"Yes, you gave me this home loan based upon my high FICO score (historical reputation as an individual on my ability and willingness to repay debt), but I can't repay this home loan AND all my other debt too. So I'll default on my home loan, but that will impair my FICO and hamper my ability to obtain cheap credit in the future such as Credit cards and car loan...which I am able and still willing to repay.
So I will split myself in two. You loaned money to the bad half of me. The good half will keep his reputation and FICO...Anyone dealing with me will only be dealing with my good half from now on...so don't worry about me repaying debt. Oh, and go after the bad half of me for any leins or collections. I don't know where that half of me is anymore...frankly he's not welcome around here since I'm afraid he'll still all my stuff."
Subprime is just a mess that will keep on spreading, spreading, spreading and giving lots of people work in dealing with it, lawyers especially. Hell, it might even turn out to be beneficial to the economy (joke).
I kind of agree with Joe. I still can't make sense of how this is legal. These aren't banks. If they can do this, why can't GM divide itself in two, one half would have the hummer and all the pension and retiree healthcare liabilities, seem fair?
"It appears that the combined company is worth less than the sum of the parts."
There is something sort of disingenuous about that statement. You could say the same of any entity, company or individual that had debts: it would be worth more without the debts. Similarly: inflation is controlled, ex-energy.
CR,
You are correct. The assumption is the parts are worth more than the whole. I think the munis are the "other shoe to drop" not the remaining leg that doesn't have gangrene. I suspect a bit of rope-a-dope going on. The munis spin off at a premium and no revenue and little prospect of new business while the smart money gets the other side at a deep deep discount and ongoing cash flow and divorce money and probably protection. Sweet as Casey would say.
i have a 8k income at togo's sanwich shop, but a 1,450k home, a 85 foot palmer johnson, a bell 429...all with significant notes...
my enterprise value is 5mm
Correct me if I am wrong on this: Does it matter wheather SP , Moody affirm ABK and MBI's AAA rating. In other words does anyone take SP, Moody seriously anymore. Or all this talk about splitting up ABK, MBI is an indication that they are junk at this point. The failure of so many muni auctions, the market seem to think ABK, MBI ratings are a joke.
a wholly owned subsudiary...
but does it matter...the pool was poisoned. it looked great writing a couple million essentially i/o auto loans on 50k pickups, then shuffle the debt to the undertaker...
we've seen this story in 2005, and it's replaying itself in every credit industry. abs. auto. home. cre.
i think we have a self-reinforcing ill-conditioned system here, where some holders and putative of ars are freaked that there'll be a downgrade of the monolines and thus an implicit downgrade of the ars backed by insured munis which will decrease ars liquidity and decrease ars prices by reason of dumping...
that fear keeping them from buying and that itself making the market onesided and illiquid just reinforcing the fear...
was it on this site someone said that all the gas molecules in a closed system dont tend to panic and all run to the same corner at the same time, but people do?
my favorite is the quant tail VAR model of custer, which predicted that the chance of 5,000 indians all attacking on the same day was a 12-sigma event, so it was ok to be there...
There is no restriction on a company splitting itself up into pieces. Usually, when a bank makes a loan to a company there are convenants that protect against this from happening.
This CDO "insurance" is under a CDS contract, so ISDA documentation governs the trade. I'm not sure what is in the Monoline ISDA documentation with the various banks, but I'm assuming that since they were AAA rated when agreeing to the documentation, its the bare minimum.
I think the splitting of the company would constitute a termination event (an event of default). That would mean all of their CDS liabilities would become immediately due and payable.
In terms of the sequence though I don't know if the Monolines can split first and then trigger the event of default. If they can, the banks may be out of luck.
Whether or not the net value of the bond insurance companies can be increased by splitting them up is a bit besides the point, isn't it? It's a question of honoring contracts. It's a question of whether or not a certain group of politicos, banks, CEOs, and whatnot have the right to alter these contracts. They don't have that right.
It's ethically wrong to stuff the bad policies down some people's throats in order to rescue the value of other policies. The rules of the game were supposed to be clear from the start.
I don't buy into "oh but it's for the sake of the municipalities - the munis must be protected". There's no God-given right for the munis to borrow at low rates, in fact no God-given right for the munis to borrow at all. And if they want better policies, they can start buying them from a new company, formed for example by Berkshire Hathaway. If Berk had the smarts to stay away from the bad debts, then the modest increase in bond insurance fees they would charge would be well-earned.
Why is it whenever bad things happen to certain people, the rules have to be changed to accommodate them? The rules were clear from the start. It can't possibly be good when the rules constantly look like a shell game in which you are always the "mark".
Banks tangle it up long enough in court to have munis suffer greatly. Then they all conveniently get declared insolvent and uncle sam, YOU AND ME, get the liabilities. Common gets a kick in the nuts.
I don't see how the monolines can be split up unless they file for bankruptcy first. There's no way the insured CDO holders will let this happen without lawsuits. If I were on a jury, I would side with the CDO holders.
I think the situation is similar with the banks. A lot of them will need government bailouts, but, under present law, the goverment can't do much until FDIC assumes the banks.
I don't see how equity holders will end up with anything once all is said and done.
Just because there is value to be gained from breaking up the bond insurers does not mean that the banks should get any of this increased value .
When you have almost every state and local government on one side and investment banks on the other, I would bet on the governments winning, especially since insurance regulation is a state, rather than federal function.
In general, most states defer to the home state of an insurer, but if the home state is not protecting other states' policyholders against the insurer, the other states will step in.
IIRC, the CDS business for the monolines started when the Pataki NYS Ins Commish OK'd a SIV-style set-up, with the CDS biz being housed in an entity domiciled in one of our favorite tax havens. So, to a certain extent, that CDS biz is already a separate entity, ready to be packaged off at a moment's notice.
Let us also not forget that the powers to takeover the muni monoline biz is solidly founded in state Ins law - insureds have been protected in the past (the Conseco ins co's policyholders come to mind) while the stockholders and various junior bondholders have been left holding the bag.
Of course, it all depends whether or not the CDS docs provided for guarantee by the parent company - considering the time the monolines started these sideline entities, I doubt too many of the counter-parties insisted on that - but what do I know?
Isn't that how insurance is supposed to work? I mean, the good parts covering for the bad.
When I get into a car wreck I don't expect them to pay me with only money I gave them.
The WHOLE IDEA is to have all those who pay dues and don't crash offset the few who do. It's the very concept of insurance....taking the proceeds from several parties, adjust for risk, and then use the proceeds from the many to cover the few with problems.
It would be like splitting the insurance company into two after the claims start pouring in....seperating the company into to two groups, one group which pays dues and makes no claims, another group of all those making claims. Without the ability to tap into the non-claiming group's funds what was the use of insurance in the first place?.
So they would like to segregate the insurance company with all the claims and then default on them. In the meantime they'd like to seperate and keep all the proceeds from those who don't make claims. Pure business genius if you can pull it off.
I think the question of whether it is worth more than the sum of its parts is entirely dependent on the (ficticious) S&P and Moody's rating yet to come......(Bueller?, Bueller? how long does this review take?).....using current AMBAC market value, a downgrade would cause the stock to plumment as they could no longer write muni business and still be stuck with CDO exposure.
Too early to tell.....although Bill Miller bought a big stake in AMBAC, so it is likely to go to zero....
Create a new subsidiary. The existing company pays them to assume all the muni insurance. State of NY applies receivership authority to get over any squishy bits. Done. Very unlikely the CDS contracts prohibit the insurers from disposing of unrelated obligations at a fair price. In any case, since the existing company owns the subsidiary, the CDS insurees can get all the blood to be had from the muni insurance turnip by selling the subsidiary. There's no measurable harm to whine about.
To the free-market fundamentalists clutching their pearls over contract obligations: where have you been the past 20 years while companies all over the US dumped pension and healthcare obligations via bankruptcy abuse? Especially since, as outlined above, the split can be done without either violating any contract or reducing the money available for the companies that got CDS insurance from the monolines?
"I don't see how equity holders will end up with anything once all is said and done."
Right! First it has to go BK, THEN it can be broken up. Anything other than the above is unnatural and will be structurally unsound. This is a blatant attempt at obfuscation, nothing more than a stall tactic to delay and obscure the inevitable reality. Shareholders get zero. Sorry, but that is what must happen.
Buffett's ploy seems like taking a match and lighting a powder keg. He won't be able to step in the middle of existing contracts with munis and he must know this. OTOH, he also knows plenty about derivatives and how lethal they are. Wasn't he just pushing the monolines over the cliff? At some juncture WAY down the road Buffett may be able to take all of this business, but I'm not even sure he actually wants it. The munis are not as great as everyone says, and the smoking holes in the muni balance sheets will become visible over the next couple of years. Maybe sooner.
CA is already $14B in the hole and going down fast. Whocouldanode?
They need to get the ratings agencies in there to help derive a disproportionate capital split so that the CDO side is no worse off. Then they can recapitalize the muni side.
Londonernow - You raise a good point regarding default.
Another way to do this is to capitalize a reinsurance unit that backstops the muni portfolios.
Maybe once all the complications surface, the Buffett offer becomes more appealing. A Good Man (AAA credit) is Hard to Find.
You guys wanting BK first keep forgetting that insurance is not a normal biz - most states have the right to step-in prior to BK to protect the policyholders - everyone else is tough luck.
In this case the question may be valid as to whether or not a counter-party on a CDS is an actual "insured" in insurance law, but that's a side show.
The power of the various state commissioners to takeover ins cos is not subject to BK first, unless someone else can point to law that says otherwise.
The states must protect the muni market (which includes their own debt) - all the talking is now about how to do so without destroying the CDS counter-parties. It may not be possible.
Lots of us are raising legal objections to this kind of deal but I don't see anyone citing the state laws that determine what authority the insurance commissioner has in an insolvency like this. Remember, this is not just another publicly-traded company; it's an insurance company subject to NY insurance law, and to state laws everywhere it operates. Insurance laws have special provisions that empower insurance commissioners to take over troubled companies. (It happened here in Washington state recently with some insurers whose parent company went bankrupt. Metropolitan Mortgage bankruptcy :: Ongoing coverage from The Spokesman-Review I actually tried to penetrate NY statutes to figure this out but it was beyond me. Anyone out there know what the law says?
fatbear, well yeah, sure. I mean the PTB can do whatever they want because they make the rules and can make new ones if need be. I was simply pointing out that the natural course of action for an insolvent business would be BK, followed by a reorganization of assets into various other companies or interests. Shareholders get 0 and all debt they insure gets downgraded, or at least reviewed on a case by case basis. Anything other than the above is a stall tactic and won't save anything.
How can anybody argue with a straight face that a business (especially an insurance company) is worthy of a AAA rating when they are seriously considering a break up to save the company from BK, and by extension shouldn't any debt they "insured" that required said insurance to maintain a high debt rating also be downgraded?
Also, how is any bank or municipality that may be insolvent itself going to step in to "save" the bond insurers from insolvency? BTW, I agree with you on the CDS counter-party point. They will be destroyed.
There is a big problem with NY State (or any state) having a heavy regulatory hand in this matter. Legal precedents do not allow state regulators to favor their own self-interest, and clearly NY State is self-interested via its municipal bond underwritings.
So, this will probably be decided in a federal court or even the Supreme Court, perhaps a year or two from now. I would not count on these insurance companies getting out from under the cloud of uncertainty any time soon.
The market certainly thinks the monolines are insolvent - look at MBIA's bond yield and the total collapse of the ARS market. If an objective analysis of the assets and liabilities shows the company can't pay, it's insolvent, even if it takes several more years before the checks start bouncing. Regulators of banks and insurance, in particular, are absolutely empowered to judge insolvency and need not wait for the checks to bounce before they act. Indeed, if they did wait so long, they'd have failed at their jobs.
If you anticipate that this will continue to be an important issue you may want to consider recruiting a co-blogger to deal with insurance issues, as there is great need for authoritative explanation of how insurance companies (and regulators) work. The current crop of posts are generating more heat than light, with little prospect of improvement absent a referee.
