Late Friday afternoon, the New York State Supreme Court released a decision on the suit bond insurer MBIA (MBI) filed against Merrill Lynch (BAC), alleging fraud in securing CDS protection on 4 CDOs of ABS with a face value of 5.7 billion. Five out of six causes of action were dismissed: one will be permitted to go forward. Dismissed were causes of action for fraud, fraud by omission, negligent misrepresentation, breach of covenant of good faith and fair dealing, and an action to enforce contractual rights.
What can go forward is an action for breach of contract, based on the observation that the insured tranches of the CDOs were not triple A, regardless of the label that they bore.
As an MBIA shareholder, I was initially disappointed. After reviewing the decision, which is available on-line from the court, I am encouraged that it leaves open a route to addressing the fundamental issue: the collateral was not what it should have been. The stock traded heavily during the day, at times up by 10%, due to Ambac's (ABK) announcement of a 4th quarter profit, but settled at 7.69, up 1.85%.
Breach of Contract
From the court's decision:
In Plaintiff's cause of action for breach of contract, plaintiffs allege, among other things, that the various agreements, including especially the confirmation to the CDSs, indicated that plaintiffs were entering into a transaction in which Merrill Lynch would be delivering notes not merely “nominally” rated AAA (S&P)/Aaa(Moody's) (Plaintiff's Memorandum of Law, at 42), but ones exhibiting the credit quality an AAA rating was supposed to represent. (see Plaintiffs' ex. 37, at 3.) Plaintiffs maintain that, while rated AAA, the insured or wrapped notes in the CDOs were, in actuality, not of the quality an AAA rating should have indicated (that is, that the rating was, essentially, bogus), amounting to a breach of contract.
The confirmations (which are the only documents which plaintiff's provide as a a basis for the alleged promise of AAA/Aaa ratings), only state that the notes would be rated “AAA/(S&))/Aaa(Moody's),” which apparently, they were. However, plaintiffs had a right to expect that the AAA ratings were backed by intelligence which could verify that the notes were actually of the “credit quality” an AAA rating implied. Plaintiffs may claim that the wrapped notes were not qualified to be AAA rated, as promised, regardless of the label they carried, as a claim for breach of contract.
The significance here is the acknowledgment of a right to expect that the CDOs would be triple A in fact, not merely as labeled by the credit rating agencies. The collateral contained in the CDOs was to have been 95 or 98% A rated or better: again, this would be subject to examination, whether interior collateral was A rated in name only.
Pragmatically, triple A quality bonds have a default rate in the 1% area: while the CDOs in question are all in the process of going bad. There might have been 1% of “true” triple A that defaulted; all the rest of the triple A would have been bogus. Proving that proposition is tedious but doable – just go through the interior collateral bean by bean. Merrill Lynch's basis for seeking dismissal was primarily based on the idea that breach of contract duplicated the fraud claim. No doubt as the case goes forward they will develop other lines of defense.
Fraud Disallowed Because Waived
Again from the court's decision:
In the Financial Guaranty Insurance Policy between MBIA and Merrill Lynch, MBIA represented that MBIA, “in consideration of the payment of the premium and subject to the terms of this financial guarantee insurance policy..., hereby unconditionally and irrevocably guarantees to Merrill Lynch International..., without the assertion of any defenses to payment, including fraud in the inducement or fact,” the full payment on behalf of LaCrosse of any insured amount. ...This document further states that “MBIA hereby irrevocably waives for the benefit of [Merrill Lynch], ...all defenses by way of counterclaim, set-off, deduction, abatement, recoupment, suspension, deferment or otherwise.”
There is quite a bit more. Briefly, the policy was designed to provide an unconditional grant of coverage to the insured, not subject to denial or rescission for claims of fraud or misrepresentation. In the policy cited, Merrill was the insured and also the arranger and marketer of the CDOs. By participating in multiple capacities Merrill was able to avail itself of the waivers included in the policy for the benefit of innocent third-party investors.
The wording was unambiguous and the parties were sophisticated. No doubt financial guarantors will in the future exercise greater care when doing deals with parties who are acting in multiple capacities. Still, justice is not served by a finding that it is OK for Merrill Lynch to screw themselves and then collect on the insurance.
In addition to policies insuring Merrill, there were policies insuring Societe Generale, Barclay's and HBOS. Merrill, not being the insured, would not have the benefit of fraud waivers on these policies, and it is puzzling that the decision did not address these 5 policies separately.
For that matter, Merrill Lynch International, an indirect subsidiary of Merrill Lynch, Pierce, Fenner and Smith was the insured on the remaining policies. It would appear that MBIA should be able to pay the subsidiary, which was screwed by its parent, and then collect from the parent for the fraud involved, since they are legally separate entities.
Money Damages Not Rescission
The court refused to permit rescission as a remedy, as money damages would be adequate.
Warranties and Representations
The above causes of action relate to CDOs, and do not include a more common issue on RMBS which the GSEs as well as bond and mortgage insurers are pursuing – warranties and representations. A widely held misconception, which the banks have done little to dispel, is that they have no further responsibility for mortgages that were sold into securitizations. That is frequently cited as a causal factor for the extraordinarily poor mortgage underwriting of the housing bubble.
In point of fact, the banks uniformly provided warranties and representations as to the quality of the mortgages sold. These are contractual obligations to repurchase the mortgage or otherwise indemnify the holder if the original mortgage underwriting was defective.
