Ever since Eliot Spitzer threatened the troubled monoline insurers that he’d break them up, everyone has acted as if that’s a viable option.
But this talk of a split reminds me of movies about Hollywood, where someone buttonholes a producer with his pet idea:
“See, it’s like Flashdance, except you reverse it: the girl is a Hispanic ballerina who started stripping to pay her student loans….”
Like the film proposal, the break up notion is still at the high concept stage, little more than, “let’s separate the muni operations from the rest.”
And while admittedly Ambac has had only the long weekend to work on its plan, the update as of Monday evening via the Wall Street Journal suggested that the group is flailing around.
Consider: they’ve already backpedaled. Now Ambac wants to raise $2 billion first, then divide later:
Ambac Financial Group Inc. is discussing a plan to raise at least $2 billion in much-needed capital to help the world’s second-biggest bond insurer retain its top-notch credit rating, according to people familiar with the matter.
The extra cash, to be raised by selling shares to existing investors at a discount, would likely be a prelude to a trickier and lengthier move: splitting itself into two businesses.
Remember, Ambac was trying, like all the other bond guarantors, to raise money before Spitzer delivered his ultimatum. That went nowhere. But we are now back to Plan A, except with the break up idea added. But does that make investing any more attractive?
The answer is no. Before, you had a situation that was either going to end badly, if you believed Bill Ackman and the shorts, or was misunderstood and therefore perhaps a buy, if you believed the insurers. (Aside: my sense is no one has lifted the kimono enough for anyone to get a reading as to the exposures, which does not encourage investors). In other words, you had a high degree of uncertainty (how bad will the mortgage business get? How much capital might be needed over time to keep an AAA rating?), but it could be analyzed.
Now, Ambac is seeking to raise money. It hopes to split up, but gee, we aren’t certain we can do that, and even if we can, we aren’t exactly sure yet how this will work.
Is any one with any sense going to invest in a proposition like that? You have absolutely no idea what you are getting into. This whole discussion of a breakup plan has increased uncertainty enormously and raised the specter of litigation risk. Those are not exactly comforting to investors.
Why this volte face? Remember, the earlier plan, as of Friday, appeared to be “split ’em up, we can raise capital for the good muni business, the hell with the rest.” Assuming you could segregate the muni operations, this plan might work. If MBIA could raise over a billion (albeit with a Warburg Pincus backstop), Ambac and its buddies might be able to stump up enough to pay the steep reinsurance rates that Buffett is demanding.
It appears they have discovered that they lack a legal basis for preferring the muni policyholders over the others, and even if they try not to prefer one group over another, it is going to be well nigh impossible to come up with a formula that won’t be contested. The Journal, along with others, sounded the litigation drumbeat:
Splitting the business between its municipal-bond and its riskier structured-finance operations…..would be financially and legally messy. It would pit policyholders and shareholders against both each other and regulators….
“It may sound politically convenient to separate out the muni business, but it’s going to invite a raft of lawsuits,” says Sean Egan, managing director at research firm Egan-Jones Ratings Co.
In addition, you have the minor detail that a break up may Destroy the World of Finance as We Know It. From Bloomberg:
Credit ratings on more than $580 billion of asset-backed securities may be cut, sparking writedowns by banks, under New York regulator Eric Dinallo’s plan to break up bond insurers….
“This is one of the worst possible outcomes for the market,” Gregory Peters, head of credit strategy at Morgan Stanley in New York, said in a telephone interview. Lower ratings would force banks that own the mortgage-backed debt to write down the value of the securities by as much as $35 billion, he estimated.
And that $35 billion is far from the biggest damage estimate we’ve read.
As we said, this split up idea never made any sense. If you talk to any dealer, say in estates, they will tell you that you sell items individually only if you think they will attract bidders (remember, the “good bank, bad bank” construct works because there are bidders for each portfolio).
If you have some items you think no one will buy separately, you put it in a lot with a few nice but not spectacular items. There is something weird about human nature, but generally a lot with more stuff in it will attract higher offers, even if the bidders really only want one or two items.
No one seems to expect that the “bad insurer” operations will attract investors. The comments from the regulators suggest the “bad” operation would be put in runoff mode. But that violates the rule of auctions above. The regulators would be more likely to get a good (or any) offer for the insurers in whole rather than in parts (as MBIA’s example confirms).
