A MarketWatch story on Warren Buffet’s borderline extortionate offer to struggling monoline insurers suggested it could provide a format for a rescue New York insurance superintendent Eric Dinallo. A story by the New York Times alluded to the same notion.
While I may be missing something, I don’t see how this could possibly work.
First, let’s start with the rumor. From MarketWatch:
If Warren Buffett’s $800 billion reinsurance plan is rejected by bond insurers, a leading industry regulator may end up pushing a similar solution, a person familiar with the situation said on Tuesday.
But Buffett said on Tuesday that one of the insurers has already rejected the offer and Ambac said later in the day that the plan isn’t in the interests of all its policyholders.
However, if the situation gets worse, bond insurers may have no choice.
If current efforts by the New York State Insurance Department to stabilize the $2.4 trillion industry fail, the regulator may propose a similar plan to Buffett’s, in which bond insurers’ steadier muni businesses are separated from their more troubled structured-finance business, the person said, on condition of anonymity.
There are two problems with this concept: first, that it solves no problem, and second, that it probably represents regulatory overreach if the insurers don’t go along (likely).
To the first issue, that this approach does not address the underlying issues. While Buffett has every reason to want to get the best risks out of the monolines on the cheap, that doesn’t mean it is a good deal for anyone other than Buffet, and perhaps parties in the municipal bond market. There has been quite a lot of disruption of new fundings, which means that despite the considerable press of late on how muni insurance is basically a waste of money (the rating agencies rate munis much tougher than corporate credits), municipalities are facing considerably higher costs to raise funding without the insurance wrap.
One would think that Buffett’s entry into the business would have solved that problem, but so far, he has done very few deals. And even if he entered into his proposed arrangement with MBIA and Ambac, all that does is shore up their existing portfolio of risks, that is, it helps secondary market investors but not the municipalities under stress.
What happens in this plan to the bond guarantors’ muni underwriting operations? There was no suggestion that these would go over to Buffett. Do the keep originating and then get them reinsured by Buffett? I doubt that Buffett will help a direct competitor except at worse terms than for his own operations. So unless some crucial bit has failed to be disclosed, I don’t see how this move would help municipalities.
And as the market realized as the day went on, this arrangement would be lousy for the remaining book of risks. It leaves the remaining guarantees with even less coverage. The New York Times clarified Buffett’s proposal:
In a letter dated Feb. 6 to Lazard, the investment bank that is advising MBIA, Ajit B. Jain, president of reinsurance for Berkshire Hathaway, proposed that MBIA pay Mr. Buffett’s company 150 percent of the premium it earns for insuring its municipal bond portfolio. Typically, insurers cede a share of their premiums, not more than they earn…..He noted that in recent months, Berkshire had been able to set premiums at twice as much as MBIA used to charge, or more. Mr. Jain estimated that the reinsurance premiums paid by MBIA and Ambac would total about $9 billion.
In other words, the bond guarantors have to pay out hard cash at a time when they are desperate to raise more equity in order to cede the best part of their business to Berkshire Hathaway.
I am no expert, but I do not see the legal basis for favoring one type of policyholder over another. While debt instruments set clear priority in payment, I am not aware that any priority in payment exists among insurance policyholders. Unless the muni bond guarantees have a preferred standing relative to the other guarantees, this approach would seem to be a magnet for litigation.
Now if this approach seems only to benefit Buffett, why would Dinallo be pushing it (if that is the case)? There is some speculation that he is using the Berkshire offer to bring reluctant banks to heel, but for that to work, he has to have a viable threat. I don’t see one here. This seems to be a misguided application of the “good bank-bad bank” approach used in the saving & loan workouts.
But consider the differences: the dead S&L’s landed in the FDIC’s lap. They had to figure out what to do with them, and they wanted to make a recovery on the payments they made in deposit insurance. So the Resolution Trust Corporation was set up. Note that a big issue was that the Federal government had to continue to fund the S&L’s working capital and also pay to keep some staffing going. That cost was considerable and controversial, and led the RTC to sell assets faster than it would have if it had wanted to maximize value.
