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.

An Actual Case of Reps and Warranties - CWHEQ 2006-S10

We have just published excerpts from the CWHEQ 2006-S10 deal, one of fifteen securitizations that are the subjects of the flagship repurchase case MBIA Insurance Corp. v. Countrywide Home Loans et al. We chose that deal because we thought it likely to be loaded to the brim with the stinkiest of crappy home equity. For future reference, these will be available under the label "CWHEQ 2006-S10."

The purpose for pulling these excerpts was to identify the points that we feel are the crux of MBIA's allegations. Mark Tapley may have been born in the 1800's, but not even experience compares with the certainty obtained from primary documents. We are all blessed with varying degrees of obsession, so we provide a summary here, what we consider key excerpts on the relevant posts, and links to the corresponding original documents on each excerpt post. There are also other neat documents like the insurance policy** on the SEC website. So dig as deep as you please!

In this examination, it is made plain that Countrywide made representations and warranties as to the characteristics of individual loans and the overall loan pool. Specifically in the Pooling and Servicing Agreement, Countrywide reps and warrants that "(7) the information set forth on the Mortgage Loan Schedule with respect to each Initial Mortgage Loan is true and correct in all material respects" and "(52) the Mortgage Loans, individually and in the aggregate, conform in all material respects to the descriptions thereof in the Prospectus Supplement." 

Because of their relevancy and specific citation, we have included excerpts from and links to the final Collateral Tables and Prospectus Supplement. Countrywide is responsible for the loans, individually and in aggregate, having the characteristics described. Most notably, this includes any representations of FICO, LTV, structure type, debt-to-income*, and origination type (Refi, Cash out, Purchase.) Any misrepresentation by the mortgagor not caught by Countrywide is Countrywide's problem, not MBIA's.

It is important to note that Countrywide specifically identifies residence type (primary, secondary, investment) data to be "based upon representations of the related borrowers at the time of origination." This is an important impediment against MBIA on this data point. However, in specifying such a qualification here, Countrywide strengthens MBIA's claim that Countrywide is responsible for the veracity of all other loan characteristics - regardless of mortgagor fraud. Some may consider this note irrelevant due to Countrywide's explicit representations and warranties of the loan characteristics, and we would agree.

And yes, Countrywide specifically reps and warrants that the loans it originated met its own guidelines.

"(45) The Mortgage Loans originated by CHL were underwritten in all material respects in accordance with CHL's underwriting guidelines for closed-end second lien mortgage loans or, with respect to Mortgage Loans purchased by CHL were underwritten in all material respects in accordance with customary and prudent underwriting guidelines generally used by originators of closed-end second lien mortgage loans."

Those underwriting guidelines were described in the prospectus supplement:

"Countrywide Home Loans will conduct a further credit investigation of the applicant. This investigation includes obtaining and reviewing an independent credit bureau report on the credit history of the applicant to evaluate the applicant’s ability and willingness to repay."

"Appraisals are generally performed for all closed end second mortgages" over $100k. 

Other significant reps and warranties that we think are the basis for MBIA recoveries include but are not limited to:

(10) No LTV over 100%;

(46) Appraisal by a qualified, independent appraiser;

(64) No predatory loans as defined by federal, state, or local law. 

Finally, The Pool and Servicing agreement goes on to describe the repurchase and replacement mechanism to be the contractual cure for any breach of the reps and warranties listed. The time frame in which such cure must take place is 90 days.

So if it pleases you to dig deeper see the posts published just prior to these. 

*Update: Or clarification really. We have not found debt-to-income to be an R&W in public documents - most notably the prospectus supplement - other than as referenced in underwriting guidelines which we consider weaker than the item 52 reps and warrants. All the other items have been listed publicly in the aggregate insomuch as they apply to the Statistical Calculation Pool which is basically the main piece of Initial Mortgage Loans but not the Subsequent Mortgage Loans which must not alter certain characteristics outside of a given band.
**Update again: we erroneously stated that the insurance agreement was available on through the SEC system. That document is not public as far as we know. We meant to say insurance policy.

