The monoline insurers — the firms that issued default insurance on muni bonds that never default — have been buried by more than a trillion dollars worth of derivative bets, more than 10% of which have gone bad.
That $130 Billion worth of CDO/CDS exposure makes it highly unlikely that anyone is coming along to rescue this group of risk-loving, derivative-misunderestimating, technically-bankrupt insurance managers. As we mentioned saeveral weeks ago,
While absurd rumors swirled around the unlikely purchase of Ambac (ABK) by Wilbur Ross, various other forces have been moving to make sure that the bond assurance will continue to exist for various state and city projects. Even though Munis very rarely default, the cost of Bond Assurance ends up paying for itself many times over, as it allows cities and towns to pay significantly less in borrowing costs over the life of the bond issuance.
As we mentioned several weeks ago, that was a lovely, low risk business, with little defaults and a steady
revenue stream. At one point in time, AMBAC had the highest revenue per
employee on the planet.
That situation was obviously intolerable, and so managment embraced riskier, higher yielding derivatives. Over that period, the monoline stocks have lost about 90% of their value. (Ouch!)
The latest rumor making the rounds is that Wilbur Ross will buy Ambac. Reports that Ross will invest in the battered bond insurer Ambac have soothed investors. But as Roddy Boyd argues, the deal makes no sense whatsoever:
"If Ross were to purchase Ambac in an
"as-is" arrangement, he would be buying an enterprise with a staggering
$67 billion in CDO exposure, of which $29.1 billion consists of
asset-backed CDO’s of increasingly dubious credit quality. The company
also has $8.4 billion in sub-prime mortgage paper in its portfolio. All
told, Ambac’s financials show that the insurer has $14.5 billion of
claims-paying resources to support a $524 billion guarantee portfolio,
figures so unbalanced that the company’s attempt to raise $1 billion or
more in emergency capital via an equity or convertible offering had to
be scrapped last week."
Now, with the monolines bouncing on the highly unlikely take out by Wilbur Ross, a new sheriff has come to town: Warren Buffett has "agreed" to expand Berkshire’s new bond insurer nationwide — in exchange for
faster licensing — according to a group of U.S. state regulators.
In order to come into one of the most profitable and mismanaged segments of insurance underwriting, Buffett has coyly struck a deal that fast-tracks the messiest part of the business. Now THAT’S bloody brilliant.
Here’s Bloomberg’s take on the matter:
"Cathy Weatherford, chief executive officer of the National Association of Insurance Commissioners, on Jan. 10 offered to help speed approvals if Buffett’s new company agreed to simultaneously apply to all states with a uniform application, NAIC spokesman Scott Holeman said today. "Berkshire has committed,” Holeman said in an interview.
Berkshire’s bond insurer may help stabilize debt markets, which have been roiled by the prospect that MBIA Inc. and Ambac Financial Group Inc., the industry’s biggest guarantors, may lose their top credit rankings. A downgrade may affect $2.4 trillion in assets industrywide, and Fitch has already stripped its AAA rating from Ambac after losses tied to subprime loans.
To induce Omaha, Nebraska-based Berkshire to submit the application to all states, NAIC proposed a pilot program waiving a requirement that an insurer using a uniform application have a track record in the type of insurance for which it wants new licenses, Holeman said.
I was originally going to title this "Buffett to Wilbur Ross: Up Yours" but I thought that too harsh. And Ross seems to smart to buy into the Ambacv/MBIA snake oil . . .
>
Previously:
Counter-Party Risk
Friday, January 18, 2008 | 07:30 AM
http://bigpicture.typepad.com/comments/2008/01/counter-party-r.html
A Regulator Not Stymied by Red Tape
JOSEPH B. TREASTER
NYT, January 9, 2008
http://www.nytimes.com/2008/01/09/business/09buffett.html
Sources:
Has Wilbur Ross lost his mind?
