ensure that MBIA pays valid claims on insurance it issued on defaulting bonds

TO BE NOTED: From Reuters:

"Banks sue MBIA over $5 billion restructuring

Wed May 13, 2009 9:53pm EDT

NEW YORK (Reuters) - A group of major banks including Citigroup Inc, JPMorgan Chase & Co and Barclays Plc has sued MBIA Inc, charging that the bond insurer illegally restructured its operations by moving $5 billion of assets and leaving a key unit effectively insolvent.

The group of around 20 financial institutions and affiliates are seeking to ensure that MBIA pays valid claims on insurance it issued on defaulting bonds, but did not put a value on such claims.

MBIA, along with rival bond insurer Ambac Financial Group Inc, suffered huge losses in the recent financial turmoil as they were hit by claims on insurance policies they issued on repackaged debt, which turned out to be more risky than they assumed.

A spokesman for MBIA, which reported a profit of $697 million last quarter, declined comment on the lawsuit, which was filed on Wednesday in New York State Supreme Court.

The company's shares fell 9 percent in after-hours trading to $5.16, after falling more than 7 percent in regular trading on the New York Stock Exchange.

In the suit, the banks charge that MBIA acted illegally when it created a new municipal-bond insurance business earlier this year, making it free of its contractual obligations to policyholders.

As a result of moving $5 billion in assets, the banks said in their court documents, that MBIA Insurance -- the operating unit which pays claims -- is now "effectively insolvent" with no means of paying claims.

The banks claim that MBIA could instead have used its own cash to strengthen the balance sheet of MBIA Insurance, but it chose to spend more than $900 million repurchasing its own stock and debt and lending money to its asset management business. As a result, the suit claims MBIA executives will benefit while policyholders are left facing losses.

Other major banks party to the suit include units of: ABN Amro, BNP Paribas; HSBC, Bank of America Corp, Morgan Stanley, Royal Bank of Canada, Societe Generale, UBS AG and Wachovia Bank.

(Reporting by Bill Rigby; editing by Carol Bishopric)"

it can be difficult to prove who was to blame, whether it was the rating agencies, the underwriter or the originator of the assets

TO BE NOTED: From the FT:

"Ambac expects more subprime suits against banks

By Aline van Duyn in New York

Published: May 11 2009 23:28 | Last updated: May 11 2009 23:28

Ambac, the bond insurer whose finances have been hit by guarantees on billions of dollars of securities linked to risky mortgages, expects growing numbers of lawsuits against the banks that acted as underwriters and managers of these securities.

Last week, a British subsidiary of Ambac Financial filed court papers seeking $1bn in damages from JPMorgan Investment Management. As the investment manager for $1.65bn of assets in the name of Ballantyne, Ambac said JPMorgan had placed the assets in “inappropriate securities”, including risky mortgage-backed securities.

MBIA, the largest bond insurer which, like Ambac, has lost its triple A credit ratings, recently sued Merrill Lynch, now owned by Bank of America, to avoid pay-outs on $5.7bn of collateralised debt obligations linked to mortgages.

“It will be surprising to me if you didn’t see more of these sorts of cases potentially from ourselves and others,” said Douglas Renfield-Miller, executive vice-president at Ambac.

The lawsuits come as the losses on securities backed by mortgages continue to increase. As well as subprime mortgages, the other source of significant losses are so-called “Alt A” mortgages.

Ambac said it was now assuming that the losses on such Alt A mortgages, which were long considered to be relatively high quality, would be similar to subprime mortgages. Accordingly, Ambac took an $830m charge to reflect a decline in the value of Alt A securities. It also set aside $740m for further losses on mortgage loans it has guaranteed.

Its net loss fell to $392m in first quarter compared with $1.66bn in the first quarter of last year. The bond insurer expects further declines in US house prices. The lawsuits reflect broader concerns among holders of mortgage-backed assets.

