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

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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.

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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/

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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.

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.)