and their competitive disadvantages.

And if they do go ahead and somehow write new business? Well, it allows management to preserve its holding company empire, and the nature of insurance is that you collect premiums and pay losses later. So they might be able to kick the can down the road for a few years more beyond what the endgame horizon would otherwise have been. But when the gig is finally up, it will be a larger book, and therefore a larger mess, that will need to be resolved.

Yet per Salmon, the regulator reaffirmed his confidence in the solvency of MIBA:
We think there's enough money to pay all the claims based on what the current expected losses are. Things have deteriorated a little bit, but whatever gauge you want to use, the current claims-paying resources in the industry for MBIA and Ambac are going to be sufficient to pay all the losses on the policies they wrote.

The key variable in the statement above is "current".

Warning: the [the remainder of this] post below is a bit geeky...

Did MBIA's downgrade impair as much as 25% of its claims-paying resources? Consider these statements, the first from a letter from MBIA yesterday on the Moody's downgrade of its insurance sub from Aaa to A2 (hat tip to Jason for a useful question):
This ratings action will give certain holders of guaranteed investment contracts the right to terminate the contracts or to require that additional collateral be posted. Again, we have more than sufficient liquid assets to meet any additional requirements arising from any terminations or collateral posting requirements.

The same letter notes that MBIA has $16 billion in claims-paying resources (we'll return to that concept later).

Now track back to the most recent 10-Q to see what the effect of a downgrade to A would be. It increases the cost of funding on $400 million of instruments (rounding error). Here is the part related to the GICs:
Investment agreements issued by our asset/liability products segment generally provide for collateral posting or termination in the event of a downgrade of MBIA Corp.’s credit ratings. The maximum collateral posting would occur at a single-A financial strength rating by Moody’s or S&P, and the maximum terminations would occur at a triple-B financial strength rating by Moody’s or S&P. Based on the asset portfolio as of March 31, 2008, the maximum collateral posting requirement at a single-A financial strength rating would be $12.7 billion and free collateral at a triple-B financial strength rating would be $9.2 billion. As of March 31, 2008, the Company’s collateral posting requirement totaled $8.25 billion and free collateral totaled $16.8 billion based on MBIA Corp.’s current financial strength ratings. We believe that the liquidity position of the asset/liability products segment is adequate to meet these requirements related to investment agreements under stress scenarios.

Readers are invited to correct me, but as I read this, the collateral posting requirement increased based on the last 10-Q data from $8.25 billion to $12.7 billion, an increase of $4.45 billion. Now these are maximums; the 10-Q is silent on the real values. However, if we work with the figures given, that would reduce MBIA's claims-paying resources from $16 billion to roughly $11.5 billion, a decrease of over 25%. (Note the press release gives the impression the $16 billion in claims-paying resources still stands, although there may be a bit of artwork here. That figure was mentioned in their complaint about the unfairness of the downgrade: "With $16 billion in claims-paying resources, as the Company has made clear in numerous public statements..." Although the balance of the sentence protests that MBIA has plenty of financial horsepower, that statement about the $16 billion could be argued to be past tense. Given how MBIA twisted words in its salvo against the New York Times, this reading is not as much of a stretch as it would be for most other companies).

I am shortly going to turn the mike over to a former general counsel of a bond insurer, who provides a great deal of informative detail on the issue that the New York Times raised in its recent article on MBIA, namely, what happens to the credit-default swaps contracts in the event of insolvency or regulatory takeover. He very clearly states:
Given the billions of surplus to policyholders reported by MBIA and the mechanics of statutory accounting (which is very different from GAAP), regulatory insolvency seems extremely unlikely in any future I can foresee.

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 NPV of unearned premiums. That seems like a bit of a stretch. You'd need to understand how the number was arrived at (particularly the discount rate assumption) to be comfortable with it.

Although there have been a number of red flags waved about MBIA, the biggest is its reinsurance. This discussion came from a letter Ackman sent to MBIA in January:
As of September 30, 2007, MBIA has re-insured approximately $80 billion of par value of its exposures. More than $42 billion of this reinsurance was purchased from Channel Re, a Bermuda- based reinsurer whose only customer is MBIA. The two most senior officers of Channel Re are former executives of MBIA. MBIA owns 17% of the company and has two representatives on Channel Re’s board of directors.

On recent conference calls, Moody’s and S&P have stated that they have not yet updated their ratings of the monoline reinsurers including Channel Re. Earlier this week, on January 16th, Partner Re and Renaissance Re, the majority equity owners of Channel Re, wrote off the entire value of their investments in Channel Re due to losses it has recently incurred that substantially exceed Channel Re’s capital, an impairment that Channel Re’s two majority owners have concluded is “other than temporary.”

Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and S&P continue to rate the company Triple A with a stable outlook....

Captive reinsurers whose ratings are not regularly updated offer the potential for abuse. We believe that MBIA reinsured on a quota share basis 25% of its 2007 CDO transactions with Channel Re. As a result of Moody’s and S&P not updating its ratings
of Channel Re, these exposures do not appear on MBIA’s list of exposures and have not been included in your calculation of MBIA’s capital adequacy.

MBIA’s second largest reinsurer is Ram Re which has reinsured $11 billion of par as of September 30, 2007. While the rating agencies have not updated their credit ratings of Ram Re, the market appears to have already done so. The publicly traded stock of Ram Holdings Ltd., the parent company of Ram Re, has declined 92% in the last year. The company currently trades as a penny stock with a market value of $32 million.

We believe that Ram Re is substantially undercapitalized and therefore, like Channel Re, is unlikely to be able to meet its obligations to MBIA.