It is clear that many of the assumptions underlying hundreds of billions of bonds backed by mortgages – which were assigned triple A credit ratings – were wrong. Many of the transactions were complex collateralised debt obligations that included the use of credit default swaps, which have contributed to hundreds of billions of dollars of write-downs at banks.

“These questions are being faced by many investors in structured assets,” said Joel Telpner, partner at Mayer Brown. “If there really was a problem, it can be difficult to prove who was to blame, whether it was the rating agencies, the underwriter or the originator of the assets.”

A spokeswoman said JPMorgan had received a court summons from Ambac but no formal complaint. “We believe that we managed Ballantyne’s account appropriately and thus intend to contest vigorously any allegations that we did not,” she said."

S&P also downgraded all the major US mortgage insurers, and most by multiple notches.

TO BE NOTED: From Alphaville:

"The travails of the financial guarantors Posted by Stacy-Marie Ishmael on Apr 22 15:40.

There’s been a slew of (mostly negative) ratings actions on the financial guaranty sector - the bond insurers, mortgage insurers and the like - recently. Here’s a recap.

Subsequent to a warning from FGIC’s auditor that there is substantial doubt over the bond insurer’s ability to “continue as a going concern,” Standard & Poor’s on Wednesday wrote off the company completely:
NEW YORK April 22, 2009–Standard & Poor’s Ratings Services said today that it lowered its counterparty credit, financial strength, and financial enhancement ratings on Financial Guaranty Insurance Co. (FGIC) to ‘CC’ from ‘CCC’ and assigned a negative outlook.

Standard & Poor’s also said that it subsequently withdrew the ratings on FGIC and its ‘CC’ counterparty credit rating on the holding company, FGIC Corp., because of our expectation that timely and comprehensive financial information will no longer be available.

“Recently released GAAP financial statements for both FGIC and FGIC Corp. contain a statement from the independent auditor that there is substantial doubt regarding the company’s ability to continue as a going concern,” noted Standard & Poor’s credit analyst Robert E. Green. “The issuance of this opinion results in an event of default by FGIC Corp. under the terms of the company’s revolving credit agreement.” There is $46 million outstanding under the facility, and FGIC Corp., though it is attempting to secure a waiver, does not have the resources to repay this amount in full if it were to become due on an accelerated basis. In addition, because FGIC is in a negative earned surplus position, it is not able to pay dividends to FGIC Corp.

The negative outlook reflected the possibility that additional losses incurred, as suggested by our RMBS and CDO of ABS loss estimate, could result in capital and surplus below the minimum statutory requirement of $65 million. The negative outlook on holding company FGIC Corp. reflected the independent auditor’s issuance of a going concern opinion, which triggered an event of default on the company’s revolving credit facility.

S&P also downgraded all the major US mortgage insurers, and most by multiple notches. Companies affected include Radian, PMI, Genworth Mortgage Insurance and RMIC.

But - in a rare display of confidence - S&P affirmed the triple-A rating on Financial Security Assurance (FSA) and removed it from credit watch negative.

Over at Moody’s, Ambac was downgraded to Ba3 from Baa1 (deep, deep into junk territory):

The downgrade of Ambac’s ratings primarily reflects weakened risk adjusted capitalization, as Moody’s loss estimates on RMBS securities have increased significantly (particularly with respect to Alt-A transactions). These higher loss estimates increase the estimated capital required to support Ambac’s sizable direct RMBS portfolio (including securities owned as well as securities guaranteed) and also the insurer’s large portfolio of ABS CDO risks. The rating agency noted that the claims-paying resources of Ambac remain above Moody’s expected loss estimates for the firm, though this cushion has been significantly eroded, and losses in more severe stress scenarios would exceed available resources.

Related links:
Moody’s sets its sights on the mortgage insurers - FT Alphaville

This entry was posted by Stacy-Marie Ishmael on Wednesday, April 22nd, 2009 at 15:40 and is filed under Capital markets. Tagged with Ambac, FGIC, Financial Security Assurance, Monolines, PMI, radian.

Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank

TO BE NOTED: From Accrued Interest:

"Muni Swaps: Let's hope we don't have a burnout

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

So the VRDN itself is killing you. The swap is killing you. Basically, you're dead unless something changes.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County."

"In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index."

A story on Bloomberg with lots of interesting points:

"By Michael McDonald and Michael Quint

Dec. 24 (Bloomberg) -- Six years after embarking on an effort to lower borrowing costs using derivatives, New York is watching those savings evaporate.

The state( THAT'S CORRECT, THE GOVERNMENT BOUGHT SWAPS ) says it paid bankrupt( NOW YOU KNOW WHY THIS WAS A DISASTER. IT TRIGGERED A WHOLE INFINITY OF PEOPLE HAVING TO GET CASH. IT'S LIKE A BANK RUN ) Lehman Brothers Holdings Inc. and other Wall Street banks at least $75.9 million since March to end interest-rate swap contracts that were supposed to lock in below-market rates. That money and the costs of issuing new debt to replace bonds linked to swaps( IN THIS ENVIRONMENT ) gone awry are eroding the $207 million in savings New York budget officials say the derivatives produced since 2002.

New York isn’t alone. Lehman’s bankruptcy filing on Sept. 15 triggered the termination of similar contracts across the country, forcing state and local governments and other borrowers in the $2.67 trillion municipal-debt market to buy out the agreements( PAY MONEY BACK ). They suddenly find themselves making unexpected payments at a time when their revenue is already under pressure from the worst recession since World War II ( A TERRIBLE TIME TO HAVE TO COME UP WITH CASH ).

“People are fixing problems right now,” said Nat Singer, managing partner at Swap Financial Group in South Orange, New Jersey, and the former head of municipal derivatives at Bear Stearns Cos. The number of new deals has shrunk to a “fraction” of the amount a year ago as issuers unwind failed swaps( BECAUSE OF THE BANKRUPTCY ) with Lehman, Singer said.

Bentley University in Waltham, Massachusetts, and a school district in Pennsylvania vowed never to use swaps again after losing money. The added costs in New York come as the state faces a record $15.4 billion budget deficit over the coming 15 months.

Lowering Costs

In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index. Borrowers may benefit by using swaps to lower interest expenses or lock in rates for future bond sales."

Here's a definition:

"An exchange of interest payments on a specific principal amount. This is a counterparty agreement, and so can be standardized to the requirements of the parties involved. An interest rate swap usually involves just two parties, but occasionally involves more. Often, an interest rate swap involves exchanging a fixed amount per payment period for a payment that is not fixed (the floating side of the swap would usually be linked to another interest rate, often the LIBOR). In an interest rate swap, the principal amount is never exchanged, it is just a notional principal amount. Also, on a payment date, it is normally the case that only the difference between the two payment amounts is turned over to the party that is entitled to it, as opposed to exchanging the full interest amounts. Thus, an interest rate swap usually involves very little cash outlay."

And an example:

Copyright ®2004 International Swaps and Derivatives Association, Inc.
Alfa Corp Strong
Financial
Floating rate payment
(3-month Libor)
Fixed rate payment
(5% s.a.)
Terms:
Fixed rate payer: Alfa Corp
Fixed rate: 5 percent, semiannual
Floating rate payer: Strong Financial Corp
Floating rate: 3-month USD Libor
Notional amount: US$ 100 million
Maturity: 5 years
Interest Rate Swap example
• Alfa Corp agrees to pay 5.0% of $100 million on a semiannual basis to
Strong Financial for the next five years
– That is, Alfa will pay 2.5% of $100 million, or $2.5 million, twice a year
• Strong Financial agrees to pay 3-month Libor (as a percent of the notional
amount) on a quarterly basis to Alfa Corp for the next five years
– That is, Strong will pay the 3-month Libor rate, divided by four and multiplied
by the notional amount, four times per year
• Example: If 3-month Libor is 2.4% on a reset date, Strong will be obligated to pay
2.4%/4 = 0.6% of the notional amount, or $600,000.
– Typically, the first floating rate payment is determined on the trade date
• In practice, the above fractions used to determine payment obligations
could differ according to the actual number of days in a period
– Example: If there are 91 days in the relevant quarter and market convention is to
use a 360-day year, the floating rate payment obligation in the above example
will be (91/360) × 2.4% × $100,000,000 = $606,666.67.
A fixed-for-floating interest rate swap is often referred to as a “plain vanilla” swap because it is the most commonly encountered structure"

