ome banks used the monolines to hedge their exposure to CDO tranches while they waited to offload them to investors

TO BE NOTED: From A Credit Trader:

"The Monoline Delusion

"monoline n. a company specializing in a single type of financial business, such as credit cards, home mortgages, or a sole class of insurance" DON

In late 2007, as the monoline act of the crisis drama played out, credit traders were being repeatedly pulled off the desk to attend two kinds of meetings. In both they heard bad news.

CDO Writedowns
In the first type of meetings, heads of trading desks would say they were writing down their exposure to a particular monoline. For instance, in the case of ACA, the ugly stepchild of the monoline business, Merrill wrote down $3.1bn in exposure, CBIC wrote down $2, Calyon $1.7bn and Citi $900mm in the fourth quarter of 2007 when ACA was downgraded from A to CCC. Prior to that, the banks had reported having little net exposure to CDO’s as their long bond positions were matched by CDS hedges.

The problem was, of course, that the hedges, or short positions, were done mostly with monolines. Merril, for example, gave their net CDO exposure only as $7bn, which consisted of $30bn gross CDO exposure against $23bn of hedges. What the bank omitted to say was that $20bn of those hedges were on with monolines. Assuming, 50% losses on the CDOs and a default by the monoline, real exposure was actually more than double the declared amount.

Lehman

Estimates of net CDO protection written by monolines come to around $125bn of mostly super-senior but also some junior super-senior and mezz exposure. Assuming 40%/60% recoveries, losses from monolines defaults would come out to around $50bn. This is a conservative assumption as

1. not all monolines would default
2. the banks hold some collateral / have collateral agreements in place (AAA monolines had much less strict collateral posting provisions and it appears even ACA, which due to its A rating was required to post collateral, won forbearance agreements from its counterparties)
3. the banks hold hedges against the monolines (though this will have been recognized long before the writedowns on the cash assets as vanilla CDS on liquid names are marked-to-market)

Without going into detail, the case of Merrill is particularly disheartening from a risk management perspective as it appears to have committed two basic mistakes. Just as the investors were becoming wary of CDO’s, and ABS CDO’s in particular given the apparent weakness in the housing market, one division of Merrill continued accumulating cash ABS assets just as another division was failing to find buyers for the securitized products.

Why Merrill was aggresively buying up assets it knew could no longer be offloaded is puzzling and speaks of disincentives in the firm. At some point though, the bank did realize that this practice was not a particularly wise strategy and if it couldn’t find buyers of the cash assets it was going to find a seller of CDO protection. At that point the only insurer willing to stick its neck out was ACA (XL Capital having walked away) which was even then on particularly shaky ground. Merril put on $10bn of hedges with the firm, however, soon after ACA was downgraded and the bank was again swimming naked.

The obvious question is why did banks have exposure to monolines in the first place? The short answer is the negative basis trade (isn’t it always?).

Moody's

The slightly longer answer is that, as mentioned, above some banks used the monolines to hedge their exposure to CDO tranches while they waited to offload them to investors.

1. For example, say a bank comes out with a $1.5bn issue of a CDO but can only find interest for half the size. The internal trading desk, whether it wanted or not, would have to hold whatever wasn’t placed.
2. Another reason was that a monoline wrapped tranche could be marketed as a higher quality product (super-AAA rather than a plain AAA) and so could reach a broader set of investors.
3. Also, buying protection from monolines was often the only way to manage the risk of CDO assets as single-name CDS on ABS CDOs hadn’t come into the existence (or at least standardized existence) yet.
4. Finally, this trade was attractive from a regulatory capital perspective and, more importantly, was positive carry which meant that holding it on the books seemed like a good strategy given the cheap balance sheet cost and a failure to recognize that funding costs may rise in the future.

Monoline Risk
The second type of meetings that credit traders were ushered into were with internal sales teams who marketed wrapped products to the banks’ clients. These were typically municipal bonds, including the poster child of muni distress: auction-rate securities. Prior to the monoline crisis, banks and investors were not particularly concerned with proper valuation of the credit risk in these securities as the monolines stood ready to pay up if the issuer were unable to do so.

However, with the monolines faring far worse than the issuers whose credit risk they were guaranteeing, investors began discounting the wrap and focusing on the underlying risk in the products. Suddenly, salespeople, whose eyes would glaze over at any mention of credit risk, were forced to understand first and second-to-default basket products and the concept of default correlation.

In a way, these “vanilla” folks had a better sense of what was happening than the more “exotic” CDO originators. They understood the fact that the guarantees offered by monoline wraps were largely illusory and offered no protection or diversification of risk.

Prior to the crisis, monoline wraps were viewed as monoline risk. This leap of faith required two assumptions: first, that the rating of the monoline was higher than the rating of the product it was insuring – this seems commonsense (ignoring for the moment the controversy over artificially low muni ratings), however this is an assumption that went out the window in the case of ACA-insured CDO tranches. The second assumption was that the default risks of the monoline and the underlying product were uncorrelated. I go into this in more detail below, but siffice it to say that in the extreme case of perfect correlation between the two entities, the monoline is expected to default at the same time as the underlying product, suggesting that the wrap added no extra protection. If 100% correlation seems high, consider the fact that the monolines were thinly capitalized relative to the risk they guaranteed (something that was made clear after the fact) and that both the monoline and the product were fundamentally exposed to systemic risk, a scenario in which both would and did suffer massive losses.

