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Monoline Death Watch: Breaking Up is Hard to Do

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Be careful what you wish for.

New York insurance superintendent Eric Dinallo seems to be getting what he wants. FGIC, the number four bond insurer, was downgraded six grades by Moody’s on Thursday, from Aaa to A3, which meant it has lost its AAA rating from all agencies, and Moody’s warned it could be downgraded further. The insurer followed the rather firm suggestion of Eliot Spitzer (one might more accurately call it a gun to the head) of either finding new money in five days or having the state regulators split the companies into a muni insurance business versus everything else (the everything else being largely real-estate-related structured finance).

But this may turn out to be a Phyrric victory. FGIC is a special case; it’s owned by mortgage insurer PMI Group and private equity firms Blackstone, Cypress Group, and CIVC Partners. Thus, no public shareholders and thus no worries about stockholder lawsuits.

But even then, it isn’t clear that this break-up is as beneficial as it is perceived to be, or whether even its mere operational objective, namely, establishing a healthy muni insurance business and leaving the rest to run off, can be realized.

First, to the assumption that the split is a good solution. As we’ve said before, it’s based on the model used for the savings and loan workouts run by the Resolution Trust Corporation, the “good bank/bad bank” approach. That succeeded because the banks held assets that would appeal to two different investor groups, namely, banks that would buy the good bank bit, distressed investors and speculators who would buy the bad bank portfolios.

In this case, the FGIC is going to be split according to its liabilities, not its asset (its assets are investments it makes with the insurance proceeds). Superficially, this does not address the problem that the business has insufficient equity (or in insurance lingo, reserves) If the newly created muni business does not attract additional capital, all this has done is rearrange the deck chairs on the Titanic.

To be clear: Buffett’s reinsurance offer did NOT involve new investment; in fact, he wanted MBIA and Ambac each to pay him $4.5 billion, which is 1.5 times the expected value of the muni insurance premiums. In other words, this would constitute a transfer to Buffett, reducing the total equity available to the good and bad businesses. Thus, saving the good business would make the bad one vastly worse off than doing nothing. And as we have said, there appears to be no legal basis for treating one group of policyholders, in this case, municipalities, more favorably than another.

And recall, while the panic in the auction rate muni market has everyone spooked (frankly, that product was trouble waiting to happen), the systemic consequences of screwing the policyholders of the bad business could be dreadful. UBS estimated the losses to the banking system resulting mainly from bond insurer downgrades could reach $203 billion. We’ve already had chaos, unprecedented central bank interventions, and rescues by sovereign wealth funds to get through $150 billion of losses. Even if that estimate is too high by a factor of three, it would still be a body blow to a faltering financial system.

Now if the new venture could attract enough new equity to get its own AAA or to pay the premium that Buffett wants over the expected value of the muni insurance premiums, then it is possible for the split to produce a better outcome. But worryingly, the rating agencies have either been silent or cool, which suggests they may not have been consulted as to what had to happen for this strategy to achieve sufficiently high ratings from them. If true, that’s a shocking oversight. From the New York Times:

It is unclear how the ratings agencies — Moody’s Investors Service, Standard & Poor’s and Fitch Ratings — would react to a split and how they would rate the two resulting companies. In a statement released Friday, S.& P. voiced concern that dividing Financial Guaranty might leave some policyholders “disadvantaged.”

And then we come to second potential stumbling block, the operational and legal issues. One widely repeated quote:

“You’re trying to unscramble the egg,” said William Schwitter, chairman of the leveraged-finance practice at law firm Paul Hastings. “When you take a balance sheet that is supporting a variety of obligations and try to split it in two, it’s difficult.”

Bizarrely, Dinallo and his investment bankers Perella Weinberg have comported themselves in a way to alienate the FGIC policyholders who were exposed enough to be considering a rescue operation. The Wall Street Journal reports:

Calyon, the investment-bank arm of Credit Argicole SA, is leading the bank group. A Calyon spokeswoman declined to comment.

The full bank group has had only tentative discussions with FGIC. One question that has dogged the group is whether the principal negotiating partner should be FGIC, its shareholders or regulators.

The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a “bizarre situation.”