Now unless Dinallo and some brilliant lawyers comes up with a way to cut the Gordian knot (ie, they find a legal theory that permits them to discriminate among policyholders), we see a complete mess here. The split up idea has made matters, as bad as they were, even worse:
1. Ambac may have backed off the idea, at least until it has a legal basis for the breakup and a plan for how to accomplish it, thinking (as the Journal intimates) that the rating agencies won’t hold off their downgrades that long. But no investor with an operating brain cell will invest until the break up plan is fleshed out.
2. At least for FGIC, the way the breakup idea was announced angered the rescue group (such that it was, it hadn’t gotten very far). Ambac appeared to have had the most serious investor discussions, but the switch over last week to trying to shore up the muni business is of no interest to the banks who had been solicited before (remember, they wanted to rescue Ambac to save the “bad” part that is now being written off). Thus the most likely investors have been shooed away.
3. If Spitzer or Dinallo tries to force a break up on any of the insurers, they may encounter fierce opposition. The regulator has the authority to step if there is an impairment of the insurer’s ability to meet its obligations to policyholders. But what authority does he have to step in to avert a downgrade? I’d wager he has none.
Microsoft has long used FUD, Fear, Uncertainty, and Doubt, to paralyze its competitors. This bunch has managed to introduce a ton of FUD into something they want to move forward. Good luck.
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This whole Spitzer demogoguery is an exercis in self preservation. this guy grandstands on behalf of the “people.” Bloomberg article sighting the doubling of City University financing costs explains all the grandstanding. The monoline will get bailed out because the governement will do what is in its best interest. that makes munis a screaming buy at the moment at least the hardest hit ones.
The monolines are not stupid they want to preserve their cash flow machine and so are eager to break up (as opposed to haveing the golden goose stolen by Buffet/other) and the regulators are giving them the out. Yet another inside job by your governement at work.
I am curiouson what comes of Ackman’s and other shorts if the asets are divided? he is short the parent, so unless they move all the asets into a completley new company, his perfect short will come true. The only business supproting the dividend is the muni business and if that gets ripped out of the structure then wave goodbye to the holdco (curent structure). Even if the existing co gets equity position, it will be entitled to a pro rate dividend, no? it would appear a split is good for Ackkman as it basically affirms this call which is the holdco is not a viable entity.
Yves –
There’s an easy way to separate the muni from the structured finance portfolio. (Replacing the fund with a separate account, which provides support for specific liabilities by dedicating assets held in separate accounts, would also work if New York/Wisconsin law recognizes those accounts; haven’t checked.)
The structure is based on the property and casualty funds that have been established by several states. This financial guaranty fund would be dedicated to financial guaranty insurers, with a sub-fund for each insurer to precisely align the required support to the relative soundness of the insurers’ respective portfolios. It would be an accredited reinsurer and would provide excess-of-loss reinsurance for the insurers, portfolios or risks that were deemed ppropriate. Providing excess-of-loss reinsurance leaves the financial guaranty insurers (and their stockholders, including their directors and officers) with the entire risk they have committed to insure. To reassure policyholders and counterparties, the reinsurance would be provided on a cut-through basis.
Funding would be in an amount sufficient to stabilize the ratings from all three ratings agencies. It would initially be provided by (1) investors (including policyholders or counterparties), (2) guarantees
(for example, letters of credit from the Federal Home Loan Banks, as suggested at Thursday’s hearing, or other highly-rated institutions), or (3) any combination. Funds would be invested in Treasuries or other
“risk-free” instruments. Investor funding and/or guarantees would be replaced over time by a surcharge on the insurers’ premiums, which would be implemented by statute or regulation simultaneously with the
financial guaranty fund. The statute or regulation would also limit the distribution of any dividends (whether special or regular) to an amount that would not imperil the insurers’ ratings, as is currently mandated by their by-laws. The amount of the fund would be reduced if and to the extent it would not affect the insurers’ ratings.
Since payment of claims is not expected to be required for several years, such an arrangement would in essence require the financial guaranty insurers to make good on their own risks, while reassuring the financial markets that the ratings on the policies are stable and reliable.