The reason for segregating assets was simple: there were two different types of investors who might want to acquire them: banks that hadn’t been too badly damaged were interested in the “good bank” assets; distressed players and wealthy individuals went after the “bad bank” assets. The bad bank assets were going sufficiently on the cheap that even parties that had never dabbled in that sort of deal like Ron Perlman made acquisitions and did very well.
But what does a segregation achieve here? No one but an AAA rated party would make sense as a buyer/reinsurer of the muni portfolio. Buffett already having decided to enter the business on a de novo basis means the only interest another insurer is likely to have is reinsurance. But per the discussion above, this is a huge market inefficiency; the insurance adds no value (but sadly appears to be necessary).
And who would buy the rest? The parties who best understand the CDO/CDS exposures and have reason to do a deal are already at the table. You aren’t going to have new parties appear out of the blue. Private equity investors like TPG and Bain Capital predictably said no thank you, we don’t understand this stuff. I’d be curious to know who might materialize.
So a simple runoff of the portfolios would make the most sense. Any other activity appears to be for the benefit of lawyers and Perella Weinberg, not the policyholders.
Now to regulatory matters. Ambac is at most immediate risk, by virtue of not having raised more equity and having a big CDO portfolio (those have a relatively short life). MBIA has proportionately less CDOs but has commercial real estate, below investment grade, HELOC and second mortgage guarantees, I can’t be certain, but their poisoned fruit might not be rotting quite as fast as Ambac’s.
But Ambac is in Wisconsin. Dinallo has no authority over them, and Sean Dilweg, the commissioner of insurance in Wisconsin, said on January 23:
Eric is looking at the overall issue, but I am pretty confident that we will work through Ambac’s specific issues. They are a stable and well-capitalized company but they have some choices to make.
That doesn’t exactly sound like someone who is eager to do a rescue.
So let’s consider the current state of play. Both the big bond insurers insist they are adequately capitalized; presumably the statutory accounts they will file will say the same thing. MarketWatch says that MBIA disputes Dinallo’s authority to impose a plan on them:
Still, it’s not clear whether the New York State Insurance Department could impose such a plan on bond insurers if the companies are against the idea.
MBIA, which is regulated in New York, questioned a bailout like this during a conference call with analysts and investors on Jan. 31.
It also said that insurance regulators could only take control of the company if it is deemed to be insolvent under regulatory and statutory accounting standards.
“I can assure you that we will be showing a substantial, in the billions of dollars, amount of statutory capital beyond requirements for the New York State Insurance Department,” Gary Dunton, chief executive of MBIA, said, according to a transcript of the conference call.
However, later in the call, Greg Diamond, head of investor relations at MBIA, clarified Dunton’s comments. The New York State Insurance Department can take control of companies even if they’re not insolvent, he explained.
The regulator could take control if a company is found to have violated law or regulatory orders or if the department is concerned about the company’s ability to pay its claims, Diamond said, according to the transcript.
Here is the interesting dilemma: a crisis. or at least some disruption and uncertainty, will be triggered if either MBIA or Ambac are downgraded by Moody’s or Standard & Poor’s. But there is a big difference between being less than AAA and being unable to pay claims (I don’t imagine Dinallo can charge them with violations; the big area of dispute would be their accounting, and my impression is that insurance accounting allows reporting entities a lot of latitude). MBIA has kept up an aggressive front. I don’t know that Dinallo can claim in all honesty that MBIA is at risk of not paying claims, at least for the next two years. I don’t know what recourse MBIA would have if it decided to fight Dinallo, but I would expect them to go to the mat.
Dinallo can achieve the same outcome, although it will take a bit longer, by forbidding the regulated insurance subs from upstreaming cash to the holding company. When the executives are forced to realize that they are on a sinking ship, they will become much more compliant.
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A Trillion pardons here for this long post, but I began to wonder today what the actual resolution was for the LTCM “crisis” as it relates to this current “crisis”?
II feel the following summation is worth looking at. It is also worth noting that we seem to have a much larger group of collusive idiots involved this time around, and obviously the regulation-people failed 100% with LTCM and Enron and within just a few years after The Bogus Sarbanes-Oxley Act and The Patriot Act, we have more collusion and corruption!!