"New York agencies used them to lower the cost of almost $7 billion in bonds sold between 2002 and 2005, according to an Oct. 30 report from the budget division. The average fixed rate the agencies agreed to pay Lehman and other banks was 3.78 percent, compared with 4.5 percent if they had sold conventional tax-exempt debt( THEY GOT A LOAN AT LOWER INTEREST ), officials calculated.

The state failed to comprehend the extent of the risks( TOO MUCH ) involved in entering into the long-term contracts, which often last more than 20 years, the report said. They included the likelihood an investment bank would go out of business, triggering the termination of the agreement ( THAT'S IT ).

930,000 Contracts

“One of the main risks with swaps, which is that a sudden bankruptcy of a counterparty could terminate a swap in unfavorable mark-to-market conditions( CURRENT PRICES ), was not effectively addressed in the existing laws and agreements,” the budget division wrote in its annual report.

A budget-division spokesman, Matt Anderson, said in an e- mail that “given the current volatility in the market, we currently don’t anticipate entering into further swap agreements at this time.”

Lehman had about 930,000 derivatives( OH MY ) contracts of all types when it collapsed, according to bankruptcy filings. About 30,000 remain open( THAT'S NOT BAD WORK ), Robert Lemons, a Weil, Gotshal & Manges lawyer representing Lehman, said last week. The contracts are worth billions of dollars to Lehman’s creditors, though their exact value isn’t clear, he said.

The cost of ending a contract depends on current interest rates. Since New York and other issuers agreed to pay a fixed rate to Lehman when borrowing costs were higher, they must pay the bank to end the deals( THAT'S IN THE CONTRACT ). The three-month dollar London interbank offered rate, or Libor, upon which many agreements are based has tumbled to 1.466 percent from 5.5725 percent in September 2007.

Swaps Approval

Because they are private agreements, no comprehensive data exist on how many municipalities( GOVERNMENTS ) are involved in the almost $400 trillion interest-rate derivatives market or the total paid to exit the contracts. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather( TRUE ).

New York passed a law in 2002 expanding the ability of state agencies and authorities to use swaps. It was signed by then-Governor George Pataki, a Republican. New Jersey, California and other states also use derivatives in their public financing.

Bentley University entered into swaps with Lehman and Charlotte, North Carolina-based Bank of America Corp. on $85 million of debt between 2003 and 2006. The school also had to pay a fee to end the swaps when Lehman collapsed, based on its contracts with the bank.

Upfront Cash

“It’s going to take awhile for people to get comfortable again, if ever,” said Paul Clemente, the chief financial officer at Bentley, who declined to disclose the amount of the fee. “As far as the future for interest-rate swaps, for me there is no future.”

Some borrowers also use swaps as a way to generate upfront cash, an attractive feature as the recession eats into municipal finances. At least 41 states and the District of Columbia face a combined budget shortfall of $42 billion this fiscal year, the Center on Budget and Policy Priorities in Washington, a non- partisan budget and tax analysis group, said Dec. 23. The estimate on Oct. 10 was $8.9 billion.

The Butler Area School District in Pennsylvania decided in August to pay JPMorgan Chase & Co. $5.2 million to back out of such a deal, more than seven times what it was paid to enter the agreement, rather than risk losing even more money over the 18- year contract. The district superintendent, Edward Fink, said he now thinks it’s inappropriate for school systems to dabble in such trades( NOT COMPETENT ), even though they were explicitly backed by the General Assembly in 2003.