All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC’s move could result in “instant litigation.” FGIC didn’t respond to queries about the banks’ reaction to Friday’s announcement.

One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.

And make no mistake, it’s not just the parties at the table who have reason to sue. A large group of policyholders would be damaged:

One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn’t clear how those “credit default swaps” would be valued, since one half of the new company would have a higher risk of default than the other.

The problem is that the “commuting” plan requires cash or some sort of deferred payment, when that will hurt the finances of the new muni entity. Similarly, selling an interest in the muni business to the disaffected bad company policyholders makes the new muni business less attractive to new investors (it would effectively dilute their investment).

And then we have the biggest bond insurer, MBIA, who has signaled that it is not on board with the Dinallo program. It has raised equity on its own, and maintained that it had sufficient reserves, although Standard & Poor’s promptly disagreed. MBIA’s conduct suggests that it would fight a split-up, despite the Spitzer ultimatum. The Times says that this could lead to a nasty legal row:

….on Thursday, MBIA’s chief financial officer, Charles E. Chaplin, vigorously defended his company at a hearing in Congress and said it did not need any help.

If MBIA and Mr. Dinallo remain at odds over whether the company needs to do anything, the dispute could end in court, legal experts say. Mr. Dinallo has significant power as superintendent to take control of insurers if he believes there are not enough assets to pay claims by policyholders, but the company and its policyholders can fend him off if they can prove his decisions are “arbitrary and capricious,” said Francine L. Semaya, an insurance lawyer at the law firm of Cozen O’Connor.

jck at Alea, who has a fiendishly good understanding of complicated financial instruments, has argued that in fact MBIA is right and the nay-sayers have the economics of its contracts wrong (ie, the use of mark to market proxies vastly overstates the losses likely to be incurred over the lives of the policies). While he may narrowly be correct, what makes me dubious is if matters were this straightforward (ie, Bill Ackman did the math wrong and the monolines are fine), the inability of the insurers to persuade the rating agencies and most important, the regulators who ought to understand this business intimately, says there is something rotten in Denmark.

Ackman has been very transparent in how he has done his computations for MBIA and Ambac, breaking down his assumptions by financial product. If either company wanted to dispute his analysis in private, which is where it counts, they simply could have gone through any one of the products in detail to show the magnitude to which Ackman was wrong. That would have driven a stake in the heart of his campaign. The fact that no one has been persuaded, and that Dinallo (and presumably his Wisconsin peer, since discussions with Wisconsin-domiciled Ambac are also moving forward) says the bond insurers were unconvincing. They have concluded that they are inadequately reserved, even if Ackman is wrong in the particulars of his analysis.

If MBIA tries to block a break-up, it will have to prove the validity of its assertion that it is adequately capitalized and has reasonably good odds of keeping its AAA. That means it will have its accounting and loss assumptions, versus those of the regulators, discussed in court in some detail.

If nothing else, expect to have an entertaining next couple of weeks.

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  1. Independent Accountant

    I have followed Ackman for years. I am an Ackmanike. I ‘ll take his analysis of the monolines over: Moody’s, S&P, Fitch and Dinallo. Combined. My own analysis of the monolines indicates they should not exist.

  2. RK

    I think that, as apt as the scrambled egg analogy is, there is a more instructve one. Here goes:
    The monolines are a ship cruising in the middle of the ocean, will 1000 passengers on board. An explosion in the engine room brings propulsion to a halt. The ship slowly begins to take on water.
    Regrettably, there is only one lifeboat, which can carry a maximum of 300 people- any more and it will probably sink. The passenger list contains
    300 women and children (the municipal bond book), their husbands, and others. A distress call
    is sent, but no rescue vessel is near enough to
    arrive with certainty before the ship sinks.
    Solve for best outcome!

  3. Anonymous


    Yesterday, Dinallo was interviewed by Kathleen Hayes on Bloomberg TV around 2:15 (if you access to a bloomberg terminal, you can watch it). She asked him what is going to happen to the guarantees in non-muni business. He said “I don’t know” and they proceeded to talk about the importance of saving the muni-side.

    A few weeks ago Barclays said the banks would lose $143 billion if the monolines were downgraded. Yesterday UBS said $203 billion. Opco (Meredith Whitney) said $40 to $70 between Citi, Merrill and UBS alone.