Thanks to Fatbear, Fair Economist and others who appear to know something about it.
I agree with Rob Dawg in that the "munis are the other shoe to drop," so the splitting off of the supposedly "good" munis is a faulty assumptions. The munis are about to get hammered themselves. So the question people need to ask themselves is whether all this discussion and manuevering is just a colossal waste of time? Is it like trying to save the other terminal patient who just has a little longer to live?
What else can you say when your about to face some major mark to market hits if the good is seperated from the bad? They want to hold the Muni Market hostage to their jackass mistakes. Typical slimeball Money Center Bank talking it's book. They dig their own hole deeper each time an acronym finance product blows up.
Feb. 18 (Bloomberg) -- Standard Chartered Plc's $7.15 billion structured investment vehicle may default this week after failing to repay maturing debt, Standard & Poor's said.
Whistlejacket Capital Ltd. would become the sixth SIV to fail on its debt obligations after defaults by funds including Axon Financial Funding Ltd., Victoria Finance Ltd., Cheyne Finance PLC and Rhinebridge LLC. SIVs have defaulted on more than $27 billion of senior debt since October, according to S&P data.
SIVs, funds that use short-term borrowing to buy longer- dated assets, are collapsing because they're unable to attract investors recoiling from securities that package mortgages and other assets. Banks led by HSBC Holdings Plc and Citigroup Inc. have stepped in to support their SIVs after the collapse of the U.S. subprime mortgage market.
Deloitte & Touche LLP, the receiver appointed last week to oversee the winding down of Whistlejacket, didn't pay notes due Feb. 15, S&P said in a statement. The SIV will be in default if it doesn't make a payment by Feb. 21 when a three-day grace period ends, the ratings company said last week.
The HoldingCo. is in NY. AMBAC Assurance Corp is domiciled in WI. The WI insurance commissioner is the primary controlling authority for that entity, so I would expect them to make the final call.
Am I the only one who is finding the term 'monoline' a bit oxymoronic given the current proposal?
Feb. 18 (Bloomberg) -- Qatar is buying shares in Credit Suisse Group and plans to spend as much as $15 billion on European and U.S. bank stocks over the next year, the Gulf state's prime minister said in an interview.
I don't think that self-dealing will apply to NYS Ins Commiss - if it does a takeover, it's to protect the bondholders, not the bond originator. (Some protection of bond originator is always present in insurance - sorta a freebe side benefit - but the bondholder is the beneficiary as far as the ins policy is concerned.)
And to ForgetIt - yeah, AMBAC is regulated by WI, but do you really think that if NYS moves to takeover any monoline that WI will dig in and stand by AMBAC - now that's a lawsuit waiting.
Any approach to insolvency on the part of a monoline requires state action - to ask them to wait means that they are literally closing the barndoor after the cows have flown the coop.
I would really appreciate a comment by someone who has authority to speak re whether or not CDS writing is really "insurance" in the legal sense - or if it's just an option contract to buy a bond at par - which it seems to be to me, but what do I know.
PS - I'm no expert, I just like to read the small print.
tj- It's all hand-waving. No one knows why the market goes up or down. There may be some rhyme or reason in individual stocks; eg. a biotech whose lead drug gets approved or not by FDA. For the market as a whole, SI swimsuits may be just as good an indicator as anything else, a damn sight better to look at.
A no holds barred DeathMatch - winner gets a AAA rating.
Municipal Bond Insurance IS Insurance - State Regulators have the WIDE powers mentioned by Fatbear because the States backstop the insurance companies policy holders. Muni Bonds WILL be protected.
Now CDS can NOT be an insurance policy, otherwise the sellers would need to be licenced by the state to sell it. Do you think anyone got a "CDS" licence ? ummmm No I thought not.
Qatar's announcement is political, and it will likely support the prices of the banks that they wish to invest in; hence, it's financially counterproductive.
This isn't the "Minority Report" with convictions for Pre-Crime.
Good point, Dawg.
Someone please correct me if I'm wrong (like I have to ask this crowd), but the impetus for this was not NY's insurance regulator wanting to take over AMBAC; if anything, they are wishing to avoid that scenario. Rather, the request to be divided into two 'monolines' is coming from AMBAC (and also FGIC).
Shnaps - you're right - the split scenario is a last ditch effort by the monolines to avoid the takeover - the "public interest" question is which is in the greater interest of the muni policyholders - but that points to the next shoe to fall, which is the effective destruction of the CDS market if the muni biz is takenover.
I don't know where that half of me is anymore...frankly he's not welcome around here
Having a split personality comes in handy sometimes. As in, "honey that wasn't me who came home drunk with lipstick on my collar, it was my evil twin." Didn't Bill Clinton or maybe the Menendez brothers try this defense?
But seriously folks, all this obsession with the details of who gets screwed when Spitzer/Buffett breaks up the monolines is fascinating, but perhaps we are losing sight of the forest for the trees.
Once the plan goes through, one would have to think that the days of insuring CDO/MBS are over. The "good corp" will be strictly insuring "safe" muni bonds, while it's evil doppelganger (badco) gets stuck in a zombie state, with any money going to pay past claims on the sludge. No new claims will be paid or insured, one would think.
This may have dramatic effects on the housing market moving forward. One more step towards the old days of banks actually holding the loans they write.
Late last night, rating agency Standard & Poors did some quiet housekeeping...It will mean huge new downgrades on CDO tranches from the 2005 vintage through to 2007...
We suspect this will push hundreds more CDOs through events of default and a significant number into liquidation - a likely repeat of the disastrous events in November and December, when CDOs went into meltdown and banks were forced to admit further humiliating writedowns. The last time S&P tweaked their loss-curves was at the end of October.
the purpose of insurance is to collect premiums in excess of claims, thereby making the seller the richest man in babylon
Not really. The purpose of insurance is to get people to lend you money at a below-market rate, which you invest and collect profits on, before they come and demand it back.
In the long run, insurance companies tend to pay out more than they take in, and make their money investing the float. (At least this is true in commercial property and casualty.)
Knowing this fact always makes me feel better when I come out ahead of an insurer on some deal. (Usually poor AAA, who has towed my '78 landcruiser many, many miles for me.)
If anyone cares, my guess is that the CDS counter-parties wind up owning the rump carcass after the muni biz is takenover. If there's anything left after the CDS write-down, then the monolines' own bondholders (those that own AMBAC, MBIA bonds, not the muni holders) get the rest. Current stockholders get zilch - see Conseco, et alia.
And Mr. Ackman cashes in his zillions of puts and shorts - in this case, he deserves his reward.
The 'splitting' concept fundamentally is flawed. Although it sounds dandy and swell from the business standpoint of unlocking value, there's just a leeeeeeeetle problem called...successor liability. From a legal standpoint, you don't have a license to, in essence, dump the trash and stiff those whose policies remain with the 'bad company.' And once -that- is realized and appreciated, the 'value' of doing the split evaporates.
There will be no policyholders subject to the "bad" carcass - the only real policyholders are those on the muni side - the CDS folk seem to be contract counter-parties, but not policyholders in the sense of insurance law. (If I'm wrong, someone please follow-up and correct me - I'm no lawyer.)
The question is not whether the monolines go down. It's whether they go down and take the muni market with them. No number of bankers' paperhangers will change that. Let them split, otherwise they're just going to go BK and screw up the muni market. There's no reason our local governments should pay 10-15% on their bonds because the big boys screwed up. And the monolines could countersue on the basis that the banks misrepresented the risks to the instruments.
And, btw, the powers of the state commishes to protect policyholders are probably far greater than the rights of the CDS counter-parties - the whole purpose of state ins regulation is to safeguard the policyholders.
The CDS counter-parties thought that the AAA rating was safeguard enough - they have no greater rights than any other contract party, and most certainly far less rights than policyholders under state regulation. CDS counter-parties are not consumers, and most certainly are considered sophisticated investors as they say (don't laugh). I would be very, very surprised to find any court would give them equal weighting in comparison to a policyholder.
The reason for the kerfluffle is not the CDS counter-party legal rights - it is that the removal of the muni biz to safeguard the policyholders will lead to CDS write-down and the possible destruction of several counter-parties - a mess so to speak.
So, do we castrate the muni biz to make sure that the former Masters of the Universe can continue to run their yachts, or do we face up to a severe credit crisis?
Late last night, rating agency Standard & Poors did some quiet housekeeping...It will mean huge new downgrades on CDO tranches from the 2005 vintage through to 2007...
article is over a month old, check date on your link
the ny statute would seem to indicate that a contract of financial guarantee issued by an insurer which pays the non-insurer in the event of the default on the financial obligations of a specified third party is a contract of insurance.
however.
a cds with a corporate bond underlying would typically contain a "soft default" specification triggering liability in the event of a hard default on the credits of a name, or certain credits, or in the event of certain other non-default things, such as some m&a activity.
if these cds contracts were like that, then, arguably, they are not contracts of financial guarantee, but contracts of hedging, which is not quite the same thing (for one thing, you could have, like delphi, 10x the notional size of the actual credits).
on the other hand, if these are simple cds contracts based on one exact specified tranche and only 1:1 in size ration with the physical underlying then it seems much likely to be insurance.
this is NOT silliness; of such things is litigation made.
furthermore, if the split occurred and the muni successor were sued on this account, then the ratings agencies would have to stay the whores they in my opinion are or would have to refuse the AAA rating until the litigation was settled.
QUESTION FOR THE GROUP:
its not the math, either on simple uncorrelated binomial distributions or more complex copula or other models that went wrong, its the assumptions, basically the behavioral assumptions, the lack of considering the huge fraud and so on.
so...
(i) as to normal, plain vanilla CSO stuff that involves pure corporate names, would there still be someplace to go to lay off the 85% of the risk thats classcially super senior? i havent seen any indication that the moody or s&p default rates on investment grade corporates are expected to be hugely and historically off?
(ii) as to CDO stuff with underlying CMO or for that matter CMO super senior waterfall tranches themselves, if theres no market to lay off that senior risk, how do you do a deal?
fred - thanks for the info - how do we find out if the CDS in question are one or the other? Is any of that info public, or is it all clouded in the OTC swirl? And is this very question the reason that AIG got slapped on the wrist by its auditor for "material info" to the tune of $5B or so?
Credit markets beware: CPDOs on the cusp of forced deleveraging
On Friday afternoon, Moodys downgraded 16 constant proportion debt obligations (CPDOs) - all linked to corporate names.
In fact, all of those downgraded reference a GLOBOXX portfolio - that is iTraxx EUR IG and CDX NA IG in equal measure. Weeks of widening spreads have naturally taken their toll, with net asset values for the CPDOs now hovering around 60 per cent, according to Moodys (the range quoted being 45 - 75). The NAV is simply a measure of portfolio asset worth to noteholder par.
Now CPDOs dont cash out - liquidate - typically until that NAV drops to around 10 per cent. For now, that is a little way off (not so of course, for all those bespoke second generation CPDOs referencing purely financial names). So at first glance it might seem like there are still grounds to be sanguine.
But the 60 per cent mark is nonetheless a dangerous tipping point: beyond it, CPDOs go into forced deleveraging.
At its birth a CPDO usually has about 15 times leverage. (Among other things, its the leverage and the huge notional CDS portfolio sizes that have credit traders worried)
Leverage in a CPDO is capped by two rules: 15 x the note notional and 25x NAV. Whichever of these has the lesser value is applied.
min(15 x note notional, 25 x NAV)
At inception then, imagine a CPDO which issues £100 of notes. NAV is, accordingly, 100. Leverage is thus determined as 15 x 100 = 1500. (the higher of the two cap tests, in this case 25xNAV - 2500, is discounted). Lets say the market moves against this CPDO and the NAV drops to 90 (reflecting, perhaps, a MtM portfolio loss). Leverage remains at 15x (because 25xNAV = 2250 and 15x 100 = 1500)
But now lets say - as is the current real world case - NAV drops to 60. What happens to leverage? Well, 15 x note notional is still 1500. But 25xNAV is now also 1500. In other words, if the NAV drops any further, then the second leverage cap suddenly becomes applicable.Lets say NAV drops another 10 per cent, to 50. Now, 25 x 50 = 1250. Accordingly, the CPDO delevers from 15x to 12.5x.