Valuing Risk

JPMorgan said in September it would stop selling derivatives to states and local governments amid federal probes into financial advisers and investment bankers paying public officials for a role in swap agreements( COLLUSION ).

Borrowers “never put a value on the risks associated with the swaps( THE LENDERS SHOULD HAVE MADE IT PLAIN. THIS IS AT LEAST NEGLIGENCE ),” said Joseph Fichera, president of New York-based Saber Partners LLC, a financial adviser to corporate and public sector borrowers. They only estimated the savings investment bankers and advisers were telling them they would get, he said.

The use of swaps began faltering in February when the market for auction-rate securities collapsed. States, local governments and nonprofits sold about $166 billion of the debt, and as much as 85 percent of that was then swapped to fixed rates, according to Fichera.

Bond Insurers

The collapse of the auction-rate market left issuers such as the Port Authority of New York and New Jersey paying weekly or monthly rates of up to 20 percent. The swap agreements failed to adjust to swings in the underlying variable rates, leaving New York and others exposed to higher borrowing costs.

Interest rates on other types of municipal variable-rate debt also rose this year as investors boycotted bonds backed by MBIA Inc., Ambac Financial Group Inc. and other insurers that lost their AAA ratings because of their expansion into subprime- linked credit markets.

Some borrowers entered into new swaps after Lehman’s collapse, agreeing to pay higher than market rates in exchange for upfront payments to help cover the termination fees they owed Lehman( INTERESTING ), according to Swap Financial’s Singer. London-based Barclays Plc, which acquired Lehman’s brokerage, is among the banks bidding on this business, he said.

“The combined message from all of that is you cannot have complete confidence in your counterparty,” said Milton Wakschlag, a municipal finance lawyer in Chicago at Katten Muchin Rosenman LLP. “People will be taking a hard look at some of the conventions of the marketplace” after they finish cleaning up from Lehman’s bankruptcy."

I consider this negligence if the borrowers were not clearly explained the risk. You also see Fraud and Collusion in this post. Point taken.

"Instead they are rating based on public relations."

Accrued Interest has an important post about how the Credit Ratings Agencies, as I've said, are erring now in being too tough on companies:

"Here is the problem with Moody's stance. It has nothing to do with their actual view of municipal insurance. Its painfully obvious that this is nothing more than CYA. Its like a referee doing a make-up call. They completely screwed up structured finance ratings from 2002-2007 or there abouts. And thus they have a lot of egg on their face in regards to FGIC, Ambac, MBIA, etc.

So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?

Consider this. Let's say that a new municipal insurer is created and that insurer acquires all the municipal policies from Ambac. Now let's say that the new insurer has enough capital such that if it immediately went into run off, it could pay all realistic potential premiums with a significant cushion. What is "realistic" and "significant" in the previous sentence would need to be defined, but there is no reason why Moody's can't come up with those numbers.

Why can't such a firm be rated Aaa?

Notice how in the above scenario, the firm's ability to generate new revenue isn't relevant. The firm's ability to raise new capital isn't relevant. Its simply does the firm right now have adequate capital to pay its liabilities. Why is that concept so unreasonable?

For Moody's to claim they cannot rate on this basis is a total cop out, because this is exactly how all securitized deals are rated. A securitization is always a closed loop. The ratings have to be based on available capital versus expected losses. Obviously mistakes were made in rating securitized deals in recent years. But for Moody's to claim they cannot rate on such a basis is complete bullshit. Do we need to alter our models? Absolutely. But Moody's cannot on one hand claim to be a competent ratings agency and on the other hand claim they can't estimate muni losses versus available capital.

Municipal insurance benefited both investors and municipalities. Now it will die, all because Moody's doesn't have the courage to rate insurers based on dollars and cents. Instead they are rating based on public relations."

