Syncora, formerly SCA, defaults on bond insurance claims; MBIA sues Merrill Lynch

Two potentially significant events in bond insurance land... Syncora becomes the first bond insurer to default on its payments... and MBIA is suing Merrill Lynch.

First... Syncora, which was formerly known as SCA, became the first bond insurer to default on its insurance claims. In the history of the 37-year industry, I don't believe a bond insurer has ever defaulted on its claims. On top of causing losses for insurance buyers, this has also triggered CDS payments for those who wrote CDS on Syncora:

The company, formerly known as SCA, suspended payments to allow it to replenish its finances and turn a policyholders deficit of $2.4 billion into a state-required minimum surplus of $65 million, a company spokesman said on Friday.

The company is the first U.S. bond insurer to suspend claims payment as it struggles to reduce losses on about $8.6 billion of residential mortgage-backed securities it insured.

The notional value of CDS written on the debt of Syncora is about $18 billion, but the net value is about $1 billion, according to industry data.

Well, the good news is that the derivatives market is a zero-sum game. So the estimated $1 billion loss will be a gain for someone else. It should have no economic impact in the grand scheme of things. The only exception is if there is counterparty risk (i.e. someone that cannot pay.) Who knows who was writing the CDS on Syncora but the net amount seems quite small here (only $1 billion.) In addition, it is likely that some who wrote CDS hedged their CDS (possibly by shorting the stock or other similar companies) so the losses accruing to the CDS writers may be less than perceived.

As for the insurance on the mortgage bonds insured by Syncora, supposedly around $140 billion of nominal value, this will be a real loss (since Syncora is defaulating and doesn't have the money.) Most of the insurance buyers have written that off so there won't be any surprises.

This is a significant event because it may foreshadow what happens if other monolines, particularly the big two, MBIA and Ambac, were to ever default. Unlike Syncora, other monolines were much bigger and more respected (which means a lot of investors likely wrote CDS on these other monolines with greater confidence.) This is also what would happen if the financial products division of AIG were allowed to default (so far the US government is preventing an AIG default.)

On another note, not surprisingly, MBIA is suing Merrill Lynch:

MBIA Inc., the largest bond insurer, said two of its units sued two Merrill Lynch & Co. businesses now owned by Bank of America Corp. over protection sold against mortgage-debt defaults.

The suit, filed in New York State Supreme Court, seeks to unwind or recover payouts for $5.7 billion of credit-default swaps and related insurance sold against collateralized debt obligations, Armonk, New York-based MBIA said today in a statement.

Merrill Lynch misrepresented the nature of the debt being protected as part of a “deliberate strategy to offload” billions of dollars of “deteriorating” subprime mortgages between July 2006 and March 2007, as homeowner defaults began to soar, the insurer said in the statement.

I think it'll be difficult for MBIA, or other monolines, to successfully win. I am not a lawyer but I would imagine that it will be difficult to prove that Merrill Lynch, now Bank of America Merrill Lynch, was lying when it bought insurance.

Although the lawsuit probably won't go anywhere, the consequences can be significant if the courts rule in favour of MBIA.


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