MBIA (MBI) reported 3Q 2012 ABV (Adjusted Book Value) of $30.64, down from $31.23 the previous quarter and $40.06 as of 4Q 2008. While the continued erosion of this metric is disappointing, the most worrisome aspect of the earnings conference call was the discussion of the possibility of a liquidity shortfall. The issue is not new, but received increased emphasis in the presentation. Here's CEO Jay Brown on the topic:
Unfortunately, while loss payments by MBIA Insurance Corp uninsured securitization backed by ineligible residential mortgages continue to decline, the flow of new delinquencies is not abated as quickly as we had expected. We also have taken additional loss reserves against CMBS pools where the dominant counterparty is Bank of America's Merrill Lynch subsidiary.
Although these transactions were structured with deductibles, those deductibles are now likely to be eroded, resulting in claims being made to MBIA Insurance Corp. Depending on the timing of the deductible erosion, as well as the timing of collections on our putback claims, MBIA Insurance Corp could experience a liquidity shortfall. Ironically, Bank of America, having manufactured that shortfall by defaulting on its obligations to us, might be the company's largest debtor and also one of its larger potential creditors.
Since the outcome of a liquidity shortfall would likely be adverse for both MBIA Insurance Corp and for Bank of America, our base case assumption continues to be that there is a negotiated global settlement between the 2 companies, but we will not accept a noneconomic settlement. So clearly, there is a risk that a settlement doesn't take place.
This whole situation is reminiscent of the debt ceiling last year and the fiscal cliff this year. Both parties would be better off with a settlement, but it just doesn't seem to happen.
MBIA's position is simple: the company will not accept a noneconomic settlement. By that, Brown means a settlement where the company receives less than the damages caused by the defective collateral in the RMBS involved, or pays more than the expected future losses of the CMBS involved.
"We've been chipping away at this, we settled a group of them this quarter," Moynihan told employees in an Oct. 17 town hall meeting. "You should expect that if people are reasonable, over a period of time," more accords will be reached.
Moynihan's definition of reasonable differs from Brown's, of that much we can be sure. I examined BAC's belief system back in September, finding much that I consider peculiar, and contrary to the law of contracts as I understand it.
Intransigence as a Negotiating Tactic
Brian Moynihan, in an November 2010 investor conference, described negotiations on warranties and representations as "day-to-day, hand-to-hand combat." Understandably, people stop being "reasonable" when what should be factual discussions turn into hand-to-hand combat.
Alternatively, Assured Guaranty (AGO) CEO Dominic Frederico described negotiating with BAC as "like Chinese water torture." Very few will tolerate that kind of treatment, if they have a choice.
Tactics of this kind can enjoy considerable success. A majority of human beings are willing to see the other person's point of view and compromise in the interest of going forward. The stubborn one gets a free ride on the tolerance and flexibility of others. However, there are limits. It ends with "see you in Court."
Those who have taken that approach with BAC include FHFA and more recently, the United States. U.S. Attorney Preet Bharara has weighed in with a suit that provides considerable support for MBIA's position.
As an MBIA investor, being exposed to Moynihan's bizarre belief system and intransigent negotiating tactics requires very high risk tolerance. Very possibly, the banker will be able to abuse the power inherent in his TBTF empire and cause MBIA significant, unnecessary and avoidable economic loss. Brown is doing the right thing: "See you in Court." He owns over 4 million shares, and has a large personal stake in the matter.
Consent Solicitation and Sabotage Attempt
The liquidity shortfall would manifest at MBIA Corp. (the structured finance subsidiary). An event of default would trigger an acceleration of the bonds, which are obligations of MBIA, Inc. (the holding company).
MBIA Inc. would not have sufficient liquidity to pay the accelerated amounts, most likely resulting in bankruptcy and destruction of value.
As a prudent measure, MBIA Inc. has issued a consent solicitation to bondholders, offering $10 per $1,000 face amount to secure their approval to substitute NPFG (National Public Financial Guaranty, the municipal bond subsidiary) in the definition of Principal/Restricted Subsidiary. By doing so, the threat to the holding company is removed. Both MBIA Inc. and bondholders would benefit.
Bank of America has now offered to buy one series of the affected notes. From the press release:
Affiliates of the Offeror are party to certain credit default swap transactions for which MBIA Insurance Corporation (a subsidiary of MBIA) has provided credit support with a notional value of $6.15 billion (against which we have established credit valuation adjustments for a significant portion). Bank of America believes that if the MBIA Consent Solicitation is successful, the risk of MBIA Insurance Corporation being placed in rehabilitation or liquidation will increase, which would jeopardize all policyholder claims, including Bank of America's claims under these transactions.
The purported purpose is to reduce the chance of a regulatory intervention. It is more likely that the actual purpose is to increase the odds of a holding company bankruptcy and the attendant destruction of shareholder value, as a negotiating tactic.
Having created the pressure on MBIA's liquidity by refusing to honor its contractual commitments under warranties and representations it issued to induce the insurer to cover various RMBS securitizations, BAC is now attempting to manufacture a default at the holding company level.
Briefly, a global settlement with BAC would put MBIA in a strong position to resume writing profitable new business and increase share price to perhaps 70% of ABV, or $21. Allowing 2 years for the company to receive upgrades from the rating agencies and demonstrate the ability to write new business, and discounting at 15%, shares would be worth about $16 after the settlement or equivalent legal victories.
In the event of a liquidity shortfall and the ensuing regulatory intervention, there would be considerable destruction of economic value, and shares might well become worthless. BAC is attempting to make these consequences more likely and more severe.
BAC's announcement triggered a flood of short sales, driving MBI shares down by 19%, to close at $6.81. MBI is a favorite of short-sellers, and their efforts can be expected to be ongoing.
These developments have created a binary outcome. Based on the legal rights of the parties, MBIA is the probable winner. Based on the monetary power of the contestants, the odds favor BAC.
I've castigated the big banks as a rogue industry. BAC's conduct is simply more of the same. Having already indulged in the requisite moral fulminations, as a retail investor my immediate reaction is to avoid being trampled by a rogue bank.
This is a speculative situation, and difficult to quantify. I had been away from my computer Monday and half a day Tuesday, and elected to close most of my position based on the adverse price move and the heavy volume.
Better risk/reward may become available in the future.
After suffering larges losses on MBIA in 2008, I undertook a project of recovering some part of them in early 2009, planning to use a combination of diagonal spreads and risk reversals to minimize the capital involved and control the risk of further losses.
Over the ensuing 4 years, an ongoing series of trades has netted an IRR of 67%. I gave up on the idea of getting my money back, and have focused instead on using my understanding of the situation to accumulate gains as long as the odds remain favorable.
The original idea was, that with the stock in the $3 area, and ABV at $40, options premiums simply didn't reflect the upside or the potential for the stock to gap upward. The options strategies captured most of the move from $3 to as high as $13.50. Almost all of that has been taken off the table: I'm holding 100 shares as a marker position.
If MBIA stock trades below $5, I may do something with options in an effort to capture the next gap up.