naked capitalism

Eric Dinallo, the New York Superintendent of Insurance, is trying to orchestrate a rescue of on-the-ropes bond insurers and according to the Financial Times, has approached various unnamed banks for an immediate $5 billion and an ultimate sum which could be as large as $15 billion. Note that the Pershing Square estimate of capital needed for MBIA and Ambac, the two biggest insurers, to maintain their AAA rating was roughly that amount.

The Bloomberg story cited below gives hints of the Fed’s involvement, which is that New York Fed President, Timothy Geithner, has been monitoring the situation (his beat is innovation, derivatives, and risk management) and speaking to bank officials. The Bloomberg piece wasn’t clear on the Fed’s involvement in Dinallo’s efforts, but one can assume that Geithner, who is respected as being particularly smart and candid, is nudging parties to the table.

I very very much hope I am wrong, since a meltdown of the bond insurers would have truly awful consequences, but this operation will be much harder to pull off than the wind-down of Long Term Capital Management, the only precedent for this sort of operation. As told in gory detail by Roger Lowenstein in his account, When Genius Failed, the Fed orchestrated a surprise meeting among the main creditors, a group of 24. The heated, sometimes bitterly contested, but ultimately successful negotiations depart in ways from this situation in ways that lessen the odds of success.

First, despite the fact that the bond markets were having a very bad year, the firms were all sound. The rescue was not coming at a time when capital was precious and further impairment seemed likely. Second, the situation with LTCM was deteriorating rapidly, which increased pressure on all the participants and enabled them to overcome reluctance to accept deals that each could have argued was unfair given its exposure (although in an ironic contrast to today, Goldman was hurting, having taken a $1.5 billlion loss in August). Here, the bond industry crisis, while having a greater certainty of a bad outcome (for LTCM, a systemic crisis was possible but not guaranteed), the disaster is slower moving. Urgency is always a pls in deal-making.

Third, due to the relative number of participants (24 in total) after much wrangling, agreed on a two-tier deal, with the bigger banks ponying up $300 million and the smaller or less exposed $100 million. Here we have vastly more players, exposed to greatly differing degrees, and (a corollary of the first point) the most exposed doubtless include Merrill and Citi, who are in no position to put in anything beyond a token amount of money. Finally, with all due respect to Dinallo, the New York insurance department is no Fed. The Fed was able to merely assemble a meeting, point out how bad things were and strongly suggest the parties work something out. Here, Dinallio, who has no regulatory authority over the affected parties, and less prestige, is having to play a more active role.

If Dinallo can pull this off, he will have done something vastly more difficult and important that what the far better connected Henry Paulson attempted with his SIV rescue plan. While I hope he prevails, the odds are against him.

Further thought 10:00 PM: Dinallo will presumably focus his fundraising efforts on a relatively small number of institutions, so the size of the group (if one could be convened) would probably be no bigger than the LTCM group. But a separate feature of that negotiation was that the Fed called the heads of all the firms together and they all were heavily involved in the negotiation of key terms ($ and main contract provisions). They then pretty much handed it off to attorneys.

I can’t imagine Dinallo will be able to get an equally senior group unless the Fed pulls strings big time behind the scenes. And it will be vastly harder to reach a deal with less senior officers involved. You can easily have a syndrome I call double brokering. Some firms will send people with considerable authority to deal, others will send ones who have to get everything approved, and some will be somewhere in the middle.

The problem is that the ones with authority to make commitments, if the negotiating gets involved (likely) will come to be frustrated and possibly distrustful of the process if they get retraded. That happens when they put forth a commitment they can live with, other firms’ representatives say, “yes that sounds good, I just have to get that approved” and then they come back and say, “well we were wrong, the mother ship said no,” and proceed to use the first firm’s proposal against them. That is one reason it is so hard to reach deals among large numbers of players.

