The story in today’s Financial Times, “Bond insurers want $125bn of cover wiped out,” seems more that an tad inconsistent with bond insurers’, particularly MBIA’s, claim that everything is hunk-dory with their financial condition and contention that the rating agencies were mean and capricious.
The story in brief:
Bond insurers such as Ambac, MBIA and FGIC are talking to banks about wiping out $125bn of insurance on risky debt securities in what could be the only way to limit the financial damage surrounding the bond insurers.
Discussions about “commuting” these insurance contracts, which were sold by bond insurers to banks in the form of credit default swaps, have taken on a renewed sense of urgency amid a rash of ratings downgrades in the bond insurance, or monoline, sector last week….
The talks centre on CDS contracts issued by bond insurers to guarantee payments on collateralised debt obligations, complex debt securities often backed by mortgages which have plunged in value amid a wave of foreclosures on mortgages issued in recent years.
I’m a little disappointed as to why the FT fails to mention why it is these exposures in particular that the bond insurers want to get out of. They repeatedly asserted that critics didn’t understand how these policies had been written, that in many (most?) cases they were not obligated to pay out until the underlying assets had reached final maturity, which could be twenty or thirty years out. Readers are encouraged to provide further insight.
The article also fails to mention that this move now may work for both parties given the downgrades. Any one who has bought an insurance policy in an insurer that has suffered a ratings cut is now paying for an overpriced product. For instance, someone with an MBIA guarantee signed up at a AAA rate and now has a A policy. And worse, the market is pricing it at Caa. So the policyholders should be willing to pay something to get out of the policies to save future payouts.
But can they agree on price? The banks may push hard, assuming insurer desperation, and may also be angry with being stuck with a turkey product. Insurers are notably pig headed negotiators. While in theory there should be a win-win resolution for at least some of these contracts, if the tone of discussion becomes adversarial, all bets are off.
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Forgive my ignorance, but why can’t the policy holders
just “mail in the keys”? Or do the policies, written for multiple years, contain penalties beyond mere cancellation of coverage?
WHOOPS! Misread who gets paid.
“I’m a little disappointed as to why the FT fails to mention why it is these exposures in particular that the bond insurers want to get out of. They repeatedly asserted that critics didn’t understand how these policies had been written, that in many (most?) cases they were not obligated to pay out until the underlying assets had reached final maturity, which could be twenty or thirty years out. Readers are encouraged to provide further insight.”
Because unlike ordinary guarantees, CDS a) require collateral to be posted in the event of a downgrade, and b) will be terminated on insolvency (eg a regulatory takeover), requiring an immediate payment. Technically speaking, there isn’t an inconsistency – so long as the monolines remained triple-A, or even double-A, they’d be able to pay out as and when claims come due. With the downgrades and the threat of regulatory takeover, however, the monolines face the prospect of claims far exceeding their capital coming due immediately.
As for why a bank would agree to a deal, well, according to a number of people in the know, the NYSID is quite likely to favour municipal policyholders over CDS holders, maybe even refusing to honour the CDS contracts at all. CreditSights have put out some very good research on this subject recently. You should ask them for a copy.
I fail to see how any of this “limits the damage” for failing insurers. What it may do is stave off the inevitable receivership for a little while longer.
“Commutations” are quite common in the reinsurance industry. Generally they are a way to get cash up front when the downstream liabilities are clear and there is only a slight risk of deterioration. However, another reason for entering into such commutations is when the counter-party is known to be financially weak. Better to get some cash up front than less down the road.
All of this talk of posting collateral and accelerating obligations seems very interesting in this context. We are dealing with insurance here folks, not finance. There is enormous risk poised on the back of these entities with precious little capital underneath. Furthermore, this is a state regulated entity. The NYDOI has great leeway in handling the run off of this entity once it goes in the tank.
Once the entity goes in the tank, none of this stuff matters. The DOI has full control over all assets and liabilities. This is not Federal bankruptcy court with all of its preferences, etc. This is a state regulated insurance entity. The Commissioner controls it with the blessing of the New York courts. I know there are ways of getting some edge over other creditors but it is not as easy and straightforward as regular bankruptcy.
I fail to see how any of this will help anyone. The injurers need to pony up cash up front. The supposed “insureds” will need to recognize the loss up front if they are taking a discount on the claim. How this even helps maintain the insurers solvency, let alone allows them to write business going forward, is beyond me. It will just crystalize the loss that is already there.
If the holders of these CDSs agree to commutation, they will surely have to write down the positions those swaps were held _against_ to the tune of billions if not tens of billions. So what we really have here is an argument regarding who will take billion of dollars of losses in the near future, probably insolvent banks and hedges holding swaps or probably insolvent monolines issuing those swaps. . . . All of this has the whiff and smack of arguments about who has the right to claim nonexistent revenues from a distant province irretrievably overrun by barbarians, as has come to mind before. These discussions aren’t the beginning of ‘solutions’ but the fat tail ending of ‘problems.’
“Once the entity goes in the tank, none of this stuff matters. The DOI has full control over all assets and liabilities. This is not Federal bankruptcy court with all of its preferences, etc. This is a state regulated insurance entity. The Commissioner controls it with the blessing of the New York courts. I know there are ways of getting some edge over other creditors but it is not as easy and straightforward as regular bankruptcy. “
Indeed. The CreditSights research makes exactly this point, with considerable evidentiary support. Their fundamental message is that if the NYSID takes over one or more monolines, they’ve got enormous leeway to decide what happens to the CDS holders, and nobody can know what will happen.
Finally tracked down a source for that estimated $10Bn write-off arising from a monoline downgrade
http://www.housingwire.com/2008/01/18/fitch-cuts-ambac-to-aa/
…the $10Bn actually related to ACA. Ambac and MBIA are bigger insurers but the downgrades have been smaller, so far.
“So the policyholders should be willing to pay something to get out of the policies to save future payouts.”
Yves, I think you and others are missing the point. Commutation involves the insurer paying the policyholder, not the other way around. As the FT article states: “To commute an insurance contract, the policyholder usually receives an upfront payment in exchange for agreeing to tear up the policy.”
Future payouts are the least of the policyholders’ concerns. Recall that these insurance policies via CDS were not very expensive to begin with (they cost basis points relative to the notional value of the CDO tranche being insured). If the insurers are indeed solvent, those policies are worth way more than what the banks are paying for them (when the policies were written, both the banks and the insurers thought it very unlikely that they would ever see a claim). The only reason the banks would accept a payment to terminate the contracts is because of the risk that the insurers may become insolvent and fail to pay on the policies.
Anon of 9:18,
Agreed in general, but I had taken these policies now to be a negative NPV proposition from the perspective of the policyholder and therefore thought things might be different. Guess not.
Based on what both Ginger Yellow and a former general counsel of a bond insurer said in an earlier post. policyholders not only have to pay premiums, but may also have to incur legal expenses to pursue their rights in the event of a default if the insurer goes into runoff or the NYSID intervenes (note Wisconsin is the domicile for Ambac, not sure how aggressive they intend to be).
It’s rational to pay to get out of a negative NPV proposition.
However, if the costs are as low as you suggest, keeping the policy going is more like an option. Many holders might decide to play things out a bit longer and see if the insurers become more desperate and offer better terms.