    What I’m leading up to is the rating on the banks themselves. If this split plan comes down, or MBIA and/or Ambac get downgraded, shouldn’t the rating of Merrill, Citi, UBS, et. al get slashed a bunch too? Without their hedges in place, are not the ratings on large financial institution as big a fiction as the monoline ratings?

  4. Anonymous

    I don’t have a dog in this fight and, frankly, have no way of evaluating the credibility of the commentators–Alea, Ackman, the monolines, the rating agencies, or financial pundits. Broadly speaking, I don’t think these people have everyone’s interests in mind, only their own.
    I condemn the ratings agencies for their horrendous performance in accurately assessing the risk associated with collateralized debt in anything resembling a timely manner. They are a key cause of the credit crunch and resulting illiquidity we face broadly in this economy. I don’t know their liability for their failure, but I’m sure there are any number of attorneys trying to figure the angles–again for their own gain.
    I’ve finally come to the conclusion that the Dinallos, Bernankes, and others offering “solutions” to this problem should just step aside and let the market–including ratings downgrades–take their course. Any other solution is unfair to someone.

  5. Taylor

    the truth is that neither ackman, dinallo, the rating agencies nor MBIA have any clue what the ultimate losses on mortgage exposures (in both CDO and RMBS form) will be. nor do they really know how much capital the industry needs to set aside today to account for losses that, in some cases, may not be paid out for 30 years.

    the fundamental uncertainty is how borrower default rates will change in an environment of steeply declining home prices. this hasn’t happened in “modern” times, hence no one has the statistical data that would enable them to come up with a good estimate of potential losses.

    if you take a look at the ackman model (which i have) and know anything about the underlying asset exposures (which i do), it’s pretty clear that his number is a reasonable worst case assessment of the nominal losses. very few would dispute that.

    but the important question which ackman never answers is what the PRESENT VALUE of those losses will actually prove to be. the structure of his argument against the companies indicates that he is well aware that the time value of money greatly reduces the economic value of the exposure. if you read his published documents, you’ll see that he talks about *saving* the guarantors by severing the relationship between the holding companies and the operating subsidiaries. he even says that the underlying entities are solvent, and that the problem is the holding company structure which takes capital out of the regulated sub.

    so how does this impact the current situation? well, the underlying mortgage pools in question are very close to hitting the triggers that will divert the cash flows from the junior tranches to the senior tranches. that cash flow will sustain principal & interest payments to the senior holders for several more years. this will defer the large cash payout required of the guarantors, which in turn reduces the PV of their liability.

    but wait, it gets even better for the guarantors. under the terms of the CDS, the FG’s control the work out. principal repayments aren’t due until the CDO’s are liquidated or the cash flow from the underlying mortgages is exhausted. guess who gets to determine whether or not a liquidation event has occurred? that’s right – the guarantors. it many cases, it will be 20-30 years before these CDO’s mature – and they have to true up the principle deficiency, which greatly reduces the PV of their risk exposure.

    having spent quite a bit of time on this issue, my conclusion is that the banks wrote a TERRIBLE contract with the guarantors. that’s not to say the guarantors were wise to write the business – of course, it was boneheaded. rather, the banks were very sloppy in their dealings with the guarantors (no collateral requirements, allow the FG’s to control the workout, no triggers which would accelerate repayment, etc). my conclusion is that the banks were much more interested in using these contracts to avoid mark-to-market risks than they were in true risk transfer.

    the bottom line is that frequency of loss is what matters and no one has a good model for predicting what that will be. and, given the timing issues, ackman can be right on the nominal exposure, but wrong in arguing that the companies are “insolvent”. in a business where contracts span 30 years, the time value of money matters. ultimately, that’s why he’s spending so much time & effort lobbying the regulators. if he can goad them into an intervention, he can potentially bankrupt the holding company and thereby be left with the perfect short (stock goes to zero and the trade is never closed out, hence there is no tax liability.)

  6. Anonymous

    The very simple reality here IMHO and probably off topic and an uneducated thing to suggest, but WHY would a policy holder continue a policy?