The Monolines’ Way-ward Ways
In my AIG post, I’ve described the concept known as “way-ness” which, essentially, requires us to consider the likely state of the world in the scenario a given entity of product defaults. This is particularly relevant in managing counterparty risk. For example, all else equal, you would much rather have an airline client sell you puts on WTI than calls. This is because a lower oil price (though not too low) is more likely to boost airline profits and the company would have less difficulty in making good on the put contracts.

What are the considerations for monoline way-ness risks:

1. An important question a bank has to ask itself each time it does a trade with a client that may expose it to counterparty risk (i.e. a derivative rather than a fully funded trade) is what is the client’s motivation for doing the trade. For example, if a client is punting in the market in an attempt to make up for heavy losses on other trades, the bank should be more cautious. In recent years, municipal insured penetration has steadily declined, driven by increased investor risk appetite (less need for wraps) and a perception by municipalities of a fundamental bias in the rating methodology for their sector. This has led the monolines to expand into new markets and consider new business opportunities just as the price of risk was hitting new lows. Rating agencies were also keen to expand the structured products business for which they gathered high fees. They may also have influenced the monolines to pursue the business as a way to diversify their revenue stream and ultimately keep their AAA ratings. Also, a client that is aggresively pursuing highly leveraged opportunities outside of its historic mandate, for example a corporate putting on exotic curency trades, is particularly at risk as it points to possibly broken risk controls and poor risk management. As the market discovered later, the monolines that were particularly aggressive in bidding for structured finance business, such as ACA, were the ones that would be less able to withstand losses in a stress environment



2. The key difference between the staid muni bond insurance business and the new CDO tranche insurance business that monolines were underwriting has to do with the static/dynamic mark-to-market risk profiles of the two products. This is an important consideration as the mark-to-market gains and losses are linked to the capital the insurer is required to hold as well as the collateral it may be required to post. An insurance provider prefers a lower mark-to-market sensitivity (and hence less onerous capital charges and potential collateral calls) if the product it is insuring performs badly, all else equal. For example, for a typical bond, the MTM sensitivity decreases as the credit risk worsens (since the duration of the bond decreases) – exactly what the insurer prefers. In the case of a super-senior tranche, however, the MTM sensitivity will actually increase – precisely in the worst possible time (since the delta of the tranche will increase). To provide intuition for this, consider the tranche as a initially deep-out-of-the-money option on expected loss. The wider spreads rise, the closer the super-senior tranche is to suffering impairment and hence the higher its sensitivity to credit spreads. So, as the performance on these tranches suffers, the insurers would be marginally more on the hook for each basis point wider in spread. An attempt by the insurer to delta-hedge its exposure is likely to lead to losses since the monoline would be hedging a negative-gamma position and locking in losses with each rebalancing trade as spreads move.
3. If at some point, monolines decided to offload their super-senior tranche exposure because of their view of the market or as a preventative measure to shed risk, they would likely find it very difficult to do so. The scenario in which super-senior tranches are under stress is a scenario when liquidity is at a premium and buyers of risk are on the sidelines.
4. Going back to the point briefly mentioned above, super-senior tranches are likely to sufer in a “systemic” crisis environment – precisely the one in which we find outselves today. This environment is the one where the monoline itself would be struggling, unable to source new business as issuance and risk appetite dry up. It would be difficult for the monoline to find new sources of revenue to offset the bleeding in cash due to collateral postings or recapitalization efforts.
5. Poor performance of super-senior tranches would put additional stress on the monolines which may ultimately lead to ratings downgrades – precisely what we have seen in the last few years. Ratings downgrades would automatically trigger collateral calls and increased capital cushions, precisely when the monolines would be least able to afford it. Though rating agencies try to rate companies “through the business cycle”, the fact is that there are more downgrades than upgrades during recessions.
6. The hedging of monoline exposure by banks will increase the stress on these companies. Since the monoline spreads are correlated to super-senior tranches, banks having counteparty exposure to these insurers found that their exposure increased as credit spreads widened. This caused them (at least for the one who were actively hedging their exposure) to buy protection on the monolines exacerbating the perception of monoline risk in the market and leading to a self-fulfilling spiral.
7. Recoveries in an environment of high defaults would be lower than average putting further pressure on monolines.
8. An alternative to buying protection on the monolines to manage the banks’ exposure was to buy protection on the underlying bonds in the CDO. This was not possible in the early stages of the market as single-name ABS CDOs did not trade. However, in the last few years liquidity improved and banks were able to source protection. However, buying protection on CDS will likely push cash bond and CDO spreads wider which will increase banks’ exposure and cause further MTM losses to the monolines
9. We should differentiate willingness from ability to pay. Insurance companies are generally loath to make payouts on policies, so it is not surprising that we would witness monolines balking at making payouts on the CDO tranches. Merrill, sued SCA over $3bn of CDS positions. AIG has also tried to wiggle out of some protection it wrote. This is not surprising as none of the insurers ever considered it remotely possible to have to pay out on these contracts which contributed to insufficient reserves and lax risk management. There is also some controversy over side letters suggesting that neither the insurer nor the insured expected cash to change hands on these contracts.
10. Though few people take ratings very seriously (especially now), the fact was that Merril entered into contracts with ACA (then A-rated) to buy protection on a AAA underlying. The ratings suggest that ACA is more likely to default than the product on which it is providing insurance. This is actually worse than “buying insurance on the Titanic from someone on the Titanic”.

The monoline crisis provides a textbook case for the do’s and don’ts of managing counterparty risk and why some banks ended up suffering much more than if they had pursued a more sound risk management strategy. Greed will get you every time…"