Thursday, February 21, 2008 5 comments ++[ CLICK TO COMMENT ]++

Good Recap of the Monoline Situation by The Economist

(all quotes from Splitting headaches, Feb 21 2008, The Economist)

(source: The Economist; Illustration by Satoshi Kambayashi)

"We were not designed or structured to be the most important company in the entire financial system. -- Jay Brown, MBIA CEO"

So starts off the article titled Splitting Headaches from The Economist (February 21, 2008). That quote is from Jay Brown--the executive that ran MBIA during the early 2000's. He also happens to be the nemesis of Bill Ackman (Ackman's prior hedge fund likely collapsed upon investor withdrawl due to the SEC investigation initiated by MBIA--although he had other problems as well). The quote pretty much sums up the present situation in the monoline world. The monolines as I like to call them are commonly called bond insurers in the press. Companies a fraction the size of a large international bank have ended up playing a crucial role in the financial world.

With rating agencies preparing to downgrade them to levels that could destroy their business, and regulators pushing for bail-outs or break-ups, the monolines' moment of truth has arrived. For anyone linked to the $2.4 trillion of securities they have guaranteed, it is nail-biting stuff.

If you are a shareholder, it's beyond nail-biting (CAK may have some metaphors to describe the emotional toll of owning shares in these forsaken creatures :) ). I have followed quite a few companies in distress situations but the monolines are something. They literally move up and down 2% every day, with 10% moves on rumours happening on a weekly basis--and this has been going on for almost 3 months now.

The life of the monolines have taken many twists and turns, with so many vested interests trying to help and hurt them, that it is on par with a Shakespearan play. Unlike a play, though, the end can pop up any minute; or the end may be in 10 years (when we are certain of subprime mortgage losses and recoveries). Like all plays this too shall end... For once (I generally don't like films with Hollywood endings), I seek a happy ending to this tale.

Though no agreement had been reached as The Economist went to press, the industry had begun to embrace radical change. FGIC, the fourth-largest monoline, filed an application to split itself in two. Ambac, the second-largest, began work on plans to raise $2 billion in capital as a possible prelude to a break-up. And the rehiring of Mr Brown was seen as a sign that MBIA, too, is thinking the unthinkable.

I have generally looked upon a break-up of the monolines with some suspicion. The legal liability from the structured product insurance buyers can be massive. However, like MBIA--which was against a split early on--I have come around to the thinking that a split can work. If the state provides legal cover and if enough claims-paying ability rests with the structured products, I think a split is quite attractive.

Some see this as a negotiating ploy. The monolines know that, by threatening to break apart, they may force Wall Street banks to stump up the cash to keep them whole.

I also used to wonder if this whole split idea was a bluff. Right now, though, I'm of the opinion that it can work as long as the insurance regulator approves of it and the structured product insurance buyers think it is the best possible plan.

Calculating the banks' potential monoline-related losses is more art than science, and estimates range from $7 billion to ten times that. A new report by Moody's puts the CDS exposure alone at $120 billion for a group of 20 large banks. In the event of monoline downgrades, the banks may have to raise their counterparty reserves by a combined $7 billion-10 billion, reckons the rating agency, rising to $20 billion-30 billion if the value of hedged securities falls far. Spread around perhaps two dozen lenders, that number, though big, does not look terrifying.

One thing I don't get is how almost everyone assumes that the structured product insurance buyers were the banks. How about hedge funds, investment funds, and others who bought the insurance? In any case, the whole loss argument, as pointed out in the article, is a guessing game with huge error tolerance. Needless to say, guessing a large number puts you in newspaper headlines so it is in every media-seeking person to publish a big number. Given that everything is a guess, no one can refute it rationally.

The regulator and governor are shedding no tears over lenders' losses. Their primary concern is the $2.6 trillion, tax-exempt municipal-bond market, used by cities, universities and the like to raise long-term funds, much of it from individuals. Were the monolines to lose their top-notch ratings, they fear, many issuers could struggle to meet higher funding costs.

I don't agree with the article here. I don't think the regulator will value muni bonds over structured products. Eric Dinnollo has repeatedly tried to maintain a neutral stance. The people who are biased towards one side or other are politicians (like Elliot Spitzer, the New York Governor), shorts, or those with vested interests (eg. citizens who don't want to pay the higher premiums being charged by Berkshire Hathaway Assurance or others untainted by the present problems).

There are definitely issues in the municipal bond arena...

Municipal borrowers are already being affected by the lack of confidence in the insurers. Overall issuance was 38% lower in January than the year before—though other factors, such as the economic slowdown, were also to blame.

Worse, two little-noticed but important bits of the market have imploded this month, and there are fears for a third, known as closed-end municipal-bond funds. In the first, vehicles sponsored by banks raise short-term money by issuing “tender option bonds” (TOBs), then use it to invest in longer-term municipal bonds and the like. Buyers have fled these programmes, in part because of worries over muni-bond insurance. The banks behind TOBs are having to buy up the unsold bonds, further straining their balance sheets—though losses should be manageable as the bonds are high-quality.

Problems in “auction-rate” securities are causing even more alarm. In this $330 billion market, long-term bonds are, in effect, transformed into short-term ones by having the interest rate reset in auctions every week or month. The allure for issuers, including hundreds of municipal bodies, is lower interest rates than typical long-term bonds, and the ease of paying down debt if they build up a surplus, by simply taking part in the auction themselves...

This month, however, dozens of auctions have failed as investors have questioned the quality of the assets on offer. Tens of billions of dollars of bonds went unsold last week...

Auction-rate bonds may never recover. That would not be catastrophic. They are extra gears, engineered by over-achieving bankers, rather than essential market cogs.

I don't have much knowledge of auction-rate securities but I suspect this is probably the beginning of the end of them.