Our Ally

We write a lot about MBIA here for several reasons, the main one being that they are the leader in recovery litigation. So, when the SEC document alert arrives from MBIA informing us of Jay Brown’s testimony, we pump up "Eye of the Tiger" and dive in. But the specifics we discuss apply to other guarantors.

First we found some very helpful, new information in the form of claims-paid information by sponsor:

“As a result of their actions, we have paid out over $4.2 billion in claims through September, including $2.5 billion on Countrywide-sponsored transactions, $1.3 billion on transactions sponsored by what is now Ally Bank, $333 million on a Credit Suisse-sponsored transaction, and $76 million on a Morgan Stanley-sponsored transaction.”

JP Morgan and Barclay’s are notably absent. This suggests that losses if any would be CDO form. We have previously noted that our perceived prevalence of CDO exposure in the case of JP Morgan contributed to the ease with which a commutation would be effected. This is because of the lack of recovery bookings on the part of MBIA and the long tenor of the counterparty exposure on the part of JP Morgan.

There is nothing really revolutionary in that. But we were surprised by Ally being so far up the list. Then we started thinking about another excerpt:

“All but one, which commendably recognized its obligation and amicably resolved the issue, have demanded that the parties engage in “loan-by-loan combat”.”

The first bank that comes to mind is JP Morgan and their higher reserves and recognition of liability, but that is far from a certainty. Why not Ally? Could be. Who knows? Its not so important.

What follows might be.

Thinking back to Ally’s settlement with the GSEs (our thoughts at the time are here), the reserves Ally had booked were higher than their outstanding put-back requests. Perhaps we should have surmised at the time that such could only be the case if a guarantor was pursuing legal remedies rather than actual put-back requests. We found Ally to have about $800M in reserves after settling with the GSEs. Wouldn’t you know that their 2010 YE reserves are $830M after the GSE settlements.

So far our speculation suggests that MBIA could be a big part of that. But the Devil is in the details and wouldn’t you know that there is a great footnote on page 96 of Ally’s Q3 2010 10Q:

“(a) A significant portion of monoline unresolved repurchase demands are with one counterparty.”

Now let’s pair that with what we know about MBIA’s booked recoveries. Importantly, MBIA has booked recoveries for $2.2B related to mortgage repurchases or roughly half of already paid claims. Just for some insight lets consider what Ally's recovery bookings would be at half: $650M. We think MBIA will get more, but its feasible that MBIA and Ally do not mismatch by an insurmountable margin.

Ally has publicly been trying to put the repurchase baby to bed. They have made significant progress as related in a February 2 presentation at a Morgan Stanley Conference:

“• Ally is addressing repurchase risk through settlements and established reserves

• Settlements

– Completed settlements with seven counterparties, including both Freddie Mac and Fannie Mae

– Settlements have been generally in line with established reserves”

Fannie, Freddie and five others have reached settlements. Based on MBIA’s significant losses and Ally’s significant monoline disclosure, lets say that MBIA has not settled, several others have, and this mortgage math might be summing up nicely. We are encouraged by what we perceive as MBIA not settling for too low a number. Even if both companies have booked a similar amount.

Ally is not a plaintiff in the Article 78 case. They also appear to be the front runner for first major RMBS settlement.

Unimaginable

To what does this title refer? Perhaps it is the devastation that has occurred in the financial guaranty market. Or it could be the conduct of bankers in the world's largest banks. It could be the developments in the guarantors’ struggles for restitution. It could be extreme credit developments that happen far too often.

Art and crappy blogs necessitate interpretation, so we'll have to let you decide. But at this point in the resurrection of bond insurance, it is worthwhile to take a look at where we stand as it relates to less certain recoveries.

Jaw-dropping developments are following jaw-dropping developments. Though only of anecdotal value, having non-business-centric news stories aghast at the transgressions of your alleged wrong-doer is encouraging. Such is the case today with Louise Story of the New York Times reporting on Bear Stearns' ill-mannered handling of ineligible mortgages.

For almost a year or more, it has been publicly revealed that these underwriters generally used reviews by Clayton Holdings to negotiate and not pass on pricing on mortgages. The individual crystallizations of these trespasses make for powerful legal ammunition, not to mention reading.