Advantages:
– Targeting support to specific insurers and/or specific portfolios
– Minimizing the risk to be assumed by investors or other support providers
– Eliminating “moral hazard” by leaving the insurers with all the risk they’ve created
– Not requiring consent from or permitting objection by any insurer or policyholder
– Facilitating reduction (or even elimination) of the support if, as and when possible
– Simple, comprehensible, targeted and minimal
RBL,
With all due respect, your solution makes certain assumptions that aren’t applicable here. If the insurers or investors that were approached initially had the answers, they presumably could have valued the insurers and figured out a formula for their respective exposures (one issue was that everyone had different exposures and therefore a different degree of interest in a rescue plan).
The whole reason that these companies are in trouble is that they have inadequate reserves to maintain an AAA. The only reinsurance on offer is from Buffett, and demands that the insurers cede 1.5X the muni premiums. Thus shoring up the muni business drains reserves from the rest of the risks.
Even if you first raise funding (assuming that can be done; as much as MBIA was able to raise money, that was under very different circumstances, and they may also have tapped out anyone who was up for this sort of risk), you still have the problem that the intent is to allocate reserves disroportionately to the muni operations. There is no legal basis for that, for discriminating against certain policyholders when all entered into contracts guaranteed by the entire entity. This raises issues of fraudulent conveyance.
The muni policy holders can’t possibly put in more cash; you have a very large, heterogeneous group, some of which is already badly burned by their auction rate misadventure. It won’t be politically acceptable or practical to demand more from them in a rescue.
Similarly, the structured finance policyholders don’t have much incentive to go along. Indeed, I would assume that the policyholder is a special purpose vehicle that holds mortgage assets. In any of these structured finance deals, changing the distribution of cash requires the approval of at least a majority, in some cases 2/3 of the holders of EACH CLASS (ie, each tranche). No way is that going to happen (if you couldn’t get them to agree to do loan mods above the level provided in the initial deal, which no one was willing to even attempt to do, hence the New Hope Alliance plans to work around that, it isn’t happening here either).
The FHLB cannot provide these loans. They only go to member banks, and I believe against posted collateral. Similarly, a line of credit was discussed early on in the rescue efforts. If the Wall Street firms were unwilling to provide one then (remember, before the auction rate bonds got in trouble, the rescue was to be for their benefit), they won’t be receptive now when they are about to be screwed.
Finally, the structure of the insurance varies from the muni side to the structured finance side. As of 2003, the structured finance deals conformed with ISDA documentation (at least according to the Wall Street Journal). But despite the similarity in documentation, these gurantees (at least according to remarks by former MBIA CEO Dunton) are not tradeable and have very different payment triggers, So you can’t use the CDS market to value them.
And those policies very heteorgenous (in terms of expected payout timing) because there is no commonality in CDO structuring. It would be very difficult to determine fair payment on those deals. And you have other types: RMBS where they “wrapped” the deal, CMBS, and in the case of MBIA, home equity loans, second mortgages, and below investment grade credits.
This is like Solomon’s suggestion to cut a disputed baby in two, except he expected that at least one woman would refuse to do that. Here the proposal was evidently made in all seriousness, as opposed to a threat to bring the bank policyholders (who have a lot to lose) to heel.
The monolines are desperate to protect the municipal business as they know perpetuity when they see one. Problem for them is the PE/Buffet crowd also knows it!
The split gives the good bank an ability to earn, which would in theory mitigate the hit you take from the runoff/loss “bad bank” scenario. The bad bank would have to then either reinsure itself and post sufficient capital. This may be the pull to get the capital injection with the carrot being the back end return (ROE) from owning the perpetual muni business. The muni business is relatively easy to value given collateral performance and market dynamics. The gamble will be on the collateral hit to the bad bank. At a minimum at least one of the enterprises escapes the ICU and lives to breathe another day. In essence auction the municipal business and drive down the cost of capital for the bad bank. Not a bad idea unless you are a sharholder. And how do you do it when the compny is not in bankruptcy and doesn;t need to be put in bankruptcy/ that is a major legal issue aside from the liabilities/lawsuits
Wouldn’t a downgrade of AMBAC or MBIA actually move the process forward for regulataors-forcing MBIA and AMBAC to do the splits? Why would regulators discourage a ratings downgrade from Moodys and S&P at this juncture? IMO downgrades will come soon for this reason.
s,
Neglected to answer your earlier question. The Journal article had a discussion of what a break-up might mean for the credit default swaps (remember, they are on the holding company, not the insurance co’s themselves, which are subsidiaries).