But First (Dont take my word for it): Fears of a global slowdown triggered by US housing market woes wiped $5.2 trillion (£2.7 trillion) off global stock markets in January, say analysts.
http://news.bbc.co.uk/1/hi/business/7239506.stm
According to ratings firm Standard and Poor’s, 50 out of 52 share indexes around the world ended the month lower.
>>>>Now On To The Lesson:
LESSONS FROM THE COLLAPSE OF HEDGE FUND, LONG-TERM
CAPITAL MANAGEMENT
By David Shirreff
http://elsa.berkeley.edu/users/webfac/craine/e137_f03/137lessons.pdf
In the first two weeks after the bail-out, LTCM continued to lose value,
particularly on its dollar/yen trades, according to press reports which put the loss at
$200 million to $300 million. There were more attempts to sell the portfolio to a
single buyer. According to press reports the new LTCM shareholders had further talks
with Buffett, and with Saudi prince Alwaleed bin talal bin Abdelaziz. But there was
no sale. By mid-December, 1998 the fund was reporting a profit of $400 million, net
of fees to LTCM partners and staff.
In early February, 1999 there were press reports of divisions between banks in
the bailout consortium, some wishing to get their money out by the end of the year,
others happy to “stay for the ride” of at least three years. There was also a dispute
about how much Chase was charging for a funding facility to LTCM. Within six
months there were reports that Meriwether and some of his team wanted to buy out
the banks, with a little help from their friend Jon Corzine, who was due to leave
Goldman Sachs after its flotation in May, 1999.
By June 30, 1999 the fund was up 14.1%, net of fees, from last September.
Meriwether’s plan approved by the consortium, was apparently to redeem the fund,
now valued at around $4.7 billion, and to start another fund concentrating on buyouts
and mortgages. On July 6, 1999, LTCM repaid $300 million to its original investors
who had a residual stake in the fund of around 9%. It also paid out $1 billion to the 14
consortium members. It seemed Meriwether was bouncing back.
Despite the presence of Nobel laureates closely identified with option theory it
seems LTCM relied too much on theoretical market-risk models and not enough on
stress-testing, gap risk and liquidity risk. There was an assumption that the portfolio
was sufficiently diversified across world markets to produce low correlation. But in
most markets LTCM was replicating basically the same credit spread trade. In August
and September 1998 credit spreads widened in practically every market at the same
time.
A working group on highly leveraged institutions set up by the Basle
Committee on Banking Supervision reported its findings in January, 1999 drawing
many lessons from the LTCM case. It criticized the banks for building up such
exposures to such an opaque institution.
Supervisors themselves showed a certain blinkered view when it came to
banks’ and securities firms’ relationships with hedge funds, and a huge fund like
LTCM in particular. The US Securities & Exchange Commission (SEC) appears to
assess the risk run by individual broker dealers, without having enough regard for
what is happening in the sector as a whole, or in the firms’ unregulated subsidiaries.
The sad truth revealed by this testimony is that the SEC and the NYSE were
concerned only with the risk ratios of their registered firms and were ignorant and
unconcerned, as were the firms themselves, about the market’s aggregate exposure to
LTCM
t is possible to argue that a market solution was found. Fourteen banks put up
their own money, regarding it as a medium-term investment from which they
expected to make a profit. From a value-preservation point of view it was an
enlightened solution, even if it did seem to reward those whose recklessness had
created the problem.
Federal Reserve chairman Alan Greenspan defended the Fed’s action at the
October 1 hearing in the House Committee on Banking and Financial Services as
follows: “This agreement [by the rescuing banks] was not a government bailout, in
that Federal Reserve funds were neither provided nor ever even suggested.
Agreements were not forced upon unwilling market participants. Credits and
counterparties calculated that LTCM and, accordingly, their claims, would be worth
more over time if the liquidation of LTCM’s portfolio was orderly as opposed to being
subject to a fire sale. And with markets currently volatile and investors skittish,
putting a special premium on the timely resoluton of LTCM’s problems seemed
entirely appropriate as a matter of public policy.”