Perhaps equally powerful to involved parties were last week’s same-day announcements of two rulings on MBIA v. Merrill Lynch. One ruling dismissed the remaining Breach of Contract claim while another, lower court ruling granted MBIA access to rating agency files on the disputed deals. There are three explanations for the appearance of coordination in these rulings. 1) Coincidence. 2) At least one of the two presiding judges/panel of judges considered this case to be an important component of potential settlement talks. For that reason, coordinated announcements were sought to minimize swings in the balance of power at the negotiating table. 3) Eileen Bransten, the lower court judge, saw the dismissal ruling and – in what one might describe as an “oh shit” moment – expedited her ruling to facilitate the since announced amended complaint by MBIA. The Honorable might be inspired in such an action by a deeper familiarity with the case.

Assign weights of probability to these scenarios as you may. However you do so, the likelihood of what most consider a long-tail event continues to grow. Considering that much of what we know today was known by these parties at some earlier time, the information value provided by MBIA’s 4^th quarter financial release could be the largest it has ever been, going into or coming out of the recent calamity, or any other time. Ever.

For those sitting in an Ambac office, we think you will be underwriting deals again someday, albeit after a total rebranding or acquisition of the company. Of course it will be years either way, but on March 2^nd we will have a much better idea if that time will come in 2013 or 2020. For those at Nat’l PFG, don’t write off 2011 just yet, though we consider 2012 most likely.

Change begets itself. George Soros pounds this home the idea of reflexivity. Developments in the courtroom may already be spilling over into the supply of capital for financial guarantor recapitalization, as very mildly suggested by Radian’s recent comments. With that in mind, our post's title may refer to the future for this industry.

With Love, Jamie Dimon - Reserves Revealed

A faux letter from Jamie to Jay.

To my only Jay,

Thank you for suing us. Without that action, all would be revealed and so much would be lost.

Pleased to tell you more.

We realized over a year ago that we were going to pay you for all that crap that Bear Stearn's, Washington Mutual and our legacy underwriters crammed into the securities that you guaranteed. And as an honest banker I resolved to reserve for it. You, my knight in shinning armor, gave me the opportunity to funnel these reserves into a litigation reserve rather than an outright and obvious repurchase reserve. It was so sweet of you, Jay!

This allowed me and my peers (Brian asked to be remembered to you) to begin building reserves to your exposure without revealing how much we have reserved. I had over $5B stowed away for you boys even before our little deal! (The little deal: Link.) As we did create an account expressly labeled "repurchase reserves" for the GSE exposure, quietly segregating the non-GSE exposure helped downplay the rewards to those who seek and might seek retribution against us.

We've all done it! Brian just fessed up to it today. So again, thank you for suing us. It has been a great excuse to hide this stuff, even though the temptation to show our swollen reserves in time overcame us. The SEC and public questioning increased that temptation markedly. As for our recent settlements now that they are done, let me tell you more.

They say I have betrayed them by settling with you, Jay. But consider this: if the passage of time will reveal the insolvency of MBIA Corp, why on Earth are they pressing for expedited consideration from the NY Court of Appeals? The roles are inapposite to their allegations, as your team drags things out and they push it through. Here's why: the fraud case won't stand a chance if actual subrogation recoveries exceed the paltry $2B you have booked and loss developments peter out. Perhaps its the boys at Sullivan & Cromwell trying to earn fees before the gig is up. Or perhaps the banks would like a better hand at the negotiating table. Regardless, the uncertainty of the future becomes the certain present all too quickly, making discounts disappear. An Edgeworth box can shrink around one's neck like a Chinese finger trap in these situations. So, JP Morgan followed RBC and the little maple leaf squads, taking the first movers haircut now rather than the close shave of the law later.  You know the rest of the salient points, as they have been told here before.

All the banking conference calls will have questions and comments on litigation reserves from here on out. Some will continue to mask the quantity. Brian will continue with the ostrich approach before throwing out another kitchen sink. We have done a good job, and will let further expense trickle through as need be. In this situation, we've been one step ahead. It's been a pleasure benefiting you benefiting us.

Thanking you,

Jamie

MBIA/JP Morgan Commutation II - Shhh!

