Felix Salmon and I see the contretemps between MBIA and the New York Times quite differently, as our posts (and e-mail exchanges) illustrate. I like Salmon, but ironically, the way we got to know each other was when he savaged a Gretchen Morgenson piece, and I took issue with some of his arguments, so this latest discussion has an oddly familiar feel (I give Felix credit for being a good sport).
By way of update, Felix has weighed in twice on the MBIA/NYT contretemps (here and here) both times on the MBIA side. The second post addressed some of my and Sam Jones of FT Alphavillle’s issues with the MBIA retort to the New York Times article.
Felix seems to have missed the point of my post, which is clearly flagged in the headline, “MBIA Lies in Attack on New York Times,” namely, that MBIA’s attempts to rebut the NYT article were simply untrue as far as the main points at issue were concerned. And note that Salmon in his initial post said that he’d take the veracity of MBIA over the NYT (“According to MBIA, and frankly I trust them more than I trust the NYT on this…”).
Felix’s second post, instead of acknowledging where MBIA dissembled, plays up other arguments the company has made (“gee, things have changed, so we have better uses for the dough.”). That fails to address the lack of candor of the company, which is one of the reason it’s in the shape is in. It is no longer trusted in many quarters. As the case of Bear Stearns and Lehman make all too clear, trust in management is even more important in financial services than in other industries. Their financial statements have substantial opaque elements, as our buddy Charles Gaspario has noted, so investors are put in the position of having to take a lot on faith.
And if things have changed, and putting $900 million into its current sub makes no sense, why not dividend the money back to shareholders? That’s unconventional to be sure, but not completely unheard of (but we all know that no management will admit that they just went though a difficult, highly dilutive fundraising for naught). But if the executives were really out to maximize shareholder value, which is widely asserted to be their primary duty, that’s precisely what they’d do..
Most observers believe the monoline business model is dead, between the changes in muni bond rating procedures that are being forced on the rating agencies (ie, no more free lunches by insuring credits that were better than the rating agency marks suggested they weret) and the entry of Warren Buffet, who has an uncontested AAA, vastly more capital, and unlike the monolines, has very successful insurance operations that take real risks. Buffett will cherry pick the best risks (that’s Ajit Jain’s the head of his insurance op’s MO); good luck to anyone who’d go up against them (and that’s even assuming a new MBIA sub could get an AAA, particularly if required to reinsure the existing exposures on the current muni book, which Dinallo indicated was something the wanted).
And we have the additional complication that thanks to the fall in housing prices, which are the basis for real estate taxes on which many local authorities depend, this isnt’ exactly the greatest time to be seeking new business in the muni bond guarantee business. Historical models will prove singularly unrelaible. I find it difficult to believe that any new insurance operation under MBIA has a realistic chance of commercial success.
Felix also accepts the company line that MBIA is solvent. That is obviously currently true, but the idea that they will continue to be solvent is far more contested than he admits. He contends that (aside from the “strong” AA rating) critic Ackman and Dinallo have never disputed the solvency of the insurance ops. That is only narrowly accurate. Ackman called for both bond insurers to be put in runoff mode before the end of 2008 to keep the holding company expenses from draining funds needed to pay insurance obligations. Since that hasn’t happened, it isn’t clear what Ackman’s views would be now (he has closed his position and moved on). Dinallo is in an awkward position, having basically admitted the accuracy of Ackman’s analysis via his January-February efforts to have MBIA and Ambac raise $15 billion (the amount Ackman had indicated that the insurers would need to maintain their AAAs). It does not behoove Dinallo (or any financial regulator) to raise red flags about solvency unless a regulatory seizure is imminent. Given that he is in negotiations with MBIA, the NYT article may have been singularly unhelpful from his standpoint, since it paints a picture that the company has the upper hand.
The markets see the situation differently. As a recent Bloomberg article noted,
Moody’s Investors Service has created a new unit that surprises even its own director.
The team from Moody’s Analytics, which operates separately from Moody’s ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody’s official grades.
The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody’s credit ratings signify. And here’s the kicker: The swaps traders are usually right…..
Using CDS market prices, Munves’s unit assigns implied ratings of Caa1 to both MBIA and Ambac. That’s seven notches below junk and 15 below the official Moody’s rating.
This is the definition of a CCC/Caa rating:
Bonds of poor quality. Issuers may be in default or are at risk of being in default.
Similarly, Salmon eventually acknowledges the point made in the earlier post, that the NYT was correct in its contention that the investors would have the right to accelerate (demand immediate payment of) the credit default swaps in the event of a regulatory takeover, a point that MBIA attempted to dispute. Again, my main bone of contention with the company is the persistent dishonesty of MBIA management; I wouldn’t trust them to run a dog pound.
Felix argued that investors might chose not to exercise that option, citing the example of ACA, which was downgraded and has received a number of waivers from swaps holders. Again, correct, but he misses some key elements. For instance, he asserts the waivers are being used to permit the run-off to continue. Not exactly true. From the press release of the third waiver notice:
The extended forbearance period will permit the Company and its counterparties to continue their productive discussions to develop a lasting solution for the Company’s capital and liquidity issues. During this period, the Company plans to work with its financial advisor, The Blackstone Group, to further build upon the significant progress achieved since early December 2007. The Company seeks to finalize the terms of a solution by the end of this extended forbearance period and to proceed to closing as soon as practicable thereafter.
