Bond Insurer Shockwaves Expand

One of the big news items yesterday was the turmoil in the auction-rate securities market, a $330 billion corner of the muni market, which is a direct casualty of the distress with the bond insurers. The specter of Bristol Myers taking a $275 million charge on an $811 million, announced at the end of January, has badly spooked investors, particularly other corporate buyers. The Wall Street Journal, in a rather odd first page story, reduces the dangers of the auction-rate securities market to the woes of the Mahers, two brothers who, having made over $1 billion selling their shipping business, then shortly lost $286 million after one of their money managers, Lehman Brothers, put two-thirds of the money allotted to them in ARS. (Felix Salmon argues that the money isn’t lost if the market comes back, but Lehman clearly had the option of buying back the Mahers’ position before things got really ugly, and their failure to do so is a vote of no confidence).

So none of them wants to be stuck with the hot potato of muni paper that is downgraded because its guarantee has been marked down a notch or two. S&P and Moody’s have been regularly saber-rattling that they will downgrade MBIA and Ambac post haste if they don’t make considerable progress on improving their balance sheets, so worries are acute.

Not surprisingly, the buyers have dried up, and the dealers, who might at other times step into the breech, are sufficiently impaired that they want none of it. So there was considerable hand-wringing about the damage this was causing poor hapless government bodies. From the Financial Times:

Bond insurers guaranteeing much of this debt could face rating downgrades – is the latest incarnation of the credit crisis…..

“The auction securities market is falling apart,” said David Cooke, chief financial officer at Park Nicollet Heath Services in Minneapolis.

Municipal borrowers are scrambling to seek letters of credit from banks and other fresh sources of finance….

“Dealers who would normally pick up a slump are not doing so as their balance sheets are full,” said Jon Schotz, chief investment officer with Saybrook Capital.

The importance of bond insurers to municipal borrowers has prompted regulators to push banks to provide capital or credit lines so that Ambac, MBIA and others can retain their triple-A ratings.

It is difficult to say what impact this is having on the rescue efforts being orchestrated by Eric Dinallo, New York superintendent of insurance, except obviously putting more pressure on him. Unlike the failed SIV rescue operation, this initiative has had remarkably few leaks.

However, the muni panic (and Buffett’s offer) appear to have shifted focus (at least in the public mind) 180 degrees away from the initial target. Recall that the objective was to somehow get more capital into the insurers somehow because downgrades would End the Financial World as We Know It. Why? Remember, the monolines were deep into credit enhancement of structured credits, particularly CDOs, but also commercial and residential real estate deals. The Wall Street firms are still sitting on inventory. Many investors also hold this paper, but if it were downgraded, a fair number would be forced to sell, because regulations and/or investment guidelines restrict them to certain levels of holdings of specified ratings. Forced sales at a time when no one is remotely interested in buying this sort of paper would lead to distressed prices, requiring banks and investment banks, all subject to mark-to-market accounting, to take further writedowns against their already weakened capital bases.

Before, the muni exposures were considered to be a non-problem. (Accrued Interest reminded us that even though in theory muni bond insurance is a scam, in practice it is valuable to municipalities for whom getting a rating is more costly than buying credit enhancement, and to muni buyers who are often very dependent on ratings in their purchase process).

Now they have emerged as a huge issue, and one that vastly complicates the already difficult task of trying to keep the monoline garbage barge afloat.

And in case you think the risk to Wall Street is exaggerated, consider this bit of uplifting news from the Financial Times. The bond insurers insisted the credit default swaps they wrote were so stellar that they did not need to post collateral, unlike most other counterparties.

The resulting problem is two-fold. First, Wall Street firms entered into what were called negative basis trades in which (in grossly simplified terms) the use of a monoline CDS enabled them to accelerate all the profit over the life of a trade into the current accounting period. A failure of the insurance means the profit will have to be reversed. Second and worse, many players hedged their CDS positions with other CDS. Thus, a failure of a counterparty means supposedly hedged positions are unhedged or only partially hedged, which can lead to losses, unwinding of CDS, and further counterparty failures.

The CDS market is over $45 trillion in face value of outstandings, Problems in even a small percentage of swaps would have serious consequences.

From the Financial Times:

Goldman Sachs has made plenty of canny decisions in relation to the credit crunch. One of the smartest might have been its treatment of MBIA, the world’s biggest bond insurer.

While many rivals have in recent years been cheerfully using bond insurers to hedge their structured credit bets, Goldmans has refused to do so due to concern about counterparty risk.

MBIA did not post collateral, arguing, like other bond insurers, that its creditworthiness was rock solid, as reflected by its AAA credit ratings.

Now Goldman’s stance is paying dividends as MBIA and others such as Ambac and FGIC struggle to maintain their credit ratings and banks with exposure contemplate another round of multi-billion-dollar writedowns.

In taking $2bn and $3.1bn writedowns in hedges with insurers whose ability to honour those commitments is in doubt, CIBC and Merrill Lynch respectively have become the face of Wall Street’s nightmares.

Both thought complicated debt investments they held both on their balance sheet and off were hedged with the value of those investments guaranteed by monoline insurers including MBIA, Ambac, ACA Capital and a handful of others.

That is, until the providers of the guarantees began facing downgrades from the rating agencies, throwing their ability to stand by their commitments into question.

“It’s just a shell game,” says the head of credit risk for one investment bank in London. “Many firms worry about the risk that a security will drop in value, so they get someone to guarantee it.

“But they have just substituted one kind of risk – counterparty risk – for another. They are just passing around the risk, not eliminating it.”

In doing so, many banks and brokerages seemed to have overlooked what now seems obvious.

