Monoline Capital Finesse?

Apologies for the high concentration of monoline items tonight, but that’s where the meatiest material is right now.

I received a surprising e-mail from an investor on a rumor he heard from a well-placed source. He was a bit incredulous as to what he was told, and I am skeptical too. Nevertheless, I thought it would be worth posting in case anyone else had heard something along these lines.

His message:

I had a conversation today with someone who is friendly with someone with access to the monolines, and he suggested that the path out of the current situation for the monolines was, assuming they did a split into a muni book and structured book, that the capital requirements for the muni only book would be lowered dramatically by the rating agencies and that this would free up a $10B+ amount of capital to support the structured book. This was, I believe, informed speculation on his part.

My reaction to it was that I had trouble believing that the rating agencies would cut the capital requirements for the muni business that much, despite the good loss record, given that they were revamping their models to indicate that substantially more capital was needed in the business as a whole. But I’m beginning to wonder whether this might actually be “the plan.” I thought Dinallo’s reaction to Ackman’s proposal was a little curious, since I think his plan or a variant of it is the most viable path to get some capital into the business while retaining the muni business as a continuing franchise and delivering as much economic value as possible to the SF policy holders, and it is a trade the SF policy holders might actually do if they didn’t have to put up much or any capital themselves. When Dinallo said it wouldn’t work because it doesn’t provide a AAA rating for the SF side of the house, I thought, what is he smoking – how much capital is going to be needed to really do that – there is no way they can raise that much. But perhaps this change in the muni reserve requirement is the path to maintaining the AAA fiction that the politicians are trying to orchestrate – the rating agencies “discover” that the muni biz has few defaults, suddenly realize it can be AAA with substantially less capital and release that capital for the benefit of the SF policy holders.

It seems to me that this flies in the face of a lot of history of what has been viewed as the appropriate capital levels for the muni business and against the rating agencies’ newfound religion that these entities were undercapitalized.

This frankly makes no sense. If the capital (technically, reserves, that’s the name for the cushion at the insurance subsidiary level) is insufficient for the combined entities, merely splitting them cannot suddenly make things better. In fact, the boundary condition is that the reserves needed to properly capitalize the combined book of risks is less than or equal to the reserves needed to insure them separately.

But recall what we said early on in this mess:

The mistake is believing, as we perhaps have too much, that the rating agency saber rattling means they have the will to downgrade. They don’t. The very last thing they want to do is be accused of causing The End of the Financial World as We Know It.

The rating agencies would welcome any excuse not to downgrade the bond guarantors. But this ruse seems too much of a reversal for them to pull off without destroying what little credibility they have left. It would make crystal clear that any claim of independence and objectivity is a complete sham.

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  1. Peter

    so the idea is that they can get people to invest in the non-muni entity by claiming that the non-muni business will get ~10bil from the muni , and investors need to match it.
    and this will look more attractive to investors than investing in the original ‘cum muni’ entity ??

    or did i misunderstand something?

    (if i didnt it just sounds like most things we have seen the last few years, the AAA ratings for structured issues, the insurance given by the monolines..etc)

  2. RebelEconomist

    If its not a stupid question, I would ask why it matters so much whether the monolines themselves have a AAA rating. In order for the owner of a security that they guarantee to suffer loss, both its issuer and the monoline have to default. Since it is unlikely that their defaults are perfectly correlated, I would guess that, say, a A-rated monoline only is enough to raise debt issued by a municipality, which can’t be that risky, to AAA.

    Is there something wrong with my thinking? (I am from the UK, so I might be missing some knowledge of how the system works).

    Thanks for any enlightenment you can provide.

  3. SPECTRE of Deflation

    Have you seen this little gem? It is riddled with unintended consequences:

    NEW YORK ( — A plan that would help troubled mortgage borrowers today – and might make lenders whole later on – was unveiled Wednesday in Washington.

    The Office of Thrift Supervision (OTS) is urging the federal savings and loans lenders under its authority to refinance loans by reducing mortgage balances to the current market values of the homes. Thanks to falling home prices, many homeowners are now stuck with mortgages that are actually worth more than the houses themselves.

    But instead of having lenders forgive the difference between the old mortgage and a house’s current resale value, called a short sale, the OTS advises that lenders issue a warrant or “negative amortization certificate” for the difference. If a home regains its market value and is then sold, lenders have first claims to the profits.

    “If a house has a $100,000 mortgage originally,” said Bill Ruberry, a press spokesman for the agency, “and the fair market value is $80,000, there’s $20,000 in negative equity. The lender could refinance for $80,000 and a warrant [for the $20,000 in lost value].”

    If the house later sold for $100,000, the lender would collect the $80,000 mortgage balance plus the $20,000. If the sale realized more than $100,000, the certificate holder might even get interest on top of the $20,000. Any profit beyond that would go to the borrower. The warrants could be publicly traded.
    Home prices still falling

    The hope is that this plan will help prevent foreclosures while minimizing the hit that lenders will take, all without putting any burden on the taxpayers.

    All borrowers are likely to be eligible, according to Jaret Seiberg of the Stanford Group, a policy research company, but the proposal appears to be aimed at those with subprime ARMs, negative amortization mortgages and interest-only mortgage borrowers. They’re the ones most likely to have negative equity.