In market terms, that deleveraging translates into the CPDOs arranging bank having to close out earlier CDS positions and buy an equivalent amount of protection back, which in turn, will likely push spreads wider still in the markets. Another factor to look out for on the credit indices in the next couple of weeks.
For the CPDOs in question, a bad situation might well become worse, since higher spreads, of course, will have a further MtM impact on CPDO NAVs. Add in too the scare factor of banks buying big protection positions, and the markets could well move disproportionately.
For what its worth, the swap counterparty for half of those CPDOs downgraded (The SURF series) is ABN Amro.
The leverage in these structures is profound and will be a vicious circle when the deleveraging spreads across the structures due to the concentration of names. And let's not forget about the over $200 billion of super-senior CDS referencing overlapping names in the Canadian ABCP fiasco that is still being sorted out.
How can you get long credit spreads as a private investor?
"There's no reason our local governments should pay 10-15% on their bonds because the big boys screwed up."
Munis themselves will have their own day of reckoning - how many of them got big eyes when revenues climbed and committed to programs they cannot fund with a lower tax base?
fred-If I held it personally, I would just hold the notes to maturity. Some borrowers will pay; some won't. Some value will be realized on foreclosure of those who don't. I know there are accounting issues that a corporate entity faces that an individual doesn't, but when you cut through the crap, that may be the best strategy here-hold to maturity and collect what you collect.
In the long run, insurance companies tend to pay out more than they take in, and make their money investing the float. (At least this is true in commercial property and casualty.)
Right you are. And those who need that kind of insurance in the next year or two are going to get a nasty surprise at renewal time. When the investment climate sours for insurers, premiums go up a bunch. This often leads to renewed cries for "tort reform," even tho the lawyers won't really be to blame for the premium hikes.
BTW, regarding the futures market, that's why I said "may have something to do with it". You're right, you can never really tell. However, The NR thing just didn't fit time-wise.
Sandy has a good point with that article though. If you read through it, the first S&P risk model adjustment came towards then end of October, and there was a nearly 1500 pt market drop thereafter. Now, they do it again in mid January and the market goes up 700pts?!?!
Me thinks this is a delayed reaction and we haven't yet seen the fallout from this. Huge credit market losses cannot ultimately be met with big equities rallies. Something doesn't add up.
"Huge credit market losses cannot ultimately be met with big equities rallies." Sure they can. It's pointless to try to predict or understand the market. Individual stocks may sometimes move in a logical way with company-specifc news (your drug was just found to kill patients; your tires blow up at 60 mph), but there are simply too many pieces of "news" that could move "the Market" to vere make sense of them. We're all just along for the ride, whether long or short.
Author is an attorney in DC practicing insurance law. A really good blog. This page includes a post about distinguishing between warranties vs. insurance that Fred might enjoy, although it may not answer his good question regarding whether an insurance company that sells puts is writing an insurance policy.
AOTC, I agree with you short term, but my statement still stands. You cannot have massive credit losses and huge stock market rallies. The reason is very simple: too much leverage (ie credit) and fictitious capital goes into supporting stock bubbles.
When the credit market craters, the stock market must follow, just as night follows day. Although not immediately, as you have pointed out.
Behind the curve - "It's pointless to try to predict or understand the market."
Then what's your point? Is it your beief that no matter how dire things get in the credit markets equities will go higher? Do you own equities with an outlook like that?
Balance sheets don't matter today just like PEs didn't matter in 2000.
in all modesty, you might find this stimulating (and if not, im sure you'll tell me, just keep it ad rem, not ad hominem)
most of my work is in the federal income taxation of financial transactions. in that area, i routinely am confronted with seemingly "robust" and "profound" rules of law that fall apart because they are based on 19th century concepts that do not translate into 21st century reality.
in the case of insurance law, where i have only limited knowledge and disclaim expertise, i can say that the leading common law rule in new york defines insurance as an arrangement whereby one party agrees to pay another based on the occurrence of a fortuitous event.
that has over the centuries produced concepts such as "insurable interest" whereby one cannot buy insurance on an event (typically a life) without a legally recognized interest therein, for policy reasons including such mundane concerns as not allowing unrelated persons to insure the life of someone and then proceed to have them killed (a form of moral hazard).
it is also one source of prohibitions against contracts of wagering, the idea that absent a legally cognizable interest in an event, contracting to be paid on its occurrence is wagering and void.
this view is incompatible with 21st century finance.
it would produce ridiculous results to the extent that someone buying protection from a monoline on an existing physical bond, such protection by its terms confined exactly to that bond, has purchased insurance, whereas someone who doesn't own the bond but believes it more likely to default than is reflected in the quoted cost of protection buys such protection as an investment (query why that's an investment and not a wager; is there a difference??)
to digress a bit, initially in many states derivatives contracts were held void as wagering, a consequence of which was federal preemption --
so the point is, by the statutory definition, if i buy protection on a financial obligation from an insurer, i've bought insurance; if i buy it from a non-insurer, i theoretically have as well by common law but presumably no one would seek to attack that by reason of desuetude; but if the underlying risk is not with respect to one bond or tranche but to a "soft default" then who the hell knows; and thereby hangs the problem.
sorry if this is longwinded but its length is not inversely correlated with its possible importance if only to help people think regardless what conclusions they reach.
throwing around words like "insurance" can be very dangerous in parlous times like these.
i have a huge problem with a bank that bought protection to create a negative basis trade claiming that it bought insurance instead of a hedging contract...
because...
(i) if there is no difference between hedging contracts vs. insurance then a lot of people are going to jail; and
(ii) if the definition of the trigger event (soft default or whatever) is exactly the same, and the payoff is exactly the same, as owning the physical, then there can't be an arbitrage and there can't be a zero basis trade (relative to each party's cost of funds, of course); therefore if a soft default defines payoff events other than classical default, i submit that at least one possible interpretation of this is that its not statutory (financial guaranty) insurance as its not just default thats triggering the obligation.
as a thought experiment:
is buying insurance against a downgrade, so that you are compensated in the event a AA credit is downgraded to, say, BBB, really insurance? its not a contract that pays off on the failure of a reference name to pay, is it...
because this is what is going on, the argument that reducing credit ratings on monolines is reducing credit ratings on munis and that's grounds for takeover...the mathematical equivalence is arguing that by some equitable (in this case, read "bulls--t") theory, the insureds or issuers are entitled to rely on the ratings enhancement throwoff benefit of the policy...yet this isnt insurance in the statutory sense (triggered by default) but only (if at all) in the common law sense (payment on the occurrence of a fortuity)...and if thats insurance then everyone who ever sold a put has sold insurance and should be in jail.
my purpose in all this is to be a law professor at large and stimulate thinking.
its also to suggest that what we think we know when subject to the light of day may not be so clear.
im sure someone will rely on potter stewart and tell me that they can't define insurance but "they know it when they see it."
but what else would you expect from a bunch of guys and gals who went into law cause they couldn't pass calculus or organic chemistry
A shame then Merck didn't separate its business from its Vioxx line then. And Bayer should separate the Trasylol from everything else. Remington could separate the guns from the bullets too, it's only the bullets that create the problems after all. Oh, and all business should spin off bad assets and liabilities from the good stuff. "It makes sense" because that way the remaining entity can... [insert reason]. I'm sorry, I can't follow CR here. Business make good and bad decisions and they have to live and die by them. If they are really different, self sustaining concerns (cars, finance, building satellites) so that they can be invested in separately, I can go with that. Breaking them up just to isolate their "tumors", to make an end run to force somebody else to hold the bag just isn't right. (Even though you might shoehorn a legal strategy around it.)
sorry screwed that up again i meant to say that unless someone is on dope the cost to insure exactly a specific bond must equal the expected return (ie negative) on that bond or something is wrong and there's an arbitrage; so the existence of a negative basis trade must imply either a dispariy in credit rating and thus the available cash returns on the parties or, more likely, that the soft default definitions in the cds are not exactly one-to-one and onto with the bond, in which case it's starting to look less like insurance and more like hedging, and if there's no justiciable difference between insurance and hedging, a lot of people are in trouble.
" Is it your beief that no matter how dire things get in the credit markets equities will go higher?"
I don't make any predictions for where the market will go. There are too many variables to predict.
" You cannot have massive credit losses and huge stock market rallies."
I haven't seen any huge rallies lately. If analysts expect $ 500 billion in losses and the market goes down concomitantly and then losses are "only" $ 400 billion, you very well could get a rally.
There is an infinite amount of information at any given time and the market chooses to focus on some and not others. It ignored the credit issues until last July. Then it paid attention. At some point it may choose to ignore them again (or not).
All I ask is to find 1 or 2 stocks in areas where I have specialized knowledge that the analysts have misunderstood. Otherwise, it's a total crap-shoot and let's not pretend otherwise.
One more thing-when the market turned around in mid-2002, PEs were still over 20 (around 23, I think). Any market expert would have told you that no bear market ends with PEs in the 20s; they should go down to around 8-10. But it did turn around. And PEs kept falling through the 2002-2007 period as the market rose. Impossible, but true.
"LaCrosse Financial Products, LLC (LaCrosse) was created in December 1999 to act as a counterparty for structured derivative products, primarily pooled credit default swaps. While MBIA does not have a direct ownership interest in LaCrosse, it is consolidated in the financial statements of the Company on the basis that substantially all risks and rewards are borne by MBIA. MBIA's guarantees of synthetic CDOs are typically executed through LaCrosse, which enters into a credit default swap with the counterparty. MBIA Insurance Corp., through a financial guarantee policy, then guarantees the obligations of LaCrosse under the credit default swap."
In terms of detail.....I think you need to look at this. If the derivatives were "fronted" by a non insurance entity and then that entity was insured by MBI, then it the counterparties may not have any direct connection with MBI. Or at least with the regulated insurance subs.
Among other ironies, the only reason that there is anything to fight over is because of the archaic nature of the monolines based on experience from the version 1.0 of mortgage backed securities failures in the 1930's.
Namely, the assets are associated with the 'contingency reserve' and the 'unearned premium reserve'. Neither of these is based on financial theory but rather backward looking regulation from the 1930's regarding what would have prevented the version 1.0 meltdown.
You know that mbi and the monolines were going nuts for years about the requirements to keep 'excess' capital, the lack of capital efficiency, how they couldn't compete with thinly capitalized entities in the unregulated financial markets, etc.
If anyone cares, take a look at the size of these two balance sheet numbers.
im now out of my depth and these are thought experiments only.
important point: in ny insurers are not the fiduciaries of their policyholders and its almost impossible to win a bad faith litigation (failure to pay claims); what implication this has for related litigation that might arise i have not thought through.
given the lasalle spv structure, i think any court of equity would not accord much dignity to the lasalle entity if such would work an injustice.
the question is whether that means the lookthrough would say (i) its insurance with respect to lasalle therefore its insurance with respect to lasalle's counterparties (my view), or (ii) if its not insurance with respect to lasalle's counterparties, they are not insureds of the parent.
my only point here was that whether the cds counterparties are insureds or simple (so to speak) swap counterparties is likely of huge consequence in terms of the available remedies and legal theories.
i simply have no expertise in opining on the degree (if at all) to which a regulator can ignore or modify non-insurance contracts to protect policyholders.
even more, to the extent its relevant, if such contracts are swaps (ie this is on the theory the banks are not insureds; i think that is the weaker theory, but not implausible), then i dont know whether theyre deemed executory or not (prospectively).
This in inherently complicated. I don't think anyone is talking about modifying contracts at the moment.
They are talking about restructuring the entity with whom the contracts are made.
This is the intersection of financial engineering, traditional/archaic accounting (statutory accounting for insurance), more contemporary accounting (fair value concepts), and political power.
Using Lasalle as an intermediary may not work from the perspective of equity, but that seems to be the mechanism by which derivatives were transformed into financial guarantees.
Also, at the moment, the credit derivatives haven't been triggered for the most part, so they don't have claims that are being compromised.