Roddy Boyd
Fortune, January 25 2008: 4:19 PM EST
http://money.cnn.com/2008/01/25/news/newsmakers/boyd_ross.fortune/index.htm
Buffett’s Bond Insurer to Go National, Regulators Say
Josh P. Hamilton
Bloomberg, Jan. 28 2008
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aAgiUPbIXPTs
One aspect of all this I don’t understand: will Berkshire simply start underwriting new applications, or will it also underwrite policies bought by municipalities from AMBAC that have now been downgraded? If it does the latter, will Berkshire then receive a new premium from the municipalities themselves, or will AMBAC have to pay the premium?
The reason I am asking this is that my understanding is that the municipalities are required to be insured by a AAA insurer, or do I have that wrong?
I have said this in other posts elsewhere on this blog, but here’s an opportunity to be top of the heap.
First of all, it’s important to understand the length of the time over which actual economic monoline losses will happen. Think cash here — put yearly claims payments on one side and premium income/portfolio income less expenses on the other side and compare the outcome. Really, keep this in mind: All the mark to market adjustments killing the banks are irrelevant to a bond insurer. The risk the monolines face is whether investors lose principal and interest on the underlying investments and trigger their guarantees. Even if the guarantee is called, the monolines pay out claims on principal only at the original redemption date so the NPV exposure is a fraction of the notional sums insured.
That means you need to look at these monolines as ongoing concern basis and in a runoff scenario. See what happens — even if it means, believe it or not, that these entities can make it as ongoing, though crippled, concerns.
What is the probability of a truly armageddon type of scenario in the housing market and the overall economy? Warburg did exactly this and figured that the conservative value during a runoff for MBIA would be about 30 dollars.
Another way to think about it is this: monline exposure can be compared to a written out-of-the-money put option to protect investors against extreme market events.
Look, I agree — the monoline business model is a complete wreck. And from a cash point of view, it could unravel for them, and fast.
But, to reiterate, so far we have had mark to market losses in a portfolio that is supposed to be kept until maturity. To date all the brouhaha has been about covenant triggers, valuations, and accounting entries — green eyeshade stuff. Of course, the level of capital required to maintain an AAA is far larger than that required to merely assure that claims are paid for the next year or two. But again, that’s a labeling issue, not an REAL economic issue.
The real economic losses will occur when claims are paid.
Was there ever any truth to the ‘anonymous’ source of Ross buying AMBAC?
The guy doesn’t buy until the loss is taken, this is one of those hedge fund rumors.
Buffett is a true genius.
DEFINITION: “A genius is a person of great intelligence, who shows an exceptional natural capacity of intellect, especially as shown in creative and original work”
Buffett was writing and talking about all of these derivatives blowing up years ago. His 2002 Berkshirehathaway annual report includes an extensive write up on derivatives where the key phrase he uses is “…derivatives are FINANCIAL WEAPONS OF MASS DESTRUCTION.” He talks about how they are not only an investment risk they are a systemic risk to the economy.
So now derivatives have blown up much as he predicted, he comes in with a pile of money (some $40 billion in cash the last I knew) and he starts a very profitable plan to insure municipal bonds. He is saving the economy from the greedy, incompetent management that messed up a very profitable business that is part of a chain that put the entire economy at risk (just as he predicted would happen). You can lay your life on the line that he won’t be using phony derivatives to goose his earnings, he will simply coin money in the old fashioned way by writing insurance on very solid municipal bonds. I knew there was a reason I make it a point to go to the annual meetings and listen to this very rare, honest, person who is also a great investor.
What a genius.
Don’t expect munis to be quite so safe if falling house prices lead to lower assessments and thus to lower tax revenues. There will be defaults.
Ackman vs. Whitman steel cage match. Ackman wants the AAA stripped and he wants it done now. If it can be delayed while the credit markets become more & more liquid, then a capital infusion/workout solution has a chance of happening.
Say what you want about those guys but they both have major sack.
I think Buffett sticks with the boring and profitable Muni business.
Buffett Fan:
Warren doesn’t chase profits like the monolines did. He doesn’t get emotionally involved at all. When it gets down to it, he is a math wiz.
missing in that piece is that the rumor was used to juice the DOW almost 600 pts .