If the environment is so bad that the investments will plummet in value, the likelihood is that those who guarantee the value of the investments will find themselves under pressure and may not be able to make good their promises.

And the existence of rock solid hedge counterparties has allowed banks to book profits on trades that take advantage of price differentials for credit in the bond and derivatives markets.

The upfront gains on “negative basis trades” may evaporate if they are no longer hedged. A downgrade from AAA on bond insurers used for the hedges would do just that.

It is a Catch-22: if you really need the guarantee, you cannot assume it will be there.

That sort of correlation seems to have been a lesson that nobody learns from one crisis to the next.

Ten years ago, when the market for credit insurance was young, participants who had big exposure to Indonesian companies bought insurance from Indonesian banks.

But when the currency sank during the Asian financial crisis, many institutions were no longer able to honour their dollar debts – not only the corporate borrowers but the Indonesian banks selling the protection, rendering their guarantees meaningless…

Of Merrill’s $3.1bn writedown on hedges from the financial guarantors, $2.6bn was related to “writedowns of the firm’s current exposure to a non-investment grade counterparty” on the (at least nominally) safest slices of debt backed largely by mortgages, according to Merrill’s financial statements. (That “non-investment grade counterparty” is ACA.)

The firm also wrote down its exposure to other guarantors by a smaller amount.

Still, at the end of December Merrill had $24bn in insurance against a drop in value of such debt, known as the super senior tranches of asset backed collateralised debt obligations, which it had bought from “various third parties including monoline financial guarantors, insurers and other market participants”, most likely hedge funds.

Merrill was hardly alone in placing its faith in the ability of the guarantors to stand by their pledge to support the value of these complicated slices of mortgage and other kinds of debt.

There is another reason why worse may be to come. It is that the guarantors also stood on the other side of Wall Street as a major counterparty in providing insurance in the oddly named credit default swap market, where parties buy and sell insurance against defaults.

That role is now spooking Wall Street.

“As a market with huge notional volumes, a large number of counterparties, rising default risk and financial counterparties among the most affected by the current market turmoil, concern is by no means surprising,” Morgan Stanley analysts said in a recent report.

The report notes that generally both sides to a credit default swap post collateral, and as the value of the trade moves against one side, that side has to post more collateral, a feature meant to reassure participants since the market is an over-the-counter one with no exchange in the middle.

But in the past, these guarantors refused to post collateral, arguing that their credit quality was so rock-solid.

Now that their credit looks more like crumbling sandstone, fears of the creditworthiness of these guarantors as counterparties has become a legitimate source of alarm.

Despite the grim news, there was a bit of comic relief. MBIA has gotten positively screechy, trying to blame its woes on evil Bill Ackman of Pershing Square and other less visible shorts. This posture conveniently ignores that rating agency Egan Jones and several Wall Street analysts have posted even more dire loss forecasts than Ackman. Moreover, Ackman has made his latest model and assumptions completely transparent and has invited comment.

This move was met with derision. From Herb Greenberg at the Wall Street Journal’s MarketBeat, “MBIA vs. Shorts: They’re Kidding, Right?“:

I had to do a double-take when I saw a Reuters story earlier today that said MBIA planned to urge lawmakers at a Congressional committee hearing Thursday to curtail “the unscrupulous and dangerous market manipulation of short-sellers.”

Memo to MBIA: Take a number and get in line. The bond insurer is the latest in a long list of companies that, over the years, have pleaded with the government to do something — anything — about those dastardly short-sellers who have dared raise red flags over their precious companies.

That’s right: They should tar-and-feather the likes of Bill Ackman of Pershing Square Capital, the most vocal bear on MBIA, who had the audacity to very publicly write a 60-page paper in December 2002 headlined, “Is MBIA Triple A?”. They should further tar-and-feather the guy, and those like him, for taking the other side of the bullish bet on company’s like MBIA — and telling the world they’re doing so — because of their conviction and willingness to warn others about what they believe is looming trouble. (Funny, nobody ever complains about “dangerous market manipulation of longs,” but I digress…) And they should tar-and feather the guy for being right and pretty much forecasting what has happened.

It was, after all, in that paper five years ago that Ackman started warning about the very kind of collateralized debt obligations that have landed MBIA in hot water and, as Ackman suggested at the time, put its Triple-A rating at risk [boldface theirs]…

At the same time Ackman also was first to point out that MBIA had engaged in a questionable transaction that, in effect, involved insuring a loss after the loss and then collecting on the insurance. (I wrote about it several times; nobody gave a hoot.) The issue, which strikes to the heart of the company’s culture, prompted an investigation by regulators; MBIA settled the civil securities fraud charges last year by paying $75 million.

So, here we are, five years after Ackman first surfaced on MBIA. The ratings agencies have downgraded thousands of CDOs. Thousand of others have been put on credit watch. MBIA had had to pay that fine for engaging in questionable practices. And its stock has been crushed. [boldface theirs]

Now, rather than accept the reality that it caused its own problems with bad business and actuarial decisions, MBIA is complaining to Congress about the guy who blew the whistle.

Michael Shedlock also took a very dim view:

For starters anyone blaming shorts is in trouble. It is an act of desperation that has a 100% failure rate for as long as I can remember. Any company baling shorts deserves to have shareholders walk away. It is an implicit admission of failure. Companies that execute well, welcome shorts. The shorts provide fuel for driving the market higher.

What’s galling is the request for taxpayer money for the sole purpose of bailing out the company doing the asking. This is not about “far reaching effects on the U.S. and global economies” this is a request for a government handout.

Note MBIA is also trying to blame the rating agencies, which is positively deranged given the free pass they have gotten for so many years.