More Morgan Stanley and MBIA Numbers

In case you tried to block MBIA's traumatic CMBS loss development out of mind, we must remind you as Chuck Chaplin noted full year loss developments "primarily due to the establishment of $1.1 billion of reserves for CMBS-related policies."

Life and 10-K's are full of coincidence. Morgan Stanley noted in its year-end report regarding "amounts related to MBIA derivative counterparty exposure... at December 31, 2010, the aggregate value of cumulative credit valuation adjustments and hedges exceeded the amount of gross exposure of $4.2 billion by $1.1 billion." 

And it continues in the next paragraph. "The Company’s hedging program for Monoline counterparty exposure continues to become more costly and difficult to effect, and, as such, the losses in 2010 reflected those additional costs as well as volatility on those hedges caused by the tightening of both MBIA and commercial mortgage-backed spreads."

Never say never, but at this point it seems safe to assume that Morgan Stanley is not engaging in volatile, large, naked, hairy CDS speculation. Rather, Morgan Stanley likely has hedged all or close to all of its gross notional exposure to lots of crappy CMBS wrapped by MBIA and established a credit allowance for about $1.1B.

Meanwhile, this hedged exposure consists of the best performing fixed income index wrapped by an even better performing individual credit. Unless it made a bold call to unhedge their exposure, Morgan Stanley is bleeding. 

These hedges were expensive to implement to begin with. In its own words, Morgan Stanley's "hedging program for Monoline counterparty exposure continues to become more costly and difficult to effect." The company is almost considering out loud that eliminating such costs is one benefit that must be considered in settling this exposure.

Another consideration is the RMBS repurchase litigation between these parties. But that is a whole other, albeit smaller can of worms.

RBC Reports Gain on MBIA Commutation

Believe it or not, it looks like we were right about something: both sides of commutations are gaining from unwinding those contracts.

RBC today reported a gain of $102M on its commutation settlement with MBIA. While this may indicate that MBIA could have bargained for a better deal, it should help attract other banks to the settlement table.

MBIA CFO Chuck Chaplin said on the Q4 conference call that "the cost to commute these deals was somewhat below our loss reserves, contributing to a net reduction in economic losses of $182 million" on $15.7B of notional commutated policies.

We are happy with what Chuck also said regarding commutations: "We acknowledge that we've got a ways to go in this regard, but we're satisfied and believe that we have a positive trend at this point." As we said previously, we think commutations were a clear but below-potential positive in the quarter. While MBIA cannot force banks into mutually beneficial agreements, at least they appear to be trying.

National PFG Eyes Reentry

National Public Finance Guarantee, MBIA's public finance guarantor, appears to have launched a new ad campaign as part of a renewed bid to reenter the public finance guaranty market. This development comes on the heals of MBIA's Q4 2010 financial results conference call in which Jay Brown said he expected the key Article 78 case challenging MBIA's split between public and structured exposure to be "resolved in our favor this year."

Chuck Chaplin, MBIA's CFO then weighed in on the Tuesday call saying "We expect that as the transformation litigation is resolved, we will be in a position to generate new business in National."

While there are other law suits challenging MBIA's transformation outside the Article 78 case, one of the main suits was recently dismissed. That decision has been appealed by the plaintiffs.

Meanwhile, MBIA Corp., the structured finance guarantor, continues to stabilize its finances. This implies that a recombination of the public finance and structured finance units - however unlikely - would be incrementally less negative.

In light of these developments, advertisements on The Bond Buyer's website showed NPFG with the slogans "Built to last. Built to serve." and "Strength. Endurance. Commitment." The advertisements linked to NPFG's main web page that featured the phrase "We're at the bridge. It's time to cross it."

This all boils down to one thing: at least one entity other than The Blue Dragon thinks that National can write business this year. It is not apparent what type of outreach NPFG is currently conducting, but the most likely place for NPFG's first policy to source from is an institutional investor.

There is clear value over and above ratings in a guaranty featuring the type of due diligence and subrogation work done in the Vallejo case. In that case, NPFG recovered essentially 100% of it's claim on $4.8M of defaulted COP's plus $400k of its $500k in legal expenses. They also rallied the National Federation of Municipal Analysts and the California State Treasurers office to publicly support their case.

MBIA/NPFG employees have in the recent past told Mark Tapley that they view underwriters as their primary client. If that idea is still widespread at the company, it should be tossed in favor of looking through to the actual investor beneficiaries. The easiest way for NPFG to write its first policies will be small obligor deals in the secondary or primary market in which one buyer - perhaps a mutual fund or insurance company - dominates the issue. The value of due diligence and subrogation will be more apparent to large investors compared with the retail investors that solely rely on ratings.

