Monoline Downgrade Fallout: Muni Prices, MBIA Collateral

In the anxious January/February period, when New York Insurance Superintendent Eric Dinallo made Herculean efforts to come up with $15 billion for MBIA and Ambac, it was a high-stakes drama, since it was assumed that the loss of the AAA ratings would End the World of Finance As We Know It.

Now that the once-unthinkable has come to pass and the two big bond guarantors are no longer AAA rated, the reaction is more muted. Hey, when you’ve got the Fed backstopping the financial system, why worry? But the monolines have been on the ropes for months; the rating agencies have given plenty of warning of the likelihood of downgrades (although Moody’s cutting MBIA from Aaa to A2 on its insurance sub was a big surprise), so investors have had time to arrange their affairs accordingly. While we’ll no doubt see knock-on effects for some time, perhaps we’ll escape worst-case scenario of cascading forced sales.

But don’t kid yourself that there won’t be dislocations, particularly since they’ve already started. Indeed, the generally positive Wall Street Journal is chastened:

The long-anticipated credit-rating downgrades of the nation’s big bond insurers are pressuring financial markets, perhaps worse than expected.

The Journal describes another shoe that is dropping:

Financial firms like Bank of America Corp., J.P. Morgan Chase & Co., Depfa Bank of Dublin, Citigroup and several other European banks are involved in the business of backstopping municipal-bond issuers, whose debt often is also insured by bond insurers. If Wall Street can’t sell the bonds, called variable-rate demand notes, in weekly or daily scheduled sales, they or the investors can exercise their right to sell it to banks that have agreed to be buyers of last resort.

Those obligations are coming home to roost as money-market-fund managers sell out their positions on bonds insured by Ambac or MBIA. In some cases, the bonds must be sold by the funds to these backstop banks if the ratings of the insurance company reach a certain threshold.

Of the approximately $420 billion market for variable-rate demand notes, about $70 billion is insured by Ambac or MBIA, according to industry estimates. Of that $70 billion, bankers said as much as $35 billion is likely to be sold back to these banks, further straining their balance sheets.

When these banks do step in, the interest rate on the bonds typically rises, hurting issuers. Issuers are also forced to repay the full principal on their debt sooner than their original 30- or 10-year maturity.

Bloomberg reports that the muni bond market was hard hit, since it already had a fairly heavy calendar of new issues:

U.S. municipal bonds dropped, driving benchmark 30-year yields to the highest since July 2004…

The municipal market sagged for two weeks amid above- average issuance, selling related to bond-insurer downgrades and property-and-casualty companies liquidating to meet flood- related claims in the Midwest, according to David Thompson, president of Chicago-based bond dealer Griffin, Kubik, Stephens & Thompson Inc.

“A `perfect storm’ of supply” has been driving declines, Thompson said in market commentary today…

Most benchmark yields rose this week to levels last seen after the collapse of the auction-rate securities market and liquidations by some municipal-bond hedge funds in late February…

“There’s virtually no bid out there right now,” said Michael McKenna, a trader with Livingston, New Jersey-based GMS Group LLC. “There’s such a huge liquidity issue in municipals again. We’re getting hit.”

The Financial Times tells us that banks and investment banks have $125 billion of guarantees from Ambac and MBIA, which support various structured credits and other assets. The only recent estimate we’ve seen of possible losses from them is $10 billion for Citi, Merrill, and UBS, the firms with the greatest exposure.

We had commented yesterday on MBIA’s need to provide extra collateral on its guaranteed investment contracts as a result of the downgrade (and corrected an erroneous surmise of its impact on claims paying resources). MBIA announced that will have to post $4.5 billion in collateral on its GICs and may also face $2.9 billion in termination expenses on GICs. The insurer said it has $15.2 billion available to satisfy these needs. This is consistent with the estimates in their latest 10-Q.

The Financial Times provided further detail:

The ratings cuts are not expected to have a significant impact on the need for the bond insurers to post collateral on derivatives and other contracts. According to analysts, only further downgrades to the triple B category would likely trigger demands from banks for collateral payments.

