A MarketWatch story on Warren Buffet’s borderline extortionate offer to struggling monoline insurers suggested it could provide a format for a rescue New York insurance superintendent Eric Dinallo. A story by the New York Times alluded to the same notion.
While I may be missing something, I don’t see how this could possibly work.
First, let’s start with the rumor. From MarketWatch:
If Warren Buffett’s $800 billion reinsurance plan is rejected by bond insurers, a leading industry regulator may end up pushing a similar solution, a person familiar with the situation said on Tuesday.
But Buffett said on Tuesday that one of the insurers has already rejected the offer and Ambac said later in the day that the plan isn’t in the interests of all its policyholders.
However, if the situation gets worse, bond insurers may have no choice.
If current efforts by the New York State Insurance Department to stabilize the $2.4 trillion industry fail, the regulator may propose a similar plan to Buffett’s, in which bond insurers’ steadier muni businesses are separated from their more troubled structured-finance business, the person said, on condition of anonymity.
There are two problems with this concept: first, that it solves no problem, and second, that it probably represents regulatory overreach if the insurers don’t go along (likely).
To the first issue, that this approach does not address the underlying issues. While Buffett has every reason to want to get the best risks out of the monolines on the cheap, that doesn’t mean it is a good deal for anyone other than Buffet, and perhaps parties in the municipal bond market. There has been quite a lot of disruption of new fundings, which means that despite the considerable press of late on how muni insurance is basically a waste of money (the rating agencies rate munis much tougher than corporate credits), municipalities are facing considerably higher costs to raise funding without the insurance wrap.
One would think that Buffett’s entry into the business would have solved that problem, but so far, he has done very few deals. And even if he entered into his proposed arrangement with MBIA and Ambac, all that does is shore up their existing portfolio of risks, that is, it helps secondary market investors but not the municipalities under stress.
What happens in this plan to the bond guarantors’ muni underwriting operations? There was no suggestion that these would go over to Buffett. Do the keep originating and then get them reinsured by Buffett? I doubt that Buffett will help a direct competitor except at worse terms than for his own operations. So unless some crucial bit has failed to be disclosed, I don’t see how this move would help municipalities.
And as the market realized as the day went on, this arrangement would be lousy for the remaining book of risks. It leaves the remaining guarantees with even less coverage. The New York Times clarified Buffett’s proposal:
In a letter dated Feb. 6 to Lazard, the investment bank that is advising MBIA, Ajit B. Jain, president of reinsurance for Berkshire Hathaway, proposed that MBIA pay Mr. Buffett’s company 150 percent of the premium it earns for insuring its municipal bond portfolio. Typically, insurers cede a share of their premiums, not more than they earn…..He noted that in recent months, Berkshire had been able to set premiums at twice as much as MBIA used to charge, or more. Mr. Jain estimated that the reinsurance premiums paid by MBIA and Ambac would total about $9 billion.
In other words, the bond guarantors have to pay out hard cash at a time when they are desperate to raise more equity in order to cede the best part of their business to Berkshire Hathaway.
I am no expert, but I do not see the legal basis for favoring one type of policyholder over another. While debt instruments set clear priority in payment, I am not aware that any priority in payment exists among insurance policyholders. Unless the muni bond guarantees have a preferred standing relative to the other guarantees, this approach would seem to be a magnet for litigation.
Now if this approach seems only to benefit Buffett, why would Dinallo be pushing it (if that is the case)? There is some speculation that he is using the Berkshire offer to bring reluctant banks to heel, but for that to work, he has to have a viable threat. I don’t see one here. This seems to be a misguided application of the “good bank-bad bank” approach used in the saving & loan workouts.
But consider the differences: the dead S&L’s landed in the FDIC’s lap. They had to figure out what to do with them, and they wanted to make a recovery on the payments they made in deposit insurance. So the Resolution Trust Corporation was set up. Note that a big issue was that the Federal government had to continue to fund the S&L’s working capital and also pay to keep some staffing going. That cost was considerable and controversial, and led the RTC to sell assets faster than it would have if it had wanted to maximize value.