MBIA Mortgage Math Victory Overwhelmed by CMBS Seizure

Mark Tapley was neither emotionally nor intellectually prepared for outsized CMBS deterioration. Commutation gains were of course far from surprising though slightly underwhelming, but the details are interesting.
This quarter sums up the quarter nicely:

"… $604 million of incremental economic losses on transactions backed by pools of commercial mortgage-backed securities offset by a reduction of approximately $227 million in economic losses on multi-sector ABS CDO transactions, primarily as a result of commutations during the quarter."

The commutations appear to have been roughly 2/3 AAA exposure and 1/3 BIG exposure. CIBC, CMBC, RBC, Barclays, and JP Morgan were most likely the five counterparties commuting in the fourth quarter and Citi is the only commuter in the first quarter.

We are eager to learn who Barclay's struck a deal with in January. As for MBIA, we hope for more color on CMBS tomorrow.

Update 3/2: Based on Jay's comments, the CMBS losses suggest that in addition to adverse developments and model changes, MBIA is increasingly trying to settle these exposures via commutations. Perhaps the Citi deal was in this vein. The biggest positive we took from the call was Jay's affirmation of targeting full recoveries through putbacks rather than booked loss reserves. We previously assumed this to be the reason that a deal had not already been struck with Ally in this post. 

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.

Barclay's Confirms Our Expectation of Commutation

Jay said it. Mark said Jay said it. We think Barclay’s just said it again. (Most recently we said it Here but previously Here and earlier (see all in MBIA link and accounting link for why these deals make sense.))

Note: Barclay's did not specifically identify MBIA. But here is the key excerpt from Barclay's annual financial release:

THE TABLE BELOW INCLUDES ALL ASSETS HELD BY PROTIUM AS COLLATERAL FOR THE LOAN. AT 31ST DECEMBER 2010, THERE WERE ASSETS WRAPPED BY A MONOLINE INSURER WITH A FAIR VALUE OF $4,806M (2009: $4,095M). FOLLOWING THE COMMUTATION OF CONTRACTS WITH ONE MONOLINE INSURER IN JANUARY 2011, THERE ARE NO LONGER ANY ASSETS WRAPPED BY MONOLINE INSURERS. ¢ASH AND CASH EQUIVALENTS AT 31ST DECEMBER 2010 WERE $1,364M (2009: $688M) INCLUDING CASH REALISED FROM SALES AND PAYDOWNS AND FUNDS AVAILABLE TO PURCHASE THIRD PARTY ASSETS. OTHER ASSETS AT 31ST DECEMBER 2010 WERE $811M (2009: $567M) INCLUDING RESIDENTIAL MORTGAGE-BACKED SECURITIES PURCHASED BY PROTIUM POST INCEPTION AND OTHER ASSET-BACKED SECURITIES.


It looks like the Barclay’s commutation that we have previously discussed will fall into the first quarter. See the full release for more info on Protium.

We of course think this deal is related to MBIA due primarily to Jay's comments and the Barclay's withdrawl from the transformation litigation.

We are surprised that Barclay's didn't squeeze this into the same quarter as JP Morgan and the Maple Leaf banks in order to mask the particulars of their deals. This could have been due to an inability to squeeze it into the quarter. Then again maybe this was planned to facilitate other deals in the first quarter. Morgan Stanley comes to mind, see more on their math here.

Update: There were commutations in Q4 that we did not previously show here. MBIA could be both or either of these transactions. We think they are at least one. Here is the Barclay's excerpt:

CLO ASSETS WRAPPED BY NON-INVESTMENT GRADE RATED MONOLINES AND CLASSIFIED AS LOANS AND RECEIVABLES DECLINED TO A FAIR VALUE OF £5,873M (2009: £7,994M), FOLLOWING THE UNWINDING OF CERTAIN PROTECTION DURING THE YEAR WITH A NOTIONAL OF £2,745M. AS A RESULT, THERE WERE CLO ASSETS WITH A FAIR VALUE OF £1,969M AT 31ST DECEMBER 2010 (2009: NIL) NO LONGER PROTECTED BY A MONOLINE INSURER. THE REMAINING ASSETS CONTINUE TO BE MEASURED AT FAIR VALUE THROUGH PROFIT AND LOSS.

More Mortgage Math, Commutations and Morgan Stanley

Shannon Harrington of Bloomberg News published a good article on MBIA CDS recently. (Available here.) Here’s a key quote:

“Swaps traders are speculating that banks are overpaying for default protection as MBIA, based in Armonk, New York, seeks to compel banks to repurchase faulty loans and settles guarantees it made on subprime mortgage-linked securities. Morgan Stanley reported $535 million in losses in the last two quarters from the cost of bond-insurer hedges, including MBIA.”

We don’t know where Shannon gets his information, and this may in fact be third-party market participants moving the CDS. However, we think that given the math we have pointed out regarding commutations, this CDS movement may be due to an unwind. As may have been the movement in October. This may even be Morgan Stanley.

Also of note in the above quote is the losses on hedges against MBIA. There are two key points on this. First, in contradiction to the implications we drew from the 2009 10-K (here), this makes it clear that Morgan Stanley has significant direct hedges on MBIA itself and not just the underlying transactions.