Now, to continuing debates about the endgame, which (let us stress) is not imminent. However, the monolines having nada in the way of a viable long-term business strategy (limited credit enhancement opportunities to begin with due to absence of AAA; bona fide risk assumption now required due to changes in muni bond rating practices thanks to Congressional pressure, something they’ve never done intentionally; and generally bad outlook for municipal creditworthiness). So while they may find the occasional bit of viable business, they are effectively moving towards a run-off, whether they have admitted it to themselves yet or not.

Felix Salmon had a interesting conversation with Josh Rosner, who (like Felix) has been talking to the NYSID. Rosner said that the regulator would block the credit default swaps holders right to accelerate (demand immediate payment) in the event of insolvency or custodianship (which we indicated was unlikely). Felix quoted Rosner:

I expect that the NYSID would ultimately attempt to abrogate any attempts by counterparties to use the acceleration clause. That is not to say I agree that it is right to violate contracts that the NYSID knew existed nor is it to say that I believe they could do so without it leading to protracted court challenges, rather it is to say that is my expectation of what they would likely do to protect claims paying resources for muni policyholders.

Felix also asked if Rosner thought the monolines would make good on their commitments:

If policies were all to pay over time, assuming no further degradation in the macro economy and thus deterioration of CMBS and other commercial asset classes they should be close to being able to meet their obligations at maturity. I do, however, expect further deterioration so, at this point, I am comfortable saying that no one can honestly tell you whether they will ultimately have enough $.

Finally, the GIC misque led me to dig deeper into MBIA’s statement that it has $16 billion in “claims paying resources”. It appears that MBIA defines the term in a way that departs from that used by the industry association, the Association of Financial Guarantee Insurers. Since this figure, although mentioned in SEC filings, is published and computed in an operating supplement that is subject to neither GAAP nor SAAP, this deviation no doubt is permissible.

I’d be curious to get reader input. I’m disturbed by MBIA’s propensity to stretch the truth to near the breaking point, and the differences to me look significant. One item, flagged in the discussion below lifted from the revised version of the post, seems particularly aggressive. There are other disparities, but it isn’t clear whether other financial guarantors take similar liberties.

However, the reader input on the GIC question led me to look deeper into the definition of claims paying resources, and I am troubled by what I see. MBIA’s statutory surplus, as shown for its combined insurance companies at the end of 2007, was $3.7 billion (versus $4.1 billion the prior year end). That is a lot less than the so-called claims paying resources. This concept is used by bond insurers (my impression is not by the insurance industry generally; “claims paying ability” which is usually a rating, is a different concept).

CPR is equal to capital (which in insurance lingo is surplus) PLUS the unearned premiums (this definition comes from the financial guarantors’ industry association, the AFGI). Yet in MBIA’s case (per its statutory filings) the unearned premiums (year end 2007) show $3.5 billion of unearned premiums (see the liablity side of the balance sheet) while the asset side shows $7.3 billion of uncollected premiums. Query how you get to $16 billion if the definition of claims paying resources is surplus + unearned premiums.

Aha, but it’s in the operating supplement, page 7, which as our former general counsel points out, is prepared in accordance neither with GAAP nor SAAP and “should be treated with due caution”. Using the year end figures to make it comparable to the statutory report, they add a $2.7 billion contingency reserve to the surplus and $2.6 billion of present value of installment premiums (I have serious problems with that concept; if you are a bank, you don’t get to discount your future interest spread and count its as some sort of capital). They also show $900 million in “Loss and LAE reserves” and “soft capital” of $850 million.

What raises my eyebrows (aside from the notion of the present value of installment premiums) is that the operating supplement shows that their claims paying resources increased by $1.5 billion by the end of the first quarter versus year end The change is largely explained by the change in “Loss and LAE reserves” which increased by $1.2 billion since year end (note that “Loss and LAE reserve” corresponds to the total shown for “Loss” on the year end statutory balance sheet).

Any readers who know this area are encouraged to comment.

