Monoline Death Watch: CDO Unwind Disputes

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Reader Abdul sent me a piece that ran in the New York Post on simmering disputes between investment banks trying to unwind CDOs and monolines that provided credit enhancement. Yes, I know the Post isn’t the usual place to see what amounts to breaking financial news, but it was the first out with some stories on quant meltdowns, so it isn’t completely unheard of.

I’m posting this for two reasons:

1. To see if any readers can confirm, deny, or refine

2. To clarify a wee point that is a bombshell if true. One of the big defenses of the bond insurers against Ackman, the other shorts, and the regulators, was “You don’t get it. On many (by implication, most) of these structured finance guarantees, we don’t have to pay the piper till so far down the road that on a DCF basis this is chump change.” I dimly recall that the terminus was asserted to be when the CDO was finally dissolved and all claims finally settled (or it might have even been when the underlying mortgages finally matured). Given that most CDOs have a three to five year life, I failed to understand how these vehicles could have gotten AAAs if the insurance really worked in most cases as asserted (as in it would pay out only ages after the CDOs were fini). But never underestimate rating agency stupidity, I suppose.

The article suggests (but isn’t clear) that the bone of contention is that the unwinding of the CDOs would accelerate the insurer’s liability. On one level, that makes sense, but on another, if it is tied to the final resolution of the underlying mortgages, I don’t see who you can dissamble these CDOs (which was a conclusion I had reached a long time ago).

From the Post:

Battered investment banks trying to dump billions in soured mortgage securities are being challenged by struggling insurance companies that claim such efforts could cause them further pain.

It’s a battle that pits large financial firms like UBS, Merrill Lynch and Citigroup against insurers MBIA, Ambac and others. These insurers, which the industry refers to as “monolines,” provide specialty insurance used to protect investors from losses on various types of debt securities.

At issue is a type of protection that banks have obtained against defaults that is now preventing them from purging portions of their holdings of arcane mortgage securities known as collateralized debt obligations.

Under the terms of this protection, the banks need approval from the monolines in order to unwind these securities – and obtaining that OK is proving difficult in some cases.

For the past several months as the credit crunch has pummeled mortgages and other forms of debt, a lot of collateral used to form CDOs has triggered defaults due to rating agency downgrades. As a result, if the banks begin dumping these problem securities, financial guarantors would be forced to pay default claims almost immediately – a tall order for companies whose financial future is already murky.

Typically, monolines pay out claims on losses over a period of 20 or 30 years, but the types of sales that the banks are looking to score would accelerate those payments and further hammer companies already hurting.

The banks appear to recognize that the insurers are unlikely to be able to cough up the cash needed to pay off these losses. That has led to discussions about whether to waive claims payments in exchange for cash or warrants in certain publicly traded monoline companies.

“Clearly, liquidation into this market is tough but holding on long term might not be your best case,” said Joe Messineo, who runs a New York-based structured finance consulting firm. “Not many people envisioned the magnitude of this would come down to documents.”

None of the monolines embroiled in this battle returned calls for comment. Neither did the banks.

Although there are hardly any buyers for CDO paper, the banks would be able to unwind the CDOs and essentially purchase the assets that comprise the complex debt structures – a move that might allow them to better assess the value of the assets and at least eliminate the fees associated with holding onto the debt as CDOs

Update 5:00 AM: The alert folks at FTAlphaville have come to the rescue:

The Post, we assume, is picking up on disputes such as this one, between XLCA and Merrill Lynch. The quid pro quo for cheap insurance on senior CDO tranches then appears to have been “control rights” over the liquidation of those CDOs in the event of default.

The whole thing is a legal mess. Existing CDO documentation would likely have given “control rights” to the most senior noteholders, not distant swap counterparties, so there’s plenty of room for disagreement.

They have some further comments….but any readers with insight are most welcome to provide input.

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  1. Anonymous

    OT: Regardless of a few trillion burned up here and there by derivaitives, a long winter coming for everyone!

    “Heating oil, which cost $3.29 a gallon in January, will likely cost $3.83 in December, according to the government’s Energy Information Administration.”

  2. Anonymous

    Each contract written by the monolines was a specific contract, with specific terms. As I understand it, they have admitted that they are all different, but have used the deferred payout ones as the examples in their rebuttals to Ackman.

    Their problem is they are so highly leveraged that, even if 5% to 10% of their deals are of the type Ackman asserts, they are dead in the water.

