Tuesday, March 1, 2011

Mortgage Bond Math Coming to a Head - MBIA, Citi

When we asked readers for direction, they demanded that we relentlessly repeat ourselves ad nauseum. We oblige with this.

Tomorrow we will see what the mortgage bond math we previously discussed brought to MBIA through the end of 2010. (Click the accounting tab or here for relevant posts.) As we have said before, in many cases we think that there is room for both sides to declare accounting and economic victory in commutations settlements. We also think you will see a good amount more deals at the end of the first quarter.

The reason behind the first quarter's announcements will be brought to fruition less by the accounting than those in the year end report. Of course there will be elements of math, economics and law tied to any commutation settlements. Those will continue to be the powder, but the spark is coming from human tendencies and game theory.

By human tendency we allude to the manner in which people fail to recognize a good thing until its gone. Look to any market as an example, assets are no longer cheap when they are widely loved. Or look to the particularly relevant dynamic of refinancing in interest rate cycles; refinancing surges when mortgage rates start to tick up off the bottom. People plan to sell at the top and buy at the bottom.

By game theory we allude to the Mexican standoff in which a ring of banks saw RBC and some smaller Canadian banks shoot first. Once the shooting starts, everybody fires. JP Morgan, Barclay's, and - it seems - Morgan Stanley joined in. Today by way of stipulations for discontinuance with prejudice in MBIA's transformation suits, we learned that Citi has joined in the fray. Some combination of these last four banks were a big reason for MBIA's sharp tightening of CDS spreads over the past month.

These were the incentives to shoot early:

-Unwind hedges while spreads are wide, before other banks drive them lower by exiting first.
-Use transformation litigation exit as bargaining instrument before adverse case developments weaken bargaining position (via discontinuance of other parties and/or further plaintiff-adverse rulings.)
-Achieve more advantageous price before MBIA Corp achieves a stronger financial - and therefore bargaining - position.
-Garner goodwill with a potentially reemerging structured finance and municipal heavyweight.

In our view, the transformation challenge has little hope of success. While this on its own suggests the dropouts are not part of significant deals, we view it as overwhelmed by:

-The incentives to shoot early.
-MBIA CDS movement.
-Disclosures by banks.
-Disclosures by MBIA.
-Various media and research reports.
-Bank benefits in achieving capital relief.

Finally, we think that our stance will be widely accepted by March 2nd due to JP Morgan and Barclay's deals in Q4. However, these deals may have been structured to be realized in Q1 to take advantage of a longer period of less disclosure, including wider credit spreads. Morgan Stanley, Citi and perhaps a follow on (or the only) Barclay's deal are top candidates for Q1 realized commutations.

Mortgage bond transactions held by, widely dispersed and actively traded amongst third parties and will be more difficult to settle than the "derisking" and warehouse type of deals on the banks balance sheets. For that reason, countrywide-type cases will take longer. Bank of America needs to take another bath while Ally needs more of a hand washing as discussed here.

Not surprisingly, Bank of America came to the Mexican standoff with an empty water pistol. While we don't think they will be destroyed, we agree with the market valuations in that they will be shot by billions more in losses.

The other banks, along with MBIA will likely have some potent disclosures in their imminent 10-K filings. When that happens, we will oblige you with more drum-beating.

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