If more than 75% of the value of the obligations go to the muni business, the CDS will all be assigned to it as the new reference entity. Presumably, that means the shorts are screwed (that’s of course assuming they prevail and get their AAA rating).
If 25% to 75% go to the muni bus, the CDS would be allocated between the good and bad entities. Less clear outcome here.
The irony is that the regulators appear to have accepted Ackman’s analysis (there are insufficient reserves) without accepting his recommendation (screw the holding company, it just drains cash off the insurance ops). Of course, any voluntary plan will be all about saving the holding company, since that’s what pays the executives. Only an involuntary plan (or dividend restrictions, which the regulators can impose) would clip its wings.
yves,
I don;t think there is a split arb here per se. It could actually be that on a stand alone basis the incremental cost may overshadow the improvement in muni business. Martin Wolfe analysis today is sobering.
Hard to disagree with Ackman that the holdco is esentially a farse. It is why it will be pryed away from management. Basically tell them to go quietly or risk prosecution a la Enron. This way it is binary and easy to understand. get someone reputrable to come in and take over the muni side and socialize the loss if need be (diluted by the capital regs can extract and still make the deal look good on a return basis assuming worst case). It is best solution for taxpayers and governement. So the banks lose out – sorry Chuck the music stopped.
Yves –
A few comments in response to your observations:
– The proposal is for reinsurance/collateral in a fund/separate account to be funded by new money/guarantees. There are no regulatory or fraudulent conveyance issues. The FHLBs can’t currently issue such guarantees, but allowing them to do so was suggested at last Thursday’s hearing by the subcommittee chair. Other entities could issue such guarantees.
– New money might be available on these terms. It’s not capital; it’s a reasonably safe debt-level investment. The fund/account only has to pay if (1) the insurance company can’t pay and (2) there’s a claim on the covered (presumably muni) portfolio, an extremely unlikely combination rendered even more unlikely by the insurers’ being required to take out the investors over time by a premium surcharge. In the meantime, the investors get the interest on the investments in the fund/account.
– As to the CDS: the CDS on the holding company are on the risk of default of the holding company. They’re more or less irrelevant to the insurance company.
– The CDS that are part of the insurers’ structured finance portfolios were done by affiliates of the insurer and guaranteed by the insurer under a perfectly normal policy. The form was filed with the insurance department. The New York Insurance Law explicitly authorizes guarantees of CDS and asset-backed securities and the insurance department has issued several letters to the same effect. That’s why insurers’ counsel routinely gave opinions that the policies were enforceable as such. There’s no legal basis for enforcing one type of policy but not the other.
Hope this helps.
Yves,
Others appear to agree with you, that the split makes it pretty hard to raise money, which is what I thought they were trying to accomplish. I can’t access the full article, not a subscriber, but maybe someone who is can provide more excerpts. BreakingViews says,
“Ambac reportedly wants to raise $2bn and will then consider splitting its muni and structured finance businesses. MBIA is considering a simlilar break-up. But acquiescing to Spitzer & Co.’s ultimatum may have sunk their chances to access much-needed capital.”
http://www.breakingviews.com/2008/02/19/Ambac-MBIA.aspx?sg=breakingstories
What would be the implication if Ambac/MBIA, instead of splitting, sold their Muni business. I’m guessing that they wouldn’t as its the profitable part, but if they got fair value, there shouldn’t be any fraudalent conveyance issues. This would raise capital to help save the remaining bad part of the portfolio, and allow them (maybe?)a better chance at raising more capital/guarantees, esp from the banks. The question would be, how bad is the bad part and how much capital do they really need to save the bad bit. If somehow they managed to save their AAA rating, then I guess they could still compete for new muni business. As said before, this is all a hypothetical scenario as I can’t imagine that any of the senior execs/Warburg Pincus would let go of the muni bus until wrestled out of their dying claws.