Tuesday, January 4, 2011

The latest settlement... until the next one.

If you're reading this, you know about it so I'll spare you the review.

My take: it's good for B of A and has good implications for Financial Guarantors too. How can that be?

Well it shows BofA's GSE reserves were about half of what they should have been but BofA will not be wiped off the face of the earth. And this is pleasing to both sides. Look at the stocks today.

Every settlement that doesn't point to exploding investment banks is good for both sides. For the banks it's obvious. For the guarantors it's deeper than just ability to pay. The more the GSE's and uninsured private labels take care of themselves or are otherwise distinguished from the guarantors, the less danger of a rush to the courthouse.

This is the case because the the court system enforces the law with economic incentives in mind. This applies to both judicial and the real economics. Most literature on the subject is focused on long-term incentives. With that in mind, if a ruling would cause one of the biggest investment banks to explode and confidence in all others to evaporate, judge Bransten might still be given pause. Talcott Franklin's innovation was actually a negative to the bond insurers. If Bransten looks out West she can see Bill Gross and his gang perched on the grapevine or the Fed down the street staring right back at her.

Now for the uninsured private labels, securities law provides some distinction from the suits brought by the guarantors. Every 10B-5 dismissal is a win not only for the investment bank/securities underwriters but also the guarantors. If the FG industry can pull in 30B without creating a rush to the courthouse from their winnings, the result is intuitively pleasing in the limited sense of having punished the banks significantly while leaving them standing and restoring the FG industry. If there is little chance of more suits following, exemplary damages could come into play. However, compensatory damages could easily be made large enough to create sufficient deterrence. Start with claims paid and go to legal fees to unearned profits to the cost of financial distress. What will restore a bankrupt Ambac to what it would have been? (Those dollars would flow to the sr. unsecureds if your curious. Quote 13/15 on the 11's. A post on Ambac and implications of ACA Holdings is currently past due. In short, a bet on Ambac Sr. Unsecured is a bet that the ACA/Goldman ruling was (or could be with a probability of about 0.5%) a reliable precedent for CDO fraud.) But as is my way, I have meandered into unbridled speculation.

The point I started to make is that there is room for the costs to grow to investment banks without hurting their prospects. Now, this was acute in especial with BofA. They were under-reserved by roughly half with regard to the GSE's and only (as far as I can make out) have about $500M reserved for insured and uninsured private label (the lion's share of which is probably for Assured.) The $100B discount to book value says the market doesn't buy it, but that is plenty of ground for guarantors to win huge and BofA to prove out. It is also ground in which any greater traffic to the courthouse is manageable for banks and Bransten alike.

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