Felix Salmon

Josh Rosner got in touch after I said he was "full of crap" for saying that MBIA thinks it can’t make its obligations. He’s been talking to NYSID too, so I asked him to elaborate on exactly what he thought was going on with MBIA. He said that

The NYSID is relying on the rating agency assumptions and has repeatedly told me this.

This surprises me, since it would seem to constitute the NYSID effectively outsourcing a large part of its regulatory function to the ratings agencies.

Rosner continued:

Moody’s analysis, at their own admission, has rated without regard for either acceleration triggers or mark to market losses.

I haven’t seen Moody’s say this, but I can believe that it’s true. The CDS written by MBIA get accelerated (and can be tendered at mark-to-market rates) only after what most of us would consider an event of default – so there’s a good case to be made for not including such an eventuality in determining the probability of such an event.

In any case, said Rosner, the language in those CDS contracts might well not be worth the paper it’s written on, since "NYSID told me in no uncertain terms that they would rip up the CDS before they let them pay out to the detriment of muni policyholders".

I expect that the NYSID would ultimately attempt to abrogate any attempts by counterparties to use the acceleration clause. That is not to say I agree that it is right to violate contracts that the NYSID knew existed nor is it to say that I believe they could do so without it leading to protracted court challenges, rather it is to say that is my expectation of what they would likely do to protect claims paying resources for muni policyholders.

I think he’s exactly right on this front.

I then asked about his view of whether MBIA was able to meet its obligations, assuming the CDS aren’t accelerated but rather simply pay out only when the underlying reference security defaults. He replied:

If policies were all to pay over time, assuming no further degradation in the macro economy and thus deterioration of CMBS and other commercial asset classes they should be close to being able to meet their obligations at maturity. I do, however, expect further deterioration so, at this point, I am comfortable saying that no one can honestly tell you whether they will ultimately have enough $.

Again, this seems reasonable to me.

Finally, Rosner talked about something which hadn’t even occurred to me: if MBIA does set up a new insurance subsidiary, should it be a sister to the existing one, or should it be a subsidiary of the existing one?

I personally believe, that the new company should be stacked under the old insurance co so that the policyholders have the benefit of any future appreciation of that business and to aid its capital position. While management and the rating agencies seemed to prefer that a new company be a sister (under the holding co) as opposed to stacked under the old co it may now be easier to do it as a stacked co given the higher rating on the old operating co than the holding co.

Subsidiaries nearly always have a higher rating than their parents, so not much has changed there. But I’m entirely agnostic on this particular issue. The really important question is whether the $900 million stays within MBIA at all, or whether the company tries to give it back to shareholders somehow. NYSID would be quite unhappy if MBIA tried to do that, but Jay Brown has definitely raised the possibility, and Yves Smith says that "if the executives were really out to maximize shareholder value, which is widely asserted to be their primary duty, that’s precisely what they’d do".

I’m pretty sure that NYSID is going to ensure that MBIA keeps that $900 million in-house. But exactly how it ends up being used is still very much up in the air.

I still don’t for a minute agree with the Rosner quoted in the NYT article on Wednesday. I think that Jay Brown does have faith in his insurance subsidiary, and, for what it’s worth, I think that NYSID and Moody’s have quite a lot of faith in it too. But ex that quote, I will say that Rosner makes a fair amount of sense.

Ouch! This news is really bad for MBIA: Moody’s has slashed its ratings by even more than it cut the ratings on Ambac. It’s a deep cut, with real financial consequences:

This ratings action will give certain holders of guaranteed investment contracts the right to terminate the contracts or to require that additional collateral be posted.

The main rating, of MBIA Insurance Corporation, the insurance subsidiary, has fallen all the way to A2 from Aaa. That’s a five-notch downgrade, which I think I’m safe in saying is more severe than anybody expected.

And there’s more:

Moody’s also downgraded the surplus note rating of MBIA Insurance Corporation to Baa1, from Aa2, and the senior debt rating of the holding company, MBIA, Inc. (NYSE: MBI) to Baa2, from Aa3.

Yes, those are Bs. Investment-grade Bs, to be sure, but Bs all the same. Both of these constitute six-notch downgrades: obviously keeping newly-raised equity at the holding company level didn’t help its ratings at all.

These downgrades severely impair MBIA’s ability to continue as a going concern. Until now, I’ve been focused on MBIA’s solvency: most crudely, whether or not its assets exceed its liabilities. (They do.) But CEO Jay Brown doesn’t just want a solvent company: he wants a company with a future. And it’s hard to see where that future lies if the holdco is barely holding on to an investment-grade credit rating. The whole point of insurance companies is that they’re ultrasafe: as soon as that safety is called into question, no one wants to do business with them any more.

Until this morning, I thought MBIA’s plan to create a new triple-A subsidiary had some hope to it. But now that seems pretty improbable. As Moody’s says, in something of a self-fulfilling prophecy, "today’s rating action… reflects MBIA’s… impaired franchise".

So, MBIA still has money. As Moody’s also says:

the group remains strongly capitalized, estimated to be consistent with a Aa level rating, and benefits from substantial embedded earnings in its existing insurance portfolio.