Second, we believe that at least a portion of the $535M losses reference are the actual realization of what we have already pointed out is a first-mover advantage. That is an advantage Morgan Stanley appears to have missed out on, while JP Morgan, Barclays, and some smaller banks captured.

Expect more deals and look forward to March 1st; a tremendous date.

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.

Mortgage Bond Math Really Means Everyone is a Winner II

Here is a real example of the accounting that we talked about in an earlier look at the alleged mismatch of reserves between monolines and banks (here.) In summary, we witnessed that monoline-credit, litigation and repurchase reserves at banks should be summed to compare against recoveries booked against monolines. Why? To the surprise of many, even investment banks can only lose a dollar once.

Special thanks to the leading analyst that pointed out this example. The excerpt that follows is from Morgan Stanley's 2009 10-k.

Monoline Insurers.    Monoline insurers (“Monolines”) provide credit enhancement to capital markets transactions. 2009 included losses of $231 million related to Monoline credit exposures as compared with losses of $1.7 billion in fiscal 2008 and losses of $203 million in the one month ended December 31, 2008. The current credit environment continued to affect the capacity of such financial guarantors. The Company’s direct exposure to Monolines is limited to bonds that are insured by Monolines and to derivative contracts with a Monoline as counterparty (principally MBIA Inc.). The Company’s exposure to Monolines as of December 31, 2009 consisted primarily of asset-backed securities bonds of approximately $458 million in the portfolio of the Company’s

45

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Table of Contents

Subsidiary Banks that are collateralized primarily by first and second lien subprime mortgages enhanced by financial guarantees, approximately $2.0 billion in insured municipal bond securities and approximately $651 million in net counterparty exposure (gross exposure of approximately $5.4 billion net of cumulative credit valuation adjustments of approximately $2.8 billion and net of hedges). Net counterparty exposure is defined as potential loss to the Company over a period of time in an event of 100% default of a Monoline, assuming zero recovery. The Company’s hedging program for Monoline risk includes the use of transactions that effectively mitigate certain market risk components of existing underlying transactions with the Monolines.

-


The disclosure states that Morgan Stanley's exposure is "principally MBIA Inc." Morgan Stanley does not reveal how exposure is measured (i.e. by total loss or total par insured). It does go on to reveal $2.8B in credit reserves and nearly $2B in (CDS) hedges by way of inference. If one only considers the credit reserves and assumes that MBIA makes up $1B of that, well then either Morgan Stanley would shockingly accounts for half of MBIA's expected repurchase reserves OR - and perhaps more shockingly to most people - Morgan Stanley's MBIA credit-loss reserves would exceed MBIA's Morgan Stanley recovery bookings.


And that gives no value to the proceeds Morgan Stanley would realize from unwinding hedges against monoline exposure, which in MBIA's case would most likely exceed a quarter of the notional value hedged. However, the excerpt suggests that Morgan Stanley actually hedged its monoline exposure using derivatives on the underlying exposure, not on the insurer. In that case, benefits from unwinding hedges would not act as an addition to loss/repurchase/litigation reserve metric. This examination has also given no consideration to any actual litigation and repurchase reserves; the beauty is in it not having to do so.

This is the math that (while still undisclosed in most cases) led JP Morgan and the Canadian Banks to commutate their MBIA exposure. Both sides probably gained. We have just gone through a hypothetical scenario that, while full of assumptions, nonetheless underpins strong incentives for Morgan Stanley to come to the table with its financial guaranty counterparties.

Perhaps they already have.

Mortgage-Bond Math Really Means Everyone is a Winner

Another letter, this one real. Perhaps the title should end with "Everyone (that was a loser) is a Winner."

Dear Mr. Weil,

I enjoy reading you regularly. The title "Mortgage-Bond Math Means Everyone is a Winner" would be apropos for a contrary look of the same topic. (Click here for the original article.)

First, Bank of America yesterday joined JP Morgan in revealing that they are expensing undisclosed amounts related to the putback and broader private mortgage securities demands into a "litigation reserve" account. This is what reminded me of your article published in mid December.

But perhaps more significantly, banks have sustained large write-downs on their counterparty exposure to the monolines. B of A mentioned in their call yesterday reducing exposure to monolines in their FICC unit, suggesting they are no exception. Given the credit leverage in the bond insurance business, such exposure could be very large. This means that a commutation settlement could result in both sides declaring accounting victory despite the mismatch you have pointed out. For the same reason, banks could pay out substantial sums but receive a net-benefit if the perception of MBIA's credit quality improves markedly as a result. Though this offends logic, such is the intersection of market and accrual accounting in this case.

Regards,

Mark Tapley

P.S. I'm going to blog this here: http://tapleysbluedragon.blogspot.com/

--
Connect with me on LinkedIn: http://uk.linkedin.com/pub/mark-tapley/29/98/83a


The Morgan Stanley example of this math has been posted here.

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.)

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

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.