The more pressing question is whether the government should intervene in any other way than encouraging talks. There are grounds for scepticism. As painful as the disruption in municipal markets is, it looks temporary. Rates fell this week, and high-quality issuers were able to raise finance in municipal-bond markets.

Moreover, there is no supply crisis in the monoline business: Warren Buffett has entered the market (even offering to take on rivals' municipal businesses) and some less-troubled monolines, such as FSA, are grabbing market share. The monolines' woes are already largely priced in. There is scant evidence that leaving their fate to market forces, though it may be painful, would bring down Wall Street banks. If the banks see the danger growing, they will have even more incentive to find the money to help.

On top of which, a state-mandated break-up could trigger a wave of lawsuits, further eroding trust in the system. Eager as they are to be seen doing the right thing, Messrs Dinallo and Spitzer should wait to see graver danger than this before they meddle in private contracts.

Speaking as a shareholder, I don't want the government to intervene. They should simply provide guidance but forcing things one way or another can have unintended consequences.

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5 Response to Good Recap of the Monoline Situation by The Economist

February 22, 2008 at 11:22 AM


You said: "Eric Dinnollo has repeatedly tried to maintain a neutral stance. The people who are biased towards one side or other are politicians (like Elliot Spitzer, the New York Governor)"

What planet are you on? Who do you think Dinallo works for and who do you think is calling the shots? Did you notice that Spitzer spoke first at the hearing last week and had about an hour of face time vs about 15 minutes for Dinallo? Do you think Dinallo is not a politician? Did you listen to his testimony last week that clearly stated that his first priority was propping up the muni market - and when asked about the fate of the banks' policies more or less said they are on their own? He only started to care about the banks this week - no doubt after they promised to sue his ass back to the stone age if he proceeded to do a split that left their policies worthless.

This thing has become entirely political at this point and it is only the threat of litigation that has kept Spitzer from imposing a split so far. Did you notice how MBIA has done a 180 in the space of a five days? A week ago their strategy was raise capital, hunker down and outlast the storm. Since Tuesday they have fired the CEO who was defiant in opposing a split, brought in a new guy who was talking split on the first day on the job, and just in case anyone missed their change of heart, they made a public display of leaving a trade group because they no longer believe the muni and structured finance books belong in the same company. They are clearly trying to curry favor with the regulators so they won't put them into rehabilitation.

I think it is hard to predict what will happen because there are so many non-economic factors at play here. The only viable plan from an economic and legal standpoint, I believe, is something along the lines of what Ackman proposed earlier in the week - unless you assume there is some massive amount of capital poised to enter the business. I don't see anyone with a big checkbook who is ready to invest in any configuration that exposes them to the risks of the structured finance book. The only way I see a lot of capital becoming available is if the rating agencies suddenly move the goal posts on the muni business and say it only needs a fraction of the capital they thought it did in the past. Doing so would be the coup de grace for their credibility, but stranger things than this have happened when politicians get involved in a financial crisis. It would not shock me to learn that Spitzer will promise the rating agencies a free pass on litigation/investigation by NYS if they give the monolines a get out of jail card here.

Stay tuned. I suspect we'll have some clarity by the end of next week. The rating agencies can only hold off for so long.

February 22, 2008 at 1:46 PM


I don't dispute your assertion that this has become very political or that Dinallo was hired by Spitzer. People maybe influenced one way or another, but they have some basic duty that they uphold. For example, a lot of key services, say the police force, is controlled by the government. The governemnt even appoints/hires the employees to run these services. But that doesn't mean that a person in such a position can arbitrarily do things even if the senior government officer wants them to do it. In this case, the insurance regulator likely has to follow the rules set out by insurance regulations. We know the Governor only cares about muni bonds (he also doesn't get along with Wall Street--as per his past confrontations). But I don't think one can say that the regulator will pick one side no matter what.

If they absolutely had to pick to pick one side, they will pick the muni bond side but we are not dealing with a clear-cut binary choice. It's more complicated.

Maybe I'm biased (being long Ambac) but I perceive what happened in the last week differently from you. I actually think Spitzer backed off due to Dinallo--not the other way around. If you remember, Spitzer said that something should hapepn within a few days. But his office backtracked later, I believe, due to influence from Dinallo.

Ackman's plan is nothing new. It's basically status quo, except for cutting off dividends to the holding company. I mean, if nothing was done right now, Ackman's plan will unfold (except dividends will be sent to the holdign company). As things stand right now, the company will offset the losses in the structured product side with earnings from the muni bond business. The amount sent to the holdign company is very small anyway (generally a few hundread million on revenue of a billion). His "new" plan is nothing new at all (even his call for cutting off the dividends is nothing new; he said that over an year ago).

This whole affair will end soon. It just can't keep going on. I say we'll know the strategy within a few weeks.

February 22, 2008 at 4:58 PM

The pace is picking up. FT reported
2- 3 bill cash injection + ABK capital raise pplan MAY be announced early next week.

February 22, 2008 at 7:30 PM

Share dilution is going to be MASSIVE--but we have little choice (unless we go into run-off). I just hope they do a rights offering backstopped by the bank consortium.

It's all very complicated. I don't know how you are supposed to raise $2 billion when the market cap is $1b and book value is $2b. Isn't that kind of theoretically impossible? I'm guessing, as has been mentioned in the past, that the banks will offer a line of credit or some sort of loan for part of the capital.

I'm thinking a split is still in the works. I've been reading up on insurance company splits and will post something on that soon (nothing major but just a historical recap). For anyone interested, look up Cigna. It was a P&C insurer that did a split (but I"ll note that it was not a monoline)...

February 22, 2008 at 7:31 PM

If there is a rights offering, it may have to be priced at least 50% below the current price :(

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