Monoline Death Watch: A "Bad Insurer/Worse Insurer" Split?

The market is wiling to treat thin gruel as nourishment. We saw an impressive 250 point rally in the Dow on Friday and an over 400 point gain in the Nikkei based on the improving odds of a rescue of troubled number two bond guarantor Ambac.

But what is this salvage operation, exactly? The Wall Street Journal gives us some insight into the smoke and mirrors:

Ambac plans to raise $2.5 billion in a rights issue, in which shares are offered to existing shareholders at a discount to the market price, according to the people familiar with the matter. The bank group, which includes Citigroup Inc., UBS AG, Royal Bank of Scotland PLC and Wachovia Corp., would likely “backstop” the issue, meaning they would commit to buying up any unsold shares.

A rights offering with a mere backstop? The existing shares will be heavily diluted and the bank group hopefully puts up nothing, The fact that this group won’t make an outright equity purchase is so inconsistent with their supposed downside exposure that it can say only one of two things. Either enough of them have taken deep enough writedowns that they don’t think they have much at risk or they believe this rescue will be inadequate. In the latter case, they are better off keeping their powder dry rather than become the sugar daddies for the possibly insatible monolines.

That, needless to say, is a big vote of no confidence. Remember, the rescue program started January 23. Ambac has had over a month to persuade the banks that it has good business prospects. Obviously, that effort was less than a rousing success.

Further proof of the “vote of no confidence” thesis:

Additionally, Ambac plans to sell $500 million of debt, probably in the form of a surplus note issued by the municipal side of the business, to further bolster its capital in order to satisfy requirements of the rating providers, who need to sign off on the plans, and maintain its triple-A credit rating.

Ooh, as of Friday, the rumor was the the banks would provide a $500 million line of credit. For a group this large, that’s peanuts. But they aren’t even willing to take that risk. They are instead making Ambac raise the dough itself, on what is sure to be very costly terms.

And what is this heroic effort expected to achieve? Not all that much:

Meantime, credit-rating providers Moody’s Investors Service and Standard & Poor’s are expected to announce actions in coming days that could include moving the ratings of bond insurers that have raised capital, such as Ambac rival MBIA Inc., a step further away from imminent downgrade.

MBIA, the biggest bond insurer, which has guaranteed $679 billion of debt, recently raised about $2.6 billion in capital to buttress its top-notch rating. Moody’s, S&P and Fitch Ratings have placed MBIA’s triple-A rating on watch for possible downgrade; a move to negative outlook would be considered by debt investors as an improvement in MBIA’s health.

In other words, this financing has gotten the firms out of intensive care but they remain hospitalized.

It seems inevitable that if the economy continues to weaken, the prospects for the bond insurers will fade as well. This round of fundraising has been difficult and costly. Will they be able to go to the well again? And since Wall Street turned a deaf ear to the requests for cash, this precedent of offering only token support will make it easier for them to do little or nil next time.

Furthermore, if the real estate market continues to head south, the supposedly “good” municipal bond business won’t look so hot. An investor passed along a note from Jim Walker, ex-chief economist at CLSA); this part caught my eye:

The markets go on and on about how healthy underlying financial assets are, nowhere more so than in the municipal bond market. If only the monoline insurers could strip out the bad business from the good business. Well, my thanks to Chris Burn at Goshen for pointing out that this might not quite be accurate. Have a go at Googling Vallejo County in California. In fact, here is a weblink to save you the trouble.

Vallejo is a municipality. Presumably its debt would be considered AAA. Yet its civic leaders are talking about filing for bankruptcy. You wonder why local government and public works-related auction bonds are failing left, right and centre? US state and municipal finances are in dire shape – just as you would expect when the housing market is in deep depression and the economy is in recession.

And if you think Vallejo is a one off, consider California itself (isn’t it something like the tenth largest economy in the world in its own right?). Remember, US states are constitutionally bound to run a balanced budget. California is now faced with a US$16bn deficit (see here). Some legislators are calling for unilateral tax INCREASES (where’s your $170bn stimulus package now Mr Bush?) as well as spending CUTS. The US is in deep, deep trouble and it isn’t coming out of it for years.

So, what would happen if the monolines spun off their bad assets, as MBIA seems close to doing in overnight news? Well, in the first instance banks would have to absorb even more gigantic writedowns because, presumably, they would have to swallow the “bad monoline” assets in order to avoid counterparty failure. There is no doubt that the ‘bad bank’ portion of the monolines would fail – they wouldn’t be able to raise the requisite capital in the markets. Secondly, we could then watch the “good” assets deteriorate swiftly as the economy plunges further into recession. Remember all those smart guys – Greenspan, Bernanke, Milken et al – talking about how well contained this whole problem was to sub-prime USA? That must now be considered one of the sickest jokes of all time

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  1. Barry Ritholtz

    Nice analysis.

    Amazing that so many people hear a whiff of a bailout and think its positive for equities.

    Normally, when the Docs give the patient more morphine, its not a good sign . . .

  2. Anonymous

    The Vallejo situation is not unique. California cities are not able to raise taxes at will (think property tax revolt of the late ’70’s), and Vallejo has seen its revenue driven by the housing bubble evaporate while at the same time it has a huge unfunded pension liability, especially for fire and police. The immediate crisis seems to be caused by a rush of retirements to beat the threat of bankruptcy, which require the city to fund its pension obligations to those personnel immediately. Talk about negative feedback/vicious cycle.

  3. Ginger Yellow

    FWIW, Bank of America and Morgan Stanley both estimate the writedowns from a monoline split at $30bn, based on CDOs of ABS alone.

  4. Anonymous

    The Vallejo situation is a perfect example of why insurance works! If Vallejo decides to restructure, and that is a BIG if, they will have the benefit of working solely with one creditor (Ambac) as opposed to thousands of municipal bond holders. Ambac continues to make up the difference in what Vallejo contributes to the bond trustee and what is paid out to bondholders, and when their bonds mature in 20-30 years, hopefully the issuer will be in a better financial situation. Ambac retains any claims against Vallejo until said claims have been discharged. So dont go all chicken little yet on the muni market, things are functioning quite fine at the moment. Yields are low, buyers are ample, and taxes are only heading higher.

  5. Anonymous

    vallejo won’t bankrupt ambac… but this is just the first shot across the bow. Cities are losing tax revenue at a rapid rate, many more to come. The US has never been in worse shape to face a serious recession, debt is huge and widespread and low interest rates won’t fix the problems…

  6. peter

    what happens with ABK, when the debt they issue at 8 or 9 or 14 pct cpn?….how will the rating agencies reconcile that with AAA or AA, and who will buy insurance from them (“monolines”) going forward…they mkt will determine very early this won’t work (at least with current proposals).

  7. Anonymous

    Personally I know nothing about Vallejo, but on another blog some commenters indicated it is a perfect storm of financial disaster: tax base cratered when a nearby military base was shut down, and its political system is approaching dysfuction–well beyond the usual dithering that goes on in muni-land.

    So maybe they are not a harbinger of anything. I suspect a muni or two goes broke every now and then in good times and bad, when these kinds of things happen.

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