Friday, June 13, 2008 2 comments ++[ CLICK TO COMMENT ]++

MBIA Somehow Manages to Outmaneuver Opponents

Wow. On a day when Netherlands beats France in the Euros (assuming he is a Netherlands fan, at least ContrarianDutch is getting some good news, even if it's only on the soccer field), wild action in the monoline world, mostly to do with MBIA.

Starting off, there is a report from Bloomberg pointing out that MBIA holding company CDS swaps are trading at a lower spread than the insurance subsidiary.

Protection against a default by MBIA Insurance Corp. costs more than for MBIA itself, credit-default swap prices from CMA Datavision show.

``For the moment, there's no risk at the holding company'' with the parent holding about $1.5 billion in cash, enough to cover outstanding debt of roughly the same amount, Rob Haines, an analyst at independent research firm CreditSights Inc. in New York, said in a telephone interview...

Sellers of credit-default swaps, which allow investors to speculate on a company's creditworthiness or to hedge against losses, demand 29.5 percent upfront and 5 percent a year to protect MBIA Insurance guarantees for five years. For the parent, the cost is 23 percent upfront and 5 percent a year.

The credit-default swap trading means it would cost MBIA insurance policy holders $2.95 million initially and $500,000 a year to protect $10 million in securities for five years, $650,000 more than it would for MBIA bondholders to hedge against the risk of default.

All this is temporary yet you get the unusual case where the holding company is perceived as safer. What is happening illustrates the market perception of MBIA. It gives an indication that the market thinks (i) the insurance subsidiary is riskier than the holding company, and (ii) the market also thinks the holding company can default even though the probability of that happening is pretty low (at least over the next year or two). In my admittedly bullish view, both of these stance by the market are totally irrational. For instance, it doesn't make any sense in my eyes for the holding company to have lower risk than the insurance subsidiary. Even though the holding company has $900 million (plus a few hundread million more), the insurance company is more secure for the bondholders (the holding company can spend the money to benefit shareholders at the expense of bondholders, whereas the insurance company has little leeway to do anything).

There is also heavy speculation over what MBIA plans to do with that money. Somehow MBIA ended up outmaneuvering all its opponents, including regulators (Elliot Spitzer in particular, although he fell under his own actions), short-sellers (William Ackman), and even the rating agencies. However, it's too early to call a win and it's simply a small win.

The redeployment of MBIA's capital away from MBIA Insurance is a sign the company is looking at other options to revive its business, said an industry participant that declined to be named. "You don't want to just be a punching bag for the regulator, you want to be able to show 'we have some leverage too,'" he said.

I concur with the anonymous analyst's opinion. Monolines have been steered into a corner by the regulators and rating agencies, not to mention short-sellers, and it's good to see MBIA flex its muscles a bit.

I personally don't like the new bond insurer idea but MBIA will have an easier time doing that than Ambac:

JPMorgan views MBIA as most likely to activate its dormant Capital Markets Assurance subsidiary to seek top ratings and insure muni bonds.

"While this structure is disadvantageous to both the operating company and current policyholders, in our opinion, the regulators are limited in their ability to prevent it seeing as though MBIA does not need regulatory approval to use the holding company cash as an investment," they said.

Ambac, meanwhile, said last week that said it wants to launch a new top-rated bond insurer, Connie Lee, which would be funded by surplus capital from Ambac and potentially one or more third parties.

In this scenario, however, Ambac's insurance arm, Ambac Assurance Corp, would benefit more than the holding company as Connie Lee would operate as a subsidiary of Ambac Assurance, JPMorgan said.

If MBIA can start a new insurer as a subsidiary of the holding company, it will prolong its life. Ambac already transferred the capital to its insurance subsidiary, which is regulated, so unless it can transfer than money out (government officials generally won't let you, even in good times), their only hope is with a new insurer within its insurance subsidiary.

In either case, Ambac or MBIA, I think they should wait and see how the business environment unfolds. The market for muni bonds in America is dissapearing as this Bloomberg piece alludes to with the Moody's change in municipality ratings:

A plan by Moody's Investors Service to assess states and local governments by the same scale as corporations will sap demand for bond insurance as it results in higher ratings for municipal debt, investors and analysts said.

The proposal, announced yesterday after months of pressure from public officials, will lead to upgrades for thousands of tax-exempt securities, according to Merrill Lynch & Co. That will diminish the need for states and local governments to improve the rating on their bonds by buying credit enhancement from companies such as MBIA Inc. and Ambac Financial Group Inc...

Moody's said it will unveil its plan to transition to one scale by July 31 and that it expects to upgrade some of the 78,000 municipal credits it ranks. An estimated 98 percent of investment-grade municipal bonds sold through May 19 this year would be rated in the Aa category or higher under the new criteria, Philip Fischer, a Merrill Lynch analyst, wrote in a report last month.

Moody's already rates 44 of the states Aa3 or higher, with Louisiana the lowest at A2, five steps below the top rating, according to a report it released last month.

We will have a bizarre situation if Moody's goes through with standardizing their scale, which will result in upgrade to many muni bonds. The interesting thing is that S&P says that it already uses one scale and doesn't plan to alter its rating scheme (from what I understand of their stance). We may end up with a highly complex rating scheme. On top of all this, the rating agencies are under pressure to change their rating of structured products as well (this will cause further confusion).

