MBIA vs Smith and Jones

With respect to MBIA’s attack on the NYT’s reporting, it’s clear at this point that the newspaper doesn’t need to defend itself: there’s no shortage of bloggers willing to do that for it. Yves Smith is probably the most vocal: she uses words like "bald-faced lie" to characterize parts of MBIA’s statement. For a more balanced view, there’s Sam Jones.

The "lie" that Smith is talking about is the statement that MBIA never promised to send $900 million downstream to its insurance subsidiary. I’m thoroughly bored of this debate; I think the facts are pretty clear at this point. Yes, MBIA intended to do that, back when the ratings agencies were telling it that such an action would preserve its triple-A rating. And in fact that was MBIA’s stated reason for raising the money in the first place. Once the rating was gone and the ratings agencies made it clear that no amount of money would change that fact, it no longer made sense to send the money downstream. Was there a "promise"? MBIA says no, Smith says yes, I guess it depends on what you consider a promise to be.

Smith then says that at MBIA "the parent exists to serve the subs, not vice versa," which once again mistakes MBIA as it is today with MBIA as it was when the subsidiary had a triple-A rating. The job of the holdco isn’t to pour hundreds of millions of dollars into a certain subsidiary even if doing so wouldn’t actually make any difference to the business operations of that subsidiary. Right now there’s a new, much more attractive, option on the table: take that $900 million, put it into a new subsidiary, and use it to reinsure the municipal bond guarantees made by the original subsidiary. It’s quite an elegant solution, actually, and citing old business plans from the days when the old subsidiary still had its triple-A rating doesn’t change that.

But the focus of attention right now is the question of what happens to CDS contracts which were written by MBIA under certain scenarios. Here’s how the NYT reported it:

MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.

But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.

The language here is very clear. The CDS can be accelerated if MBIA becomes insolvent, or if it is taken over by Dinallo. And if the CDS were accelerated, there would be all manner of nasty consequences. Therefore, Dinallo can’t easily take over MBIA, and MBIA can hold on to its $900 million with impunity, even if Dinallo would rather see that money in the insurance subsidiary.

The facts are very different. Dinallo has very broad powers, and can take over pretty much any insurance company he likes, for just about any reason. Such an action, in and of itself, would not trigger the clauses in MBIA’s CDS contracts. For that, MBIA would need to be declared insolvent. So really the word "or" in the NYT article should have been an "and".

(Update: Kamekon, in the comments, says that the mere appointment of an administrator who takes over MBIA’s assets would indeed trigger the relevant clause in the CDS documentation, which would mean that the NYT was right and it should be "or" rather than "and".)

What’s more, Dinallo has repeatedly and publicly said that he is not worried about MBIA’s solvency. And the ratings agencies don’t seem to be worried about MBIA’s solvency either: they rate the insurance subsidiary at AA, which is extremely strong indeed. Now, it’s possible that both Dinallo and the ratings agencies are wrong, and that there is indeed a serious risk of MBIA becoming insolvent. But at the very least the article should have made that clear: the scenario it’s talking about is one which the entities with the greatest access to MBIA’s books all say is extremely remote.

But that’s not the end of it. Just because CDS holders can accelerate the bonds in such an eventuality, doesn’t mean they will. Smith is convinced that they would:

If the NYSID initiates receivership proceedings, the counterparty can terminate the swap. Pray tell, which counterparty that had an operating brain cell wouldn’t avail itself of that opportunity? You’d want to be at the head of the payment queue in a wind-down scenario.

Except, we actually have a real-world counterexample. As Bloomberg reports:

Even in an insolvency, regulators may step in to halt the payments or banks may decide not to demand compensation, Abruzzo said. ACA Financial Guaranty Corp. has reached five agreements with banks since December, allowing it to avoid posting collateral on CDOs it guaranteed using swaps.

Accelerating CDS in the event of an insolvency proceeding is a bit like accelerating a bond in the event of a technical default: just because you can do it doesn’t mean that it’s a bright idea. A rush-to-the-courthouse feeding frenzy would benefit no one; an orderly runoff, by contrast, could well involve no payment defaults at all. Jones puts it well:

As in the case of ACA, it’s likely that they’ll see sense and waive any such rights – preferring run-off to run on.

Jones does raise one worrying possibility, however. He says that MBIA doesn’t need to be insolvent in order for this scenario to play out – it doesn’t need to run out of capital entirely – it just needs to have less capital than the regulator requires.

MBIA need not go bust; simply breach its regulatory capital requirements. That could quite easily be considered a dealbreaker under the ISDA terms. And MBIA is not all that far from breaking those regulatory levels.

I think he’s wrong, here. After all, according to Bill Ackman, MBIA has already breached at least one regulatory capital requirement:

MBIA and Ambac risk becoming insolvent by eroding their statutory capital if they continue to set aside loss reserves at their recent pace, Ackman said. Under an alternative New York State Insurance Department test of solvency, which requires a company to be able to buy reinsurance for its guarantees using its assets, the companies already are insolvent, Ackman said.

It seems improbable to me that breaching a regulatory capital requirement would be such a drastic event under the CDS documentation that it would allow holders to accelerate. After all, the capital requirement is a cushion: it’s an amount of money which reassures the rest of the financial world that there’s a long way to go before you reach insolvency. If you consider breaching the requirement to be tantamount in and of itself to insolvency, you largely defeat the purpose of having a cushion there in the first place.

If you own credit default swaps issued by MBIA, the main thing you’re worried about is that MBIA will run out of capital entirely, and not be able to pay out if the reference entity you’re insuring against itself goes bust. If MBIA can still pay you out of its existing stock of regulatory capital, you’re basically fine. The regulator won’t be allowing MBIA to write new insurance, but at least the old insurance is still worth something.

There’s no doubt that Ackman is right: if MBIA continues to set aside loss reserves, then it will rapidly eat up its capital base to the point at which it could risk insolvency. But MBIA is adamant that it will not have to continue to set aside loss reserves. And Dinallo, for one, seems to believe them.

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