    I guess, they are also having trouble convincing their auditors that they shouldn’t have to take fair value write downs…and I presume they’re showing the auditors the actual contracts?

  3. RowdyRoddyPiper

    As Anonymous said, the specifics may vary from insurer to insurer and even from deal to deal at the same insurer. However every monoline I have dealt with has their own form of confirm that they start all trades with. There is an exceptionally small amount of room for negotiation on these terms and in at least the last 2 years, I’ve never seen them budge on being the controlling class.

    Additionally every contract I have ever seen doesn’t require payment for default losses until the legal final maturity of the deal which is a long long way in the future (20-30 years). I don’t think the monolines are in anything resembling good shape, but they do have on their side the tried and true tool of any insurer trying to make a back, deny and delay claims payments.

  4. Anonymous

    The overwhelming practice of the insurers is to have control rights on the CDOs. The rating agencies required this for the companies to get high ratings. The agencies also required that the companies not post collateral in their guaranty business and as of yet we have not seen one of the Aaa guarantors have to post collateral. Most of the examples of deals where there is not control is in 2004 or earlier deals which are less likely to default.

    The XL case is instructive. They are suing Merrill simply because they say Merrill transferred their control rights to another party. That is how serious the insurers took the rights.

    The risks are not so much that they don’t have control rights on the direct CDOs it is the inner CDOs that they don’t control that have given them problems.

  5. Anonymous

    Interesting conflict of interest…

    …first, the ratings agencies required that the monolines possess control rights in order for the *monolines* to get AAA ratings…

    …*then* the ratings agencies granted AAA ratings to *CDOs* whose monoline insurance was worth much less than it appeared on a TVM basis…

    …which the ratings agencies *had* to know since they required the insurance companies to essentially structure things this way.

    It really looks like the ratings agencies had to have intentionally structured market terms so that CDO purchasers were going to be misled as to the TVM value of their monoline insurance coverage.

  6. Ginger Yellow

    Re: the XLCA case

    It’s a bit more complex than people are making out. XLCA’s involvement wasn’t as a primary market guarantor but as a secondary market wrapper in a negative basis trade. Basically ML held onto the triple-A tranches, took out a CDS with a monoline, and pocketed the difference between the cash and synthetic spread, thinking that the wrapped bonds were basically risk free. Big mistake. Loads of banks encountered similar problems with their negative basis books when the monolines ran into trouble late last year.

    What happened in the Merrill/XLCA case is that ML took out protection on the subordinated ‘A-2’ triple-A tranches with XL, while taking out protection with MBIA and/or other parties on the super senior ‘A-1’ tranches. Now, according to XL, some of the contracts state that XL will have voting rights for the ‘A-1’ and ‘A-2’ tranches.

    The thing is, XL’s argument that ML has given someone else those voting rights is entirely speculative. XL only cites a statement by MBIA that it has sole controlling rights in the CDOs it participates in, which may or may not be true, and it has no good evidence that MBIA has actually wrapped any of the deals. There’s also a lot of back and forth about whether representations made in emails but not included in the final documents have any force (probably not, if precedent is anything to go by).

    A far more pertinent case is one between Merrill and UBS over the CDOs Hartshorne, Lancer Funding 2 and ACA ABS 2007-2, where the documentation is ambiguous as to who gets the final say in a liquidation. The senior noteholder is the controlling class, but the subordinated noteholders get a veto if the action would cause a default. The trustee has had to file an interpleader motion to get a judge to resolve the inconsistency.

    My publication has written many articles about this issue – if you have specific questions, fire away.

  7. Yves Smith

    Ginger Yellow,

    This is very helpful. Let me ask some very basic questions:

    1. How often are these liquidations arising (order of magnitude) and what is the triggering event? I assume it’s not happening all that often given the legal food fight that erupts.

    2. Am I missing something, or are the monolines’ (let’s stick with the primary guarantor case) position (in having the controlling say in a liquidation) not as unambiguous as they indicate? I’d be surprised you’d be seeing this sort of litigation (assuming this is more than one or two oddball cases of disputes between primary and secondary guarantors) if there wasn’t a bigger issue, such as scenarios arising that weren’t covered in the original documents, or the monolines having asserted rights that somehow can be breached.

    Thanks again for the clarification.

  8. bobo7874


    Thank you very much for your analysis. I would very much like to see your thoughts on Frederick Feldkamp’s articles in the International Finance Law Review laying out a position that various SEC and FASB rules, have increased credit spreads.