In numbers:

Moody’s has re-estimated expected and stress loss projections on MBIA’s insured portfolio, focusing on the company’s mortgage-related exposures as well as other sectors of the portfolio potentially vulnerable to deterioration in the current environment. Based on Moody’s revised assessment of the risks in MBIA’s portfolio, estimated stress-case losses would approximate $13.6 billion at the Aaa threshold and $9.4 billion at the A2 threshold. This compares to Moody’s estimate of MBIA’s claims paying resources of approximately $15.1 billion… Relative to Moody’s 1.3x "target" level for capital adequacy, MBIA is currently $2.6 billion below the Aaa target level and is $2.8 billion above the A2 target level.

But money alone might not be enough. Especially since Moody’s is leaving the door open to further downgrades:

The outlook for the ratings is negative, reflecting the material uncertainty about the firm’s strategy and the non-negligible likelihood of further adverse developments in its insurance portfolios or operations.

At this point, the best-case scenario for MBIA is that credit markets calm down enough for the company to be acquired by someone with credibly deep pockets. (Sounds a bit like Lehman Brothers.) Absent that scenario, which admittedly is pretty improbable, things are likely to be pretty precarious at MBIA for the foreseeable future.

I had a very interesting conversation with Hampton Finer of the New York State Insurance Department this afternoon, on the subject of MBIA. He’s a regulator, it’s his job to be worried about the entities he’s regulating. And when one of those entities has seen its share price drop from $69 to $6 in the space of less than a year, one can understand why he might be more worried than normal. That said, however, the overall impression I got was that NYSID has a pretty constructive attitude towards MBIA, is not worried about its claims-paying abilities, and is not particularly upset about the insurer’s failure to send $900 million downstream to its insurance subsidiary.

MBIA "needed a capital infusion to help them ride this out at triple-A," said Finer: "they weren’t hitting the rating agency ratios". This is almost exactly the same as the Jay Brown talking points. The capital-raising was done for the sake of the ratings agencies, and once the ratings agencies said that it wouldn’t do any good, there was no obvious point in doing so any more.

Was NYSID upset that MBIA didn’t send the money downstream? Not particularly. If it had really wanted MBIA to do that, it could have forced the issue, but it didn’t. "We have a lot of authority over how that money gets used," said Finer. "We’d like to see what else can be done with it." If that involves sending it to a different subsidiary, that might be fine; the only thing he seemed keen not to see was the money getting sent directly back to shareholders.

More generally, is NYSID concerned about MBIA’s solvency? No. He was pretty unambiguous about that:

We think there’s enough money to pay all the claims based on what the current expected losses are. Things have deteriorated a little bit, but whatever gauge you want to use, the current claims-paying resources in the industry for MBIA and Ambac are going to be sufficient to pay all the losses on the policies they wrote.

But isn’t MBIA already technically insolvent, in that it can’t afford to reinsure all of its guarantees? Maybe, said Finer, but "in markets where there are liquidity issues, that might not be the most reliable test of solvency", and in any case "coming up with a reliable answer about whether they can reinsure is difficult". MBIA has $16 billion in claims-paying abilities; that’s enough to buy a lot of reinsurance.

And what about this latest storm over MBIA’s credit default swaps being accelerated if the company gets taken over by its regulator? Well, for one thing, if MBIA goes below its minimum capital requirements, NYSID is not obliged to take it over. The regulator would of course step in if MBIA looked as though it was about to declare bankruptcy or otherwise have an event of default. But there’s a very long way to go before things get that drastic.

That said, Finer was no fan of the language in those credit default swaps: in fact he called the relevant clauses "poisonous provisions". The reason is that if the CDS gets terminated at a mark-to-market price, the buyer of protection can easily end up getting paid, in panicky markets such as this one, much more money than he would ever get if he simply held the insurance to maturity.

On the other hand, said Finer, "we believe there are ways of controlling those events of default".

Finer was also keen to see MBIA back in the business of writing insurance again. "We don’t really want companies in indefinite run-off, they’re kind of poisonous," he said, since such companies have much less incentive to pay out than one which stands to lose a lot of business if it starts denying claims. "Companies should be downgraded, frankly, in indefinite runoff."

What about a corporate structure where the old insurance subsidiary was in de facto runoff while a new subsidiary was writing new policies? That could be made to work, said Finer, so long as the reputation of the new subsidiary rested to some degree on the alacrity with which the old subsidiary paid its claims.

My opinion – and this is just my opinion, it’s not something that NYSID has told me – is that NYSID’s biggest worry with respect to MBIA is not the company’s solvency, but rather its ability to persuade anybody to buy insurance from it in future. MBIA has lost an enormous amount of reputation at this point, and if no one’s interested in the products it’s selling, then eventually it might have to be taken over just because it’s not writing any new policies. But that’s a medium-term worry. In the short term, MBIA has to work out what it’s going to do with its $900 million, and whether it’s going to have to take any further write-downs, on top of the charges it’s taken already. And so long as Jay Brown wants to invest that money in his business somehow, I get the feeling that NYSID is likely to be reasonably supportive.

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.