There has been a large commutation. The evidence suggests it was good for MBIA. (see The Eureka Moment: http://tapleysbluedragon.blogspot.com/2011/01/commutation-settlements-jay-told-us.html).

Unfortunately, there may not be much to learn from JP Morgan's Q4 earnings call this Friday. JP Morgan has done a good job of building above average reserves while shrouding the litigation under a fog of war. A Jamie Dimon quote on the company's Q3 call typifies the company's enigmatic strategy:

"I think the way you should look at this topic is that we're bearing today $7 billion of charge-offs, foreclosure, repurchase costs - this affects reserves. That $7 billion will go up or down based upon the economy and stuff like this. I'm not sure stuff like this is going to dramatically change that number. It may extend it a little bit longer and stuff like that but - and remember we have in total, between repurchase reserves and the $11 billion, we have $14 billion of reserves for repurchases or loan losses. And look, the mortgage thing is - we're halfway through all this."

Analyst's interpreted this as everything from $7B with $1B left to expense to $14B with potentially the same amount left to expense. But what can we really learn from this? There are $7B of loan loss reserves. Elsewhere, we see there are $3.3B of repurchase reserves. What's left is litigation reserves, though JP Morgan doesn't expressly say so. But lo, a footnote on page 31 of their Q3 fnc'l supplement notes that they have $4.3B of non-compensation litigation expenses YTD. Dimon indicated that none of this was in regards to "foreclosure-gate." Either this is the greatest coincidence since the cookies disappeared and your 1st grader had chocolate all over her face or 14-7-3= JP Morgan knows its ponying up.

This is no coincidence. This cryptic quote by Mr. Dimon is the hint we needed to know that most of that $4.3B is related to repurchase and related litigation. But it hasn't actually been disclosed to us and probably won't be - even in this opaque fashion - again. Having an undisclosed reserve means an undisclosed settlement. In the case of a settlement that is good for the guy across the table, undisclosed terms help prevent a rush to the courthouse (as contemplated here: http://tapleysbluedragon.blogspot.com/2011/01/latest-settlement-until-next-one.html).

What this all means for investors and observers: don't get down on MBIA and the bond insurers this Friday if Dimon is popping Champagne on great earnings. A large realized gain at MBIA is not precluded by a solid JP Morgan quarter. As I've argued before, the finances make sense on both sides but the opportunity for investors is greater with the guarantors.

Here's one more reason this deal made eminent sense: JP Morgan just took out the star running back of the repurchase/CDO fraud rush to the courthouse. We'll see if it took a defensive end or a safety to do it, but its safe to say it took more than the ball boy. My guess is that it was the linebacker. So - and this is interesting from a JP Morgan point of view - how will the rest of the guarantor team move the ball down field? Mr. Frederico described himself as a glutton for punishment on Assured's Q4 call, but don't expect him to lead his parched competitors to water. He is busy in the tub.

Ambac, Syncora, FGIC are going to have to muster up the resolve and cash to see their cases through. They won't get any inspiration this week.

Commutation Settlements - Jay Told Us!

On Nov. 9, MBIA held their conference call in which Jay Brown, MBIA CEO said:

"First, we had a significant commutation of $4.4 billion of par reduction for approximately $70 million going out the door. We announced last quarter that $2.9 million was done immediately. It's now been completed in the $4.4 billion of exposures left to our books."

This is from Bloomberg today:

"MBIA had sued RBC in January 2010 over $4.4 billion of credit-default swaps the insurer sold the bank to protect against losses on three collateralized debt obligations created and marketed by RBC, according to a copy of the complaint on MBIA’s website."

So this is how some reporter felt when she put together Assange's bank dump and the year-earlier B of A computer disclosure right before that combination became news 24 hours later. This evening, The Bond Buyer also reported that MBIA could not discuss a settlement involving S.F., Asian Art Museum, and JP Morgan due to a non-disclosure agreement. Such a non-disclosure agreement could be part of the larger JP Morgan settlement involving a commutation.

But Jay continued:

"There are no other commutations that we are going to announce today, although I do expect that you're going to see a number of them occur in the fourth quarter, which we'll discuss approximately 90 days from now."

Jay told us these were coming and they came. These are undoubtedly very large or global settlements.

