Saturday, May 2, 2009

Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions

TO BE NOTED: From Alphaville:

Bond insurers vs investment banks, redux

Funny thing, déjà vu.

About one year ago, Merrill Lynch and SCA Capital - known, somewhat ignominiously, as the first triple-A rated bond insurer to be stripped of that designation - were involved in a messy legal dispute over insurance on collateralized debt obligations. Now, history is repeating itself - only this time, it’s MBIA and Merrill that are busting out their lawyers.

First, some background:

SCA Capital used to be a fully-owned subsidiary of XL Capital. In 2006, SCA debuted in the US equity markets in what MarketWatch described as “the richest US initial public offering from the insurance sector in more than two years”. XL retained a 46 per cent stake (the valueof which it had completely written off by July 2008).

Somewhat confusingly for anyone not familiar with the minutae of the bond insurers, SCA also operated a financial guarantee subsidiary known as XL Capital Assurance (XLCA). Last year, Merrill sued XLCA over the latter’s attempt to get out of $3.1bn of CDS it had written on CDOs held by Merrill. The bond insurer counter-sued, asserting (emphasis ours):

Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions… Determined to get these CDO risks off its books at all costs before the third quarter of 2007 closed, Merrill Lynch made the decision to blatantly ignore its prior commitments to XLCA.

Attorneys specialising in the business of derivatives and in insurance told FT Alphaville at the time that XLCA’s claims were unlikely to hold water in court.

“Bond insurers are supposed to be extremely sophisticated. Any argument that they didn’t know what they were getting into is not going to cut it in court,” one NY-based lawyer who asked not to be named said. “And any claim that there was fraud involved is going to come up against a very high bar - it takes a lot to prove fraud.”

Still with me? Good. Merrill and XLCA eventually settled the dispute: Merrill agreed to tear-up the CDS contracts in exchange for $500m.

Subsequently, XLCA rebranded as Syncora Guarantee Inc - except that, legally, that had been its denomination since 2006.

Anyway - XLCA/Syncora is making headlines again, because it has “suspended payment of all claims and is operating only in the ordinary course and as necessary to complete a successful comprehensive restructuring.”

Clients, of course, are less than impressed. Per this FT story:

Banks and other investors face a bill of more than $1bn after a large US bond insurer became the first since the credit crisis struck to cease paying out claims, an event expected to trigger payouts on billions of dollars of credit derivatives.

Syncora has guaranteed more than $140bn of bonds, mainly municipal debt and structured finance. In spite of the pressures wrought by the credit crisis on the bond insurers, or monolines, such as Ambac and MBIA, no others have so far been forced to cease paying claims.

Banks, insurance companies and other investors involved in the market put up collateral against their credit derivatives exposures, which means some of the $1bn in payouts will already be in the hands of those due to receive them.

Syncora has been negotiating with banks since last July as it has attempted to write off or “commute” some of the $56bn of guarantees that SCA wrote on collateralised debt obligations (CDOs).

From mega-bucks IPO to “comprehensive restructuring” in just three years. How the mighty have fallen, etc.

Which brings us to another fallen bond insurer - and once the mightiest of them all - MBIA.

On Thursday, MBIA said it had filed suit against Merrill Lynch. From the statement, emphasis ours:
The lawsuit seeks the rescission of certain credit default swap contracts (”CDS Contracts”) and related insurance policies issued to Merrill Lynch as well as damages resulting from Merrill Lynch’s misrepresentations and breaches of contract in connection with MBIA’s $5.7 billion in gross exposure to a series of structured product transactions that Merrill Lynch arranged and marketed between July 2006 and March 2007.

More specifically, the suit seeks to void the policies and credit default swaps where Merrill Lynch is the counterparty and to recover damages for MBIA’s losses where the CDS Contracts and related policies were issued to third party counterparties other than Merrill Lynch. LaCrosse is a special purpose vehicle that entered into the CDS Contracts with Merrill Lynch and others that were in turn insured by MBIA.

MBIA believes that Merrill Lynch’s effort to market the CDS Contracts to MBIA was part of a deliberate strategy to offload billions of dollars in deteriorating U.S. subprime residential mortgages that Merrill Lynch held on its books by packaging them into collateralized debt obligations (”CDOs”) or hedging their exposure through swaps guaranteed by insurers.

Sound familiar? See XLCA v Merrill, above.

Based upon Merrill Lynch’s misrepresentations regarding, among other things, the credit quality of the collateral underlying the CDOs and the level of subordination protection, MBIA, through LaCrosse, insured over $5.7 billion of credit default protection on the super-senior and senior tranches of four CDOs. As a direct result of Merrill Lynch’s misrepresentations and breaches of contract, MBIA now faces expected losses on these four CDOs presently estimated to be in excess of several hundred million dollars. Various learned counsel contacted by FT Alphaville say the burden of proof required for MBIA to be successful in this suit remains enormous. No matter what happens, this case will be watched with interest, not least because it could set a precedent for other bond insurers to follow.

All of this is separate and distinct from questions over whether MBIA’s decision to split its bond insurance unit into a “good” municipal insurer and a “bad” insurer exposed to assets like CDOs triggered a CDS succession event.

Which is itself separate from the lawsuits filed by shareholders (the possibility of which FT Alphaville warned about back in February 2008).


UPDATE: ISDA ruled on Friday that Syncora’s decision to halt payments resulted in a failure to pay credit event. In other words, anyone who sold protection (through CDS) on debt issued by Syncora will have to may payouts to their counterparties. Notional CDS contracts written against Syncora’s debt are about $18bn, but the net value - i.e. the amount that will have to be paid out, without accounting for collateral already posted - is about $1bn, according to DTCC data.

Related links:
MBIA not screwing around in suit against Merrill - Economics of Contempt
Who’s super senior? - FT Alphaville
More monoline trouble looms - FT Alphaville (March 2008)

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