Remember that the unearned premium reserve is a liability. Now everyone seems to think that it is overstated and there is future profit embedded in the liability. This is one of the things that people are fighting over. However, there is no way that anyone can make much of a case that this isn't directly tied to the muni exposures. It is calculated bond by bond using statutory formulas.
I would like to bill by the hour on this one also.
Has anyone been tracking to see if the Financials are still using their cash to buy back stock in order to inflate their stock prices (as opposed to preserving their limited capital bases)? If so, can that individual (or individuals) post the cash spent by each entity? Thanks in advance.
Raising $2B on a $1B market cap will be quite a feat. The story says the banks are being targeted to provide a backup on the rights offering - we'll see if they sign up for that. My guess is they want to see more of a sustainable solution before they put up any money. This looks like an effort to buy some more time with the rating agencies.
A fraudulent conveyance, also fraudulent transfer is a civil cause of action. It arises in debtor/creditor relations, particularly with reference to insolvent debtors. The cause of action is typically brought by creditors or by bankruptcy trustees. The usual fact situation involves a debtor who donates his assets, usually to an "insider", and leaves himself nothing to pay his creditors as part of an asset protection scheme. However, it is not uncommon to see fraudulent conveyance applications in relation to bona fides transfers, where the bankrupt has simply been more generous than they should have or, in business transactions, the business should have ceased trading earlier to avoid giving certain business creditors an unfair preference (see generally, wrongful trading). If prosecuted successfully, the plaintiff is entitled to recover the property transferred or its value from the transferee who has received a gift of the debtor's assests.
There is an old equitable maxim: "One must be just, before one is generous."
[edit] Fraudulent conveyances or transfers in the United States
In the United States, fraudulent conveyances or transfers[1] are governed by two sets of laws that are generally consistent. The first is the Uniform Fraudulent Transfer Act[2] ("UFTA") that has been adopted by all but a handful of the states.[3] The second is found in the federal Bankruptcy Code. [4]
There are two kinds of fraudulent transfer. The archetypical example is the intentional fraudulent transfer. This is a transfer of property made by a debtor with intent to defraud, hinder, or delay his or her creditors.[5] The second is a constructive fraudulent transfer. Generally, this occurs when a debtor transfers property without receiving "reasonably equivalent value" in exchange for the transfer if the debtor is insolvent[6] at the time of the transfer or becomes insolvent or is left with unreasonably small capital to continue in business as a result of the transfer.[7] Unlike the intentional fraudulent transfer, no intention to defraud is necessary.
The Bankruptcy Code authorizes a bankruptcy trustee to recover the property transferred fraudulently[8] for the benefit of all of the creditors of the debtor[9] if the transfer took place within the relevant time frame.[10] The transfer may also be recovered by a bankruptcy trustee under the UFTA too, if the state in which the transfer took place has adopted it and the transfer took place within its relevant time period.[11] Creditors may also pursue remedies under the UFTA without the necessity of a bankruptcy.[12]
Because this second type of transfer does not necessarily involve any actual wrongdoing, it is a common trap into which honest, but unwary debtors fall when filing a bankruptcy petition without an attorney. Particularly devastating and not uncommon is the situation in which an adult child takes title to the parents' home as a self-help probate measure (in order to avoid any confusion about who owns the home when the parents die and to avoid losing the home to a perceived threat from the state). Later, when the parents file a bankruptcy petition without recognizing the problem, they are unable to exempt the home from administration by the trustee. Unless they are able to pay the trustee an amount equal to the greater of the equity in the home or the sum of their debts (either directly to the Chapter 7 trustee or in payments to a Chapter 13 trustee,) the trustee will sell their home to pay the creditors. Ironically, in many cases, the parents would have been able to exempt the home and carry it safely through a bankruptcy if they had retained title or had recovered title before filing.
Even good faith purchasers of property who are the recipients of fraudulent transfers are only partially protected by the law in the U.S. Under the Bankruptcy Code, they get to keep the transfer to the extent of the value they gave for it, which means that they may lose much of the benefit of their bargain even though they have no knowledge that the transfer to them is fraudulent.[13]
Some of the most egregious fraudulent transfers occur in connection with leveraged buy outs, where the management/owners of a failing corporation will cause the corporation to borrow on its assets and use the loan proceeds to purchase the management/owner's stock at highly inflated prices. The creditors of the corporation will then often have little or no unencumbered assets left upon which to collect their debts. LBO's can be either intentional or constructive fraudulent transfers, or both, depending on how obviously the corporation is financially impaired when the transaction is completed.
Although not all leveraged buy outs ("LBO's") are fraudulent transfers, a red flag is raised when, after an LBO, the company then cannot pay its creditors.[14]
[edit] Footnotes
^ The term fraudulent conveyance is included within the more general term fraudulent transfer, as a conveyance is more descriptive of the transfer of title to real property. Fraudulent transfer, however, includes all types of property and in the U.S., both are generally all governed by the same law. Therefore, the transfer will be used for the remainder of this section.
^ Promulgated by the National Conference of Commissioners on Uniform State Laws (NCCUSL) in 1984
^ As of June, 2005, 43 states and the District of Columbia had adopted it. See NCCUSL website, NCCUSL Home. A complete copy can be found there or at http://www.stcl.edu/rosin/ufta84.pdf
^ 11 USC § 548. Much of the language of this section was adopted from the Uniform Fraudulent Conveyance Act, which is the predecessor of the UFTA.
^ 11 USC § 548(1); UFTA § 4(a)(1).
^ Under the Bankruptcy Code, insolvency exists when the sum of the debtor's debts exceeds the fair value of the debtor's property, with some exceptions. It is a balance sheet test. 11 USC § 101(32)
^ 11 USC § 548(2); UFTA § 4(a)(2).
^ This is done through the mechanism of avoidance of the transfer. 11 USC § 548.
^ 11 USC § 551
^ Within two years prior to the filing of bankruptcy - 11 USC § 548(a)
^ 11 USC § 544(b) allows trustees to employ applicable state law to recover fraudulent transfers. The time period under the UFTA is in most cases four years before action is brought to recover. - UFTA § 9.
^ UFTA § 7.
^ See, Gill v. Maddalena, 176 B.R. 551, 555, 558 (Bankr.C.D.Cal. 1994) (citing 11 USC § 548(c))
^ See, for example, Murphy v. Meritor Savings Bank, 126 B.R. 370, 393, 413 (Bankr. D. Mass. 1991), in which an LBO left the corporation with insufficient cash to operate for longer than 10 days.
AHEAD OF THE CURVE: "One more thing-when the market turned around in mid-2002, PEs were still over 20 (around 23, I think). Any market expert would have told you that no bear market ends with PEs in the 20s; they should go down to around 8-10. But it did turn around. And PEs kept falling through the 2002-2007 period as the market rose. Impossible, but true."
Good point. P/Es can be highly misleading. When companies post low profits, as growth stocks did back in the early 2000's, P/Es were elevated. A similar thing is happening now with financials posting negative profits (some, like the monolines, are even posting negative revenue).
Having said that, I still think the stock market will go into a correction (most likely a sideways correction like the in the mid to late 60's). The main reason I am cautious is because corporate profits as a percent of GDP is high. Corporate profits are more likely to decline than go up, and stock prices are driven by earnings (and interest rates/inflation too).
But unlike the bears who roam around these boards, I think most assets are going to suffer. Due to the massive run-up in all assets (due to so-called cheap liquidity), a correction in all assets is inevitable. A lot of bears who are bullish on gold, commodities, etc, are probably going to get hit the worst.
A brief comment on the difference between an insurance policy and a contract.
1. All insurance policies are contracts, but all contracts are not insurance policies.
2. An insurance policy is a contract written on a form approved by a regulatory authority and is subject to a wide variety of non-contractual provisions generally designed to protect the policyholder.
3. Insurance companies write policies for customers (their primary business), and also enter into a wide variety of other contracts and commercial arrangements, ranging from branch office leases to buying advertising and everything else.
4. 'Everything else' includes trading investment securities and entering into counterparty arrangements in the capital markets.
5. People loosely refer to the monolines' activities in the capital markets as writing insurance policies, but as I understand the arrangements, they were not on written on policy forms approved by the relevant insurance commissioner (instead, you had industry standards like ISDA swap agreements and so on).
6. So the capital markets transactions aren't policies and it is a mistake to treat them as such. (A mistake Goldman Sachs did not make, incidentally, when it refused to deal with counterparties who would not post collateral).
7. Consequently, the rights of contractual counterparties--whether a landlord or an investment bank--should be evaluated with reference to contract and bankruptcy law, while the rights of policyholders should be reviewed with reference to insurance regulation and insolvency law. Presumably, the treatments and the outcomes will differ.
Finally, litigation risk. This bugaboo, used to threaten private sector types tempted to risky business, isn't a showstopper in the regulatory context. It simpoly comes with the territory. Here, the chances of permanent injunctive relief are trivial, the standard for judicial review of regulatory action is deferential, and at the end of the day, what's the claim--that excessive reserves were transferred to the ring-fenced newco reinsuring the policy liabilities?
I don't think that self-dealing will apply to NYS Ins Commiss - if it does a takeover, it's to protect the bondholders, not the bond originator. rc helicopter Tactical Flashlights video game
Bring on the lawyers, let the games begin!
Shut them down and let the competition replace the market with solvent companies. Buffet is already licking his lips to take the business.
Hmmmm, not sure how a split would work.
Certainly individuals should try it:
"Yes, you gave me this home loan based upon my high FICO score (historical reputation as an individual on my ability and willingness to repay debt), but I can't repay this home loan AND all my other debt too. So I'll default on my home loan, but that will impair my FICO and hamper my ability to obtain cheap credit in the future such as Credit cards and car loan...which I am able and still willing to repay.
So I will split myself in two. You loaned money to the bad half of me. The good half will keep his reputation and FICO...Anyone dealing with me will only be dealing with my good half from now on...so don't worry about me repaying debt. Oh, and go after the bad half of me for any leins or collections. I don't know where that half of me is anymore...frankly he's not welcome around here since I'm afraid he'll still all my stuff."
Subprime is just a mess that will keep on spreading, spreading, spreading and giving lots of people work in dealing with it, lawyers especially. Hell, it might even turn out to be beneficial to the economy (joke).
"steal all my stuff"
who made the call on the good Kirk/bad Kirk Star Trek on an earlier thread?
damn transporter malfunction, but hey we have that insured...no wait
I kind of agree with Joe. I still can't make sense of how this is legal. These aren't banks. If they can do this, why can't GM divide itself in two, one half would have the hummer and all the pension and retiree healthcare liabilities, seem fair?
Average Joe --- LOL! Loved it.
It worked for Frank Lorenzo. Anybody fly Eastern lately?
"It appears that the combined company is worth less than the sum of the parts."
There is something sort of disingenuous about that statement. You could say the same of any entity, company or individual that had debts: it would be worth more without the debts. Similarly: inflation is controlled, ex-energy.
GM already did split in two...
the former gmac that, at the height of ponziness, sold itself to a three headed dog.
If there wasn't enough honesty and lack of greed to handle running one company, how will they ever manage to run two companies?
CR,
You are correct. The assumption is the parts are worth more than the whole. I think the munis are the "other shoe to drop" not the remaining leg that doesn't have gangrene. I suspect a bit of rope-a-dope going on. The munis spin off at a premium and no revenue and little prospect of new business while the smart money gets the other side at a deep deep discount and ongoing cash flow and divorce money and probably protection. Sweet as Casey would say.
sans debts is known as "enterprise value"
i have a 8k income at togo's sanwich shop, but a 1,450k home, a 85 foot palmer johnson, a bell 429...all with significant notes...
my enterprise value is 5mm
Average Joe writes:
"steal all my stuff"
Address? Oh wait, this is already happening on Craigslist.
CR and Tanta,
Correct me if I am wrong on this: Does it matter wheather SP , Moody affirm ABK and MBI's AAA rating. In other words does anyone take SP, Moody seriously anymore. Or all this talk about splitting up ABK, MBI is an indication that they are junk at this point. The failure of so many muni auctions, the market seem to think ABK, MBI ratings are a joke.
