MarketWatch, Bloomberg, and Reuters, among others, reported on the disclosure by the largest bond guarantor, MBIA, of its exposure to $30.6 billion in “complex mortgage securities.” What was particularly worrisome was that in the total is $8.1 billion of collateralized debt obligations of the particularly risky “CDO squareds” variety, or CDOs of CDOs. Bear in mind that the bond insurer has only $6.5 billion of equity.
The reaction was fast and harsh. The stock price, already battered, fell a further 26%. As Bloomberg reports, the prices on credit default swaps rose sharply:
Credit-default swaps for MBIA soared as much as 145 basis points to 625 basis points, the widest ever, before narrowing to 560 basis points, according to prices from CMA Datavision in London. That means it costs $560,000 a year for an investor to protect $10 million in MBIA bonds from default for five years.
One-year contracts surged to 1,050 basis points, prices from broker Phoenix Partners Group show. That implies investors are pricing in a 20 percent chance of default by March 2009, according to a JPMorgan Chase & Co. valuation tool used by Bloomberg.
Contracts on MBIA’s bond insurer, MBIA Insurance, climbed 58 basis points to 303 basis points after reaching 340 basis points earlier today, CMA prices show. Contracts tied to Ambac rose 13 basis points to 578 basis points, according to CMA.
Standard & Poors had lowered MBIA’s outlook to negative prior to this disclosure. Fitch today said it would reexamine the insurer for a potential downgrade, and gave it four to six weeks to raise $1 billion in capital. Note that while the Warburg Pincus deal would seem to fill the bill, some now feel its completion is in doubt. From Reuters:
The announcement may scuttle MBIA’s $1 billion investment from buyout firm Warburg Pincus LLC WP.UL, according to rating firm Egan-Jones Rating Co. Warburg said on December 10 it would initially invest $500 million by purchasing MBIA shares at $31 each, a move that helped restore some investor confidence and had pushed MBIA shares as high as $37.50 the day the deal was announced.
The agreement between Warburg and MBIA does not have a “material adverse change” clause, or MAC, sources close to the deal said, meaning Warburg cannot cite that as a reason for backing out of the offer.
But with any acquisition, it’s always possible to back out of a deal until it actually closes — even a deal without a MAC clause. Cerberus Capital Management pulled its offer for equipment company United Rentals, citing liability limits in the merger agreement instead of a MAC clause. The two sides are battling in court over the deal.
Bloomberg mentioned that a filing said the pending deal was “deal was contingent on performance-specific covenants and referenced a schedule of undisclosed conditions.”
It’s a no-brainer that Warburg Pincus will try to renegotiate the price, and MBIA does not have a lot of leverage. It needs the money post haste, and so the recourse of going to court is less useful to them than it would ordinarily be.
Analysts generally were critical, although there were exceptions. From Bloomberg:
“We are shocked management withheld this information for as long as it did,” Ken Zerbe, an analyst with Morgan Stanley in New York, wrote in a report yesterday. “MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors.”….
The “eleventh-hour” disclosure by MBIA “ignites concerns all over again about the prospect for future losses,” Kathleen Shanley, an analyst at bond research firm Gimme Credit in Chicago, wrote in a report. She said outside investors didn’t know about the CDOs-squared, which she called the riskiest type of CDO….
“How is confidence expected to return to the capital markets when these types of surprises continue to pop up?” said Peter Plaut, an analyst at New York-based hedge fund manager Sanno Point Capital Management…..
Potential losses from the CDOs-squared are “hardly the kind of hit that should cause severe spread widening or the stock to crash,” Barclays Capital credit analyst Seth Glasser said in a note to clients today. He said the CDOs MBIA disclosed yesterday may be less risky than investors are betting.
The securities industry cannot afford to have MBIA downgraded; the firms already are taking losses on mortgage securities and CDOs independent of any insurer downgrade. If MBIA loses its AAA, that will lead to forced selling by some entities that are required to hold only top-rated paper, which will depress prices further, leading to more writedowns.
I don’t know how it can come about, but expect a deux ex machina for MBIA. Bankers Trust officers told me the Fed played a role in its purchase by DeutscheBank, While there is precedent for regulators lending a helping hand, MBIA is not under the purview of any banking regulator, which raises the question of who might take it upon themselves to orchestrate a solution.
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It’s a dumb question but what exactly is the purpose of cdos square, credit default swaps technically buys some form of protection against default (that’s highly questionable seeing how they’re increasingly becoming indexes for risk) but what are CDOs squared for? Transferring the risk of the original CDOs or merely a 2nd mortgage kinda thing?
Could Albany orchestrate it, perhaps with innovative use of the Martin Act?
Fees. Getting paid to flush. Sorry, I meant meeting investor demand for bespoke rated long/short yield-enhanced diversified-collateral low-correlation-risk vehicles in the CDO space ;-)
SOHAIL RASUL, GROUP MANAGING DIRECTOR, SECURITY CAPITAL ASSURANCE LTD.: Yes, good morning, Darin. Yes, we obviously have visibility into the inner CDOs, as Ed said, and we are looking at the performance of those inner CDO buckets. The ratings of each of the positions within those are coming under stress, as you would imagine in this market. Where we take comfort is that we have at the outer CDO levels, sufficient subordination to be able to absorb a significant amount of deterioration within those inner CDO buckets. And that still remains the case today.
DARIN ARITA: All right. So you’re — I guess just to be clear on that, are your expectations for these inner CDOs, I guess, different from what the current rating agency ratings are? Because the expectation — and we are already seeing some pretty large downgrades of some CDOs out there, and there is the expectation that there is much more to come.
http://www.insurancenewsnet.com/article.asp?n=1&neID=20071026560.2_989f1e77c8398009
The securities industry cannot afford to have MBIA downgraded; the firms already are taking losses on mortgage securities and CDOs independent of any insurer downgrade.
Help me out here, I’m a newbie. Is a “negative basis trade” a trade made on the basis of getting a negative return?
foesskewered,
Here’s a Nomura document from 2005 describing CDO-squared, via Calculated Risk
It was interesting to read that the CDOs that go into a CDO-squared are usually purposely put together solely in order to be put into the CDO-squared.
A negative basis trade is when you can earn more on a bond than the cost to insure the bond. So it’s that magical thing, a free lunch. Except that you now need to worry about the insurer, your counterparty. The worst outcome is a loss on the bond and a default by the insurer (whom you’ve paid for worthless insurance).
The no-arbitrage principle says that either the insurer has mispriced the risk on the bond or you have picked the wrong insurer. If an insurer misprices his risk often enough, he will go out of business. If someone picks the wrong insurer, his loss is magnified (through wasted premiums). Of course this is all academic theory with no relevance to recent headlines :-)
foesskewered
The way I understand the situation is that around 2004 there were two problems with the CDO market (i) the fact that most US homeowners had already refinanced meant that there were fewer new mortgages to put into cash CDOs and (ii) yield spread compression meant that the upper tranches of standard CDOs weren’t paying much of a premium.
CDO squared can solve the first problem by building on “synthetic” CDOs (i.e. packages of credit default swaps) In other words by simply referencing existing assets. They can solve the second problem by increasing risk (and therefore the risk premium).
Thanks to:anonymous December 20, 2007 11:44 PM, ST and Steve for all your definitions.
ST- the 3rd article in Bloomberg’s series on the subprime talks about how the situation that you talked about caused the boom of the repackaging of subprime into CDOs
as far the explanations go, it seems the original CDOs became part of the new CDOs (squared, so to speak) , hence the forming of layers, so, as the unwinding goes on, have we actually seen the unwinding to the core CDOs, or are we still at the outer layers of the onion?