Here's my comment:

Don said...

"So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?"

It made sense going up, because they made a lot more money. It makes sense going down because they were trading on their reputation going up, and they're trying to get it back now. In doing so, they are abetting, once again, not focusing on fundamentals.

The model here is broken. I be interested if you have read this, or I've missed your ideas on this problem:

http://www.glgroup.com/News/White-Paper-on-Rating-Competition-and-Structured-Finance-(Part-1)-23549.html

Don the libertarian Democrat

11/26/08 2:30 PM

I didn't get a reply, or I would have posted it.

"Ambac said that it expected to make “positive adjustments” to its mark-to-market and impairment reserves as a result of the settlements"

I'm interested in Ambac because of this Alphaville post. Here's the recent reaction to a downgrade from the NY Times:

"The big bond insurer Ambac Financial Group said Wednesday that it had agreed to pay $1 billion in cash to counterparties to cancel default protection on $3.5 billion of collateralized debt obligations.

Ambac said the settlements should improve the capital position of its insurance unit, the Ambac Assurance Corporation, which lost its AAA rating on its debt in June because of its exposure to mortgage-backed debt.

“My immediate focus as Ambac’s new C.E.O. is to restore confidence in our balance sheet through aggressive risk reduction,” David Wallis, Ambac’s chief executive, said in a statement. “Ambac has consistently emphasized that in this period of extreme uncertainty in the capital markets, the de-risking and de-leveraging of our balance sheet is our highest priority.”

Once again, Flight From Risk.

"Earlier Wednesday, Standard & Poor’s cut its ratings on Ambac Financial and its insurance unit by three notches, to A, saying the company remained exposed to heavy losses from mortgage-backed securities. Ambac’s shares fell by a third following the S.&P. downgrade.

Ambac said that it expected to make “positive adjustments” to its mark-to-market and impairment reserves as a result of the settlements, and that the move should improve its standing in capital models at rating agencies.

“It’s a positive deal for Ambac,” David Havens, a desk analyst at UBS, told Reuters. “At the end of the day Ambac would probably have had to pay more than $3.5 billion to its counterparties, though that would have happened over a longer period of time.”

Here's my comment:

So:
1) Ambac’s credit rating was downgraded, so:
2) It had to meet higher capital requirements, so:
3) They bought back some insurance policies for less than their full payout price, thereby getting their debt limit down and so saving them from putting up more capital, but they did have to buy the policies out
Is that it?
And the people getting the cash for a possible higher payout later got, what, a tax deduction?

— Posted by Don the libertarian Democrat

Unlike Alphaville, the NY Times doesn't respond to posts.

Here's from Bloomberg:

"Nov. 19 (Bloomberg) -- Ambac Financial Group Inc., the second-largest bond insurer by outstanding guarantees, agreed to pay $1 billion in cash to cancel default protection on $3.5 billion of collateralized debt obligations, further freeing itself from the largest source of losses in its industry.

The settlement will result in positive adjustments to the Ambac's mark-to-market and impairment reserves, and improve its standing in rating-firm models, according to a statement today from the New York-based company.

Ambac and rivals including Syncora Holdings Ltd. and FGIC Corp., after being stripped of AAA ratings because of their CDO guarantees, have been able to cancel some of their contracts on mortgage-tied CDOs at discounts to their projected losses. In some cases, the banks with the protection also have benefited, after marking down the guarantees to reflect the insurers' declining creditworthiness amid surging U.S. foreclosures.

``My immediate focus as Ambac's new CEO is to restore confidence in our balance sheet through aggressive risk reduction,'' Chief Executive Officer David Wallis said in the statement."

Same basic story.

"Ambac's ``exposures in the U.S. residential mortgage sector and particularly the related collateralized debt obligation structures have been a source of significant and comparatively greater-than-competitor losses and will continue to expose the company'' to potentially greater-than-expected losses, Standard & Poor's said in downgrading the company earlier today.