    If a have auto insurance from Statefarm and they give me bad service, I shop around for a more efficient deal with greater utility, thus I cancel my obligation to statefarm to pay future premiums and then I get a better deal with someone else. If I know that statefarm is in dire financial trouble, why would I continue to use them?

    However, if Im insuring a CDO or have taken on substanial risk and because my CDO looks like a teenager with two traffic accidents, geee, Im gonna have to pay more for a policy and think really hard about parking the car and taking the keys away from little Betty, until she grows up. Furthermore, of Betty had been a drunk teenager involved in a wreck, where she was at fault, for hitting a school bus filed with pre-school kids, there is a very good chance that my sweet Betty will have to go to jail and repay a debt to society, and then as a parent, I might be sued or be liable for damages and I would have to take on obligations for Betty being out of control.

    Splitting up FGIC is retarded and what has to happen, is that people involved in these scumbag casino bets will have to accept responsibility for being drunk teenagers, I hope to God a lot of these people do go to jail for abusing discretionary powers! When you gamble with other peoples money after drinking and being reckless, you need to pay a price and not get a simple scolding!

  7. Anonymous

    Re: my conclusion is that the banks were much more interested in using these contracts to avoid mark-to-market risks than they were in true risk transfer.

    Great, someone that has some info and clarity!! This is a risk transfer issue and the banks and munis that were playing casino, need to take the hit and eat the bad calls, because these bad bets are related to avoiding obligations and transferring obligations into synthetic packages where these casino bets are spun offshore for tax evasion or to take a big bet; too bad, they lost, pay up, your shareholders eat it!

  8. RK

    Taylor: Thank you for an outstanding post. Can you shed any light on how extensive leverage embedded within the CDOs might effect the time frame of ability to continue to service the super senior tranches?

  9. Yves Smith

    Anon of 8:35 AM,

    Oof, that confirms my suspicions. This is going to be a bloody mess.


    Good analogy.


    That was indeed helpful, and you have explained the issue more clearly than jck did (who although highly knowledgeable, can be a bit terse in his explanations) and the insurers themselves.

    However, I keep coming back to the question: if that’s the case, why are the rating agencies threatening to downgrade the monolines, and why are the regulators taking such drastic and completely untested measures?

    It isn’t an issue that Ackman raised, but I suspect someone may be worried that the insurers can be forced to pay as soon as the senior tranches are breeched. I’ve been party to contract-related litigation, and there are often bases for voiding what would seem to be clear contractual language. Consider what Cuomo is doing to the health insurance industry. Their agreements limit payments to “reasonable and customary” but it turns out they determine what “reasonable and customary” is.

    That (like the monolines being able to wait 20-30 years before making payment) would seem to be clear, but it isn’t.

    A very simple example: there is a notion in the law called “good faith and fair dealing.” It’s most often used in employment law, but I’ve seen it used successfully elsewhere. In the US, employment is at will (meaning you can be fired at any time for no reason) in the absence of an employment agreement. Yet people who were made promises by employers and induced to give up good jobs, then fired (say Big Corp is starting a new business, hires senior team, promises it will fund it for so many years, then changes mind and cans everyone) have been very successful using this line of argument.

    I’m not sure of Cuomo’s legal theory, but I bet it’s similar. People buy insurance with an expectation that it works, that there is bona fide risk transfer. But if the insurers have institutional mechanisms to evade that obligation, their product could be deemed to be a fraud, particularly if their advertising suggests much broader coverage than the policy provided (if nothing else, he could get them on advertising fraud, but I suspect he is going for bigger game).

    Consider what happened with the monolines. The rating agencies were the ones that blessed the paper that relied on the monoline guarantees. Who made the representations to them as to how it worked? If it was Wall Street, it may be hard making the case against the insurers, but if the insurers had any direct participation (and I assume they did, they wrote custom contracts), the failure to correct obvious misunderstandings of their policies, say as evidenced in cash-flow models and whatnot, could probably be deemed as fraud.

    You get the drift. I think clever lawyers could take them down, or at least so tie them up in litigation as to force settlements. And again, once the value of their contracts are called into question, new business goes bye bye.

    Anon of 1:11 PM,

    That may be another reason for the drastic measures. Once the monolines are downgrades, they could start seeing payment defaults to force unwinding of agreements.