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  1. Richard Smith

    If Ram Re and Channel Re are drastically downgraded, or go bust (I can’t guess how likely either of these events is), does MBIA suddenly have an extra $50Bn of ABS CDO risk? Things might happen rather fast after that.

  2. Sivaram Velauthapillai

    With respect to claims-paying resources, although you claim MBIA is “stretching the truth” that is pretty much an industry standard. If you are expecting MBIA and Ambac to have $15 billion in excess cash, they don’t. The claims-paying resources includes non-cash items such as present value of future premiums (for muni bonds this is genereally already collected in advance (i.e. pre-paid in some sense.))

    To the monoline bears and the clueless, this may seem like “stretching the truth” but it kind of makes sense to me (as a layperson shareholder). Many of the claims that may arise (interest and principal due upon default) are due over the next 10 to 20 years (in some cases as much as 40 years I believe.) So, it doesn’t make any sense to require $15 billion in cash up front. As long as the cash will be there, the claims will be met. The bears, most of whom really don’t know much about credit instruments, never seem to understand why changes in credit instruments held to maturity doesn’t mean much. If you buy a bond and it drops in value it doesn’t mean anything if you get re-paid on maturity. Unfortunately for monoline shareholders like me, the accountants are totally incompetent with their fair value accounting (they have caused hundreads of billions in losses for the banks in my opinion (if marks reverse) and the accounting profession really needs to re-evalute themselves if my scneario unfolds (the rating agencies also seem quite incompetent.))

    Furthermore, a lot of the premium is pre-paid so the insurers have collected the money but haven’t claimed it. This is generally the case with muni bonds (they are pre-paid upon issuance). Insurance on structured products may not be pre-paid to the same degree (however, most of the core business of these monolines are the muni bond business, and if someone wants to “cancel” insurance on a structured product (assuming it’s possible), the mononlines will happily avoid receiving the payments while getting rid of the exposure.) The fact that a lot of the insurance is pre-paid is one reasons the monolines don’t face a “run on the bank” and can operate for 10+ years without any new business. This is also why the regulator really can’t do anything legally (there is ample claims-paying ability; politicians, however, are irrational so, although Eric Dinnallo seems to be a good guy, it’s hard to say if something crazy will happen.)

    Needless to say, the short-sellers, who otherwise wouldn’t make any money, propagate misleading opinions in order to overcome the claims-paying ability. Where I can see a weakness with the monoline is if they need to post collateral (SCA had to) or pay losses right away. I’m not an expert on this but this is likely only possible with structured product insurance. The short-sellers have poucned on this weakness lately (they really have nothing else to do add anymore). I suspect the insurance buyers (mostly banks) will not have an economic interest in asking for payment up-front (assuming they can) because it will bring down the whole system and they will end up with nothing anyway. But that is the only risk I see.

    On a different note, the short-sellers seem to muddle the issue further by bringing in risk related to the investment business of the monolines and mixing that up (on purpose I assume) with the insurance business. Most monolines have a side business where they manage portfolios (money collected on behalf of issuers are invested rather than sitting around doing nothing) and that investment business is sensitive to ratings, asset declines, and so forth. This is where MBIA and others may need to post seemingly large collateral upon rating downgrade or possibly capital losses on positions.

    For instance, William Ackman’s new attack on FSA, a AAA-rated guarantor with seemingly low exposure to subprime mortgages, seems to be related to their investment portfolio and not necessarily their insurance business. I’m not privy to Ackman’s analysis or presentations (only the shadow world consisting of some investment funds and hedge funds have access) but he seems to be claiming that FSA’s assets have declined substantially and hence their liabilities are higher than assets by several billion (he has said that all the monolines except BHAC will fail (I assume this includes Wilbur Ross-backed Assured Guaranty as well) but his main point with FSA seems to be the investment losses). Of course, the fact that assets (say US Treasuries) can be sold off to meet the collateral requirement is never mentioned by anyone (I assume purposely to paint a more riskier picture of the monolines.)