Accounting Wonders

There has been a well publicized mismatch in reserves between financial guarantors and the banks they are suing. By commuting the deals as part of the settlement, the accounting could become even more alchemical in that both sides may be able to book gains or limit losses. While the banks have little or no litigation or putback loss reserves, they may have a large writedown on the payoffs of insurance policies due to MBIA Corp's poor credit. MBIA meanwhile has no such writedown in its operating book value, operating income, or statutory financial statements. This creates a large area for both sides to claim accounting victory.

Furthermore, MBIA has not booked any benefit for CDO recoveries (as mentioned in prior posts), so any benefit would drop straight to equity through income.

They Were Good Deals

Management indicated that these deals were advancing as of the Q3 call, slightly before MBIA's stock purchase window opened. MBIA's stock fell from $13.17 to below $10 in November at which time Jay Brown bought 100,000 more shares bringing his total ownership to roughly 4M shares or 2% of the company. Now let's ask the audience: do you think they are good deals?

JP Morgan has been credited with a more conservative reserve for its exposure compared with its peers. That they are among the deal makers should be unsurprising and indicative of the notional value exchanged. The term notional exchange is meant to de-emphasize the transfer of cash in these multi-faceted deals. MBIA could theoretically send cash out the door net on these deals and still record very positive reserve benefits.

B of A's recent deal insisted they materially settled their putback exposure with the GSEs for a $3B cash payment. However, B of A already had well over $3B in reserves for that exposure and booked an additional $3B of loss expense in the quarter implying the GSE exposure would cost them over $6B for Q4 and beyond. Similarly the $2B goodwill writedown could be an admission that future losses on other exposure could overwhelm the legacy Countrywide units profitability.

B of A CEO Brian Moynihan has previously claimed mortgage putback claims would be fought one-by-one after Judge Bransten said "Its going to be a sample." This may have been unsettling for well-informed investors fearful of dishonest or misinformed executives.

I'm Back

Leadership shows us that intangible assets can contain real value. Jay Brown is showing us that litigation recoveries are no exception. According to MBIA employees, Brown wrote a message to his relatively small company upon his return to his former post. It began with "I'm back." MBIA's Q4 conference call may carry the message of "We're here to stay." Meanwhile, Brown may prove the real value of leadership again.

(Updated 1/7 12:33 AM EST U.S. to include Asian Art Museum settlement.)

Ambac Sr. Unsecured and ACA/Goldman

Find a chair and sit in it. Some investors find this type of combobulating discombobulating. Anyway:

Consider yourself agnostic on future loss developments (including recoveries) for a moment. Under such a circumstance you would feel that Scenario 1 under the WI Insurance Commissioners rehabilitation plan (see www.ambacpolicyholders.com) is a balanced forecast. In that scenario, by 2020 statutory surplus net of surplus notes would be roughly 2x the par value of hold co. debt outstanding as of that corporations bankruptcy filing. That multiple goes up if you assume that the $400M of DISC's (similar to TRUP's) is wiped out in reorganization. All the active pari pasu maturities of sr. debentures and notes are quoted and recently trading under 20. With this type of math, you needn't bother unsheathing your HP 12c.

But you really aren't agnostic on loss developments or mortgage-gate, are you? You aren't all jolliness floating down the River Styx like Mark Tapley. That's OK. Here's a big piece of potential upside to lift your spirits.

No financial guarantors are booking benefits for non-putback recoveries. Any recoveries in this area would come from lawsuits under motions relating to breach of contract and negligent misrepresentation. For this class of suit all eyes are on MBIA vs. Merrill. I am still surprised that I still have not seen any commentary relating the ACA/Goldman settlement to this class of suit. IT IS THIS CLASS OF SUIT.