The true test of moral hazard is whether the Fed would be expected to
intervene in the same way next time. Greenspan pointed to a unique set of
circumstances which made an LTCM solution particularly pressing. It seems
questionable whether the Fed would act as broker for another fund bailout unless
there were also such wide systemic uncertainties.
Bruce Jacobs, who has followed the systemic implications of
the 1929, 1987 and subsequent mini-crashes, fearful of the dangers of globally traded
derivatives, writes in a new book: “Had LTC not been bailed out, the immediate
liquidation of its highly leveraged bond, equity, and derivatives positions may have
had effects, particularly on the bond market, rivaling the effects on the equity market
of the forced liquidations of insured stocks in 1987 and margined stocks in 1929.
Given the links between LTC and investment and commercial banks, and between its
positions in different asset markets and different countries’ markets, the systemic risk
much talked about in connection with the growth of derivatives markets may have
become a reality.”
Bonus History Treat:
Warren Buffett’s Wild Ride at Salomon October 27, 1997 Warren Buffett’s Wild Ride at Salomon A harrowing, bizarre tale of misdeeds and mistakes that pushed Salomon to the brink and produced the “most important day” in Warren Buffett’s life.
http://chinese-school.netfirms.com/Warren-Buffett-Salomon.html
So on that Thursday, Salomon began to experience a run. It materialized out of left field in the form of investors who wished to sell this big-league trader and market maker, Salomon, its own debt securities–specifically, the medium-term notes that the company had outstanding. Salomon had always made a market in these securities, but that was ordinarily a yawn, since nobody wanted to sell. But now the sellers poured in. Salomon’s traders responded by lowering their bids, trying to deter the traffic–dying to do that, in fact, because every repurchase of notes they made melted down the capital base that was holding up the whole Salomon structure. Finally, after the traders had bought about $700 million of the notes, Salomon did the unthinkable: It stopped trading in its own securities. That called a halt on the rest of the Street too. If Salomon wasn’t going to buy its own paper, it’s for sure nobody else would.
** The one who reported the wrongdoing of its employee to Gutfreud, the CEO, was no other than John Meriwether, the legendary top manager of Long Term Capital Management (LTCM), which was again saved from imminent bankruptcy by the Fed effort in 1997 for nearly identical reasons.
Buffet said in the CNBC interview that he wasn’t making the offer for charitable reasons. But I believe he also said that this would free up capital currently supporting the muni business to be applied to the structured finance portfolio. Don’t know if this is true, but it may make sense. There would be a running cost on the reinsurance, but if more capital is freed up to support the structured business, the result would buy some time.
It may not solve the problems of the insurers, but it can keep us from having additional ones in the Muni Business. The Muni business must not be allowed to falter. Period!
Re: The Muni business must not be allowed to falter. Period!
>> This is becoming an interest to me, because I feel this entire financial mess is the result of the abuse of discretionary powers, which if one follows the tangent, can be traced back to abuses by local governments, i.e, perhaps our best model is The LGIP in Florida, which as you may recall, is related to discretionary abuse of power.
Following this tangent further, we may need to go back to either 9/11 or The Bush Homeownership Society, which he brought up in his second inaugural address/dictum.
I am not sure if this matter began with a Federal objective to dilute Iraq war debt into a an offsetting housing bubble/boom, i.e, The Fed promoted ownership and encouraged illegal aliens to become a part of building boom, underwritten by cheap global liquidity products; the bubble was enhanced by the stupidity of Greenspan and the web of collusion efforts which are related to the fact that every regulator, supervisor and person of accountable authority in America looked the other way and abused the discretionary powers they had. Greenspan mildly suggested that the housing market might be a little frothy, when infact almost every home in America had doubled in appraised value — which mortgage people bought into, bankers, county treasurers, obviously any realtor, every lawyer, ever state and fed official, and every bond underwriter and every bond insurer!
As a further example of this, the community I live in is small, and back in 2001, we had the unfortunate problem of a walmart superstore that just had to be built no matter what, and although the town did not want that business to be built, the local government pushed the agenda and ignored the impacts to our community, because it seemed at the time, that there was a very STRONG Republicn political party that wanted to help push The Bush Ownership Society, no matter what, because these fascist minded people wanted to push a dogmatic agenda, which included pumping the housing bubble!