When it comes to honoring these obligations, the Big Banks have distinguished themselves by recalcitrance and stonewalling. From Jay Brown's most recent letter to owners:
It’s that intransigence that ultimately forced us to pursue legal action. The documents in all of our insured mortgage transactions include clear procedures that the parties must follow with regard to ineligible loans. In every case we have been diligent in doing what is required of us, complying with both the spirit and the letter of the agreements only to find the majority of our counterparties ignoring their responsibilities, refusing to communicate with us and deliberately frustrating the process at every turn. We have repeatedly been denied access to files that we are clearly entitled to examine and, in one case, submitted a legitimate repurchase claim involving over 1,500 ineligible loans only to have the originator reject every single one of them. Given no other choice, we reluctantly turned to the courts.
Bank of America's Attitude
The following remarks by CFO Joe Price from the 4th quarter earnings conference call transcript are revealing:
Few and far between. If you think about the hierarchy of reps and warranties, think of them as quite frankly, they are probably the clearest in GSEs, monolines and in private sales the reps and warranties generally by this time are somewhat unenforceable, not from a data standpoint but just from a lack of time and they have run out. I wouldn’t put that one on your radar screen.
Price's attitude is that while the facts (data, as he puts it) might support the case, anybody except the GSE's (who have the implied backing of their owner, the USG) has run out of time. The belief is that they will be bankrupted and swept into oblivion, with their claims mysteriously vanishing into the mists of time.
The banks have been grudgingly and none too transparently establishing reserves against losses of this type, and it is entirely possible that by continuing to aggressively pursue warranties and representations putbacks MBIA will prove Price wrong.
Developments at Ambac
It should be noted that while Ambac (ABK) was superficially very similar to MBIA at the outset of the troubles, developments over the past two years leave much to contrast between the two financial guarantors.
That having been said, it was encouraging to see both companies trading higher after Ambac unexpectedly reported a profit for 4Q 09. Ambac's profits came from a tax refund, created by legislation that permits carrying NOL's back further than before. MBIA received a similar sized refund, generating far less hoopla.
The Wisconsin Insurance Department required Ambac to place certain liabilities, predominantly structured finance, in a segregated account where they will be rehabilitated. At the same time, provisional commutations of unnamed CDOs were announced, and the holders will be receiving surplus notes in payment of part of their claims – IOUs bearing very low rates of interest.
The significance to MBIA is that structured finance was not treated the same as municipal bonds. This demonstrates that Eric Dinallo's permission granted to MBIA to separate its structured finance and municipal bond operations was well within his discretion, although motivated by a different set of considerations. This strengthens MBIA's case in defending its transformation against legal challenges.
If MBIA prevails on the warranties and representations issue, the transformation will be a moot point, because any solvency questions will be put to bed. If these same banks that are suing to block the transformation would simply honor their obligations under warranties and representations, the whole issue of solvency would go away, and society would have the benefit of MBIA's guarantees on billions of dollars of bonds that are not tainted by the bankster's fraud.
The value of MBIA's stock is contingent on the company's success in litigation. CEO Jay Brown has articulated a strategy of pursuing legal remedies against every party who wrongfully harmed the interests of MBIA shareholders.
The big banks have no intention of honoring any of their agreements, or acknowledging any wrong-doing, unless or until they are forced to do so by litigation. The situation is likely to take another 3 to 4 years before clarity on the legal issues is obtained.
MBIA's nonGAAP ABV (adjusted book value) is management's best estimate of the present value of the company's assets and liabilities, and includes about 1.5 billion in expected recoveries under warranties and representations. As of 12/31/2009 ABV stood at 36.35 per share. Jay Brown, in his letter to shareholders for 2009, was willing to put forward 45 as an intermediate goal.
ABV as computed by the company does not include any expected recoveries for fraud or breach of contract claims on CDOs, so the courts decision discussed earlier would not affect that metric. There is 3.5 billion MBIA is suing for that is not reflected in ABV; that works out to about 17 per share.
I am now investing in MBI on the basis that share prices will reach 25 within four years, with a jagged trajectory. That works out to 34% annualized, a return sufficient to compensate for bearing substantial risk.
Strategy and Tactics
Implied volatility stands at 80% - high, but down form the 140% area six months ago. Beta checks in at 2.40 – way high, and short interest is much reduced, down to 13.6% from 30% or better at the height of the troubles. Schwab no longer lists it as hard to borrow, and Ameritrade lists it as marginable under normal terms, except they don't want an excessively concentrated position. As clarity on MBIA's future increases, and the likelihood of a double dip recession declines, perceived risk on this situation has been decreasing.
Always a shareholder, I had been taking most of my exposure to MBI by means of bullish reversals – short puts and long calls at a higher strike. Eventually I was assigned on puts at 6.00 and made a variety of trades adding exposure while the stock was down under 4.00. At Friday's close of 7.69 I have enough gain since January 2009 that I can cut my position in half and limit my investment to an amount equal to the accumulated profits. Also, a reduction is needed to conform to limits on the amount invested in any one stock. I plan to do so during the next two weeks, bearing in mind that options expiration may generate some short-term action.
For those who use options, the high volatility makes it attractive to use strategies that harvest time premium, although from my point of view it is important to maintain exposure to the upside. The announcement of a meaningful court victory or setback could cause the shares to gap one way or the other.