Despite the seeming absence of news on the bond insurer rescue front (the only development reported was the selection of the boutique M&A advisory firm Perella Weinberg to assist the State of New York in its efforts to put a deal together), the Financial Times has four articles on it today, from the neutral to upbeat in tone, including the lead article, “US bond insurer rescue takes shape.”
One robin does not make a spring, and although the FT is generally more sober than the Wall Street Journal, there were a couple of occasions during the failed SIV bailout effort when the pink paper slipped into an uncharacteristic cheerleading role. (Note I am focusing on the FT because the only other news sighting was a report on the Perella Weinberg engagement in the Journal).
The positive reading from the FT comes from three developments: the Perella Weinberg appointment, the Fed encouraging a deal from behind the scenes, and the claim by some analysts that the amount required is less than the $5 billion pretty pronto/$15 billion in total that insurance superintendent Eric Diallo is seeking. Let’s deal with each separately, and also discuss the economics of a deal from an investment bank’s perspective.
Perella Weinberg involvement. We had commented that Dinallo and his team almost certainly lacked dealmaking skills, and they were essential for an undertaking like this, particularly since Dinallo is regarded with some antipathy on Wall Street.
While Perella Weiberg has a very senior and seasoned team of merger and acquisition pros, they would not have been my first choice. While the all star team has highly regarded individuals, its knowledge of trading and risk management looks thin (they have one partner, William Kourakos, led Morgan Stanley’s capital markets operations at various points through 2004. However, his experience appears to be in high yield bonds and emerging credits, in other words, “story paper” that is more equity than bond like. Similarly, looking at the partners’ bios, I saw no evidence of deals experience in financial services. The reason that is a negative is that regulatory issues create another level of complexity, particularly when you have at least two (insurance and investment banking) and possibly three (commercial banking) sets of regulations that might impinge. (Mind you, counsel typically works through the nitty gritty regulatory issues, but if the principals negotiate a deal that somehow runs afoul of a regulatory constraint, it will be very difficult for an agreement with many players and moving parts to be rejiggered).
Similarly, while the partners of the firm are highly regarded, I am not certain how much their stellar reputations and networks buy them with the leaders of the trading operations who will play a key role in any deal.
Had I been Dinallo, I would have tried to get someone with the deal equivalent of star power who also had experience with government or regulatory issues, with Paul Volcker and Felix Rohatyn as first choices (although Rohatyn’s senior advisor role at Lehman might be perceived as a conflict of interest). I’m not current on who the best picks might be, but top M&A lawyers also have ample deal making-cat herding skills, and the right law firm in combination with an eminence grise would have been a more powerful combination (in fairness, Dinallo might have tried this route and not been able to get the parties on board).
Fed involvement. The FT article on the Fed’s support itself is oddly ambiguous. The title, “Fed quiet on bond insurers rescue,” suggests the central bank is doing comparatively little, while the text suggest more may in fact be happening:
In public, at least, it would seem not. In recent days, it has been Eric Dinallo, New York Superintendent of Insurance, who has spearheaded efforts to cut a deal…
By contrast, the New York Fed, and its president, Tim Geithner, have been notably silent, avoiding comment on the issue altogether. This stance is partly because official responsibility for overseeing the bond insurers rests with the state insurance regulators, not the Fed. Thus the insurance regulator from Wisconsin, which regulates Ambac, one of the two biggest bond insurers, also took part in the meeting with banks.
Bankers believe the Fed also wants to avoid derailing private sector efforts to resolve the crisis, either by stepping in too early or forcefully. “LTCM means everyone is now looking to the Fed but the Fed does not want to give the impression that it will just sort things out,” says one former US official, who points out that the “impetus must come from the private sector”.
But there is little doubt that many Wall Street bankers fervently hope the Fed will become involved. Mr Geithner commands considerable credibility on Wall Street. Mr Dinallo, by contrast, invokes more mixed emotions among some bankers because of his previous involvement in enforcement actions.
“This . . . should be organised at a Federal level, not by state regulators,” a senior official at one Wall Street bank claimed in Davos last week.
Bankers involved in the monoline discussions say that, while the Fed initially hung back, it is now an active player in the discussions, albeit discretely. “The Fed is absolutely involved now,” says one policymaker.