Sure, the SEC was sitting in the FGs seat and with much more leverage, but the circumstances of the case are largely the same. Sure, the suit was resolved by settlement without admission. And sure, one could argue Goldman's motivation was PR, political, or otherwise unrelated to their position in the case. But that does not change the fact that Goldman paid 55% of the initial par value of the deal to put the issue behind them. The FGs don't have subpoena power or public and political ire on their side. They do have a large amount of powerful and incriminating information (think Clayton Holdings. The best summary I have seen on the subject is from John Mauldin toward the end of this article: http://www.johnmauldin.com/frontlinethoughts/the-subprime-debacle-act-2-part-2-mwo102310/)

Ambac has a lot of losses in this area and hasn't booked any recoveries. If it recovers 25% of par in compensatory damages, then the residual value of sr debt is double Scenario 1 or $2B higher. That implies a 1900% return over 9 years. If recoveries look like 55% or 100% or more, then we can switch from multiples to exponents.

It is also worthwhile to note that 1)litigation is beta neutral and 2)a very low probability of Scenario 1 (no CDO recoveries) or better makes these bonds very interesting.

See the February update on developments and DISCS here.

MBIA and JP Morgan, Barclays: Settlement?

This would be consistent with Jay's comments of keeping settlements quiet. Multiple settlements in a quarter would make it more difficult to surmise the details of any one agreement. However, given the parties that have dropped out of the 78 proceedings, the lion's share should be coming from JP Morgan.

This deal makes particular sense at this point in the game because so much of the exposure is in CDS/CDO form for which MBIA has recognized zero benefits. So any recoveries will drop straight down into equity through income. This will occur in GAAP and statutory statements. Meanwhile, JP Morgan isn't in the same state of denial as some of its peers. Given the dark cloud that this litigation is creating for JP Morgan and like firms, there seems to be plenty of room for them to increase their recognized costs and still add value to their enterprise.

Still though, there may have been no settlement but rather just an acknowledgment of the hopelessness of the 78 suit paired with an intention to create goodwill with the team across the mortgage litigation table. But boy, it sure would make sense...

Thank you to Patrick McGee. He mentioned the possibility of a settlement in his article at the Bond Buyer:

http://www.bondbuyer.com/issues/120_3/mbia_insurance-1021754-1.html?ET=bondbuyer:e2681:2207096a:&st=email&utm_source=editorial&utm_medium=email&utm_campaign=BB_Daily_Briefing_010411

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.

The Global Imbalance

Sure there are lots of imbalances in the global economy. But one is more pervasive and persistent than any other. Let me ask you: are emerging markets net exporters? The U.S.? We know the answers. So why? Here's the answers we've heard ad naseum: the U.S. has lost its drive, it's become bloated or slowed by entitlements, taxes, bureaucracy, demographics, over regulation and under regulation.

OK sure. But why would emerging countries, the have-nots endlessly give developed countries more goods than they receive? Not for just for any money. For dollars of course. Perhaps, in focusing on net export imbalances we are analyzing the symptoms and not the disease.

Said another way, one could view the situation not an under production in the US but an over investment. That's right those proletariat types are at it again. Now they are forcing us to into deficit-financing! But why? Law and order. Institutions and property and contract rights. Emerging markets are importing the security of the U.S. system (and military might) when they bring in dollars.

Looking at investments from within the U.S. or a highly developed country, emerging market investments are a no brainer. Look at the growth potential! But consider the inverse. Looking at the U.S. and developed nations from the outside, surrounded by unstable governments, heirarchical non-pluralist bureaucracies, rampant inflation, large criminal organizations, and otherwise lacking and untested law, order, and institutions, well from that point of view, I'ld like a helping of dollars please... and seconds if nobody minds. This is the type of logic that leads me to view capital flows as the tail ever so slightly wagging the net exports dog.

Well all I do here is post diatribes of varying length, but now its time for something really tangential. Both pre- and post- world wars rounds of globalization have been marked by a convergence of institutions. As a communist Deng Xiaoping would have said, we are all just trying to catch mice. In so doing, we seek the best mouse trap (or cat). When the best is found, who wouldn't want to use it? I'ld like the best whether it's black or white, capitalist or communist, 12% risk-adjusted total capital ratios or 9% tier-1 common ratios. Hence, convergence.

Now pretend that I've convinced you that capital flows have an under appreciated responsibility for the persistent net export imbalance. The security of the dollar (and investments in the U.S.) from the perspective of the emerging market based investor is a way of attaining the benefits of the best institutions. Governments that collect dollars attain those benefits as well. Of course, the effect of having a mountain of dollars doesn't replace the need for a proper political-economic systems. Just look at what has happened to Argentina since WWII. Dollars are more of a compliment and only a very slight substitute for institutions. When things get ugly, a country can to a certain extent buy its way out of a problem that might have also been cured by better institutions.