CDOs repackage assets such as mortgage bonds and buyout loans into new debt with varying risks. The debt, much of which was tied to subprime-mortgage securities, has been the largest source of more than $966 billion of writedowns and credit losses reported since the start of last year by global financial firms.

Ambac today fell below $1 a share for the first time since going public in 1991 after its insurance rating was cut three levels to A by S&P. The shares declined 38 cents to 76 cents as of 4:15 p.m. in New York Stock Exchange composite trading, though they rose as high as $1.09 in late trading.

The shares are down 97 percent over the past 12 months.

Moody's Investors Service cut Ambac on Nov. 6 to Baa1, two steps lower than S&P's current ranking, prompting the bond insurer to post collateral and terminate contracts by shifting cash from its guarantee unit to its investment division."

Now, I want to follow Ambac because Alphaville believes that its whole mode of insuring bonds is dead, and this fascinates me.

"The outlook for the bond insurance industry is, flatly, bleak"

Wow. From Stacy-Marie Ishmael On Alphaville:

The death throes of the bond insurers

Ambac’s share price hit an all-time low on Wednesday, falling below $1 a share for the first time in the company’s history as a public company.

Why? A rather savage downgrade from S&P, which cut the bond insurer’s financial strength rating to A from AA, The outlook on the ratings is negative, meaning further cuts are likely in the medium term.

S&P’s rationale (emphasis FT Alphaville’s):

The rating action on Ambac reflects our view that the company’s exposures in the U.S. residential mortgage sector and particularly the related collateralized debt obligation (CDO) structures have been a source of significant and comparatively greater-than-competitor losses and will continue to expose the company to the potential for further adverse loss development.

These losses have slightly more than offset the benefits to the company of lower capital requirements that result from a declining book of business.

In addition, to support funding needs at affiliate Ambac Capital Funding Inc., a provider of investment agreements, to meet increased collateralization and termination requirements, Ambac has purchased assets from and made loans to the affiliate that have lowered slightly the credit quality of Ambac’s investment portfolio and increased the gap between the book value and fair market value of the assets in the portfolio.

Nevertheless, in our opinion, the company still exhibits sound claims-paying ability at its current rating and adequate liquidity levels…

The negative outlook reflects our view that Ambac’s exposure to domestic nonprime mortgages and related exposures to CDO of ABS have likely damaged its franchise and that the company faces extremely limited new business flow.

The move comes two weeks after Moody’s cut Ambac to Baa1, which is two notches lower than S&P’s rating. The Moody’s downgrade required the insurer to post collateral and to move money from its financial guarantee arm to its investment unit.

The outlook for the bond insurance industry is, flatly, bleak. Per RBS analyst Michael Cox this morning:

Several of the protagonists in the monoline story are experiencing death-throes. Syncora was only a reserve release away from breaching minimum statutory capital requirements. FGIC is barely better. Ambac and MBIA continue to see their ratings hacked at by the rating agencies. Even FSA, previously viewed as the safest of the major names, has had to fall into the arms of a rival in an attempt to prevent being subjected to the same treatment.

A moment of silence, please…

Related links:

Ambac and MBIA suffer major losses - FT

Bond insurers try to tap Treasury plan - Bloomberg

This entry was posted by Stacy-Marie Ishmael on Wednesday, November 19th, 2008

Now, I had to ask the following:

Posted by Don the libertarian Democrat [report]

It looks like these particular bond insurers are in bad shape. Are you saying that the whole business model is now unworkable?

Here's her answer, which was quite nice of her to do:

Posted by Stacy-Marie Ishmael [report]

Don - yes.

Here's my response:

Posted by Don the libertarian Democrat [report]

Thank You, Stacy-Marie. I love Alphaville. Cheers, Don

Now, I'm having a hard time wrapping my head around this. I can certainly see why no one would to sell insurance on bonds right now, but a whole investment and insurance mode destroyed. How can that be?