Thanks
gmac was a subsidiary.
Actually, the combined company is worth more than the sum of its parts, because one of the parts (considered separately) is so hugely negative.
There are three parts:
3 is far larger than #1. Whatever value #2 may have is certainly not great enough to make up the difference.
All this posturing is really about minimizing #3.
a wholly owned subsudiary...
but does it matter...the pool was poisoned. it looked great writing a couple million essentially i/o auto loans on 50k pickups, then shuffle the debt to the undertaker...
we've seen this story in 2005, and it's replaying itself in every credit industry. abs. auto. home. cre.
firsttopanic --
i think we have a self-reinforcing ill-conditioned system here, where some holders and putative of ars are freaked that there'll be a downgrade of the monolines and thus an implicit downgrade of the ars backed by insured munis which will decrease ars liquidity and decrease ars prices by reason of dumping...
that fear keeping them from buying and that itself making the market onesided and illiquid just reinforcing the fear...
was it on this site someone said that all the gas molecules in a closed system dont tend to panic and all run to the same corner at the same time, but people do?
my favorite is the quant tail VAR model of custer, which predicted that the chance of 5,000 indians all attacking on the same day was a 12-sigma event, so it was ok to be there...
There is no restriction on a company splitting itself up into pieces. Usually, when a bank makes a loan to a company there are convenants that protect against this from happening.
This CDO "insurance" is under a CDS contract, so ISDA documentation governs the trade. I'm not sure what is in the Monoline ISDA documentation with the various banks, but I'm assuming that since they were AAA rated when agreeing to the documentation, its the bare minimum.
I think the splitting of the company would constitute a termination event (an event of default). That would mean all of their CDS liabilities would become immediately due and payable.
In terms of the sequence though I don't know if the Monolines can split first and then trigger the event of default. If they can, the banks may be out of luck.
Can anyone enlighten me further?
Whether or not the net value of the bond insurance companies can be increased by splitting them up is a bit besides the point, isn't it? It's a question of honoring contracts. It's a question of whether or not a certain group of politicos, banks, CEOs, and whatnot have the right to alter these contracts. They don't have that right.
It's ethically wrong to stuff the bad policies down some people's throats in order to rescue the value of other policies. The rules of the game were supposed to be clear from the start.
I don't buy into "oh but it's for the sake of the municipalities - the munis must be protected". There's no God-given right for the munis to borrow at low rates, in fact no God-given right for the munis to borrow at all. And if they want better policies, they can start buying them from a new company, formed for example by Berkshire Hathaway. If Berk had the smarts to stay away from the bad debts, then the modest increase in bond insurance fees they would charge would be well-earned.
Why is it whenever bad things happen to certain people, the rules have to be changed to accommodate them? The rules were clear from the start. It can't possibly be good when the rules constantly look like a shell game in which you are always the "mark".
More . . .
FGIC Split: Let the Lawsuits Begin -- Seeking Alpha
This has Northern Rock written all over it.
Banks tangle it up long enough in court to have munis suffer greatly. Then they all conveniently get declared insolvent and uncle sam, YOU AND ME, get the liabilities. Common gets a kick in the nuts.
And yet, it appears that ABK is trading up about 9% on the Dax today.
I don't see how the monolines can be split up unless they file for bankruptcy first. There's no way the insured CDO holders will let this happen without lawsuits. If I were on a jury, I would side with the CDO holders.
I think the situation is similar with the banks. A lot of them will need government bailouts, but, under present law, the goverment can't do much until FDIC assumes the banks.
I don't see how equity holders will end up with anything once all is said and done.
Just because there is value to be gained from breaking up the bond insurers does not mean that the banks should get any of this increased value .
When you have almost every state and local government on one side and investment banks on the other, I would bet on the governments winning, especially since insurance regulation is a state, rather than federal function.
In general, most states defer to the home state of an insurer, but if the home state is not protecting other states' policyholders against the insurer, the other states will step in.
IIRC, the CDS business for the monolines started when the Pataki NYS Ins Commish OK'd a SIV-style set-up, with the CDS biz being housed in an entity domiciled in one of our favorite tax havens. So, to a certain extent, that CDS biz is already a separate entity, ready to be packaged off at a moment's notice.
Let us also not forget that the powers to takeover the muni monoline biz is solidly founded in state Ins law - insureds have been protected in the past (the Conseco ins co's policyholders come to mind) while the stockholders and various junior bondholders have been left holding the bag.
Of course, it all depends whether or not the CDS docs provided for guarantee by the parent company - considering the time the monolines started these sideline entities, I doubt too many of the counter-parties insisted on that - but what do I know?
I'd like to hear more people comment on why we don't just let the monolines go BK and transfer as much as possible to the new Berkshire insurer?
is it that the monoline BK would create untreatable systemic risk?
To continue:
Isn't that how insurance is supposed to work? I mean, the good parts covering for the bad.
When I get into a car wreck I don't expect them to pay me with only money I gave them.
The WHOLE IDEA is to have all those who pay dues and don't crash offset the few who do. It's the very concept of insurance....taking the proceeds from several parties, adjust for risk, and then use the proceeds from the many to cover the few with problems.
It would be like splitting the insurance company into two after the claims start pouring in....seperating the company into to two groups, one group which pays dues and makes no claims, another group of all those making claims. Without the ability to tap into the non-claiming group's funds what was the use of insurance in the first place?.
So they would like to segregate the insurance company with all the claims and then default on them. In the meantime they'd like to seperate and keep all the proceeds from those who don't make claims. Pure business genius if you can pull it off.
I think the question of whether it is worth more than the sum of its parts is entirely dependent on the (ficticious) S&P and Moody's rating yet to come......(Bueller?, Bueller? how long does this review take?).....using current AMBAC market value, a downgrade would cause the stock to plumment as they could no longer write muni business and still be stuck with CDO exposure.
Too early to tell.....although Bill Miller bought a big stake in AMBAC, so it is likely to go to zero....
Anonymous above is Average Joe.
There's a simple way to do the split:
Create a new subsidiary. The existing company pays them to assume all the muni insurance. State of NY applies receivership authority to get over any squishy bits. Done. Very unlikely the CDS contracts prohibit the insurers from disposing of unrelated obligations at a fair price. In any case, since the existing company owns the subsidiary, the CDS insurees can get all the blood to be had from the muni insurance turnip by selling the subsidiary. There's no measurable harm to whine about.
To the free-market fundamentalists clutching their pearls over contract obligations: where have you been the past 20 years while companies all over the US dumped pension and healthcare obligations via bankruptcy abuse? Especially since, as outlined above, the split can be done without either violating any contract or reducing the money available for the companies that got CDS insurance from the monolines?
"I don't see how equity holders will end up with anything once all is said and done."
Right! First it has to go BK, THEN it can be broken up. Anything other than the above is unnatural and will be structurally unsound. This is a blatant attempt at obfuscation, nothing more than a stall tactic to delay and obscure the inevitable reality. Shareholders get zero. Sorry, but that is what must happen.
Buffett's ploy seems like taking a match and lighting a powder keg. He won't be able to step in the middle of existing contracts with munis and he must know this. OTOH, he also knows plenty about derivatives and how lethal they are. Wasn't he just pushing the monolines over the cliff? At some juncture WAY down the road Buffett may be able to take all of this business, but I'm not even sure he actually wants it. The munis are not as great as everyone says, and the smoking holes in the muni balance sheets will become visible over the next couple of years. Maybe sooner.
CA is already $14B in the hole and going down fast. Whocouldanode?
the purpose of insurance is to collect premiums in excess of claims, thereby making the seller the richest man in babylo
I'm with Average Joe's explanation. Nice try, no can do after the fact.
They need to get the ratings agencies in there to help derive a disproportionate capital split so that the CDO side is no worse off. Then they can recapitalize the muni side.
Londonernow - You raise a good point regarding default.
Another way to do this is to capitalize a reinsurance unit that backstops the muni portfolios.
Maybe once all the complications surface, the Buffett offer becomes more appealing. A Good Man (AAA credit) is Hard to Find.
You guys wanting BK first keep forgetting that insurance is not a normal biz - most states have the right to step-in prior to BK to protect the policyholders - everyone else is tough luck.
In this case the question may be valid as to whether or not a counter-party on a CDS is an actual "insured" in insurance law, but that's a side show.
The power of the various state commissioners to takeover ins cos is not subject to BK first, unless someone else can point to law that says otherwise.
The states must protect the muni market (which includes their own debt) - all the talking is now about how to do so without destroying the CDS counter-parties. It may not be possible.
Lots of us are raising legal objections to this kind of deal but I don't see anyone citing the state laws that determine what authority the insurance commissioner has in an insolvency like this. Remember, this is not just another publicly-traded company; it's an insurance company subject to NY insurance law, and to state laws everywhere it operates. Insurance laws have special provisions that empower insurance commissioners to take over troubled companies. (It happened here in Washington state recently with some insurers whose parent company went bankrupt. Metropolitan Mortgage bankruptcy :: Ongoing coverage from The Spokesman-Review I actually tried to penetrate NY statutes to figure this out but it was beyond me. Anyone out there know what the law says?
OT-A bullish indicator from SI's swimsuit issue...
Bespoke Investment Group: 2008 Sports Illustrated Swimsuit Issue: It's Research!
Aotc,
funny example of spurious correlation - thanks!
fatbear, well yeah, sure. I mean the PTB can do whatever they want because they make the rules and can make new ones if need be. I was simply pointing out that the natural course of action for an insolvent business would be BK, followed by a reorganization of assets into various other companies or interests. Shareholders get 0 and all debt they insure gets downgraded, or at least reviewed on a case by case basis. Anything other than the above is a stall tactic and won't save anything.
How can anybody argue with a straight face that a business (especially an insurance company) is worthy of a AAA rating when they are seriously considering a break up to save the company from BK, and by extension shouldn't any debt they "insured" that required said insurance to maintain a high debt rating also be downgraded?
Also, how is any bank or municipality that may be insolvent itself going to step in to "save" the bond insurers from insolvency? BTW, I agree with you on the CDS counter-party point. They will be destroyed.
I don't see anyone citing the state laws that determine what authority the insurance commissioner has in an insolvency like this.
What insolvency? That's the point. This isn't the "Minority Report" with convictions for Pre-Crime.
Just heard on Bloomberg Radio that Moody's downgraded FGIC to A3. No link yet.
There is a big problem with NY State (or any state) having a heavy regulatory hand in this matter. Legal precedents do not allow state regulators to favor their own self-interest, and clearly NY State is self-interested via its municipal bond underwritings.
So, this will probably be decided in a federal court or even the Supreme Court, perhaps a year or two from now. I would not count on these insurance companies getting out from under the cloud of uncertainty any time soon.
The market certainly thinks the monolines are insolvent - look at MBIA's bond yield and the total collapse of the ARS market. If an objective analysis of the assets and liabilities shows the company can't pay, it's insolvent, even if it takes several more years before the checks start bouncing. Regulators of banks and insurance, in particular, are absolutely empowered to judge insolvency and need not wait for the checks to bounce before they act. Indeed, if they did wait so long, they'd have failed at their jobs.
energyecon-Now there's some assets that many here wouldn't mind investing in...
Just a reminder - Ambac is domiciled in Wisconsin, and that state is the regulator.
CR:
If you anticipate that this will continue to be an important issue you may want to consider recruiting a co-blogger to deal with insurance issues, as there is great need for authoritative explanation of how insurance companies (and regulators) work. The current crop of posts are generating more heat than light, with little prospect of improvement absent a referee.
Thanks to Fatbear, Fair Economist and others who appear to know something about it.
I agree with Rob Dawg in that the "munis are the other shoe to drop," so the splitting off of the supposedly "good" munis is a faulty assumptions. The munis are about to get hammered themselves. So the question people need to ask themselves is whether all this discussion and manuevering is just a colossal waste of time? Is it like trying to save the other terminal patient who just has a little longer to live?
What else can you say when your about to face some major mark to market hits if the good is seperated from the bad? They want to hold the Muni Market hostage to their jackass mistakes. Typical slimeball Money Center Bank talking it's book. They dig their own hole deeper each time an acronym finance product blows up.