    Anon of 1:18 PM,

    Good point, but we are back to the issue of the Taylor post. The IBs should have read the contracts and understood how the hell the insurance worked. If their models made it appear that the insurance worked in some way other than it did, they (or technically, the issuer) is the fraudster. But if the insurers gave input into the models and that input was inaccurate, then the insurers would likely be the liable party.

  10. RK

    Just a thought, and slightly off post, A propos of Gretchen Morgenstern’s piece in NYT. What if your counterparty to a CDS was a “straw man” not just a weakly capitalized entity, but a true straw man. Would you have the time, ability and funds to prove in court that a fraudulent conveyance of your contract to this party had occurred? Wouldn’t you have to meet the high standard of proving intent? And if the swap had been sold several times, what would be the chain of proofs required.
    Thoughts, anyone?

  11. s

    Ackman cares only about the Holdco and his principle interest is campaigning for a cut off of capital which would essentially suffocate them to death (surely there has to be a tax liability if f it goes to zero?) Hence all the holdco capital questions on that horrible conference call.

    Knowing a little about these structures having started out modeling CMOs in the last mortgage meltdown it was clear back then that many of the esoteric structures (jump z, ios inverse floaters etc) were simply unpricable or better yet donut bonds.

    That said, not sure I agree that the FGs have a leg to stand on. Present value or future value aside, their franchise value is permanently impaired. Take the writedown and move on.

    That the AMBAC chief can get on camera and claim we made a mistake, give us a fake rating (ie subsidy) and capital (taxpayer ultimitely) is criminal.

    I mean lets put this in perspective. There is surprisingly little outrage considering what came of the Enron folks for example. What was that a $60 billion company at its peak. Peanuts when this is said and done. If skillet is in the big house the maestro should be jailed for multiple life terms.

    So here we are with $150 billion destroyed in the early innings and we have these morons on capital hill talking about the critical service they provide. Let not lose isght of the fact that the muni insurance business is a farse. It is an inside market yielding fees to the insurers, fees to the banks and lower interest rates to the municipalities (but is consitent with the prfolgate US spend sentric model, damn the consequences). I am still not sure how this is good for the taxpayer (local)? I guess they get more debt, but it is cheaper. Oh that makes sense. Oh and those folks most benefited by the local bonds, they get a lower yield. So lets recap: the issuer (your govt) get a lower cost of capital and you get a lower return. Someone ois getting fleeced; you get the picture (other than those claiming allegiance to the redistribtion crowd- which is what this is).

    Corruption begets corruption. It is kind of interesting to watch the “quants in the know wince when asked what they are worth. The shrug is usually acompanied by a we don’t have that bond modeled anymore so we have no idea what it is worth: last trade was 85, mark it at 50. Better yet no mark, I can;t possible sell it. So while I can agree with Taylor that the ultimate “value” of these instruments (which are not overly complicated once you know the drivers – the complication knowing how low these metrics will eventually go) is unknowable. Although Tom Brown at does a nice synopysis of the ABX index and its incongruence with the underlying collateral (former DLJ bank analyst)

    The only possible explanation for the agencies inaction is they are simply afraid to make another mistake for their own livlihood or the gov’t is know running S&P (love to get a phonelog of the agency heads).

    Can we all agree that the giovernment can at least sleep a little easier knowing the Americn Public is completely clueless. Otherwise we wpould be knee deep in 1776 part duex

    Yes for all you outsiders often time this is the high science.

  12. JCK

    The purchasers of insured cds know very well the cash flow characteristics of the product. That’s the whole point of the exercise, it’s an arbitrage between a plain vanilla cds and the insured cds which allow the banks to book immediately as profits the present value of the difference beteween the two cash flows. And that’s why even the structured finance side of the monolines is safe for the simple reason that it is cheaper to rescue them if need be that to have reverse the profits that have been booked.