    I suspect William Ackman’s bet against FSA is going to fail but one can never be sure (short sellers just need irrational behaviour in markets, not necessarily fundamental detrioration). I don’t know about the quality of assets FSA has in their investment portfolio but losses don’t really mean much if they are simply paper losses. In any case, assuming my impression of William Ackman’s primary attack is correct, none of this really has any impact on FSA’s insurance subsidiary. All this just impacts their “holding company” and their parent company, supposedly a conservative-run French bank, Dexia.

  3. David Merkel

    On the variable rate demand notes, at present, the liquidity providers have to absorb bonds that can’t be remarketed, but typically there are downgrade/insolvency provisions in them that if the financial guarantor is impaired, they don’t have to buy the bonds. The liquidity provider is a fair/cloudy weather friend. When it rains, he goes away.

    BTW, the parallel to capitalizing interest margins at a bank is not exact. If a premium stream is guaranteed to be paid under an old style fixed premium insurance contract, or it goes out of force, actuaries typically take that into account in setting reserves. We certainly do that in life insurance.

  4. Yves Smith

    Thanks for these comments. However, per above, my point re MBIA was far more specific: the industry has a definition of what claims paying resources is. It’s stated on their website, if you click on the link. The MBIA operating supplement shows they threw A LOT of additional items in beyond what the industry says is CPR into their computation. I have no idea whether that’s common, but it looks sus.

  5. Scott Finch

    the uknown unknowns are most definitely lurking. caution beware.

    i too would be extremely suspicious of additional claim paying resources used to support a book. it seems to me in determining the quality and respective characteristics of the CPR’s used above and beyond industry standards one would be forced to make assumptions on little information. I would be more interested in analysing the quality of the industry standard CPR’s relative to the liabilities that they must support while removing those CPR’s that are above and beyond the norm.

    I would be more interested in dropping seemingly weird CPR’s from any analysis or at the very least breaking apart CPR’s by commonly used industry wide resources.

    like I mentioned above the unknown unknowns are usually the real destroyers.

  6. Aaron Krowne

    What a freaking cesspool. These guys are regulated neither as banks nor insurance companies, taking the worst practices of both. This could only have occurred with complicit regulators (after all, they’ve kept the spigot of easy municipal money coming for decades).

    The way they are calculating “claims paying resources” is analogous to and as fundamentally dishonest as lenders who have been counting negative amortization as profits/assets.


  7. S

    I totally agree there is somthing a bit absurd about PV of future premiums when you can;t write new business. I wonder does that PV calculation include the PV of contingent liabilities when the bond holders who have strict investment criteria are forced to sell at a loss due to forced divestitures? Then again, maybe the Fed will formaslize its collateral requrement as anything that was at one point in its life AAA. Come on the writeups are going to be huge,,

    Sivaram Velauthapillai said…st lreast you have an eventual short sequeeze to look forward to on the steady decline down. When you don;t have a business model, you are worth the PV of your existing book which is looking increasingly, though not definitiviely, like it is a funtion approaching zero. Also, as for the rediculous assertion about write ups, that is truly the last refuge of the scoundrel

  8. Sivaram Velauthapillai

    S: ” totally agree there is somthing a bit absurd about PV of future premiums when you can;t write new business. “

    A lot of the premium, particularly on the muni bond side, is already collected. The amount that is future premium is around 15% of total (for Ambac; MBIA is probably similar). As long as the insurance buyer has an obligation to pay the premium, why should it not be counted? And if it is not to be counted, then shouldn’t the potential liability arising from any claims be ignored as well? Or do you come from the William Ackman school of accounting, where you don’t discount anything to present value, ignore unearned premiums (but either collected or contractually obligated to be paid), and ignore taxes?

    S: “I wonder does that PV calculation include the PV of contingent liabilities when the bond holders who have strict investment criteria are forced to sell at a loss due to forced divestitures? “

    You don’t seem to understand bond insurance. The bond insurers never guarantee AAA ratings! What they do guarantee is timely interest and principal payments upon default. The insurers never guarantee that the price of a bond won’t drop, no more than they claim it will go up.