    If you didn’t know, Feldkamp followed up his articles with a letter to the Federal Reserve. If you want to see it, you could probably get it with a FOIA request. Or maybe Feldkamp would email it to you.

  9. realty-based lawyer


    I think I may be the source of your understanding as to the date the claims are due. (At least, I can remember posting a comment along the lines you cite.) Rowdyroddypiper and anon 10:44 are both right (I say this as the former GC of a monoline): control rights were not negotiable. Either we had the right to allow acceleration or the right to veto it. As the most- or next-to-most-senior position in the waterfall, it was in our interest for the collateral (the underlying MBS, ABS or whatever) to default, liquidate and determine recovery before we paid on the guaranty; that mitigated our risk from, let’s call it market overreaction at initiation, while at the same time delaying payment until the loss was definitively known. The downside was that the asset value might decline in the interim, but we felt that it was more likely there would be an initial drop followed by some recovery. And of course we wanted to control the process, and felt that surrendering control went with being junior (as was historically the case with senior/sub debt). The result is that we had the option to extend payment to the maturity of the CDO (or any of the underlying collateral), generally set at a period distant enough to allow for collection of recoveries on the underlying and on the CDO itself.

    I’d have strenuously objected to the sub debt/equity having a veto right. We had a whole round robin of alternatives. Of course, that doesn’t mean it didn’t happen…

    Ginger Yellow: as to the ML/XL dispute, I also have read the pleadings. It’s my view that XL has as yet no claim, whatever ML’s rights, since the XL language requires ML not to have followed their instructions. ML hasn’t defaulted until XL has told them how to vote and they haven’t complied. We’ll see how the court rules.

    Would appreciate a link to the ML/UBS pleadings, as well as your firm’s articles. My e-mail is RBLawyer at

  10. Ginger Yellow

    “Ginger Yellow: as to the ML/XL dispute, I also have read the pleadings. It’s my view that XL has as yet no claim, whatever ML’s rights, since the XL language requires ML not to have followed their instructions. ML hasn’t defaulted until XL has told them how to vote and they haven’t complied. We’ll see how the court rules.”

    That’s been my view as well, and it’s reinforced by the most recent filing from ML in the summary judgement motion. The basis of XL’s case is that by entering into CDS with MBIA, ML ceded voting rights to MBIA, meaning that at some point MBIA could vote against XL’s instructions. Now, even disregarding the fact that ML hasn’t voted against XL’s instructions (there have been no instructions yet), ML cites part of the contracts with MBIA which states that if there is any conflict between exercise of MBIA’s voting instructions and ML’s pre-existing obligations, MBIA is entitled to a termination event. This would seem to be the nail in the coffin of XL’s case, although I should note I’m not a lawyer.

    Yves: It’s hard to say precisely, but there have been upwards of 150 events of default on CDOs so far. Not all of those will be liquidated, but it’s usually in the senior noteholder’s interest to liquidate and they are usually the controlling class. There haven’t been that many lawsuits so far, but that could be because the wording is only ambiguous in some small fraction of the documents. What triggers an event of default varies from CDO to CDO and structure to structure. Typical triggers include market value (MV CDOs have constituted a disproportionate number of defaults), overcollateralisation levels, and uncured breaches of portfolio eligibility criteria.

    2. I think the focus on monolines is a bit of a red herring, except in so far as monolines are known for insisting on controlling creditor status. The issue is loose documentation, particularly with regard to the waterfall after events of default. I haven’t seen the contracts in these cases, and the court documents filed in the interpleader cases so far are a bit vague, so I can’t say for certain where the difficulty lies.

    In an interpleader case filed by US Bank as trustee, they say that the controlling party is insisting that all proceeds from a liquidation should go to the senior noteholders before any payments are made to other noterholders. The other noteholders dispute this, saying that the controlling party is misinterpreting the relevant provisions. Reading between the lines, it seems that the other noteholders want to be paid scheduled interest while the liquidation goes on, but that’s largely my conjecture. The trustee claims that the provisions are ambiguous on what happens to the waterfall after an event of default, and they may well be. It could just be they want to protect themselves from a lawsuit, however.

    I can say that I and my colleagues have spoken to many trustees who say that many problems in CDO documentation are caused by replicating previously used sections, which may be incompatible with the deal specific clauses. Lawyers tend not to have much time to go over the documents before closing, and the investors themselves almost never bother. So mistakes often don’t get caught until something blows up.

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