The housing bubble was connected to the very same dogmatic fascist exploitation in the colorful world of synthetic derivatives, where these crooks ran wild and spun out packages and pools of unregulated toxic poison and polluted the world with corrupt and bogus securities that were blessed by every rating agency — agencies that once again, were able to abuse discretionary powers and to be unregulated, and unaccountable for any of their actions.
And, now, someone like you wants to cry about the local governments or the failure of bonds that should never have been underwritten in the first place! You seem to think, these abusive people that were out of control need additional life lines and safety nets to save them from the casino chaos that they built brick by brick, in a collusive effort to abuse the people that they swore to protect! Screw them for the abuse and damage they have caused and I pray to God, that local taxpayers place these corrupted bastards under the highest power Laser Scanning Confocal Microscopes and expose the fraud these people spun out, in a mindless effort to sprawl endless expansion that was not wanted or needed. I also hope, local populations as a collective force seek tax holidays and find ways to avoid property taxes associated with this homebuilding bubble, and then, maybe these local governments will shut down the developers and start looking at how to manage the messes they created!
Yves,
I think we are closure to regulatory intervention than you suspect. I detect the hand of Dinallo in this announcement by Buffett.
Consider the world from Dinallo’s (or Wisconsin regulator’s) perspective. You have the sword of Damocles (rating agencies) hanging over the heads of these insurers. If they get downgraded they are not coming back to AAA any time soon. The auction rate muni market is a turning into a 100 car pileup which has major implications for the parties that I think he cares most about, S&L govts and the mom and pop punters out there with muni portfolios. Ambac has thumbed its nose at the rating agencies on raising capital, at least for the moment. The banks are at the table with great reluctance trying to do a deal that would be hard to arrange even in the best of circumstances. Time is running short and you could see the whole thing unravel pretty quickly.
The Buffett offer defines a sort of worst case alternative for the parties at the table (at least for the monoline mgmt and their shareholders). If Dinallo’s first concern is with saving the muni market from mortgage contagion (which I suspect it is), this is a pretty good worst case solution – putting the safety of the muni market in the hands of Buffett. He now has a lever to go back to the table with and can credibly threaten the parties at the table that he can impose a solution that is worse than what they might hatch on their own.
I don’t know all the particulars of the insurance statute and perhaps Dinallo doesn’t hold as many cards as I think he does, but I’m guessing that he can make life pretty difficult for them if he wants. Certainly an announcement by Dinallo that “in view of the stresses in the structured credit portfolio and the need to insure sufficient capital to meet any long tailed claims in the muni portfolio, we are hereby prohibiting the payment of any dividends to the holding company” would not seem out of bounds to anyone who has studied the monolines’ plight. The monolines would certainly piss and moan about this, but there are lot of people who think it should have been done already, statutory accounting notwithstanding. Even if they fight it in court and win, Dinallo will have made his point to the market, forcefully, that they need to find a financing solution.
Moreover, I suspect by now that Dinallo and the others who have studied the structured finance liabilities know that keeping the monolines at AAA is a hopeless cause and the best outcome is to have somekind of soft landing in a run off mode where you can keep the rating at a level that minimizes the damage to the banks. The bank write offs in the absence of a deal would be painful, but probably not fatal for the banks in the US (Europe might be a different story). If Dinallo had to sacrifice a solution for the banks’ problem in exchange for keeping the muni market functioning I think he would make that trade. That does not answer the question of where the incremental new issue underwriting capacity would come from, but I suspect the answer is that FSA, AGO and Berkshire would raise more capital and fill in the capacity (and more issuers would go without insurance as well)
Buffett (Jain actually) said in his letter conveying his offer to MBIA that BHAC conferred with Dinallo before extending the offer to MBIA, and I find it hard to believe he would have gone public with this, given how difficult the negotiations to find a solution must be, without bouncing it off Dinallo first or, as likely in my view, at Dinallo’s suggestion.
Brian
Anon of 3:09 AM,
The only reason for mentioning LTCM was that then too Buffett made a very lowball offer to salvage an operation that had the potential to create systemic risk.