    The savings and loan industry, which held 31% of mortgage loans last year, saw record losses of $5.24 billion for the fourth quarter of 2007, according to the OTS.
    Can’t pay? Just walk away

    Few details about the plan have been settled, but it would not involve any legislation, nor would it be mandated in any way. Adoption would be on a voluntary basis by the hundreds of thrift institutions in the United States, like Washington Mutual (WASH) and IndyMac Bancorp (IMB).

    Indeed, banks may not want to take this approach in markets where prices have fallen so steeply that it is unlikely they’ll recover any money.

    The plan’s biggest attraction for lenders, according to Seiberg, is that rather than spending $50,000 to foreclose on a home or to write-off the negative amortization in a short-sale, they get a certificate that permits them to share in the up-side, if and when housing markets recover.

    “The plan still needs to be discussed, but it has some attractions,” said Ruberry. “We’re putting it out there and urging our institutions to give it a look.” To top of page

  4. Anonymous

    7:18 AM

    The AAA rating is based on the expectation that the monoline can meet its liabilities, in this case insured muni bonds. The rating logic is causality based (monoline risk as a function of muni risk), not correlation based.

  5. Anonymous

    Makes some sense.

    Buffet obviously thinks that the muni business is a ‘good’ business. This seems equivalent to saying that the risk of the muni business is generally overestimated and the corresponding capital requirements are generally overstated.

  6. Anonymous

    Reducing the reserve requirements for the muni side at a time when losses from the munis are expected to rise due to the recession doesn’t make sense.

  7. Anonymous

    not all ratings mean the same thing. some agencies rate based on the ability of the issuer to meet its obligations and some based on the ability of the issuer to return principal.

    as to the uk chap, the inherent value of a BBB bond insured by a BBB insurer itself indemnified by another BBB insurer is undoubtedly AAA equivalent; but the US is full of lazy morons (probably safer in the long run than eager morons, but we have those too) who dont do their own work and rely on others for a stupid simple reduction of dimensionality to a single rating; lots of them are in state legislatures or on pension boards or consultants thereto who cant vary from the accepted line and write into their documents that there has to be a rating of at least the top two or three from an nsro; also federal law often requires an nsro rating on many securities as well.

  8. Anonymous

    someone should have consulted a tax lawyer on that one.

    it would leave homeowners obligors on “contingent payment debt instruments” and lenders on the other side (obligees).

    of course the “lenders” are not the banks, as the loans have been securitized away, so we should probably use the term “holders”

    so FORGETTING the interesting and non trivial question whether the holders have a recognition event in the form of debt instrument substitution (they probably do)…

    you have a situation where the obligors (homeowners) are BY THE CODE (that is, its part of the internal revenue code of 1986 and regs and can’t be hand-waved away) “issuers” of those instruments

    or some transformer intermediary is an “issuer”

    which means the interest deductions are NOT equal to the amounts actually PAID in cash, but have to incorporate a formulaic value representing the accreting expected contingent payoff.

    which ALSO means whoever is the holder of those notes is picking up income without cash.

    think that through. you take a contingent payment debt instrument from someone and they pay you a coupon rate in cash but YOU recognize income equal to that PLUS an additional amount even though that additional amount is not paid in cash currently, but only (if ever) at the end (where it’s all reconciled).

    and who gets to take the “phantom income” hit if there are securitized tranches?

    not all of those tranches are held by tax-indifferent entities; aunt tilly has maybe some CMOS that would be affected and boy won’t she be happy to be paying tax on income she doesn’t get in cash.

    mathematically, what would probably happen would be that the taxable income would remain the same but the cash income would drop about 30% (a guess) so instead of taking in $100 and paying out $38 (federal and state, on average), you’re now taking in $70 and paying out the same $38, so your after tax income has dropped from $62 to $32…

    oh boy this is going to go over well with the aarp isnt it…


    (this just gets better)

    this assumes the transaction is aggregated (which it should be), that is warrant shmarrant its fixed principal debt being exchanged for a contingent payment debt instrument.

    if however the transaction is disaggregated and considered as the exchange of a debt instrument for a different debt instrument plus a warrant…

    thats a taxable event


    even if by MAGIC there’s no income or loss recognition on the exchange…

    the basis has to be allocated between the warrant and the new loan…

    because as warren buffett said, “i dont care how hard it is to value an option, i know the right value is not $0”

    so don’t let’s pretend that the value of that warrant is $0

    now all this could be fixed by new tax legislation making special rules…

    these would be rules that say, basically, “in all events but bail-out-the-reckless-homeowners, standard treatment applies, but in the case of bailing out these folks, then we’re all going to look the other way and bastardize tax law and by legislative fiat just say this and that and hope no one throws up”

    meaning the non-owners will wind up paying the tab…

    this is a massive wealth transfer to support artificial price / earnings multiples of homes

    (ooh, and just imagine how FASB and the other bodies will be thrilled to allow holders to value the warrants at one number for financial purposes at the same time our new tax law values them at zero to avoid a political inconvenience)

    i dont care how boring or conceptually hard this stuff is, its reality

    you get the system you deserve

    remember what franklin said when asked what kind of government they had produced: “a republic, sir, if you can keep it”

    i want to fwow up

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