Standard Chartered's Whistlejacket SIV May Default (Update1)
By Neil Unmack
Feb. 18 (Bloomberg) -- Standard Chartered Plc's $7.15 billion structured investment vehicle may default this week after failing to repay maturing debt, Standard & Poor's said.
Whistlejacket Capital Ltd. would become the sixth SIV to fail on its debt obligations after defaults by funds including Axon Financial Funding Ltd., Victoria Finance Ltd., Cheyne Finance PLC and Rhinebridge LLC. SIVs have defaulted on more than $27 billion of senior debt since October, according to S&P data.
SIVs, funds that use short-term borrowing to buy longer- dated assets, are collapsing because they're unable to attract investors recoiling from securities that package mortgages and other assets. Banks led by HSBC Holdings Plc and Citigroup Inc. have stepped in to support their SIVs after the collapse of the U.S. subprime mortgage market.
Deloitte & Touche LLP, the receiver appointed last week to oversee the winding down of Whistlejacket, didn't pay notes due Feb. 15, S&P said in a statement. The SIV will be in default if it doesn't make a payment by Feb. 21 when a three-day grace period ends, the ratings company said last week.
[snip]
Index futures up big right now, so apparently this is all much ado about nothing.
p.s.: Actually, Qatar's throwing $15B at the IBs may have something to do with it.
Aotc,
Indeed - and ALL rated AAA!
The HoldingCo. is in NY. AMBAC Assurance Corp is domiciled in WI. The WI insurance commissioner is the primary controlling authority for that entity, so I would expect them to make the final call.
Am I the only one who is finding the term 'monoline' a bit oxymoronic given the current proposal?
tj-No, European markets liked the Northern Rock takeover. They were up 2% today.
Albrt said:
"Thanks to Fatbear, Fair Economist and others who appear to know something about it."
I thank them too, this blog would be worthless without the detailed knowledge of the hosts and its contributors.
However going to the "experts" on how things operate or have operated isn't necessarily the same place to go for proper solution.
Anyone who remembers my analogies to Columbine and the 911 Hijackers will remember that the "experts" are sometimes are the last place to go.
Contributions from all is what makes this a great place.
(Albrt, I understand you weren't suggesting otherwise.)
Aotc,
Plus the Qataris buying big chunk of Credit Suisse with chatter of more to come...
Qatar Buys Credit Suisse Shares, Prime Minister Says (Update6)
By Janine Zacharia and Will McSheehy
Feb. 18 (Bloomberg) -- Qatar is buying shares in Credit Suisse Group and plans to spend as much as $15 billion on European and U.S. bank stocks over the next year, the Gulf state's prime minister said in an interview.
[snip]
Anonymous @ 1:50 -
I don't think that self-dealing will apply to NYS Ins Commiss - if it does a takeover, it's to protect the bondholders, not the bond originator. (Some protection of bond originator is always present in insurance - sorta a freebe side benefit - but the bondholder is the beneficiary as far as the ins policy is concerned.)
And to ForgetIt - yeah, AMBAC is regulated by WI, but do you really think that if NYS moves to takeover any monoline that WI will dig in and stand by AMBAC - now that's a lawsuit waiting.
Any approach to insolvency on the part of a monoline requires state action - to ask them to wait means that they are literally closing the barndoor after the cows have flown the coop.
I would really appreciate a comment by someone who has authority to speak re whether or not CDS writing is really "insurance" in the legal sense - or if it's just an option contract to buy a bond at par - which it seems to be to me, but what do I know.
PS - I'm no expert, I just like to read the small print.
AOTC,
The NR news was out yesterday, but the US futures didn't spike upward until this morning.
tj- It's all hand-waving. No one knows why the market goes up or down. There may be some rhyme or reason in individual stocks; eg. a biotech whose lead drug gets approved or not by FDA. For the market as a whole, SI swimsuits may be just as good an indicator as anything else, a damn sight better to look at.
Thank You Fatbear.
CDS holders V 50 State Insurance Regulators
A no holds barred DeathMatch - winner gets a AAA rating.
Municipal Bond Insurance IS Insurance - State Regulators have the WIDE powers mentioned by Fatbear because the States backstop the insurance companies policy holders. Muni Bonds WILL be protected.
Now CDS can NOT be an insurance policy, otherwise the sellers would need to be licenced by the state to sell it. Do you think anyone got a "CDS" licence ? ummmm No I thought not.
Qatar's announcement is political, and it will likely support the prices of the banks that they wish to invest in; hence, it's financially counterproductive.
What's their motive?
This isn't the "Minority Report" with convictions for Pre-Crime.
Good point, Dawg.
Someone please correct me if I'm wrong (like I have to ask this crowd), but the impetus for this was not NY's insurance regulator wanting to take over AMBAC; if anything, they are wishing to avoid that scenario. Rather, the request to be divided into two 'monolines' is coming from AMBAC (and also FGIC).
Shnaps - you're right - the split scenario is a last ditch effort by the monolines to avoid the takeover - the "public interest" question is which is in the greater interest of the muni policyholders - but that points to the next shoe to fall, which is the effective destruction of the CDS market if the muni biz is takenover.
I don't know where that half of me is anymore...frankly he's not welcome around here
Having a split personality comes in handy sometimes. As in, "honey that wasn't me who came home drunk with lipstick on my collar, it was my evil twin." Didn't Bill Clinton or maybe the Menendez brothers try this defense?
But seriously folks, all this obsession with the details of who gets screwed when Spitzer/Buffett breaks up the monolines is fascinating, but perhaps we are losing sight of the forest for the trees.
Once the plan goes through, one would have to think that the days of insuring CDO/MBS are over. The "good corp" will be strictly insuring "safe" muni bonds, while it's evil doppelganger (badco) gets stuck in a zombie state, with any money going to pay past claims on the sludge. No new claims will be paid or insured, one would think.
This may have dramatic effects on the housing market moving forward. One more step towards the old days of banks actually holding the loans they write.
Brace yourselves: S&P adjusts risk models
Late last night, rating agency Standard & Poors did some quiet housekeeping...It will mean huge new downgrades on CDO tranches from the 2005 vintage through to 2007...
We suspect this will push hundreds more CDOs through events of default and a significant number into liquidation - a likely repeat of the disastrous events in November and December, when CDOs went into meltdown and banks were forced to admit further humiliating writedowns. The last time S&P tweaked their loss-curves was at the end of October.
FT Alphaville » Blog Archive » Brace yourselves: S&P adjusts risk models
Roger that, fatbear. Maybe the CDS market was destined to unwind eventually. If things didn't end badly, they'd never end - right?
Anyhow - my original point was that it is ultimately WI's call to make, not NY's.
Sorry, I just have a little chip on my cheesehead.
the purpose of insurance is to collect premiums in excess of claims, thereby making the seller the richest man in babylon
Not really. The purpose of insurance is to get people to lend you money at a below-market rate, which you invest and collect profits on, before they come and demand it back.
In the long run, insurance companies tend to pay out more than they take in, and make their money investing the float. (At least this is true in commercial property and casualty.)
Knowing this fact always makes me feel better when I come out ahead of an insurer on some deal. (Usually poor AAA, who has towed my '78 landcruiser many, many miles for me.)
Cheers,
prat
Shnaps -
Yes, it is WI call - but will Dilweg hold out if NY goes ahead? I sorta doubt it....
Postscript on the totality:
If anyone cares, my guess is that the CDS counter-parties wind up owning the rump carcass after the muni biz is takenover. If there's anything left after the CDS write-down, then the monolines' own bondholders (those that own AMBAC, MBIA bonds, not the muni holders) get the rest. Current stockholders get zilch - see Conseco, et alia.
And Mr. Ackman cashes in his zillions of puts and shorts - in this case, he deserves his reward.
The 'splitting' concept fundamentally is flawed. Although it sounds dandy and swell from the business standpoint of unlocking value, there's just a leeeeeeeetle problem called...successor liability. From a legal standpoint, you don't have a license to, in essence, dump the trash and stiff those whose policies remain with the 'bad company.' And once -that- is realized and appreciated, the 'value' of doing the split evaporates.
S&P adjusts risk models
Thanks, Sandy! WOW, just WOW.
Starfish -
There will be no policyholders subject to the "bad" carcass - the only real policyholders are those on the muni side - the CDS folk seem to be contract counter-parties, but not policyholders in the sense of insurance law. (If I'm wrong, someone please follow-up and correct me - I'm no lawyer.)
Sandy...
Thank take us right to the brink of the AAA at a typical 19% of the capital structure beneath them.
God knows what they are going to do to the 2007 vintage stuff.
The question is not whether the monolines go down. It's whether they go down and take the muni market with them. No number of bankers' paperhangers will change that. Let them split, otherwise they're just going to go BK and screw up the muni market. There's no reason our local governments should pay 10-15% on their bonds because the big boys screwed up. And the monolines could countersue on the basis that the banks misrepresented the risks to the instruments.
And, btw, the powers of the state commishes to protect policyholders are probably far greater than the rights of the CDS counter-parties - the whole purpose of state ins regulation is to safeguard the policyholders.
The CDS counter-parties thought that the AAA rating was safeguard enough - they have no greater rights than any other contract party, and most certainly far less rights than policyholders under state regulation. CDS counter-parties are not consumers, and most certainly are considered sophisticated investors as they say (don't laugh). I would be very, very surprised to find any court would give them equal weighting in comparison to a policyholder.
The reason for the kerfluffle is not the CDS counter-party legal rights - it is that the removal of the muni biz to safeguard the policyholders will lead to CDS write-down and the possible destruction of several counter-parties - a mess so to speak.
So, do we castrate the muni biz to make sure that the former Masters of the Universe can continue to run their yachts, or do we face up to a severe credit crisis?
The chickens are coming home to roost.
Sandy writes:
Brace yourselves: S&P adjusts risk models
Late last night, rating agency Standard & Poors did some quiet housekeeping...It will mean huge new downgrades on CDO tranches from the 2005 vintage through to 2007...
article is over a month old, check date on your link
"article is over a month old, check date on your link"
"Thanks, Sandy! WOW, just WOW.
tj & the bear | 02.18.08 - 3:06 pm |"
WOW indeed, tj
fatbear --
the ny statute would seem to indicate that a contract of financial guarantee issued by an insurer which pays the non-insurer in the event of the default on the financial obligations of a specified third party is a contract of insurance.
however.
a cds with a corporate bond underlying would typically contain a "soft default" specification triggering liability in the event of a hard default on the credits of a name, or certain credits, or in the event of certain other non-default things, such as some m&a activity.
if these cds contracts were like that, then, arguably, they are not contracts of financial guarantee, but contracts of hedging, which is not quite the same thing (for one thing, you could have, like delphi, 10x the notional size of the actual credits).
on the other hand, if these are simple cds contracts based on one exact specified tranche and only 1:1 in size ration with the physical underlying then it seems much likely to be insurance.
this is NOT silliness; of such things is litigation made.
furthermore, if the split occurred and the muni successor were sued on this account, then the ratings agencies would have to stay the whores they in my opinion are or would have to refuse the AAA rating until the litigation was settled.
QUESTION FOR THE GROUP:
its not the math, either on simple uncorrelated binomial distributions or more complex copula or other models that went wrong, its the assumptions, basically the behavioral assumptions, the lack of considering the huge fraud and so on.
so...
(i) as to normal, plain vanilla CSO stuff that involves pure corporate names, would there still be someplace to go to lay off the 85% of the risk thats classcially super senior? i havent seen any indication that the moody or s&p default rates on investment grade corporates are expected to be hugely and historically off?
(ii) as to CDO stuff with underlying CMO or for that matter CMO super senior waterfall tranches themselves, if theres no market to lay off that senior risk, how do you do a deal?
fred - thanks for the info - how do we find out if the CDS in question are one or the other? Is any of that info public, or is it all clouded in the OTC swirl? And is this very question the reason that AIG got slapped on the wrist by its auditor for "material info" to the tune of $5B or so?
at least that stale link led me to this:
FT Alphaville » Blog Archive » Credit markets beware: CPDOs on the cusp of forced deleveraging
Credit markets beware: CPDOs on the cusp of forced deleveraging
On Friday afternoon, Moodys downgraded 16 constant proportion debt obligations (CPDOs) - all linked to corporate names.
