Thursday, July 21, 2011

The Bankruptcy Threat

-What keeps you up at night, Mr Dillinger?

Being rather lightly caffeinated, there isn't much keeping this blogger wide-eyed through the night. Still if we were at the helm of a bond insurer, pondering the recapitalization of our firm and industry the cost of buying credit insurance on Countrywide Financial Corp would seem to be a bargain with a spread ask price under 110 bps on the 2 yr contract. That implies a 3% chance of default with a 20% recovery rate.

Countrywide Financial Corp is the holding company acquired by Bank of America and it is also a defendant in the guarantors' suits.

If one supposes that BofA offered a settlement to MBIA at approximately 80% of incurred losses last week, Jay Brown could buy this hedge and drag Moynihan to court to face strong and validated claims. Of course, MBIA also has BofA on the hook for successor liability but there appears to be at least some threat of this being reversed if Delaware law is applied instead of New York law.

Other guarantors have also had BofA added to their respective suits. With CFC CDS priced below that of BofA, even a remote chance of the subsidiary being severed makes this a compelling hedge. If nothing else, it removes BofA's best negotiating tool for a very reasonable price. In fact, CFC 2yr contracts are pricing about 5 bps lower than comparable BofA contracts.

For those with access to the market, this is an equally effective hedge to a long guarantor position - similar to the original long MBIA, short BofA positions suggested by Manal Mehta and Branch Hill Capital over a year ago. A long (protection selling) MBIA Inc. (Hold Co.) CDS position could finance multiples of notional in a short (protection buying) CFC position.

The market says that this is not a substantial threat. This threat doesn't keep me awake at night either. But that is partly because Mr. Market has offered such a cost effective manner to eliminate the risk.

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