Anon of 6:25 AM,
What Buffet said about “freeing up capital” is true only in a narrow technical sense; in any practical sense, it’s utter hogwash.
First, MBIA and Ambac would EACH have to pay Buffett $4.5 billion for him to takes these risks. That’s more than Ambac has in equity and more than half of MBIA’s equity. And this is for their best risks.
Every bit of research ever done says that muni bond insurance is a ripoff to municipalities. The rating agencies incorrectly grade them much tougher than corporate credits. I don’t have the stats ready at hand, but the disparity is large, something on the order of an single A muni credit has the same default risk as an AAA- corporate credit.
So rather than perpetuating this sham, it would be better if the powers that be went on a massive education campaign. There are TONS of third party sources that could be cited. There might be some lower credit quality municipalities that would benefit from insurance, and perhaps ones where the deals are so small that the cost of paying to get rated is higher than the cost of insurance. But those should be a subset of the universe being insured now.
Brian,
Your point that this proposal may force how to deal with long-tail liabilities is a good one, and yes, I suspect Dinallo can make MBIA’s life pretty unpleasant.
The problem is that when the rescue operation was first conceived, the objective was to prevent downgrades because it would lead to forced sales of CDOs and other structured finance paper by entities that were restricted to holding instruments with a certain rating. That would lead to that paper trading at low prices which in turn would force more writedowns by Wall Street firms. It might also lead to defaults on credit default swaps, which again would lead to writedowns.
Thus, the motivation was to prevent further hemorrhaging of balance sheets. The Buffett proposal saves munis, the new hot problem, at the expense of greater damage to the banking industry and Wall Street by leaving even less capital available to cover the structured finance risks. A simple runoff is the probably the best of the bad options available.
An interesting question is, why is Warren Buffett charging 150% of what Ambac and MBIA charge? This simply guarantees that they can’t afford to say yes even if they wanted to… where would they come up with the money to pay him? Why not charge them, say, 90% of their current premium revenue to reinsure their muni bond portfolios? By leaving a few crumbs on the table for them, they might actually accept the offer, and meanwhile Buffett pockets nearly all of this (seemingly) riskless free revenue, amounting to billions.
Yes he’s setting up his own rival company, but it will take him a long time to build up new revenue streams equivalent to the existing ones. He could tap into those revenue streams right away if he made an offer the incumbents could live with.
Maybe he’s just charging what the market will bear (the current rate that the market already pays plus a hefty premium for Berkshire’s genuine AAA), figuring that Ambac and MBIA will soon be history and he’ll have the field all to himself, so why not establish premium pricing right from the start?
But an alternative idea is that he’s charging a higher, possibly uncompetitive rate because he’s actually calculated the risk and it’s higher than expected. Could there be some black swan events that could lead to a large number of correlated muni defaults (severe economic depression, earthquake, epidemic, WMD event)? Or are such events excluded from coverage?
When Bill Gross mockingly notes that tiny Ambac can’t insure the state of California, implicit in that is the notion that there does exist the possibility of rare but huge losses, otherwise why would you even care if a bond insurer was undercapitalized? So muni bond insurance is perhaps not so superfluous after all.
The blogger Accrued Interest has pointed out that muni bond insurance serves a valuable purpose: it turns a nearly no-brainer decision into a complete no-brainer. Muni bond buyers just want the tax exemption after all, they don’t want to do the slightest bit of research on credit quality (and some of them wouldn’t even know how). Bond insurance greatly improves liquidity by creating a uniformly AAA-rated product.
Consider eating at McDonald’s: you don’t want to individually research the quality of each hamburger before you bite into it, no matter how slight the risk of an unpleasant surprise. You just want a guaranteed-to-be uniform product.
Another point is that S&P and Moody’s charge a large fee for issuing a rating on a muni bond, and sometimes it can actually be cheaper for the issuer to get insurance than to get the underlying bond rating.
Yves
Buffett’s offer sounded too good to be true at first hear and now looks increasingly so, how exactly would his offer work . Incidentally, wouldn’t he just be taking over the muni business and leaving the toxins to be buried with the monoliners?
Talk about an offer you cannot not refuse.