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.

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

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.

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.

Fred

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 bankstocks.com 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.

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

RK,

Good analogy.

Taylor,

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.