THAT IS WHAT IS WRONG WITH THAT…
Not that it most likely will never happen because of the underlying rot that it has accumulated because of it’s greed and avarice.
Wild,Wild, West.
Ciao
MS
well said karl. the total valuations are misleading when attempting to understand the cost via guarantees. while some muni’s could suffer defaults by and large these are isolated events as the governments that release these always have the added advantage of extracting yet another pound of flesh from their citizens.
The safety of municipal bonds also rests with the ability of the borrower to pay the money back.
As we’ve seen before, “sub-prime” is not the only sub-prime portion of the economy. Many expenditures by cities and states were predicated on an already high and ever-increasing tax base.
What happens with slowed spending and decreases in tax base? What happens with all of the half-developed, half-opened, half-occupied projects that were funded by bonds on the basis that they would be paid back through revenue? What about all of the new, expensive public facilities that were built with the expectation of population and wealth growth?
As a result, even a purely municipal bond insurance business will not find the way forward as easy as did the insurers in the past few years.
Karl K – thanks. Excellent point. I do however think the risks are a tad higher but what they might be is a matter for debate and investigation. If we believe that Wilbur Ross, with one of the best track records in history for finding pearls in the rivers of blood, has not lost his mind then what ?
This is a guy who buys for $.10 on the $1. And from both your and Barry’s comments as well as Buffett’s moves there’s a great and profitable business model in bond insurance. All Wilbur has to do is cherry pick the sensible assets, get them for a decent price, re-assure the municipal community and let the insurers reap their just rewards. Which appears to be Warren’s strategy as well. Only he’s starting with a world-class insurer in the first place and $90B/yr of cash flow he needs to invest. Talk about carpe diem this could provide BRK with an annuity business that fits into the Buffet stock screen mantras for decades. And is an unparalleled opportunity. Bravo Zulu.
Anyone catch this?
“Officials with the New York State Insurance Department have reached out to Wall Street bond rating agencies to suggest that they postpone a downgrade of bond insurers until the state can develop a bailout package for the troubled sector, CNBC has learned.”
http://www.cnbc.com/id/22891804
Let the lawsuits fly, I say…
drew-
that is the BIG problem. You can take the other side of a trade and then just as it’s about to reward you handsomely (and send someone else to the poor house-legitimately so IMO) they take it away from you under the guise of “what’s best for everyone”
What good does it do to educate, assimilate and have a great understanding of Risk when people who failed to do any DD get bailed out time and again??
This is no longer a market……it’s a free for all……where economic rules and theories are only applied if the direction is Up…
Ciao
MS
It looks to me like Buffett is taking over only the profitable portion of this business (municipal bond insurance). That is fine, as far as it goes, but the real problem is the insurance policies on the “financial time bombs”. What about the banks and other holders of those policies?
So with their most profitable business gone to Buffet, MBIA and ABK will be left twisting in the wind. They certainly will not be able to survive (IMO, that is almost certain in any case). And we already know, or at least assume, that they can’t pay the losses on these policies. We also know that banks don’t want to give money to the insurers just so the insurers can give it back to the banks in settlement of the claims.
What then is the solution? It appears to me there is none – the losses are too big. The market cannot / will not cover the losses, so it will be up to the Government, as the lender / guarantor / insurer of last resort, to make good on the claims, at least in part. Hopefully MBIA and ABK will be allowed to fail in the process, as I think Buffet is counting on.
But the larger question is, can the Federal government bail everyone out of this housing / credit crisis? If not what will happen then?
how is the muni business going to Buffett? Are the insurers going to roll over and give it away?. No way. The longer this drags out, and the more capital the insurers get, the more probable they survive. Ackman wants the rating to be cut, and he is working through Wisconsin & NY insurance regulators to get it done. At this point, the capital markets snifing around are his enemies and the insurance regulators are his saviors.
“But the larger question is, can the Federal government bail everyone out of this housing / credit crisis? If not what will happen then?”