This basically says a liquidation or settlement of some sort is being negotiated.
More important, ACA is not a precedent for MBIA for a key reason: it’s muni operations are small relative to its total book. From FT Alphaville:
ACA was always a breed somewhat apart from the largest bond insurers, MBIA and Ambac. For a start since it started out with just a single-A rating – before being slashed to CCC – it had collateral posting written into its positions, hence its current difficulties. But that meant it was a less attractive prospect for the municipal issuers seeking a top notch rating in any case.
So the public finance portion of ACA’s (already much smaller) business is less significant – according to its website, last September, ACA had $7bn of gross par exposure in its public finance business against $69.1bn of notional exposure in its structured credit lines. So ACA is more bad bank, than good bank. Other monolines’ municipals operations are much larger overall than their lately forays into the world of structured credit.
MBIA or Ambac going asunder represents a very messy legal problem. For ACA, there is only so much in the way of assets for the policyholders to divide; the muni policyholders may or may not be treated fairly, but they are rounding error. The vast majority of claimants are in the same boat.
Per the discussion in Felix’s and our earlier post, MBIA’s CDS holders do have the right to jump to the head of the queue and take priority in payout of the insurer’s assets. The CDS holders interests are opposed to those of the municipalities who got guarantees. And to secure those rights, I think it likely that the CDS holders would threaten, or more likely, go as far as filing suit to secure their rights. Dinallo is more concerned politically about protecting the muni holders, but it isn’t clear that he can skew any settlement to (conceptually) a pro-ration among CDS and muni policy holders when the CDS policy holders clearly have a priority claim. It’s likely, though not guaranteed, that Dinallo would try to mete out an “equitable” settlement (being perceived to have screwed local communities is the kiss of death for anyone with political aspirations) and the CDS holders will be forced to pull the trigger by asserting their right to accelerate. That way, Dinallo could make clear that his options in working out a resolution were limited.
The only thing that might prevent CDS holders from asserting their rights is political considerations (for instance, pension funds who hold structured credits with CDS wraps would not want to look like bad guys with municipalities who are possible clients, ditto investment banks and banks). But these instruments got placed in a lot of hands, and it only take a few claimants to throw sand in the gears.; the others are effectively free riders.
Moody’s downgraded MBIA’s debt (the holding company) to BBB from AA. MBIA Insurance (the insurance subsidiary) has been downgraded from AAA to A.
More precisely, MBIA Insurance has gone from Aaa to A2, while MBIA Inc has gone from Aa3 to Baa2. The surplus note they used to raise capital has gone from Aa2 to Baa1
“Per the discussion in Felix’s and our earlier post, MBIA’s CDS holders do have the right to jump to the head of the queue and take priority in payout of the insurer’s assets.”
I believe Felix Salmon and you are wrong about this. To the extent a counterparty under a CDS with the MBIA regulated subsidiary has a position that has appreciated from inception to the time MBIA files bankruptcy, I believe the counterparty gets a general unsecured claim for that appreciation. And I believe the only way the counterparty would get a priority claim is for appreciation in its rights that occur after the bankruptcy, but even then only if the counterparty did not choose to terminate the contract and only if the bankruptcy court did not require MBIA to terminate the contract. Any such priority is weak gruel if the bulk of the appreciation in a counterparty’s long position under a CDS occurs before MBIA files bankruptcy.
There are select classes of creditors given priorities in bankruptcy, like certain claims for child support and alimony. If you run down the list of claims given priorities in Title 11, I believe you will not find something saying that swap counterparties get a priority for anything that happened prior to the bankruptcy filing.
Now, if the swap counterparties had contracts written by an entity other than the regulated sub, the swap counterparties may well have a priority over the policyholders with respect to the assets of the entity in privity with them. However, that is because of liability insulation arising from MBIA operating through separate entities, not from anyting in the bankruptcy code. And if the MBIA entities didn’t act appropriately with one another, then the bankrutpcy court might treat all the MBIA entities as if they’d been a single company, and undercut such liability insulation.
This lack of protection for CDS counterparties with respect to appreciation of their long credit protection positions is part of the reason why the Fed is so freaked out about credit default swaps. Some fund or bank operating out of a van down by the river and highly levered almost certainly is relying on CDSes to hedge other positions and will implode if its long positions under CDSes are vaporized because the counterparty goes bankrupt. If there’s enough people like that, the gross positions under CDSes actually matter because things do not net out.
And don’t tell me CDS holders get a priority for pre-bankruptcy appreciation because of 2005 amendments to the bankruptcy code. They do various other things, like fix certain netting and termination problems. However, they don’t fix this.
Now I have to get to sleep to wake up early for kindergarten. Anyone to relies on a kindergartener for legal advice is a nuts.