In the long run, this is a blow to the bond insurers. However, my belief has always been that the future of bond insurance lies in structured products and foreign markets. The market doesn't believe that and unfortunately the tainted monolines don't believe it in yet either. I believe bond insurers play a key role in secrutization of structured products and, although subprime mortgages have blown up badly, bond insurance is valuable in this market. Furthermore, I believe that there is going to be a blow-up in the CDS market (due to unregulated entities signing insurance-like contracts) and that should seperate a CDS-type contract written by a monoline versus one written by a mysterious hedge fund without an unknown amount of capital. Even a BBB-rated monoline is more likely to pay a claim than an unregulated hedge fund.

On the second point regarding foreign markets, I believe there is huge growth potential in foreign markets. There is very little penetration in Europe, and an even greater opportunity lies in emerging markets. Many emerging markets have big infrastructure needs and this is where the bond insurers can step in. On top of developing countries have dubious government backing (many keep defaulting all the time), many investors will have a hard time analyzing these situations whereas the bond insurers can do the homework (of course, their homework skill as evidenced by subprime mortgages may not be strong :( ). One thing though is that monolines used to use a 'zero-loss' underwriting model for muni bonds and if they ever enter developing countries, they need to change it. After the debacle with subprime mortgages, I believe the monolines will change their models no matter what (for those sitting on the sidelines and wondering why monolines have 100x+ leverage, it's because they expect very tiny, near zero, losses).

In the short run, the Moody's rating scale has no impact on Ambac, MBIA, et al. Apart from possibly destroying their new-insurer idea, these companies are writing zero business so it doesn't mean much. If anything, it may be advantageous for the bond insurers since it will drive away competitors. If there are question marks surrounding the rating scheme or the size of the industry, it may drive out companies like Berkshire Hathaway Assurance and prevent new ones from entering (those thinking of entering the market, such as the numerous rumoured private equity groups or the newly-formed bond insurer by Macquarie bank may re-consider.)

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2 Response to MBIA Somehow Manages to Outmaneuver Opponents

June 14, 2008 at 9:36 AM


What few seem to realize is what the bond insurers really are. They are arbitrage plays. The US muni market has long suffered from two inefficiencies that they have arbitraged succesfuly.

First, many small (semi)-governmental institutions and government related one-off deals have no ratings and it would be very expensive for them to get ratings. It is easier and cheaper to pay the bond insurers for a wrap.

Second, as in the corporate market the spread on a bond relative to a "risk-free" security (US treasuries are usually the benchmark) is based not only on compensation for potential loss, but also includes a premium for uncertainty as investors don't know which security may go bad and last but not least includes a compensation for greater volatility as corporates swing more then treasuries. This is also true for muni and structured credit.

A hold-to-maturity investor with exposure to a very broad range of bonds will require only compensation for expected losses and can arbitrage the additional spread the market requires.

What it all means is that the main US muni market will not disappear. The big states and such that are now likely to see their ratings improved are not the most important customers. The small towns, hospitals and what not who have no ratings will not now suddenly get them.

I fully agree that given the above there is a lot of opportunity for the bond insurers in foreign issues. Buying a wrap could be a great way for emerging market borrowers to access the deep liquid capital markets of the west and pay relatively low interest. Because of the uncertainty surrounding foreign issuers, and the fact that, sovereign states aside, almost none have ratings there is a very big spread that can be arbitraged.

You might be interestes to know there is also a bond insurer specializing in corporate debt, Primus Guaranty (NYSE:PRS). It has sufferes no material losses, has no RMBS exposure and yet is trading at about 35% economic book value (GAAP book value is negative as spread widening has caused massive swings in the fair value of the CDS contracts written by this company. (I do not hold PRS at this time but I have been considering buying it).

And of course it is good to see MBIA isn't down and out yet. Ambac has seen a "sympathy jump" in it's stock price too. Perhaps the monlines really can go over to the counteroffensive.

June 14, 2008 at 10:09 AM

Another excellent post ContrarianDutch. A lot of people don't seem to realize what bond insurance represents.

For instance, a sizeable chunk of so-called "municipal" bonds in North America (and a big chunk of bond insurance in Europe) are really with public-private partnerships, quasi-government entities, and so forth. This stuff isn't going to dissapear in the long term since the underlying entities won't be rated AAA and they generally don't have a long credit history.


As for Primus, Jeff of Circle of Competence wrote it up a while ago. I never heard of that company before and asked a few questions on that blog.

I haven't looked into it but if it's trading at 33% of book value, it looks attractive. Like the monolines, or even multi-line insurers like AIG, the underlying insured portfolio is very important.

I don't know about the quality of the bonds insured by Primus but one thing that did happen to corporate bonds is that there was heavy borrowing (mostly for LBOs but some to buyback stock or expand). One needs to be sure that the insurers didn't underprice the bonds since spreads were extremely low over the last few years. Rating agencies seem to be better at rating corporate bonds but I really wonder if there is going to be a slew of downgrades as the economy slows (it won't be anything like mortgage bonds but still). Having said all that, corporate balance sheets are very strong in general so Primus likely will do fine. A 70% haircut to book value seems extreme for a corporate bond insurer.

For what it's worth, I am not considering Primus. I don't have enough money and I am thinking of averaging down into Ambac (or MBIA) at some point. My focus right now is to find some retailer (another beaten-up sector) or find some Japanese stock. What areas do you find attractive right now?

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