"The data are ``likely to underestimate the amount of net CDS exposure"

There has been a lot of talk about CDS's. Bloomberg has another story today:

"Nov. 6 (Bloomberg) -- The most comprehensive report on unregulated credit-default swaps didn't disclose bets in the section of the more than $47 trillion market that helped destroy American International Group Inc., once the world's biggest insurer.

A report by the Depository Trust and Clearing Corp. doesn't include privately negotiated credit-default swaps that insurers such as AIG, MBIA Inc. and Ambac Financial Group Inc. sold to guarantee securities known as collateralized debt obligations. It includes only a ``small fraction'' of contracts linked to mortgage securities, according to Andrea Cicione at BNP Paribas SA in London.

New York-based DTCC's data, released on its Web site Nov. 4, showed a total $33.6 trillion of transactions on governments, companies and asset-backed securities worldwide, based on gross numbers. While designed to ease concerns about the amount of risk banks and investors amassed on borrowers from companies to homeowners, the report may have missed as much as 40 percent of the trades outstanding in the market, Cicione said.

The data are ``likely to underestimate the amount of net CDS exposure,'' Cicione, who correctly forecast in January that the cost of protecting European companies from default would rise, said in an interview. ``A broadening of the coverage to the entire market is what investors really need.''

`Increased Transparency'"

Now, I might be reading this incorrectly, but there seem to be two possibilities:

1) CDS's are so complex, no one knows their amounts

2) A lot of CDS's are unreported, though probably calculable

I'm reading the story as saying 2, while a lot of people are reading the situation as 1, concluding that CDS's are some kind of undecidable proposition. The importance of transparency is the public knowledge of these CDS's and their amounts.

"CDX Indexes

Investors hedging against losses on CDOs helped push the cost of default protection to a record last week. The benchmark Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, reached 240 basis points on Oct. 27. The index rose 5 basis points to 192 basis points as of 8:48 a.m. in New York, according to broker Phoenix Partners Group.

The Markit iTraxx Europe rose to as high as 195 basis points from as low as 20 in June 2007. It was quoted at 139.5 basis points today, according to JPMorgan Chase & Co. A basis point on a credit-default swap protecting $10 million of debt from default for five years costs $1,000 a year.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality; a decline signals the opposite."

Here's the point:

"Among the information the Fed wants to see are prices at which the derivatives trade, according to a New York Fed spokesman."

So, again, their not incomprehensible.

But this is no fun:

``The worry is that these bespoke tranches are being eaten away, and who knows if and when these losses will get realized,'' Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California, wrote in a note to clients yesterday. "

It is simply a matter of which CDS's will explode. The CDO thing is another story.

" First is Moody’s expectation of greater losses on mortgage related exposure"

Sure, I'd trust Moody's. From Alphaville:

"Moody’s cuts Ambac to Baa1

Baa1 - same rating it gave to Bear Stearns back in March. The bonfire of the bond insurers continues apace.
From the Moody’s statement, emphasis ours:

"Today’s rating action concludes a review for possible downgrade that was initiated on September 18, 2008, and reflects Moody’s
view of Ambac’s diminished business and financial profile resulting from its exposure to losses from US mortgage risks and disruption in the financial guaranty business more broadly. The outlook for the ratings is developing.

The downgrade results from four factors. First is Moody’s expectation of greater losses on mortgage related exposure. The company’s reported losses and related increases in loss reserves in the third quarter are broadly consistent with Moody’s current expectations. Second is the possibility of even greater than expected losses in extreme stress scenarios. Third is the company’s diminished business prospects. Fourth is the company’s impaired financial flexibility."

Here's my comment:

Posted by Don the libertarian Democrat [report]

Is there any reason to trust Moody's now? I mean, they might well be correct here, but surely one wonders if they're going to overdo it in the other direction now. That might not be a bad thing, but why are these ratings still taken so seriously? What happened?

Here's an old Moody's story from FT.