Bond Insurers Still Twisting in the Wind

While there was not much in the way of new developments on the bond insurer front on Tuesday, the media chatter features some interesting cross currents.

On the one hand, the Financial Times, which had some relatively upbeat coverage the day before, had an article on the impressively large level of short interest in the two big monolines, MBIA and Ambac, While the markets aren’t perfect at forecasting, this is a vote of little confidence in the rescue efforts underway:

According to Data Explorers, which tracks short selling, the percentage of shares on loan relative to the market capitalisation of Ambac stood at 40 per cent last Thursday. For MBIA, the proportion was 39 per cent…..

Current short levels are below the highest proportion of borrowed shares reached at the beginning of January for the bond insurers. However, they still represent a very high level of borrowing.

Even in other cases where shares have been shorted, such as those of UK bank Northern Rock last year, the proportion of shares on loan to market capitalisation rarely reaches the levels on Ambac and MBIA. Data Explorers said that Northern Rock’s borrowed shares peaked at about 22 per cent of market capitalisation in September of last year.

Note that the level of short interest isn’t just a function of how much investors hate the company; it also reflects how easy it is to borrow the stock. Nevertheless, the betting against Ambac and MBIA is, shall we say, noteworthy.

The Wall Street Journal has two stories today. The first is on how insurance regulators are considering closing the gate now that the horse has left the barn. While it’s probably a good idea to keep insurers away from risky instruments they have demonstrated they don’t understand, the remedy, closing a loophole dating from 1998, is a bit late in coming. The article focuses on how this bond insurers muscled their way into a business that it proving to be their undoing. Nevertheless, the regulators sound surprisingly timid, fearful of inhibiting innovation. Someone might point out that lobotomies and zeppelins were also innovations.

From the Journal:

Their problems have led New York state Insurance Superintendent Eric Dinallo in recent days to attempt a rescue plan to save bond insurers that could involve financial help from Wall Street firms….

It also is forcing insurance regulators, including Mr. Dinallo’s office, to reconsider the 1998 legal loophole that allowed bond insurers to issue credit-default swaps through shell companies called “transformers.”

Their activity in derivatives has exploded in recent years. With a credit-default swap, one party, for a fee, assumes the risk that a bond or loan will go bad. The bond insurers wrote such swaps on around $100 billion in complex mortgage securities during the past few years, according to ratings-company estimates…

In a letter to the New York insurance department in 1998, an insurer, Financial Security Assurance Inc., argued that such swaps deals were similar to FSA’s existing business of providing guarantees on other types of bonds, albeit through insurance contracts.

“From bond insurers’ vantage point, this was identical to their core business,” although it involved a different type of contract, said Bruce Stern, FSA’s general counsel, who wrote the 1998 letter. “A demand was emerging for guarantees of bond portfolios and it seemed natural for bond insurers to want to do that,” he said. FSA has avoided big losses that have hit other bond insurers because it didn’t enter the riskiest parts of the business, he said. FSA is a unit of Dexia SA of Brussels.

An insurance examiner working for Paul M. De Robertis, a supervisor in the department’s property-casualty bureau, responded in April 1999 that the insurance regulator concurred “with your interpretation of the insurance law.”

“Other insurers saw this FSA letter and that is how the ‘transformer’ business got a boost,” said Joseph Buonanno, whose law firm, Hunton & Williams LLP, represented a number of bond insurers in recent years that set up such entities. After New York insurance regulators gave bond insurers their blessing, other state insurance regulators followed suit and the business of writing credit-default swaps on packages of mortgage securities took off.

Following the regulatory green light, bond insurers set up shell companies under Delaware state law. They were known in the industry as transformers because they transformed a traditional bond-insurance contract into a credit-default swap…

The transformers, which in many cases were private companies incorporated in Delaware, issued credit-default swaps to banks and Wall Street firms on corporate and mortgage securities, including many pools of debt known as collateralized debt obligations.

The bond insurers, in turn, guaranteed the transformers’ obligations, which required them to pay the interest and principal on the bonds if the securities defaulted. The liabilities of the transformers were consolidated with the financial statements of the bond insurers.

From the perspective of the bond insurers, their obligations under the credit-default swaps business were similar to traditional municipal bond insurance. In both cases, the insurer had to make interest and principal payouts to customers if a bond defaulted…..

For Wall Street firms, the bond insurers’ willingness to sell credit-default swaps was a potential bonanza. The swings in the market values of the swaps these transformers sold to Wall Street helped the banks offset fluctuations in the value of the bonds underlying their own transactions. The swaps also benefited the banks by freeing capital, because it allowed the banks to move commitments off their balance sheets. In many cases, the deals enabled the banks to book sizable profits upfront.

The last story is a progress report of sorts on the rescue mission, and it reads very much like a PR plant. Everyone is playing well in the sandbox, even though there is no consensus on how big the rescue effort should be. The numbers bandied about are $3 billion to $15 billion, which is such a wide range as to be a bad sign, particularly since insurance superintendent Eric Dinallo wants $15 billion, a number in light of the continuing deterioration of real estate is likely to be too low; Egan Jones puts the number needed merely to cover losses at $80 billion, and maintenance of an AAA requires a cushion well beyond that While that may be high, the fact that it is so much larger than the numbers under consideration suggest the deal is being envisioned in terms of what the firms might conceivably stump up, as opposed to what level is really needed.

The other amusing bit is the discussion of the options under consideration:

Among the possible solutions being formulated are capital infusions from outside investors or the banks themselves. The Wall Street firms could also arrange to provide a massive line of credit to the bond insurers, giving those firms a cushion of cash.

Another possibility is that the banks could fund a newly created firm that would assume some of the risks or liabilities on bond insurers’ books — an arrangement known as reinsurance. This could free up capital to the insurers but is unattractive to some Wall Street firms wary of taking on unpredictable liability.

Capital infusions are structurally the easiest solution once you figure out how to divide the amount committed among the firms that need the dough (which would not be trivial). But no one expects any outside investors to come to the table, despite the rumors that Wilbur Ross is having a look. He has never done a deal in financial services or in a heavily regulated industry. The theories for his interest are cynical (he is using due diligence as a cheap way to do research on whether a de novo entry would be viable; he is currying favorable press to counter his bad guy, asset stripper image).

A credit line would be easy and appealing for Wall Street, but it isn’t clear that that will be sufficient for the insurers to keep their AAA ratings, which is the purpose of this exercise. Both of the two big rating agencies had called on MBIA and Ambac to raise more equity.

The reinsurance idea might be workable if you were dealing with only one firm, but it has the potential to break down in the structuring phase with so many firms involved. And it is vastly more labor intensive than the other options, since they will have to create a new firm, which argues against it. What are the decision rules for what assets go in and go out? How much capital does the reinsurer need? Who runs it? What are its investment policies?

Despite the upbeat talk, the lack of agreement on the funding target and structure says, no matter how many hours have been put in, no serious issues have been resolved. This airplane is idling on the runway.