Moody's downgraded Channel Re to Aa3 in February. The point is that serious impairment of either reinsurer has the potential to substantially lower MBIA's surplus (the cost of replacing the reinsurance would be substantial, and likely uneconomic).

Let me emphasize that none of the above points to solvency issues in the near term. But they do raise worries about long-term viability, particularly as the credit crunch rolls on and municipalities start showing signs of distress.

Now to the information on how CDS would play out in the arguably not-so-likely event that MBIA were to get in serious trouble. I was wrong in some of the things I said earlier. While the CDS holders do have the right to accelerate (demand immediate payment), it is far more useful to them as a bargaining chip, since forcing an insurer into insolvency is a "nuclear option". However, the reasons it plays out that way are complex.

From the former bond insurer general counsel:
I agree entirely with your position on MBIA's obligation to downstream $900 mm to the insurer.

As to the CDS, it rapidly becomes very complicated. I don't have copies of any of MBIA's CDS, but accept the accuracy of their statement that "Typically in MBIA's policies insuring CDS contracts, there are no provisions that allow a counterparty to terminate the insured CDS contract and make a claim under the policy, absent MBIA's bankruptcy or insolvency or an MBIA payment default on the policy insuring the CDS contract. Each insured CDS contract that MBIA Corp. enters into is governed by an International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement and Confirmation. MBIA's CDS contracts typically conform to the Monoline Supplement Agreement, where a bankruptcy of the credit support provider, including the initiation of a receivership proceeding by the NYSID, would give the counterparty the option to terminate the swap and receive a termination payment; it would not be an automatic termination event." The CDS I negotiated for my former employer adhered to that standard (except for the Monoline Supplement Agreement, which according to my recollection covered CDS written on monolines rather than CDS written by monolines, but it's been a while and I could be wrong or the form could have changed).

Having said that, our next stop is indeed parsing the language. I'm sure you've already noted the weasel-word "typically"; no need to discuss the implications and resulting questions.

Let's think about bankruptcy and insolvency. First, MBIA the insurance company is not subject to the Bankruptcy Code and cannot voluntarily file for bankruptcy, but they could be involuntarily filed into bankruptcy by their creditors. Such a bankruptcy filing would almost certainly be dismissed by the bankruptcy court. But it would take time. The standard ISDA bankruptcy event is triggered if the filing isn't dismissed within 15 days, which just isn't possible (absent massive intervention with the bankruptcy court); it would probably require 45-90 days, by which time the termination event would have occurred. Second, insolvency, which again is a matter of definition; probably MBIA, like other monolines, limited the definition to entering rehabilitation, conservatorship or other similar regulatory proceedings and excluded a balance-sheet test or other, broader, tests of insolvency in the normal ISDA definition. Given the billions of surplus to policyholders reported by MBIA and the mechanics of statutory accounting (which is very different from GAAP), regulatory insolvency seems extremely unlikely in any future I can foresee.

The other termination event is a default by MBIA on the actual policy insuring the CDS, which requires both an initial default on the underlying security and by MBIA on that policy - they probably didn't permit cross-default clauses in their CDS. So that again is extremely unlikely, and in any event would be limited to that single CDS.

But let's assume a bankruptcy termination event occurs. Then the question is whether the counterparties will terminate the swaps (and how long it has to make its decision, which depends in part on whether the termination event merely has to occur or, more likely, occur and be continuing). Termination of all the CDS could require MBIA to pay its counterparties the cost of replacing the CDS with an equivalent protection seller (another interesting question) - if, as is probable, MBIA agreed to make 6(e) mark-to-market payments upon termination, which again depends on the CDS documentation. It's also probable that being required to pay such an amount would render MBIA insolvent under statutory accounting, which presumably would result in their entering rehabilitation proceedings. At that point, Mr. Dinallo could refuse to pay the mark-to-market payments, which arguably are not the sort of losses intended to be covered by financial guaranty insurance - and MBIA would become solvent again, able to pay claims on defaulting securities as they became due.

My own view is that termination is a "nuclear option" that operates to the detriment of both parties, and that (like any other lender) the CDS counterparties don't want to force MBIA into insolvency. They want negotiating leverage, and presumably would get it in much the same way ACA did: a forbearance agreement would be negotiated, under which the CDS counterparties would agree not to terminate the swaps - but the counterparties would probably extract something in exchange for forbearing. Of course, all the counterparties would have to agree, because termination by any one counterparty would force the others to terminate as well, so the negotiations would be long and wearing, and probably conducted under the auspices of the NYSID. I don't think anyone really wants to go there, and in that sense agree with Felix Salmon.

The operating supplement is a filing that's conventionally made by insurers, but required neither by the SEC nor the insurance regulators and not prepared under either GAAP or stat. It's available on MBIA's website and should be read with appropriate caution, although the op supp contains much useful information not available in any other format. MBIA's statutory financials are also available on its website.

Update 6:20 AM: FT Alphaville raises an issue which complicates the analysis above:
In the case of MBIA and Ambac, we’re not talking about bankruptcy or margin calls. Indeed in many cases, the value of the insurance written is already worthless - in the case of MBIA, many wrapped bonds have an underlying rating now higher than the wrapper. Policyholders, in other words, have everything to gain from terminating the insurance contracts.

So the fact that the policyholders have no downside (except legal costs) may embolden them. If nothing else, since the insurance is worth less than the underlying bonds, it would be worth pursuing courses of action to terminate the CDS so as to end payments on useless guarantees.

It's going to be an interesting next few months....

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