Reader Abdul sent me a piece that ran in the New York Post on simmering disputes between investment banks trying to unwind CDOs and monolines that provided credit enhancement. Yes, I know the Post isn’t the usual place to see what amounts to breaking financial news, but it was the first out with some stories on quant meltdowns, so it isn’t completely unheard of.
I’m posting this for two reasons:
1. To see if any readers can confirm, deny, or refine
2. To clarify a wee point that is a bombshell if true. One of the big defenses of the bond insurers against Ackman, the other shorts, and the regulators, was “You don’t get it. On many (by implication, most) of these structured finance guarantees, we don’t have to pay the piper till so far down the road that on a DCF basis this is chump change.” I dimly recall that the terminus was asserted to be when the CDO was finally dissolved and all claims finally settled (or it might have even been when the underlying mortgages finally matured). Given that most CDOs have a three to five year life, I failed to understand how these vehicles could have gotten AAAs if the insurance really worked in most cases as asserted (as in it would pay out only ages after the CDOs were fini). But never underestimate rating agency stupidity, I suppose.
The article suggests (but isn’t clear) that the bone of contention is that the unwinding of the CDOs would accelerate the insurer’s liability. On one level, that makes sense, but on another, if it is tied to the final resolution of the underlying mortgages, I don’t see who you can dissamble these CDOs (which was a conclusion I had reached a long time ago).
From the Post:
Battered investment banks trying to dump billions in soured mortgage securities are being challenged by struggling insurance companies that claim such efforts could cause them further pain.
It’s a battle that pits large financial firms like UBS, Merrill Lynch and Citigroup against insurers MBIA, Ambac and others. These insurers, which the industry refers to as “monolines,” provide specialty insurance used to protect investors from losses on various types of debt securities.
At issue is a type of protection that banks have obtained against defaults that is now preventing them from purging portions of their holdings of arcane mortgage securities known as collateralized debt obligations.
Under the terms of this protection, the banks need approval from the monolines in order to unwind these securities – and obtaining that OK is proving difficult in some cases.
For the past several months as the credit crunch has pummeled mortgages and other forms of debt, a lot of collateral used to form CDOs has triggered defaults due to rating agency downgrades. As a result, if the banks begin dumping these problem securities, financial guarantors would be forced to pay default claims almost immediately – a tall order for companies whose financial future is already murky.
Typically, monolines pay out claims on losses over a period of 20 or 30 years, but the types of sales that the banks are looking to score would accelerate those payments and further hammer companies already hurting.
The banks appear to recognize that the insurers are unlikely to be able to cough up the cash needed to pay off these losses. That has led to discussions about whether to waive claims payments in exchange for cash or warrants in certain publicly traded monoline companies.
“Clearly, liquidation into this market is tough but holding on long term might not be your best case,” said Joe Messineo, who runs a New York-based structured finance consulting firm. “Not many people envisioned the magnitude of this would come down to documents.”
None of the monolines embroiled in this battle returned calls for comment. Neither did the banks.
Although there are hardly any buyers for CDO paper, the banks would be able to unwind the CDOs and essentially purchase the assets that comprise the complex debt structures – a move that might allow them to better assess the value of the assets and at least eliminate the fees associated with holding onto the debt as CDOs
Update 5:00 AM: The alert folks at FTAlphaville have come to the rescue:
The Post, we assume, is picking up on disputes such as this one, between XLCA and Merrill Lynch. The quid pro quo for cheap insurance on senior CDO tranches then appears to have been “control rights” over the liquidation of those CDOs in the event of default.
The whole thing is a legal mess. Existing CDO documentation would likely have given “control rights” to the most senior noteholders, not distant swap counterparties, so there’s plenty of room for disagreement.
They have some further comments….but any readers with insight are most welcome to provide input.