The reason for segregating assets was simple: there were two different types of investors who might want to acquire them: banks that hadn’t been too badly damaged were interested in the “good bank” assets; distressed players and wealthy individuals went after the “bad bank” assets. The bad bank assets were going sufficiently on the cheap that even parties that had never dabbled in that sort of deal like Ron Perlman made acquisitions and did very well.
But what does a segregation achieve here? No one but an AAA rated party would make sense as a buyer/reinsurer of the muni portfolio. Buffett already having decided to enter the business on a de novo basis means the only interest another insurer is likely to have is reinsurance. But per the discussion above, this is a huge market inefficiency; the insurance adds no value (but sadly appears to be necessary).
And who would buy the rest? The parties who best understand the CDO/CDS exposures and have reason to do a deal are already at the table. You aren’t going to have new parties appear out of the blue. Private equity investors like TPG and Bain Capital predictably said no thank you, we don’t understand this stuff. I’d be curious to know who might materialize.
So a simple runoff of the portfolios would make the most sense. Any other activity appears to be for the benefit of lawyers and Perella Weinberg, not the policyholders.
Now to regulatory matters. Ambac is at most immediate risk, by virtue of not having raised more equity and having a big CDO portfolio (those have a relatively short life). MBIA has proportionately less CDOs but has commercial real estate, below investment grade, HELOC and second mortgage guarantees, I can’t be certain, but their poisoned fruit might not be rotting quite as fast as Ambac’s.
But Ambac is in Wisconsin. Dinallo has no authority over them, and Sean Dilweg, the commissioner of insurance in Wisconsin, said on January 23:
Eric is looking at the overall issue, but I am pretty confident that we will work through Ambac’s specific issues. They are a stable and well-capitalized company but they have some choices to make.
That doesn’t exactly sound like someone who is eager to do a rescue.
So let’s consider the current state of play. Both the big bond insurers insist they are adequately capitalized; presumably the statutory accounts they will file will say the same thing. MarketWatch says that MBIA disputes Dinallo’s authority to impose a plan on them:
Still, it’s not clear whether the New York State Insurance Department could impose such a plan on bond insurers if the companies are against the idea.
MBIA, which is regulated in New York, questioned a bailout like this during a conference call with analysts and investors on Jan. 31.
It also said that insurance regulators could only take control of the company if it is deemed to be insolvent under regulatory and statutory accounting standards.
“I can assure you that we will be showing a substantial, in the billions of dollars, amount of statutory capital beyond requirements for the New York State Insurance Department,” Gary Dunton, chief executive of MBIA, said, according to a transcript of the conference call.
However, later in the call, Greg Diamond, head of investor relations at MBIA, clarified Dunton’s comments. The New York State Insurance Department can take control of companies even if they’re not insolvent, he explained.
The regulator could take control if a company is found to have violated law or regulatory orders or if the department is concerned about the company’s ability to pay its claims, Diamond said, according to the transcript.
Here is the interesting dilemma: a crisis. or at least some disruption and uncertainty, will be triggered if either MBIA or Ambac are downgraded by Moody’s or Standard & Poor’s. But there is a big difference between being less than AAA and being unable to pay claims (I don’t imagine Dinallo can charge them with violations; the big area of dispute would be their accounting, and my impression is that insurance accounting allows reporting entities a lot of latitude). MBIA has kept up an aggressive front. I don’t know that Dinallo can claim in all honesty that MBIA is at risk of not paying claims, at least for the next two years. I don’t know what recourse MBIA would have if it decided to fight Dinallo, but I would expect them to go to the mat.
Dinallo can achieve the same outcome, although it will take a bit longer, by forbidding the regulated insurance subs from upstreaming cash to the holding company. When the executives are forced to realize that they are on a sinking ship, they will become much more compliant.