Banks Being Pressured to Bail Out Bond Insurers (Updated)

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.

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  1. Anonymous

    Any thoughts as to why Dinallo is stepping up and the Fed isn’t?

    The stock market surge this afternoon indicates to me that the medicine for the current wound is not and was not a rate cut, but addressing these insurer problems.

  2. Yves Smith

    The Fed has nothing to do with the insurance business. It doesn’t regulate it and has no expertise.

    Impairment of the monolines would be a real disaster, but even if this crisis is surmounted, credit market problems are not over.

  3. Anonymous

    This hype of a rescue plan is as valuable as The SIV Bailout, what was it called MILAC or something and what happened with that coordinated effort? This story was out yesterday and there was no reaction, then today, it strikes everyone as so important as push the market 600 points? If that type of rumor is what effects the market, then why not just call it a lotto ticket and add music, this situation is looking wilder and more chaotic ever minute of each day and IMHO, that aint good long term!

  4. Yves Smith

    The funny thing is that the SIV story captured headlines way out of proportion to its importance; this insurance problem has been undercovered. The volatilty is in part due to ignorance. The vast majority of investors do not understand the insurance, and it is pretty much impossible to gauge the downside if things devolve.

    The SIV industry was about $400 billion, but in the end, despite all the handwringing, the losses (not fal in NAV, that’s completely different measure) were (roughly) 2-3% of total assets. Hardly a crisis, but a big problem for CIti, who was numero uno in that market (and a lot of forced sales could have lead to bigger realized losses).

    The two biggest insurers guarantee $2.4 trillion. There will be downgrades in the absence of intervention, and that alone will lead to a lot of forced sales of paper that, as one commentor pointed out, was often never intended to be traded. That in turn leads to mark-to-market writedowns at investment banks that are already short of capital.

    So that is a long winded was of saying this is a real problem, while the SIV situation was overhyped.

  5. Dave L

    Even assuming that a capital injection large enough to cover the monolines’ losses is arranged, what now can save the monolines’ business model?

    I’ve read a couple of stories in recent weeks about muni issuers discovering that they can do fine without insurance. You and others have pointed out more than once that writing muni insurance is a lucrative business, because defaults are rare. Well, how will Ambac, or even Warren Buffett, re-establish that business model after the issuers discover they were paying for an unnecessary service?

    (Here, for example, is a Bloomberg story from late December:

    “Muni Insurance Worthless as Borrowers Shun Ambac”

    So Ambac’s bank customers are being asked to bail out a company that is not merely insolvent, but is also losing its core business – why would they be interested in doing that?

  6. Anonymous


    How can the banks bailout the monolines and still be hedged through them?

    If they have a stake in the monolines, then the risk has not been transferred.


  7. Carl


    I have read elsewhere that if the monolines were compelled to pay a claim on a covered CDO or swap that they would really only have to pay out the regular revenue stream that such securities would generate and not the entire principal and interest at once. Is this true? If true, since they could probably do this for a while on any given stream isn’t all this predicated on multiple failures at once of many insured securities?
    How likely do you think that scenario might be in the current environment?

  8. Invictus

    Dave L,

    While not as intelligent on the economics of the matter as Yves, I can say from experience of working in Citi’s or Smith Barney Muni division that it is much easier to push AAA paper to funds. Further, many pension and fixed-income funds have stipulations requiring all or a certain % of assets to be invested in AAA rated paper. The underlying rating of many municipalities is AA or lower, or the bonds are funded by a unstable revenue stream which also can knock a AAA rated municipality to AA or lower. By forking up a small premium to be insured by Ambac or MBIA or one of the 5 others a municipality can receive a AAA rating which substantially increases the demand for the bonds and can also end up reducing the effective interest rate paid on the bond issue. So there used to be cost-saving advantages to being insured by a monoline. Now the market is in limbo, and the AAA insurance no longer results in cost-savings for municipalities. As Yves points out, many of the bonds were meant to be held until maturity. A forced sale of hundreds of billions of paper might occur if the monolines file for bankruptcy. And that paper does not have a strong underlying bid, and is unlikely to have a functioning market anytime soon.

    The flip side of this is when Berkshire really enters the market to insure municipalities a premium will likely be put on their AAA insured paper, so once again municipalities will find benefits to being insured.

    Hope this helps, I tried to keep this dangerously complex issue simple.

  9. foesskewered

    Anon January 23, 2008 8:33 PM

    That’s another aspect of the problem I was wondering about. Wouldn’t there be conflicts of interest? Banks actually owning the insurer might actually reinforce the view that the AAA ratings “lent” by these insurers to bonds are inherently flawed and opaque, making it even harder to assess these bonds on a “fair basis”.

    Yves, could this lead to a “replay” of Spitzer’s investigation into the ethical “problems” of resesarch and investment calls issued by bank analysts in the sense that should any problems surface with bonds issued by the bank and insured by their “inhouse” insurer , it’ll be harder for any transparency to emerge. This could be the start of more problems for the banks and markets in general years down the line after all, this is an industry nnot unknown for its penchant to play dirty.

  10. Anonymous

    Re: risk has not been transferred.

    Risk transfer examples can be found by examinations of Enron and that area of DD is well worth time. This was also an issue with AIG & Berkshire Hataway a few years back, when Spitzer busted lots of reinsurance scum.

    This is funny: One auditor once said that risk transfer is like pornography–you can’t define it, but you know it when you see it.

  11. Yves Smith

    Dave L,

    The press hasn’t been sufficiently clear (yet) but this effort to form a consortium is NOT to invest in the parent company. Dinallo regulates the insurance subsidiaries. This is about saving (or salvaging as best one can) the insurance ops. That means they go in runoff mode. No new business, whatever cash gets put in is part of a wind down operation.

    As in LTCM, they will keep the people who are important to continuing to manage what remains, perhaps under a contract. Anyone involved in new business will clearly go.


    The immediate motivation is to prevent further downgrades. The credit default swaps of the big monolines are trading as if (prior to today’s announcement) their odds of going bankrupt THIS YEAR was over 70%. And they are still rated AAA! No one with any brains believes the ratings, so the salvage operation won’t change that fiction.

    But downgrade will force sales. The bonds they insured would in turn be downgraded, and many investors face rating-based restrictions on what they hold. Forced sales lead to crappy prices on already crappy paper, which leads mark-to-market institutions like banks and investment banks to revalue their assets lower, which leads to more ugly writeoffs.


    Thanks for your comments, and the problem you set forth is even worse when you get outside munis, since they’d be downgraded only a notch or two. CDO downgrades have been known to go as much as a dozen to sixteen grades at a shot.


    Those charts are cool, even if a bit OT. Where is a primer on technical charts for the curious?

  12. Anonymous

    Re: The immediate motivation is to prevent further downgrades. The credit default swaps of the big monolines are trading as if (prior to today’s announcement) their odds of going bankrupt THIS YEAR was over 70%.

    Why shouldnt they be accountable for taking on excessive risk; a lesson needs to be learned from this period of excess and it will only sink in, if there is accountability and losses which hurt the risk takers!!!!!!!

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