Wednesday, June 29, 2011

Considerations of WI OCI

Assured Guaranty had a clear incentive to take a haircut on potential put-back recoveries. This because of a threat of downgrade. And so they reached a capital accretive settlement with Bank of America.

The Wisconsin Office of the Commissioner of Insurance has proclaimed that it would not take any account of the non-policyholder Ambac stakeholders. Given that the level of recoveries necessary to make AAC stable may be less than it takes to put AAC common equity in-the-money, this is not good for any security holders. By the same logic, it seems to create an opportunity for liable securitization sponsors to settle for less than if company management was at the helm.

Furthermore, taken at face value the Wisconsin OCI statement implies that the agency would issue 1 Gazillion surplus notes to Bank of America for an extra penny in recoveries. At this point, it might seem that things are not looking so hot for the AFGI Sr. Unsecured position that The Dragon has liked. We still like that position and have several consoling thoughts regarding this threat of impairment.

 First, nobody wants to see excessive surplus notes instigate a change of control that would erase the value of the deferred tax asset. So there is a hurdle the size of the DTA.

Second, the OCI is not an adversary to Ambac. The OCI wishes to see policyholders paid above all else. But the OCI has little incentive to move up the date of recovery by a year if it means severely injuring what was once one of the largest companies under its jurisdiction. Such actions would show bad faith to other current and prospective WI-domiciled companies. Along that line on should note that the insurance regulation is competitive among states. It is sometimes criticized for the beggar-thy-neighbor policies that attract business to more accommodating domiciles.

Third, the OCI does not want to impede justice, especially to the detriment of its constituent companies. The OCI also does not have the resources to man the litigation process and make fully informed decisions outside of the guidance of management.

Lastly, even if settling all repurchase litigation at say 60% of potential value would mean full payment to policyholders, the risk of having to settle with each sponsor uniquely dilutes the incentive to take the haircut. If one case is settled and no other counterparties will sit down, the risk is that the one case was the strongest and could have covered for deficiencies in others.

So this sort of impairment does not keep us up at night, though it is in the realm of possibilities. Its important to consider these risk, but the life of our call option still seems long.

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