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.