Not surprisingly, MBIA (MBI) has been sued over its transformation plan. Aurelius Master Capital and others are suing to block the split into separate structured finance and municipal bond insurance companies, because they fear it will weaken their ability to collect on various CDOs and MBS they hold which are insured by MBIA. As an investor, I dislike major litigation involving companies I own, because it creates uncertainties that I am ill-equipped to analyze. When looking at new investments I avoid situations that are dependent on litigation: however, for existing investments I try to get past the verbiage and head-lines, by reading the complaint(s) and attempting to gain an understanding of the points of law involved. Investment is about money, so the outcome of the litigation needs to be analyzed in terms of probable financial gain or loss to the investor.
Verbiage and Headlines - The complaint is posted on MBIA's website, and by my count uses the word “loot” or some version of it 10 times. The author could have spent some time with a thesaurus and come up with more colorful and less repetitious phrases, but working in a hurry I guess it was the best he could do. Extra-legal theories include a new tort, “looting” funds that should be dedicated to serving banks who have been subsidized by the USG, which of course is “looting” the taxpayer. We need a new tort, one that don't make us nervous, wondering what to do... I guess looting will do as well as anything.
The Complaint - Basically, there are two legal theories involved: 1) fraudulent conveyance, and 2) breach of an implied covenant of good faith and fair dealing.
- From Wikipedia: “A fraudulent conveyance, or fraudulent transfer, is a civil cause of action. It arises in debtor/creditor relations, particularly with reference to insolvent debtors. The cause of action is typically brought by creditors or by bankruptcy trustees. The typical fact situation involves a debtor who as part of an asset protection scheme donates his assets, usually to an "insider", and leaves himself nothing to pay his creditors. However, it is not uncommon to see fraudulent conveyance applications in relation to good-faith transfers, where the debtor has simply been more generous than they should have or, in business transactions, the business should have ceased trading earlier to avoid giving certain business creditors an unfair preference (see generally, wrongful trading). In a successful suit, the plaintiff is entitled to recover the property transferred or its value from the transferee who has received a gift of the debtor's assets.”
- Again from Wikipedia: “The Implied covenant of good faith and fair dealing is a general assumption of the law of contracts, that people will act in good faith and deal fairly without breaking their word, using shifty means to avoid obligations, or denying what the other party obviously understood. A lawsuit (or one of the causes of action in a lawsuit) based on the breach of this covenant is often brought when the other party has been claiming technical excuses for breaching the contract or using the specific words of the contract to refuse to perform when the surrounding circumstances or apparent understanding of the parties were to the contrary.”
In order for either of these theories to be applicable, it would be necessary to demonstrate that MBIA Insurance Corporation, the structured finance subsidiary, is insolvent and will not be able to pay its claims as agreed. The complaint cites an analyst from Barclay's who sees 6.5 billion of CMBS losses, while MBIA has not reserved for any losses. Moody's is also cited, because they downgraded MBIA Insurance to B3, which is six steps below investment grade. They also cite the CDS spreads, as if they were gospel.
The difficulty is that the split was performed under the supervision of Eric Dinallo, NY Superintendent of Insurance, who is the company's primary regulator. His department did a stress test, MBIA did their own stress test, and both see adequate capital for the structured finance subsidiary. Because Dinallo's responsibilities include oversight of MBIA's solvency, his determinations cannot be over-ruled lightly. S&P's downgrade announcement says:
MBIA's retained exposure will total about $233.5 billion of global structured finance and international infrastructure insured par. Through the use of Standard & Poor's capital adequacy test, MBIA's margin of safety is 0.9x–1.0x, which we view as strong.
Strong is not consistent with insolvent.
Aurelius sued the NYSID earlier this year under freeedom of information, in an unsuccessful effort to gain access to information Dinallo's department had on the identity MBIA's insured transactions. Clearly they don't know the specifics of what MBIA is insuring, which has a lot to do with what the losses will be. Eleanor Chen, an analyst from Aurelius, was on the MBIA 4th quarter conference call, citing the CDS spreads and suggesting the company is insolvent. She also was fishing for a comparison of MBIA's CDO book to Ambac's, with no success. If she were to look at public information, she could at least learn that MBIA has fewer and smaller bits of internal CDO collateral in their ABS CDOs, suggesting more prudent underwriting.
As an investor, I have been operating under the hypothesis that MBIA's structured finance losses will be much closer to their internal impairment estimates than to what mark to market or pessimistic analysts would indicate. That is, I have been operating on the rebuttable assumption that the company is not insolvent, and in point of fact has sufficient assets relative to its ultimate losses to leave a substantial amount available as the basis for a recovery in the share price. Because of this, I believe it is unlikely that the suit will not be successful in overturning the transformation. Even if it does, the whole is still equal to the sum of its parts, based on the belief that the structured finance subsidiary is solvent and has value.
However, it may delay MBIA's efforts to raise additional capital under legal clarity is obtained. That is OK with me, because National Public Financial Guarantee, the muni-only subsidiary, generates capital internally at the rate of 150 million per quarter and will become stronger while the legal action plays out. Also, there is some question about whether the municipal bond insurance business may be coming up on a rough patch, in which case the company is better off not writing new business until the severity of the problems is known.
Value Estimate – Where there is a wide range of possible outcomes, I have been using a weighted average estimation:
I saw an article in the WSJ, which put the odds of a major depression (GDP down 25%) at 2%, and a minor depression (GDP down 10%) at 20%. Using those odds for the two worst cases, and applying a 10% chance to the best case, I arrive at my weights. Analytical book value is GAAP book value plus the present value of future installments and unearned premiums: adjusted book value adds back mark to market losses in excess of impairments as figured by the company. Both figures are taken from company presentations.
MBIA's value is very much dependent on the economic scenario envisioned. In any event, the shares have been trading below 4.00 lately, so there is ample upside, as long as the economy does not go into an actual depression.
Investment Strategy – At this point I am playing MBIA with options. I have been selling 10 puts at 5.00, and using the proceeds to fund the purchase of from 40 to 80 calls at 5.00, working with short term expirations, April as of today. That reflects how I feel about the shares – I don't mind owning some at prices under 5.00, but I would like to own quite a bit more if it goes up over 5.00. Also, with the stock under compression, there is always the possibility of a sudden move. This strategy makes it possible to control of lot of upside without tying up money owning the shares, but it has the disadvantage of repetitious trading with losses on time value and bid/ask spreads. I sold off my shares and kept some of the funds available to meet the put obligations if assigned.