In a conversation that Felix Salmon had with one Hampton Finer of the New York State Insurance Department, he did everything he could to avoid a straight answer, which I take as confirmation (more accurately, the subtest is “yes narrowly you are right, but we think it doesn’t have to play out that way”). From Salmon:
And what about this latest storm over MBIA’s credit default swaps being accelerated if the company gets taken over by its regulator? Well, for one thing, if MBIA goes below its minimum capital requirements, NYSID is not obliged to take it over. The regulator would of course step in if MBIA looked as though it was about to declare bankruptcy or otherwise have an event of default. But there’s a very long way to go before things get that drastic.
That said, Finer was no fan of the language in those credit default swaps: in fact he called the relevant clauses “poisonous provisions”. The reason is that if the CDS gets terminated at a mark-to-market price, the buyer of protection can easily end up getting paid, in panicky markets such as this one, much more money than he would ever get if he simply held the insurance to maturity.
On the other hand, said Finer, “we believe there are ways of controlling those events of default”.
I believe the bits of Felix you’re quoting refer to rules that affect the size of a counterparty’s claim in bankruptcy against MBIA, but does not give the counterparty a priority over other creditors, so it gets dibs on assets before they do. More importantly, one would have to consider the amount of discretion a bankruptcy court has over the MTM that determines the size of a counterparty’s claim. Bankruptcy courts are famous for screwing over particular creditors to make sure pain is shared by all.
Those details of bankruptcy law are out of my ken. However, it seems likely that the regulator would seize control first; even more likely (well, if it were any insurer but MBIA, which seems to have a very bad case of denial) is that an insurer would go into voluntary runoff.
Having said that, there are very weird provisions of bankruptcy law regarding certain kinds of financial instruments. There would have been certain accounts (or was it exposures?) if Bear had BK’d that would NOT have been handled by a bankruptcy judge, I dimly recall a discussion of netting. Anyone who knows this area is encouraged to speak up.
And even if these CDS don’t give them a standing that trumps the bankruptcy process. the language on the MBIA website confirms their right of acceleration, which would seem to give them a priority in standing over other insurance policy holders.
I have been trying to reach a former general counsel of one of the bond guarantors on this issue. Unfortunately, he is a very intermittent correspondent. Since MBIA and Ambac seem likely to be in the press, I’ll probably have reason for more posts near term, and will include any further intelligence on this front.
Derivatives and bankruptcy as I (not a lawyer) understand it:
1. If a derivative holder with a claim holds collateral (e.g. repos and netting of swaps), the derivative holder can take possession free and clear. Other creditors are subject to the bankruptcy court recalling the assets.
2. If a derivative holder has managed to get payment before the declaration of bankruptcy, the 2005 law (and previous amendments to the bankruptcy law) exempts them from having to return the money to the bankrupt estate. All other creditors can be forced to return recent payments to the estate.
3. Etc is right that once bankruptcy has been declared, each derivative holder is just one of many unsecured claimants.
The tricky issue is that most CDS have pre-bankruptcy acceleration clauses. I would guess that the NYSID is very well versed in these timing issues by now.
Yves – re: consequences of acceleration
I agree with AnoninCA (and with most of etc’s comments), especially the point (AnoninCA’s third) that the ability to “accelerate” (or close out) derivative contracts as such doesn’t mean that unsecured CDS counterparties get preferential treatment in insolvency (or similar) proceedings. In such circumstances queue jumping becomes irrelevant: insolvency proceedings turn the queue into a group: the all-or-nothing of “first come, first served” is replaced by the proportionality of “all come, all served equally”.
The crucial issues are therefore (see also AnoninCA): (1) collateralization of derivative exposures on MBIA and (2) timing of close-out/acceleration.
Collateralization: I don’t know whether MBIA is required to post collateral under its CDS contracts. This may to some extent be prohibited under US/state insurance laws (on which I’m not an expert) or, even if that is not the case, an insurer may be averse to agree to collateralization, precisely because it would give its derivative counterparties an advantage (and in that sense: preferential treatment) vis-à-vis its policyholders. In addition, MBIA may have had sufficient bargaining power to avoid collateralization under its ISDA Master Agreements. I didn’t have time for more than a quick check of only part of MBIA’s 2007 Annual Report, but the report does say in relation to certain CDSs that MBIA does not post collateral. If anyone else knows more about this, it would be very interesting to hear from him/her.
Timing: AnoninCA also correctly indicates that the standard form of the ISDA Master contains many more close-out triggers than the Bankruptcy clause. In addition, CDSs are of course “privately negotiated” derivatives and MBIA and its counterparties (or some of them) may have agreed additional events of default and/or termination events. It is certainly possible that events such as a substantial downgrade of MBIA or its failure to comply with laws and regulations (capital requirement, for instance) would give at least some protection buyers the right to close-out their CDSs with MBIA and to demand payment of the replacement value of the CDSs long before MBIA gets even close to insolvency or take-over by the regulator.
These comments are very well taken.
I’ve just put up a post which includes a lengthy discussion by the former general counsel of a bond insurer on the issue of CDS acceleration. Some of the ways things play out are a bit different than one might expect due to the peculiarities of how insurers are treated in the event of insolvency.