  13. Anonymous

    from a securities lawyer:

    disclaimer: i do securities and bankruptcies but state insurance regulation can be very weird and is not my practice area.

    there are interesting issues i think should be addressed directly and at length.

    assume a state regulator is charged with the responsibility of protecting the insureds. certainly a receiver would have the fiduciary duty to do so.

    first: says who any or all of these are insureds to begin with. if bank X went to monoline Y and entered into a CDS where X would pay Y 15bps annually on a notional amount $Z representing some CDO tranche in return for Y paying X any losses absorbed by the tranche represented by $Z, says who that is legally a policy of insurance and that X is an insured? Do you think that every CDS is a policy of insurance (it had better not be, or a whole lot of people have liability for unlicensed insurance operations). If it’s not a contract of insurance then X is an unsecured creditor of Y and should come behind policyholders.

    But there’s a far more interesting question:

    Look at the muni “assurances” and assume for now that they are policies of insurance.

    They are insuring the policyholder for the benefit of the beneficiary the timely payment of interest and principal (I assume).

    They are not insuring the policyholder that the market will assign any particular ratings quality to them (the monoline).

    We have here what mathematicians call an ill-conditioned problem.

    A small change in something produces huge (highly nonlinear) changes in something else.

    If the ratings of the monoline got lowered from AAA to A+, and concomitantly all the muni bonds insured thereby with native ratings below AA- thus had to get dumped by their holders and the world looks like its coming to an end, exactly how is that an impairment of the monoline or its claims-paying ability or liquidity or cash flows, per se?

    If (and presumably at A+ this would be the case) it were overwhelmingly likely that in runoff the monoline could service its foreseeable claims, then exactly what is the basis for receivership or any other state-imposed remedy?

    Realize, it’s not the worry that the monolines will not be able to pay their claims that’s precipitating this, it’s the worry that third parties – remember that, it’s third parties who hold the munis, like funds and individuals and insurance companies – who have relied on a certain fourth-party rating (the rating agency) are being inconvenienced.

    If my water utility issued a bond with an implicit rating of A- and insured it with MBIA and life insurance company Q now has $100M of it on their books and if MBIA is downrated to A+ then Q has to increase its reserves by, say, $20M, exactly how does that implicate MBIA, which again has guaranteed only to make good missed interest or principal payments, not to itself be rated at any particular level?

    And obviously, if you argue that it would make it hard for new muni issuers to come to market because they couldn’t sell their paper, particularly given the presence of Buffett who is a real AAA, don’t you find it Alice in Wonderland to argue that current policyholders (assuming the CDO stuff is an insurance policyholder) get screwed for the sake of future policyholders (those putative future muni issuers) who don’t even exist yet?

    Bizarre…this purports not to be to protect the claims paying ability but rather the financial rating of a monoline, and to sacrifice what (if they are) are current policyholders for the benefit of future ones.

    Just nuts.


  14. Yves Smith


    Thanks, but I infer you are referring to negative basis trades. I was referring to CDO structuring. I don’t see how the rating agencies could have been rated AAA even when the monolines were rated AAA if an event of default does not trigger payment. The notion that you have to wait until CDO liquidation, or as MBIA said applied to some of its deals, final maturity to get paid, is absurd from an investor standpoint. The idea that the CDOs were insured is pretty close to a sham (the NPV of a payment delayed, say, 18 years represents a pretty big discount)

    I would be very curious to see how the insured CDS was treated in the famous credit models provided by the rating agencies that (at least as the press reported) investors were using for valuation purposes, and in the models they used when rating these puppies. I suspect the default scenario was mis-represented (as far as insured CDS were concerned) or perhaps not contemplated.

    And as I said, having been involved in litigation, all you need is a good theory to launch a lawsuit, even if on the surface there is no breech of contract. I suspect there are some e-mails floating around the monolines regarding CDOs that they wouldn’t want to come to light.

    Remember, Bankers Trust did nothing wrong legally in its dealings with Proctor & Gamble (please, how could the treasury department of a Fortune 500 company say it didn’t understand what it was buying?), it was the BT internal communications that were exposed in discovery that brought them down.

    So regardless of how these contracts were written, I think they would wind up blowing up in the monolines’ face as soon as defaults led to no payment.

    And I still keep coming back to this fact: why have the regulators turned on the monolines? This is unheard of; regulatory capture is the norm. If Dinallo and Dilweg (the Wisconsin regulator) had had a press conference with a few charts explaining all this, the problem should have gone away. Ditto the rating agency worries.

