Monday, July 28, 2008 5 comments ++[ CLICK TO COMMENT ]++

Merrill Lynch Commutes Bond Insurance Contracts with SCA

Merrill Lynch announced some writedowns along with a big capital raise this afternoon. Of interest to me is the fact that they commuted bond insurance contracts they had with SCA:

Merrill is being paid $500 million to commute, or rip up, guarantees it bought from bond insurer Security Capital Assurance. It's also negotiating with other bond insurers to try to commute similar guaranty agreements.

This is good news for the tainted bond insurers (and hence bad from a competitive point of view for the untainted ones: FSA, Assured Guaranty, and Berkshire Hathaway Assurance.) Generally this is a negative for the industry since it weakens the argument for buying insurance in the first place. Nevertheless, given that the bond insurance industry itself is almost on the verge of being dead, I don't think it hurts the industry as much as it generally would have.

SCA, the worst bond insurer out there (partly because their contracts required them to post collateral upon downgrade,) looks like it is paying $500 million to Merrill Lynch to get out of the contracts. Depending on the details, Ambac and MBIA will probably be paying around $1 billion to $3 billion to get out of their contracts (even then, this would only be a portion of their contracts.) I think it is less likely for Ambac, MBIA, CIFG, or FGIC to commute much of their exposure. A lot of the projected losses are coming from a few contracts (at least in the case of Ambac) and it may not make economic sense to get out of other well-behaving insured assets.


5 Response to Merrill Lynch Commutes Bond Insurance Contracts with SCA

July 29, 2008 at 11:02 AM

"Generally this is a negative for the industry since it weakens the argument for buying insurance in the first place."

Is this correct? If an insured can commute their policy for cash, at a time when they are cash constrained, isn't this a good thing? Isn't $500 million a benefit to MER that they would not have had if they did not have a policy with SCA/XL?


July 29, 2008 at 12:27 PM

The insured liabilities is far greater than the amount of money they are receiving. I don't know what the details of what was actually commuted but Merrill Lynch will be accepting several billion to tens of billions in potential losses for receiving $500 million. I don't know the details but given that monolines typically have leverage of 70 to 100, you are looking CDOs worth tens of billions.

It doesn't make economic sense for insurance buyers to commutte under most circumstances. The only reason it is being done right now is likely beause (i) some claim the bond insurers may end up insolvent (so Merrill gets something rather than nothing), and (ii) the market is killing the banks due to the uncertainty of losses surrounding the subprime assets (so Merrill reduces the uncertainty)...

Merrill really had to do something because supposedly the insurance regulator warned SCA that it was going to be taken over. If that happened, my understanding is that all the CDS contracts will default and they may end up worthless. This situation also forced XL capital to do something--and it resulted in it injecting capital while getting rid of its exposure to SCA.

The situations with Ambac and MBIA will be nothing like SCA since they are better capitalized and nowhere near being taken over.

July 29, 2008 at 3:04 PM

Look at the commutation of XL's policies to SCA. From XL's release:

"The Master Agreement provides for the payment by XL to SCA of $1.775 billion in cash, the issuance by XL to SCA of eight million Class A Ordinary Shares to be newly issued by XL and the transfer by XL of all of the shares it owns in SCA (representing approximately 46% of SCA's issued and outstanding shares) (the "SCA Shares") to a trust.

After giving effect to the closing of the Master Agreement, $64.6 billion of the Company's total net exposure (which was $65.7 billion as at June 30, 2008) under reinsurance agreements and guarantees with SCA subsidiaries will be eliminated.

It looks like XL paid SCA about $1.9 billion to tear up reinsurance on 64 billion of par CDO exposure or about 3% of the par exposure. Would MER, C or other insureds take something close to 3% of par to commutie their policies? Would this be good for MBI, ABK? Does this have the potential of being a true "win, win" for both sides?


July 29, 2008 at 3:28 PM

XL is also giving up a huge chunk of the equity (I think somewhere around 47%) to its policyholders. I do not believe MBIA will do that; and if Ambac does that, it will be horrible for shareholders.

The SCA case is quite different from Ambac and MBIA in that SCA was literally on the verge of being taken over by the regulator. Its share price was very close to zero. So the deal they cut actually seems to given an edge to SCA (it's sort of the like the joke that if I owe you $1000 it's my problem but if I owe you $1 billion, it's the bank's problem ;) ). I do not think that Ambac and MBIA have as much leverage against the policyholders because they are not under threat of being taken over.

Ambac and MBIA also have excess capital whereas SCA did not (recall that Ambac is rated AA and MBIA as A, whereas SCA was CCC--essentially the rating agencies were saying that SCA was unlikely to pay its obligations while Ambac and MBIA have a high probability of paying).

So the situation will be different. I think a good precursor might be what happens with FGIC or CIFG. These are nowhere near being taken over by the regulator so it's be an interesting negotiation.

For Ambac and MBIA, commutation will be good news as long as it does not involve massive shareholder dilution. It depends on the terms but I would view it as a big positive if both sides can commute some of their insured assets. I think the market will also look favourable upon such an agreement. Speaking as an Ambac shareholder, I just hope management doesn't do something stupid and give away half the company (like they did before) in order to get out of some questionable insurance (many of which may not turn out to be real losses.) Given that the bond insurance market is almost dead now, getting rid of insured liabilities is not as crucial as it may seem.

July 29, 2008 at 3:38 PM

"Given that the bond insurance market is almost dead now, getting rid of insured liabilities is not as crucial as it may seem."

I believe you put your finger on the key to this issue -- the monolines are in the drivers seat. They don't need to commute unless it's favorable to them. The insureds are the ones who need liquidity now.

Here's how Jay Brown described this in his 6/11/08 shareholder letter; "In the short run we expect that the de-leveraging of the insurance company will accelerate as more issues are refunded and our liability is extinguished, more installment policies are cancelled and minimal new business is added to the portfolio. In an ironic twist, the actions of the rating agencies will accelerate the speed with which we exceed the target levels of capital required for a Triple-A."


Disclosure: Long MBI

Post a Comment