    If someone sells their bond and takes a loss, that’s their problem. It’s true that some investors, particularly banks, were using bond insurance as a ratings arbitrage but the guarantors never guaranteed ratings.

    S: “Also, as for the rediculous assertion about write ups, that is truly the last refuge of the scoundrel”

    We shall see. I’m putting money where my mouth is and what are you doing, sir? If the accountants are as incompetent as I think they are, we should see some write-ups really soon… likely by the end of this year (if my thinking is right, mortgage default rates should stabilize within 6 months, and then some marks to market should reverse)… Not just at the monolines but in many of the banks as well… And no, this isn’t the refuge of a scoundrel, although I can see how you may be mistaken since you may have been hanging around them too much; this is my belief…

  9. Yves Smith

    sivaram velauthapillai,

    You have clearly not looked at the schedule I referenced in the operating supplement. The installment premiums are SEPARATE AND APART from unearned premiums. The industry definition of CPR is surplus + unearned premiums. Those two together come to less than half of the $16 billion that MBIA claims in CPR through its awfully liberal, non-standard definition.

    Moreover, for any municipality or structured deal where the underlying credit quality is single A or better, the MBIA insurance is now a complete waste of money. I expect anyone who entered into a contract with MBIA in 2007 to be looking for a way to get out of it. And given that management’s repeated assertions, that concerns about their credit quality and rating were unwarranted, proved to be false, I think a lawyer could get a case past summary judgement.

    And once they do that, they get to do discovery, which means go through internal documents and e-mails. Think they won’t find something damning? There is almost without exception in these situations a worry-wart who was ignored.

    That’s a long-winded way of saying I wouldn’t count my chickens before they are hatched, particularly in this case.

  10. Sivaram Velauthapillai

    YVES: “The installment premiums are SEPARATE AND APART from unearned premiums. The industry definition of CPR is surplus + unearned premiums. “

    I don’t work in the industry and can’t speak for the industry defintion, but Ambac, which I’m more familiar with, also has a seperate category for “present value of future premium”, which is seperate from unearned premium already collected. I suspect you are referring to items similar to that. I don’t know what MBIA is including in categories such as that but it sounds similiar to what Ambac is doing. Given that MBIA and Ambac were the founders of this industry and made up more than 50%+ of the industry, I would have no reason to suspect that they are not following the industry standard. They are the industry! Rating agencies and regulators have approved that system in the past so I don’t think they have any problems. The bond insurers did go through past crisis (New York default in the 70’s; Eurotunnel default in 2000’s; etc) and no one has raised these issues until short-sellers such as William Ackman made a big deal out of nothing.

    YVES: “Moreover, for any municipality or structured deal where the underlying credit quality is single A or better, the MBIA insurance is now a complete waste of money.”

    Why is it a waste of money? If someone defaults, the bond insurers will still make the payment. If you had two identical bonds, one with insurance and one without, holding the one with insurance is still better. Even if the insurance company is in run-off (the worst case), there is a high chance of you getting paid upon default; whereas the bond without insurance has not back up. The market is pricing the bond with insurance at a lower price but that is because the market is totally irrational right now.

    Furthermore, the municipalities are not the ones that pay the insurance. It’s the bond buyers. The insurance actually LOWERED the cost of bond issuance for the municipality! They have nothing to gain from terminating any contract (assuming it was even possible).

    The party that may be dissapointed is the bond buyer, but given that the insurance was to pay interest and principal upon default, not to guarantee ratings, I can’t see them having much merit. Politicians are dumb and act well after the fact (Elliot Spitzer almost destroyed these companies a few months ago for example) but that’s why we have courts. Speaking as an Ambac shareholder, I expect the courts to uphold any signed the contracts: both from the insurer and from the buyer.

    It’s obvious to me who will not want to pay the premiums. It’s not the municipal bond buyer. It’s the banks who bought the structured products. Many of them seem to have bought insurance, not to make whole upon default, but to arbitrage the rating (i.e. can hold more AAA-rated bonds than say A-rated bonds).