In my mind, the issue of the Fed’s involvement is an open question, It actually did very little in the LTCM crisis beyond call the heads of 25 firms to its office and tell them there was a big problem looming that they had better sort out. However, the head of the New York Fed’s trading desk, Peter Fisher, had been invited by LTCM to look at its books, which added credibility to the Fed’s hard nudge to get a deal done. By contrast, here the Fed not only has not examined the financial condition of the bond insurers, but it also lacks the expertise to do so.
Suggestions that bailout costs may be lower than Dinallo target. Dinallo is seeking an eventual $15 billion. The FT says that some firms beg to differ:
Some analysts and bankers believe that figure is too high. Compared with Merrill Lynch’s $3.1bn write-offs linked to monoline hedges, $15bn from all banks may look fairly small, but Merrill’s contracts were mostly with ACA Capital, the bond insurer closest to insolvency.
Writedowns from ratings downgrades to other monolines would not be half as painful, bankers insist. Geraud Charpin, analyst at UBS, believes an industry-wide downgrade from AAA to AA would lead to $10bn in total writedowns at the most for banks on monoline-guaranteed structured bonds such as mortgage-backed debt.
Standard & Poor’s said this month it expected total after-tax losses for the monoline industry from mortgage-backed bonds and the more complex collateralised debt obligations to be $13.6bn.
S&P’s assessment could worsen, particularly since its estimates of losses had grown by 20 per cent, or almost $2.5bn, since its previous examination in mid-December.
S&P said this growth was not significant in terms of individual companies’ capital strengthening plans. A number of monolines have talked about raising $1bn-$2bn of new capital, which across the eight or nine most important groups leads to the proposed $10bn-$15bn.
Some see this figure as inadequate. Independent Strategy, a London-based research house, believes closer to $140bn is needed. But this includes higher loss estimates of $73bn and an increase in the ratio of claims paying resources to total insured liabilities from about 2 per cent to 5 per cent.
The average ratio of monoline equity to total net exposure is a shade under 1 per cent, so a new vehicle operating on a similar basis would need more than $21bn to take on the full $2,400bn in existing industry liabilities.
Banks could ask how much might be needed to set up a vehicle to take out the most toxic exposures. UBS estimates those to amount to about $130.7bn for the six biggest companies, suggesting a starting point for equity of only about $1.3bn.
Perhaps these numbers are being bandied about for negotiating purposes, but if anyone believes them, they need their head examined. ACA has only $60 billion in guarantees, rounding error compared to what is at issue with Ambac and MBIA. And the idea that 1% in equity would be adequate with a portfolio of assets chosen for their dodgyness is ludicrous. The average loan loss reserve for commercial banks for 2006 when the economy looked good and in retrospect, banks were under-reserving, was 1.2%. Although I think rating agency Egan Jones’ estimates tend towards the pessimistic, they believe that the bond insurers will take losses of 10% to 35% on the subprimes, CDOs and other structured credits.
Another issue mentioned in the Egan Jones conference call yesterday which we have not delved into in detail is where any investment will sit in the capital structure. The two courses of action that Perella Weinberg is examining is a backup credit facility and an equity investment.
But while a backup facility normally sits high in the capital structure, for insurers, policyholders are first in line in any payout. And the problem here is that any money put up by Wall Street is not for their benefit, but for all the policyholders.
So let’s say the firms are worried about their CDO exposures. Let’s say they decide to fund $15 billion in a credit line. Let’s say $5 billion in deals go a cropper. But the firms that put up the credit line own only 15% of the deal in aggregate. So most of the payout goes to unaffiliated parties.
So the benefit of this operation is not to assure payouts, but to prevent a downgrade because that leads to forced sales by investors who can only hold paper than falls in certain ratings buckets, and in turn forces the Street to price similar holdings lower. But the level of capital required to maintain an AAA is far larger than that required to merely assure that claims are paid for the next year or two
And the estimates of what a downgrade scenario might cost in aggregate vary considerably, which means that different firms are likely to reach very different conclusions, based not merely on their exposures but on their assumptions of loss percentages on those exposures. And lack of agreement on the nature and magnitude of a problem again makes it harder to reach a resolution.
As I’ve said before, a deal isn’t impossible, but it certainly doesn’t look likely.