Then we’ll all get the reckoning we deserve for letting all the crooks take over our businesses and the country.
That Monoline Bailout: The Entity, 2008 Edition
It’s the new MLEC. And it’s probably not going to work out. Willbur Ross is not about to buy up Ambac. But, hey, everyone can be happy because Warren Buffett is riding to the rescue….
Barry, I agree with your take on Ross, or any other buyer looking to maximize returns on investment. As a strategic purchase they have minimal value, more so since Buffet has decided to eat their free lunch. But don’t you think the banks need these clowns to stay in business? What do their books look like if the monolines disappear? Same for counterparties? This does not make any of these companies worthy of investment, I am simply pointing out that I do not believe they will be allowed to fail.
Marty Whitman understands distressed investing as well as Wilbur Ross. Whitman has made some huge, concentrated bets in the monolines. Neither Ross nor Whitman has lost his mind.
They see value.
Groty wrote:
Marty Whitman understands distressed investing as well as Wilbur Ross. Whitman has made some huge, concentrated bets in the monolines. Neither Ross nor Whitman has lost his mind.
They see value.
Funny you should mention Whitman. Barry touts Ackman — a sharp guy, obviously — but here’s the other side of the ledger from Whitman–a pretty sharp guy in his own right.
http://www.thirdavenuefunds.com/taf/documents/shareholderletters/aboutus-letters-07Q4.pdf
The choice morsels from this shareholder letter.
In analyzing each of the financial institutions, Generally Accepted Accounting Principles (“GAAP”) tend to be quite misleading. This is because GAAP require that derivatives such as the Credit Default Swaps be marked to market – and market prices now are highly capricious, to say the least.
Marks to market are the most appropriate, and helpful, tool in the appraisal of publicly-traded common stocks held in trading portfolios. Marks to market are an inappropriate, and unhelpful, tool in the appraisal of credit instruments held in portfolios where the intent is to hold the credit instruments to maturity. MBIA and Radian intend to hold their credit instruments to maturity.
The real losses to MBIA and Radian will be determined not by marks to market, but by
(a) the percentage of the portfolios that suffer money defaults, plus
(b) how those money defaults work out after recoveries from foreclosures, restructurings, refinancings and reinvestments.
MBIA’s fourth quarter 2007 reported losses will be staggering. In addition to mark to market losses, the preliminary indications are that case reserves will be increased by $500 million to $800 million pre-tax. The Company, however, will remain with a quite strong capital position.
Historically, financial guaranty insurance has been a highly profitable business for the monoline insurers, even though the insureds received a very attractive deal by being able to obtain AAA ratings at low cost. Insurance company profitability is measured by a combination of underwriting profits and net investment income.
Underwriting profit is measured by the “combined ratio”, i.e., the ratio of the sum of losses and expenses to net premium income and net premiums written. Net investment income, usually all interest income, tends to be larger as long as loss liabilities
are “long tail”, i.e., the losses do not have to be paid out until long after the insurance premiums have been collected and then invested in bonds. Typically, MBIA’s insurance subsidiaries have enjoyed a combined ratio each year under 40%.
Net investment income for the MBIA insurance subsidiaries has grown over the years to almost $600,000,000 per annum. The prospects appear quite good to Fund management that, once past the current housing difficulties, MBIA will return to its historic patterns of very attractive combined ratios and relatively steady growth in net investment income.
Karl:
Ackman has been trying to bring MBIA down since 2002. Before he blew up his first hedge fund, Gotham Partners, he published and made available on the Gotham Partners website a document making the short case against MBIA. I read it at the time. It was a very thorough analysis. I think it was titled “Should MBIA be rated AAA?”. I think some regulatory agency made him take it down from the site.
So he was wrong for 5 years. I thought he might finally be right after the stock went into freefall in October, but with Ross and Whitman sniffing around I’m not so sure.
“AMBAC had the highest revenue per employee on the planet. That situation was obviously intolerable, and so managment embraced riskier, higher yielding derivatives.”
Funny about greed that way. Go figure.