    Something does not add up here. Too many people who have more to lose than gain by the monolines going down have nevertheless ganged up against them.

  15. foesskewered

    Yves and Taylor (inferred from yves’s comment)

    The PV factor is interesting but hinges on 2 factors: the existence and financial viability of the entity responsible for payment into those 18, 20 or even 30 years and the interest rate used as discount factor. If these entities encounter “events” that threaten their existence as ongoing business entities , wouldn’t these time cclauses be invalidated and immediate recovery processes triggered? Seems like ordinary good sense.

    And in such times of uncertainty, PV calculations could be screwed up real bad, what would be the appropriate interest rate? the discount factor? the risk?

    This may sound silly to both of you but why could someone provide an answer? a rather confused spectator

  16. jck

    In the case of CDOs, there are several [confusing] ways where the monolines can be involved, one is the “negative basis” trade, another is the “wrapping” of the assets in the CDOs. In the latter case the monolines are NOT insuring the tranches but the underlying mortgage/assets pool.
    In a event of default the senior tranche holders decide what to do. If they chose liquidation i.e selling the assets in the market, it has no bearing on the monolines who are insuring against default not market losses. The ultimate amount of losses to the monolines depends only on default on the assets, not the tranches.
    CDOs may be and most have been liquidated for reasons other than default like hitting price/rating trigger and again those events aren’t insured by the monolines.
    This is why I believe Mr Ackman is making misleading claims, the fact that a CDO liquidates and the tranche holders lose money does not imply that the assets will be worthless or will default and if they are liquidated in the market that the monolines have liability. At the risk repeating myself, once again the monolines don’t insure the tranches [except for super senior swap which are a different issue], they insure/wrap the assets underlying the tranches and the ultimate legal maturity of those is far in the future.
    As for the regulators they have allowed the set up whereby insured cds are written by a subsidiary, a transformer as it is called without
    taking account what would happen to the main insurance company under new accounting rules like mark to market impairing statutory capital, so they are merely trying to correct/cover what was clearly a massive failure of regulation on their part. And logically insured cds should be ring fenced from the normal monolines business. I am not a lawyer so I don’t know if or how it can be done but it makes sense to try.
    And if the ring fencing happens I am not worried because as I wrote somewhere else it is cheaper for the banks to recap the transformer sub than to reverse previously booked “profits.” Profits that are, by the way, absolutely real “fake” alpha as my chinese friends would say.
    Sorry for being terse sometimes.

  17. Yves Smith


    That was very helpful, thanks.

    Even with all that, I still fail to understand how the senior tranches got an AAA rating, since in the vast majority of cases, the monoline credit enhancement has value only under very narrow circumstances.

    I’m not a lawyer either, but aside from policies written against a separate operation (the transformers), I don’t see how the regulators can set priority among policyholders of a particular insurance subsidiary. If this could have been solved merely by recapitalizing the transformers, I think that deal could have gotten done. The fact that it didn’t suggests to me that the banks that face potential losses from other types of credit enhancement done on the senior tranches they hold OR perhaps the transformers can’t be put as a secondary claimant to the other policyholders (in other words, they can’t be ring fenced).

    The Journal keeps saying that if the regulators come up with a solution the courts will bless it. Unless there is precedent in insurance law, or contractual provisions that support their action, I think that that is a very optimistic point of view.

    The biggest reason not to sue would be pragmatic: US financial institutions wouldn’t want to risk bad PR by going after municipalities (effectively) to improve their standing. But my understanding is that the European banks are most exposed. They may be less concerned about the impact on their reputation, particularly if they have no retail operations here.

  18. jck

    “Even with all that, I still fail to understand how the senior tranches got an AAA rating, since in the vast majority of cases, the monoline credit enhancement has value only under very narrow circumstances.”
    They should not get a “credit” rating. Rating a tranche is not just about credit, it is also about a quantitative model and nobody knows how the model will behave under stress. The assets in the pool have a real credit rating with some help from enhancements by the monolines, but that does not translate into a “credit” rating for the tranches. It was a big mistake for the rating agencies to call tranche ratings “creit” ratings. They aren’t.
    For the rest, let’s wait for the lawyers, at least somebody is going to be busy.

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