    YVES: “I expect anyone who entered into a contract with MBIA in 2007 to be looking for a way to get out of it. And given that management’s repeated assertions, that concerns about their credit quality and rating were unwarranted, proved to be false, I think a lawyer could get a case past summary judgement.”

    The rating still has no impact on the signed insurance contract. I hate to beat this point to death but bond insurers do not guarantee ratings. All the rating does is to indicate probability of payment. The probability is getting lower but it is a whole lot better than a counterparty in a CDS contract written by an unregulated hedge fund paying upon default.

    YVES: “That’s a long-winded way of saying I wouldn’t count my chickens before they are hatched, particularly in this case.”

    I am not counting my chickens. We are still a long way from getting through this storm. It doesn’t help when misleading views, such as what bond insurance actually means, gets propagated by short-sellers and their allies. It’s easy to blame some small company for the world’s problems but the truth ain’t that. You know something is wrong when short-sellers claim that the fate of the entire universe seems to rest on the monoline’s shoulders…

  11. Yves Smith

    sivaram velauthapillai,

    You again choose to completely miss my point MBIA is using a definition of “claims paying resources” which differs from that of the industry association. Notably, MBIA appears to be the only bond insurer NOT to be a member of the industry association. It thus appears to be using a term, defined by the association, to its own advantage to mislead the public. This is no doubt legally permissible, since the term is defined in an operating supplement subject neither to GAAP or SAAP, but it speaks again to the lack of trustworthiness of management. Warren Buffett and other investors stress that ultimately when you invest in a company, you invest in management, so this is not a trivial issue.

    Second, you are completely wrong about bond insurance, and I am surprised that you can claim to be knowledgeable yet be in error about something so basic. The insurance premiums are paid by the issuer. See here, for instance:

    Issuers that meet certain credit criteria can purchase municipal bond insurance policies from private companies.

    Yes, the cost of the insurance is reflected in the cost of the bond, but the insurance policy is with the issuer, which in this case is the municipality, and they make the premium payments (for structured credits, the monline wraps usually were not for the entire deal, but the principle remains the same).

    A municipality has every reason to try to get out of an insurance policy. The ONLY reason they entered into these agreements was to improve their rating (for instances, to turn an underlying A into an AAA). If their rating is A or higher, any insurance from MBIA is useless. Municipalities try to cure their defaults as quickly as possible (historically, they typically miss only a payment or two) because failure to remedy a default would make it very difficult for them ever to sell bonds again. They have no motivation to stick the insurer and not remedy a default; the long run costs to them are too high.

    It wouldn’t be worth it for a small municipality to fight (the cost of litigation would probably exceed any savings on the insurance) but a large issuer might, or smaller issuers could band together.

    And per 2007, I expect both investors and buyers of insurance to be looking pretty closely through Ambac and particularly the far more aggressive MBIA’s assurances that everything was fine re their ratings. There was one incident cited here where the MBIA CEO insisted they needed no more capital and the very next day, one of the rating agencies issued a sharp rebuke, saying in effect that if they didn’t raise more capital, they were at risk of a downgrade.

    There will be synergies between any lawsuits. Any overly rose statements publicly or in the course of selling bond guarantees about their ratings strength could be used to push claims of misrepresentation and fraud. Any evidence produced in litigation in a suit that actually goes to trial can be used by subsequent claimants, they become a matter of public record unless sealed (and there is no reason to expect records of any proceedings to be sealed).

    Thus successful shareholder litigation that produced evidence of misrepresentation by the monolines would lower the cost to policyholders of pursuing claims and vice versa.

    MBIA would be smart to settle any claims along these lines, but the company has consistently overplayed its hand.

    Preventing bond insurer downgrades was important enough that both the heads of the firms that would be affected (such as John Thain at Merrill) were involved in the January negotiations, and Henry Paulson tried to give an assist. It will lead to considerable further losses in the municipal bond market and the structured credit market, which will in turn lead to further losses at banks and investment banks which are already short of capital. This was widely considered to be an outcome to be avoided, but you brush it off.

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