China for example could deal with a currency troubles by preemptively taking 'institutional' actions such as allowing for partial market adjustments and limiting public and private sector borrowing in foreign currency and taking dollar actions in accumulating trillions in reserves.

So far this post has nothing to do with financial guarantee. I can change that with a violent turn. Our institutions are strong. One could argue that U.S. contract laws are its most predictable. For that reason, JP Morgan, Barclay's and myself think their is no reason to even consider the viability of challenges to the MBIA/Nat'l PFG split given the clarity of Article 78. So lets briefly consider the weight of the topic on repurchase litigation. Let's start by way of analogy:

You bought a house with a large basement. You want to flip it. I am a prospective buyer but have worry about termites. I ask you if the house has termites. You say you won't answer, but refer me to various inspectors. You pay the inspectors. When the inspectors come to the house, you tell them it has no basement. The locked door you falsely claim leads only to a broom closet. They find no termites and they tell me the house has no termites. I buy the house. I find termites in the basement, they destroy the house. I sue you. We discover that you hired another, better equipped inspection company three months earlier before you bought the house and they found a massive termite infestation. You used that to negotiate a lower price on the house. You are guilty of fraudulent conveyance. You owe me restitution.

Strong property laws determine that the results of the above example will not change easily. They will not change if we switch the roles of you and me or you and Bank of America and me and MBIA. They will not change due to incorporation. They will not change if it is a house and termites or mortgages and bad credit, inspectors or rating agencies and Clayton, or a basement or underlying loans. And they certainly will not change if you promised to recompense me for termite damage or repurchase non-qualifying loans as the case might be. (B of A argued that fraud claims against them should be dropped because the claims against them were for failure to perform contractual agreements. Their motion was dismissed.)

If I were a defendant in such a case and realized that I was going to lose, then I would come to the table with private investors who could probably only actually cooperate in a suit if they saw huge payoffs. I would show I was willing to talk by dropping other loosely related and weak suits. Defendants have recently done these things.

The value of strong contract law supersedes the financial health of any individual, natural or corporate. Even in a closed economy, predictable property rights and contract laws encourage investment, entrepreneurship and thus growth in prosperity. Yes, somehow I just argued that that the same factors that drive persistent net exports are going to lead to a windfall for financial guarantors. I hope you found it titillating. Perhaps we can flush out the latter part of the post a bit more in future. Tata.

GMAC/Ally Settlement

Looking at the Ally/GMAC Mortgage settlement last night, my first impression was very negative for the financial guarantors. A $462 million settlement for $280 B of mortgage exposure didn't seem like much, especially when some journalists incorrectly claimed that the 280B number was outstanding repurchase requests. But a little familiarity with the MBIA and Bank of America situation helps us understand that such a thing could not be the case. Actually, Ally cited in a November 17th presentation

(Ally Financial Inc., 2010 Citi North American Credit Conference, November 17, 2010) that their outstanding repurchase requests were less than their reserves. Bottom line this is bad for B of A, good for financial guarantors... but not as good as it might become. Here's a key slide from Ally's presentation: 

Update on 12/31: it is important to note that the settlement was for more than the reserves. At the end of Q3 Ally had only $218M in outstanding claims from GSE repurchases vs. $632M from Monolines. As a % of UPB (Unpaid Principal Balance) the numbers are not as flattering. For a good report on the (seemingly consensus) viewpoint that this settlement is good for BoA et al. see seeking alpha blog here: http://seekingalpha.com/article/243930-ally-s-fannie-mae-settlement-scales-back-potential-bofa-jpmorgan-putback-costs. However UPB doesn't take into account the quality of the loans sold while reserves are at least supposed to. There is also much greater variability of loan quality and misrepresentation on the private label side. Based off the above slide and the settlement we can surmise that Ally has about $800M in reserves after settling with Fannie and Freddie (in March).

Also, I accidentally deleted the original post in editing it. Still learning. Cheerio.