Ooof, I am in possession of a hefty and detailed presentation on MBIA and Ambac by an investor that is short the stock of the two holding companies. I believe it is kosher to summarize its findings, particularly since it is all derived from public information. And you probably didn’t want to something that long anyhow.
It is one scary and persuasive document. The bottom line: there is no way these companies will survive. Their liabilities are so far in excess of their capital that there is no hope, nada.
Mind you, I have read enough analyst and consultant reports so as not to be fooled easily (in fact, I sometimes get hired to vet them). This work is the real deal.
Having read this, I owe a very big apology to the New York State Superintendent of Insurance, Eric Dinallo. I had criticized him last week for contacting Berkshire Hathaway in November and encouraging them to enter the bond insurance business. I had said the move was badly timed, since Buffett’s entry was another nail in the bond insurers’ coffin. If Berkshire was uncommitted, the fantasy that the Omaha insurer could ride in as a rescuer was still a possibility. And the shocker that a supposedly savvy private equity firm like Warburg Pincus would step up at such a late hour to commit up to a billion in equity to MBIA suggested to me that there might be other chumps, um, investors out there.
But no, Dinallo was right. Neither a rational calculus or sexual favors can explain Warburg Pincus’ planned investment; it must have been extortion. I had somehow thought that there was enough reason to keep the bond insurers on life support (the collateral damage will indeed be dreadful) that some sort of group might step forward and keep them going a while (a year? eighteen months?) till the worst of the fixed income crisis was past, and their downgrades wouldn’t be as damaging as when market psychology was fragile. But I now cannot imagine that will happen given the dreadful fundamentals.
And the truly bizarre thing is that there is so much concern and focus on the imploding equity bases of the big banks and securities firms, and the tsuris of the bond insurers is treated as a sideshow. Yet a crisis at MBIA and Ambac will feed into and amplify problems in Wall Street. Dollars spent rescuing the guarantors (not as ongoing entities, BTW; forbid them to write new business and put them in run-off mode) will stem more damage than pumping a comparable amount of dough into faltering investment banks.
Now to the high points of the treatise:
The stock in MBIA and Ambac is that of their holding companies. It is their insurance subsidiaries that are regulated and write guarantees. The insurance companies can pay dividends of 10% of their surplus per annum, plus special dividends if the powers that be permit it.
For credit guarantees to be attractive to customers, the premium has to be lower than the credit spread assigned by the market. This business model worked for municipal general obligation bonds, which never defaulted (at worst, they missed a few payments) yet the rating agencies graded them more harshly than corporate credits. By contrast, as we have seen, rating agencies have given structured credits higher rating than corporate issuers with similar default probabilities would garner. Thus, the guarantors have gone straight from a low/no risk model to not merely a high-risk model, but one where the economics could not work unless they got exceptionally lucky. To make matters worse, Investors have systematically taken too little spread for the risk of structured bond deals, and the bond guarantors were demanding only a fraction of that already inadequate risk premium for its ratings upgrades.
Now for some numbers:
Annual Premium as a Percent of Exposure:
MBIA 18 basis points
Ambac 21 basis points
Note this figure happens to equal each company’s excess capital/credit exposure. Hhhm
Leverage (Net Debt Service Outstanding/Statutory Capital)
The next section goes through the bond insurers’ exposures by business segment. For example, it applies the 3Q CDO writedowns taken by Citi and Merrill, which like the guarantors, were exposed mainly to highly rated paper. Note we’ve had more stunning deductions since then (note that MBIA is using “mark to model” on nearly 93% of its net derivatives exposure). For home equity loans and CES (closed end second mortgages), while mortgage insurers like Radian and MGIC have taken considerable reserves that the market still regards as too low, bond insurers have taken virtually no reserves against these exposures.
The report also looks at the sorry state of the commercial real estate market and other types of exposures, particularly MBIA’s incestuous relationship with its captive reinsurer, Channel Re. After estimating all types of loss exposures, the study concludes that it will take roughly $7 billion per bond insurer to keep their AAAs, if you properly account for their exposures. And that was using end of third quarter levels for the loss estimates, which are now being surpassed by a wave of even greater writeoffs.
And we haven’t even gotten to why their investments might be a tad overstated…..
MBIA also bought back equity back from insiders in 2007 after it suspended its open-market share buybacks (buying back $700+ million of stock when the credit markets were deteriorating is another example of highly dubious judgment).
There is also a section on allegedly abusive holding company/insurance subsidiary transactions by MBIA which allowed “disguised dividends” of hundreds of millions to be upstreamed to the holding company (note dividends are supposed to come only from insurance company surplus and need to be approved by regulators).
The document also has a section on how to salvage the bond insurers (which can only be done by the regulators): eliminating dividends to the holding companies, voiding illegal contracts and guarantees (CDS and synthetic CDO, guarantees on medium-term-notes issued by affiliates, and possibly home equity loan can CES liabilities). Note that this program is consistent with the short of the holding company stock, but it does make sense. The regulators’ and investors’ concern is with the fate of the insurance companies, not their parent.