Another, potentially very large stumbling block is the complexity and varied exposures of the insurers themselves. For instance, Ambac is very heavily exposed to CDOs, but has no commercial real estate guarantees. Conversely, MBIA is much deeper into CRE and home equity and second mortgage credit enhancement. How do you decide who gets how much? If Dinallo can get only a partial commitment, what approach do you use? Pro rata based on total balance sheet (simple but unlikely to bear much relationship to the economics). First come first served, in terms of what comes a cropper? Some version of triage? It’s easy to see how fast this gets hairy.

Finally, the most bizarre part of this situation is that the stock prices of MBIA and Ambac went up. This shows the collective ignorance about the situation. The insurance operations are in regulated subsidiaries. The parent gets cash ONLY via dividends from the subs, and then only as a percent of profit or as approved by the regulator. There is no cash, nada, coming to the parents out of this one. In fact, the most likely outcome is the subs are put under the control of the regulators, perhaps along with the funding group., and the new cash is used as part of an orderly runoff.

From the Financial Times:

The largest US banks are under pressure from New York State insurance regulators to provide as much as $15bn in fresh capital to support struggling bond insurers, people familiar with the matter said.

Eric Dinallo, New York insurance superintendent, has met executives at the banks and has strongly urged them to provide $5bn in immediate capital to support the bond insurers, the largest of which are MBIA and Ambac, and to ultimately commit up to $15bn. A spokesman for Mr Dinallo had no immediate comment.

Concerns about the future of MBIA and Ambac grew last week when Fitch Ratings downgraded Ambac from triple-A status. The business model of both companies depends on them keeping their top level credit rating.

Share prices for both Ambac and MBIA rocketed amid rising hopes for a capital injection. Ambac closed up 72 per cent at $13.70 and MBIA closed up 33 per cent at $16.61.

People familiar with the matter said details had yet to be worked out but that contributions to the bail-out fund would not necessarily be based on how much exposure each individual bank has to the insurers, known as monolines.

It was unclear to what extent federal officials were involved in the discussions but the health of the monolines has been a top priority of regulators at the US Treasury and Federal Reserve.

Big banks such as Merrill Lynch, Citigroup and others have been forced to write down the value of insurance they took out on mortgage-backed securities they hold on their balance sheets.

There is widespread concern that more rating agency downgrades of the monolines could force a fresh round of writedowns, which could in turn further damage already battered investor confidence.

This has led to speculation that banks would band together to prop up the insurers, which guarantee payments on billions of dollars worth of bonds issued by municipal governments and other borrowers.

However, Mr Dinallo’s plan has not met with uniform support among banks that have their own capital-raising issues following the collapse in value of mortgage-related securities on their books. One industry source said some banks would prefer to see the federal government coordinate some kind of rescue plan for the monolines.

The banks also still feel stung by a failed plan to have them bail out troubled structured investment vehicles.

From Bloomberg:

New York State’s insurance regulators met today with U.S. banks to discuss raising new capital for bond insurers, said a department spokesman….

Federal Reserve Bank of New York President Timothy Geithner has taken a central role among federal regulators monitoring the financial health of bond insurers since October, according to an official familiar with the matter. Geithner has been speaking frequently to bank executives who do business with the insurers and requesting government data on Wall Street’s involvement, said the official, who wasn’t authorized to speak publicly. New York Fed officials didn’t participate in today’s meeting….

“Clearly the market likes it,” said Gregory Peters, credit strategist at Morgan Stanley in New York. “But it’s not an easy situation to fix. The intent is good but we need the details; the details matter.”….

Treasury Secretary Henry Paulson this week said he’s monitoring the situation, although he declined to characterize the role his department is playing.

“We obviously have been looking at the monoline insurers carefully for some time now and we’re actively engaged in watching that sector and talking with other policy makers about that sector,” Paulson said Jan. 22, when asked after a speech in Washington…..

Credit-default swaps tied to the bonds of MBIA plunged to 825 basis points a year, down from 22 percent upfront and 500 basis points a year yesterday, according to CMA Datavision. That means the cost to protect $10 million in MBIA bonds for five years fell to $825,000 a year from $2.2 million upfront and $500,000 annually yesterday. Contracts on Ambac fell to 900 basis points from 22 percent upfront and 500 basis points a year, CMA prices show.