In fact, all of those downgraded reference a GLOBOXX portfolio - that is iTraxx EUR IG and CDX NA IG in equal measure. Weeks of widening spreads have naturally taken their toll, with net asset values for the CPDOs now hovering around 60 per cent, according to Moodys (the range quoted being 45 - 75). The NAV is simply a measure of portfolio asset worth to noteholder par.
Now CPDOs dont cash out - liquidate - typically until that NAV drops to around 10 per cent. For now, that is a little way off (not so of course, for all those bespoke second generation CPDOs referencing purely financial names). So at first glance it might seem like there are still grounds to be sanguine.
But the 60 per cent mark is nonetheless a dangerous tipping point: beyond it, CPDOs go into forced deleveraging.
At its birth a CPDO usually has about 15 times leverage. (Among other things, its the leverage and the huge notional CDS portfolio sizes that have credit traders worried)
Leverage in a CPDO is capped by two rules: 15 x the note notional and 25x NAV. Whichever of these has the lesser value is applied.
min(15 x note notional, 25 x NAV)
At inception then, imagine a CPDO which issues £100 of notes. NAV is, accordingly, 100. Leverage is thus determined as 15 x 100 = 1500. (the higher of the two cap tests, in this case 25xNAV - 2500, is discounted). Lets say the market moves against this CPDO and the NAV drops to 90 (reflecting, perhaps, a MtM portfolio loss). Leverage remains at 15x (because 25xNAV = 2250 and 15x 100 = 1500)
But now lets say - as is the current real world case - NAV drops to 60. What happens to leverage? Well, 15 x note notional is still 1500. But 25xNAV is now also 1500. In other words, if the NAV drops any further, then the second leverage cap suddenly becomes applicable.Lets say NAV drops another 10 per cent, to 50. Now, 25 x 50 = 1250. Accordingly, the CPDO delevers from 15x to 12.5x.
In market terms, that deleveraging translates into the CPDOs arranging bank having to close out earlier CDS positions and buy an equivalent amount of protection back, which in turn, will likely push spreads wider still in the markets. Another factor to look out for on the credit indices in the next couple of weeks.
For the CPDOs in question, a bad situation might well become worse, since higher spreads, of course, will have a further MtM impact on CPDO NAVs. Add in too the scare factor of banks buying big protection positions, and the markets could well move disproportionately.
For what its worth, the swap counterparty for half of those CPDOs downgraded (The SURF series) is ABN Amro.
How can you get long credit spreads as a private investor?
"There's no reason our local governments should pay 10-15% on their bonds because the big boys screwed up."
Munis themselves will have their own day of reckoning - how many of them got big eyes when revenues climbed and committed to programs they cannot fund with a lower tax base?
fred-If I held it personally, I would just hold the notes to maturity. Some borrowers will pay; some won't. Some value will be realized on foreclosure of those who don't. I know there are accounting issues that a corporate entity faces that an individual doesn't, but when you cut through the crap, that may be the best strategy here-hold to maturity and collect what you collect.
In the long run, insurance companies tend to pay out more than they take in, and make their money investing the float. (At least this is true in commercial property and casualty.)
Right you are. And those who need that kind of insurance in the next year or two are going to get a nasty surprise at renewal time. When the investment climate sours for insurers, premiums go up a bunch. This often leads to renewed cries for "tort reform," even tho the lawyers won't really be to blame for the premium hikes.
fred - one other question - how much of the current CDS crop is based on cov-lite paper (which only defaults when the moon turns red)?
Hey - that's tomorrow night, actually, as the lunar eclipse is supposed to turn the moon red, n'est pas?
AOTC,
Good catch!
BTW, regarding the futures market, that's why I said "may have something to do with it". You're right, you can never really tell. However, The NR thing just didn't fit time-wise.
Sandy has a good point with that article though. If you read through it, the first S&P risk model adjustment came towards then end of October, and there was a nearly 1500 pt market drop thereafter. Now, they do it again in mid January and the market goes up 700pts?!?!
Me thinks this is a delayed reaction and we haven't yet seen the fallout from this. Huge credit market losses cannot ultimately be met with big equities rallies. Something doesn't add up.
"Huge credit market losses cannot ultimately be met with big equities rallies." Sure they can. It's pointless to try to predict or understand the market. Individual stocks may sometimes move in a logical way with company-specifc news (your drug was just found to kill patients; your tires blow up at 60 mph), but there are simply too many pieces of "news" that could move "the Market" to vere make sense of them. We're all just along for the ride, whether long or short.
Insurance Scrawl: Regulation Archives
Author is an attorney in DC practicing insurance law. A really good blog. This page includes a post about distinguishing between warranties vs. insurance that Fred might enjoy, although it may not answer his good question regarding whether an insurance company that sells puts is writing an insurance policy.
AOTC, I agree with you short term, but my statement still stands. You cannot have massive credit losses and huge stock market rallies. The reason is very simple: too much leverage (ie credit) and fictitious capital goes into supporting stock bubbles.
When the credit market craters, the stock market must follow, just as night follows day. Although not immediately, as you have pointed out.
Behind the curve - "It's pointless to try to predict or understand the market."
Then what's your point? Is it your beief that no matter how dire things get in the credit markets equities will go higher? Do you own equities with an outlook like that?
Balance sheets don't matter today just like PEs didn't matter in 2000.
in all modesty, you might find this stimulating (and if not, im sure you'll tell me, just keep it ad rem, not ad hominem)
most of my work is in the federal income taxation of financial transactions. in that area, i routinely am confronted with seemingly "robust" and "profound" rules of law that fall apart because they are based on 19th century concepts that do not translate into 21st century reality.
in the case of insurance law, where i have only limited knowledge and disclaim expertise, i can say that the leading common law rule in new york defines insurance as an arrangement whereby one party agrees to pay another based on the occurrence of a fortuitous event.
that has over the centuries produced concepts such as "insurable interest" whereby one cannot buy insurance on an event (typically a life) without a legally recognized interest therein, for policy reasons including such mundane concerns as not allowing unrelated persons to insure the life of someone and then proceed to have them killed (a form of moral hazard).
it is also one source of prohibitions against contracts of wagering, the idea that absent a legally cognizable interest in an event, contracting to be paid on its occurrence is wagering and void.
this view is incompatible with 21st century finance.
it would produce ridiculous results to the extent that someone buying protection from a monoline on an existing physical bond, such protection by its terms confined exactly to that bond, has purchased insurance, whereas someone who doesn't own the bond but believes it more likely to default than is reflected in the quoted cost of protection buys such protection as an investment (query why that's an investment and not a wager; is there a difference??)
to digress a bit, initially in many states derivatives contracts were held void as wagering, a consequence of which was federal preemption --
so the point is, by the statutory definition, if i buy protection on a financial obligation from an insurer, i've bought insurance; if i buy it from a non-insurer, i theoretically have as well by common law but presumably no one would seek to attack that by reason of desuetude; but if the underlying risk is not with respect to one bond or tranche but to a "soft default" then who the hell knows; and thereby hangs the problem.
sorry if this is longwinded but its length is not inversely correlated with its possible importance if only to help people think regardless what conclusions they reach.
throwing around words like "insurance" can be very dangerous in parlous times like these.
i have a huge problem with a bank that bought protection to create a negative basis trade claiming that it bought insurance instead of a hedging contract...
because...
(i) if there is no difference between hedging contracts vs. insurance then a lot of people are going to jail; and
(ii) if the definition of the trigger event (soft default or whatever) is exactly the same, and the payoff is exactly the same, as owning the physical, then there can't be an arbitrage and there can't be a zero basis trade (relative to each party's cost of funds, of course); therefore if a soft default defines payoff events other than classical default, i submit that at least one possible interpretation of this is that its not statutory (financial guaranty) insurance as its not just default thats triggering the obligation.
as a thought experiment:
is buying insurance against a downgrade, so that you are compensated in the event a AA credit is downgraded to, say, BBB, really insurance? its not a contract that pays off on the failure of a reference name to pay, is it...
because this is what is going on, the argument that reducing credit ratings on monolines is reducing credit ratings on munis and that's grounds for takeover...the mathematical equivalence is arguing that by some equitable (in this case, read "bulls--t") theory, the insureds or issuers are entitled to rely on the ratings enhancement throwoff benefit of the policy...yet this isnt insurance in the statutory sense (triggered by default) but only (if at all) in the common law sense (payment on the occurrence of a fortuity)...and if thats insurance then everyone who ever sold a put has sold insurance and should be in jail.
my purpose in all this is to be a law professor at large and stimulate thinking.
its also to suggest that what we think we know when subject to the light of day may not be so clear.
im sure someone will rely on potter stewart and tell me that they can't define insurance but "they know it when they see it."
but what else would you expect from a bunch of guys and gals who went into law cause they couldn't pass calculus or organic chemistry
uh...
in all modesty, you might find this stimulating (and if not, im sure you'll tell me, just keep it ad rem, not ad hominem
but what else would you expect from a bunch of guys and gals who went into law cause they couldn't pass calculus or organic chemistry
A shame then Merck didn't separate its business from its Vioxx line then. And Bayer should separate the Trasylol from everything else. Remington could separate the guns from the bullets too, it's only the bullets that create the problems after all. Oh, and all business should spin off bad assets and liabilities from the good stuff. "It makes sense" because that way the remaining entity can... [insert reason]. I'm sorry, I can't follow CR here. Business make good and bad decisions and they have to live and die by them. If they are really different, self sustaining concerns (cars, finance, building satellites) so that they can be invested in separately, I can go with that. Breaking them up just to isolate their "tumors", to make an end run to force somebody else to hold the bag just isn't right. (Even though you might shoehorn a legal strategy around it.)
sorry screwed that up again i meant to say that unless someone is on dope the cost to insure exactly a specific bond must equal the expected return (ie negative) on that bond or something is wrong and there's an arbitrage; so the existence of a negative basis trade must imply either a dispariy in credit rating and thus the available cash returns on the parties or, more likely, that the soft default definitions in the cds are not exactly one-to-one and onto with the bond, in which case it's starting to look less like insurance and more like hedging, and if there's no justiciable difference between insurance and hedging, a lot of people are in trouble.
a thought experiment in socratic method.
i have a law degree. i can insult lawyers as im one of them.
that's why it wasn't mean.
it was meant to be funny. and true.
but i will apologize to anyone who was offended.
fred writes:
i have a law degree. i can insult lawyers as im one of them.
...but i will apologize to anyone who was offended.
A lawyer apologize? Now that is funny.
" Is it your beief that no matter how dire things get in the credit markets equities will go higher?"
I don't make any predictions for where the market will go. There are too many variables to predict.
" You cannot have massive credit losses and huge stock market rallies."
I haven't seen any huge rallies lately. If analysts expect $ 500 billion in losses and the market goes down concomitantly and then losses are "only" $ 400 billion, you very well could get a rally.
There is an infinite amount of information at any given time and the market chooses to focus on some and not others. It ignored the credit issues until last July. Then it paid attention. At some point it may choose to ignore them again (or not).
All I ask is to find 1 or 2 stocks in areas where I have specialized knowledge that the analysts have misunderstood. Otherwise, it's a total crap-shoot and let's not pretend otherwise.
One more thing-when the market turned around in mid-2002, PEs were still over 20 (around 23, I think). Any market expert would have told you that no bear market ends with PEs in the 20s; they should go down to around 8-10. But it did turn around. And PEs kept falling through the 2002-2007 period as the market rose. Impossible, but true.
Fred....
"LaCrosse Financial Products, LLC (LaCrosse) was created in December 1999 to act as a counterparty for structured derivative products, primarily pooled credit default swaps. While MBIA does not have a direct ownership interest in LaCrosse, it is consolidated in the financial statements of the Company on the basis that substantially all risks and rewards are borne by MBIA. MBIA's guarantees of synthetic CDOs are typically executed through LaCrosse, which enters into a credit default swap with the counterparty. MBIA Insurance Corp., through a financial guarantee policy, then guarantees the obligations of LaCrosse under the credit default swap."
In terms of detail.....I think you need to look at this. If the derivatives were "fronted" by a non insurance entity and then that entity was insured by MBI, then it the counterparties may not have any direct connection with MBI. Or at least with the regulated insurance subs.
Among other ironies, the only reason that there is anything to fight over is because of the archaic nature of the monolines based on experience from the version 1.0 of mortgage backed securities failures in the 1930's.
Namely, the assets are associated with the 'contingency reserve' and the 'unearned premium reserve'. Neither of these is based on financial theory but rather backward looking regulation from the 1930's regarding what would have prevented the version 1.0 meltdown.
You know that mbi and the monolines were going nuts for years about the requirements to keep 'excess' capital, the lack of capital efficiency, how they couldn't compete with thinly capitalized entities in the unregulated financial markets, etc.
If anyone cares, take a look at the size of these two balance sheet numbers.
False security: the betrayal of the ... - Google Books
See page 58 and following.
Not really surprising....but still.
im now out of my depth and these are thought experiments only.
important point: in ny insurers are not the fiduciaries of their policyholders and its almost impossible to win a bad faith litigation (failure to pay claims); what implication this has for related litigation that might arise i have not thought through.
given the lasalle spv structure, i think any court of equity would not accord much dignity to the lasalle entity if such would work an injustice.
the question is whether that means the lookthrough would say (i) its insurance with respect to lasalle therefore its insurance with respect to lasalle's counterparties (my view), or (ii) if its not insurance with respect to lasalle's counterparties, they are not insureds of the parent.
my only point here was that whether the cds counterparties are insureds or simple (so to speak) swap counterparties is likely of huge consequence in terms of the available remedies and legal theories.
i simply have no expertise in opining on the degree (if at all) to which a regulator can ignore or modify non-insurance contracts to protect policyholders.
even more, to the extent its relevant, if such contracts are swaps (ie this is on the theory the banks are not insureds; i think that is the weaker theory, but not implausible), then i dont know whether theyre deemed executory or not (prospectively).
i wish i were making the billing...
Fred....
This in inherently complicated. I don't think anyone is talking about modifying contracts at the moment.
They are talking about restructuring the entity with whom the contracts are made.
This is the intersection of financial engineering, traditional/archaic accounting (statutory accounting for insurance), more contemporary accounting (fair value concepts), and political power.
Using Lasalle as an intermediary may not work from the perspective of equity, but that seems to be the mechanism by which derivatives were transformed into financial guarantees.
Also, at the moment, the credit derivatives haven't been triggered for the most part, so they don't have claims that are being compromised.
Remember that the unearned premium reserve is a liability. Now everyone seems to think that it is overstated and there is future profit embedded in the liability. This is one of the things that people are fighting over. However, there is no way that anyone can make much of a case that this isn't directly tied to the muni exposures. It is calculated bond by bond using statutory formulas.
I would like to bill by the hour on this one also.
Ambac Hopes Capital Infusion Will Save Rating - WSJ.com
Has anyone been tracking to see if the Financials are still using their cash to buy back stock in order to inflate their stock prices (as opposed to preserving their limited capital bases)? If so, can that individual (or individuals) post the cash spent by each entity? Thanks in advance.
Zig,
Raising $2B on a $1B market cap will be quite a feat. The story says the banks are being targeted to provide a backup on the rights offering - we'll see if they sign up for that. My guess is they want to see more of a sustainable solution before they put up any money. This looks like an effort to buy some more time with the rating agencies.
From Wikipedia
A fraudulent conveyance, also fraudulent transfer is a civil cause of action. It arises in debtor/creditor relations, particularly with reference to insolvent debtors. The cause of action is typically brought by creditors or by bankruptcy trustees. The usual fact situation involves a debtor who donates his assets, usually to an "insider", and leaves himself nothing to pay his creditors as part of an asset protection scheme. However, it is not uncommon to see fraudulent conveyance applications in relation to bona fides transfers, where the bankrupt has simply been more generous than they should have or, in business transactions, the business should have ceased trading earlier to avoid giving certain business creditors an unfair preference (see generally, wrongful trading). If prosecuted successfully, the plaintiff is entitled to recover the property transferred or its value from the transferee who has received a gift of the debtor's assests.
There is an old equitable maxim: "One must be just, before one is generous."
[edit] Fraudulent conveyances or transfers in the United States
In the United States, fraudulent conveyances or transfers[1] are governed by two sets of laws that are generally consistent. The first is the Uniform Fraudulent Transfer Act[2] ("UFTA") that has been adopted by all but a handful of the states.[3] The second is found in the federal Bankruptcy Code. [4]
There are two kinds of fraudulent transfer. The archetypical example is the intentional fraudulent transfer. This is a transfer of property made by a debtor with intent to defraud, hinder, or delay his or her creditors.[5] The second is a constructive fraudulent transfer. Generally, this occurs when a debtor transfers property without receiving "reasonably equivalent value" in exchange for the transfer if the debtor is insolvent[6] at the time of the transfer or becomes insolvent or is left with unreasonably small capital to continue in business as a result of the transfer.[7] Unlike the intentional fraudulent transfer, no intention to defraud is necessary.
The Bankruptcy Code authorizes a bankruptcy trustee to recover the property transferred fraudulently[8] for the benefit of all of the creditors of the debtor[9] if the transfer took place within the relevant time frame.[10] The transfer may also be recovered by a bankruptcy trustee under the UFTA too, if the state in which the transfer took place has adopted it and the transfer took place within its relevant time period.[11] Creditors may also pursue remedies under the UFTA without the necessity of a bankruptcy.[12]
Because this second type of transfer does not necessarily involve any actual wrongdoing, it is a common trap into which honest, but unwary debtors fall when filing a bankruptcy petition without an attorney. Particularly devastating and not uncommon is the situation in which an adult child takes title to the parents' home as a self-help probate measure (in order to avoid any confusion about who owns the home when the parents die and to avoid losing the home to a perceived threat from the state). Later, when the parents file a bankruptcy petition without recognizing the problem, they are unable to exempt the home from administration by the trustee. Unless they are able to pay the trustee an amount equal to the greater of the equity in the home or the sum of their debts (either directly to the Chapter 7 trustee or in payments to a Chapter 13 trustee,) the trustee will sell their home to pay the creditors. Ironically, in many cases, the parents would have been able to exempt the home and carry it safely through a bankruptcy if they had retained title or had recovered title before filing.
Even good faith purchasers of property who are the recipients of fraudulent transfers are only partially protected by the law in the U.S. Under the Bankruptcy Code, they get to keep the transfer to the extent of the value they gave for it, which means that they may lose much of the benefit of their bargain even though they have no knowledge that the transfer to them is fraudulent.[13]
Some of the most egregious fraudulent transfers occur in connection with leveraged buy outs, where the management/owners of a failing corporation will cause the corporation to borrow on its assets and use the loan proceeds to purchase the management/owner's stock at highly inflated prices. The creditors of the corporation will then often have little or no unencumbered assets left upon which to collect their debts. LBO's can be either intentional or constructive fraudulent transfers, or both, depending on how obviously the corporation is financially impaired when the transaction is completed.
Although not all leveraged buy outs ("LBO's") are fraudulent transfers, a red flag is raised when, after an LBO, the company then cannot pay its creditors.[14]
[edit] Footnotes
^ The term fraudulent conveyance is included within the more general term fraudulent transfer, as a conveyance is more descriptive of the transfer of title to real property. Fraudulent transfer, however, includes all types of property and in the U.S., both are generally all governed by the same law. Therefore, the transfer will be used for the remainder of this section.
^ Promulgated by the National Conference of Commissioners on Uniform State Laws (NCCUSL) in 1984
^ As of June, 2005, 43 states and the District of Columbia had adopted it. See NCCUSL website, NCCUSL Home. A complete copy can be found there or at http://www.stcl.edu/rosin/ufta84.pdf
^ 11 USC § 548. Much of the language of this section was adopted from the Uniform Fraudulent Conveyance Act, which is the predecessor of the UFTA.
^ 11 USC § 548(1); UFTA § 4(a)(1).
^ Under the Bankruptcy Code, insolvency exists when the sum of the debtor's debts exceeds the fair value of the debtor's property, with some exceptions. It is a balance sheet test. 11 USC § 101(32)
^ 11 USC § 548(2); UFTA § 4(a)(2).
^ This is done through the mechanism of avoidance of the transfer. 11 USC § 548.
^ 11 USC § 551
^ Within two years prior to the filing of bankruptcy - 11 USC § 548(a)
^ 11 USC § 544(b) allows trustees to employ applicable state law to recover fraudulent transfers. The time period under the UFTA is in most cases four years before action is brought to recover. - UFTA § 9.
^ UFTA § 7.
^ See, Gill v. Maddalena, 176 B.R. 551, 555, 558 (Bankr.C.D.Cal. 1994) (citing 11 USC § 548(c))
^ See, for example, Murphy v. Meritor Savings Bank, 126 B.R. 370, 393, 413 (Bankr. D. Mass. 1991), in which an LBO left the corporation with insufficient cash to operate for longer than 10 days.
AHEAD OF THE CURVE: "One more thing-when the market turned around in mid-2002, PEs were still over 20 (around 23, I think). Any market expert would have told you that no bear market ends with PEs in the 20s; they should go down to around 8-10. But it did turn around. And PEs kept falling through the 2002-2007 period as the market rose. Impossible, but true."
Good point. P/Es can be highly misleading. When companies post low profits, as growth stocks did back in the early 2000's, P/Es were elevated. A similar thing is happening now with financials posting negative profits (some, like the monolines, are even posting negative revenue).
Having said that, I still think the stock market will go into a correction (most likely a sideways correction like the in the mid to late 60's). The main reason I am cautious is because corporate profits as a percent of GDP is high. Corporate profits are more likely to decline than go up, and stock prices are driven by earnings (and interest rates/inflation too).
But unlike the bears who roam around these boards, I think most assets are going to suffer. Due to the massive run-up in all assets (due to so-called cheap liquidity), a correction in all assets is inevitable. A lot of bears who are bullish on gold, commodities, etc, are probably going to get hit the worst.
A brief comment on the difference between an insurance policy and a contract.
1. All insurance policies are contracts, but all contracts are not insurance policies.
2. An insurance policy is a contract written on a form approved by a regulatory authority and is subject to a wide variety of non-contractual provisions generally designed to protect the policyholder.
3. Insurance companies write policies for customers (their primary business), and also enter into a wide variety of other contracts and commercial arrangements, ranging from branch office leases to buying advertising and everything else.
4. 'Everything else' includes trading investment securities and entering into counterparty arrangements in the capital markets.
5. People loosely refer to the monolines' activities in the capital markets as writing insurance policies, but as I understand the arrangements, they were not on written on policy forms approved by the relevant insurance commissioner (instead, you had industry standards like ISDA swap agreements and so on).
6. So the capital markets transactions aren't policies and it is a mistake to treat them as such. (A mistake Goldman Sachs did not make, incidentally, when it refused to deal with counterparties who would not post collateral).
7. Consequently, the rights of contractual counterparties--whether a landlord or an investment bank--should be evaluated with reference to contract and bankruptcy law, while the rights of policyholders should be reviewed with reference to insurance regulation and insolvency law. Presumably, the treatments and the outcomes will differ.
Finally, litigation risk. This bugaboo, used to threaten private sector types tempted to risky business, isn't a showstopper in the regulatory context. It simpoly comes with the territory. Here, the chances of permanent injunctive relief are trivial, the standard for judicial review of regulatory action is deferential, and at the end of the day, what's the claim--that excessive reserves were transferred to the ring-fenced newco reinsuring the policy liabilities?
linear algebra:
I think you've summarized the situation very well.
Thank you,
NW
I don't think that self-dealing will apply to NYS Ins Commiss - if it does a takeover, it's to protect the bondholders, not the bond originator.
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