Banks vs. Insurance Companies: Representations and Warranties

 |  Includes: AGO, AMBC, BAC, C, JPM, MBI, MTG, PMIR, RDN, WFC
by: Tom Armistead

Shares of bond insurer MBIA (NYSE:MBI) surged as much as 16% yesterday, along with Ambac (ABK), Assured Guaranty (NYSE:AGO), and mortgages insurers such as Radian (NYSE:RDN), PMI Group (PMI) and MGIC Group (NYSE:MTG). Meanwhile, shares of the big banks plummeted, with Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) off by anywhere from 3% to 5%.

A report by analyst Manal Mehta was being widely circulated, increasing awareness of the very real possibility that the insurance companies may make substantial recoveries from the banks by enforcing representations and warranties the banks made in selling and securitizing mortgages.

I was somewhat disappointed that my own article on the same issue didn't get the same attention, but experienced some consolation as my long positions on MBI generated profits.

It looks like the recent publicity given to the related issue of faulty foreclosures brought the simmering issue of representations and warranties to a boil.

JP Morgan was the first of the banks involved to report, and sitting there in the earnings release financial supplement was the following note:

Losses related to the repurchase of previously-sold loans are recorded as a reduction of production revenue. These losses totaled $1.5 billion, $667 million, $432 million, $672 million and $465 million for the quarters ended September 30, 2010, June 30, 2010, March 31, 2010, December31, 2009 and September30, 2009, respectively, and $2.6 billion and $940 million for year-to-date 2010 and 2009, respectively. The losses resulted in a negative impact on net income of $853 million, $388 million, $252 million, $413 million and $286 million for the quarters ended September 30, 2010, June 30, 2010, March 31, 2010, December 31, 2009 and September 30, 2009, respectively, and $1.5 billion and $578 million for year-to-date 2010 and 2009, respectively.

The bank also added 1.3 billion to litigation reserves.

CEO Jamie Dimon was uncharacteristically vague when discussing the extent to which repurchase obligations extend to private label (non GSE) MBS. From the transcript of the 3Q 10 earnings conference call:

In repurchase reserves and litigation, it's unclear exactly how or where it's going to show up, but we do think there will be some of that. And when we make the statement that some of these costs may go on for a while it relates also to that. That while we're burning through the vintages or the GSEs there are other vintages where there may have been more of a time lag than that. And I think it's also important to note that they're fundamentally different, because a lot of the private label stuff didn't have the same rules, requirements, disclosures. So they're all different, but loan by loan it's going to have some of the same characteristics that people are right. You're going to have to make them [unintelligible]. Hopefully if they're going to sue just to win they're making a huge mistake.

It is important to note that the banks discussed representations and warranties when presenting at Barclays Global Financial Service Conference on 9/14/2010. Here is a selection of slides:

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Bank of America will be reporting next week. A few weeks ago, the AFGI (Association of Financial Guarantors) sent an certified letter to CEO Brian Moynihan, with a copy to the company's CPA Audit firm, questioning the manner in which Bank of America is accounting for its repurchase obligations to AFGI members on HELOCs. The sum involved is large, somewhere between 10 and 20 billion, and does not include other types of mortgages. MBIA, which is not an AFGI member, has ample litigation pending against BAC on similar issues.

It's going to be very interesting to see what Bank of America has to say.

The effect on MBIA's share prices going forward is difficult to quantify. I've been investing on the basis that shares would work their way from under $4 early this year to about $25 within a four year time frame. I closed a number of vertical call spreads that were deep in the money, on the grounds there was little left to gain if shares went higher and much to lose if they gave back the gains. I left a vertical call spread, long MBI Jan 2012 5 calls and short MBI Jan 2012 15 calls, open as it gives me ample exposure at today's closing price of $13.00.

The part I liked was some MBI Nov 2010 15 calls I bought for 0.08, a while ago. All of a sudden they popped to 0.58. My response was to sell enough of the Nov 17.5 calls at 0.16 to cover my original outlay. This gives me a bunch of free lottery tickets: if something good happens, like a favorable legal decision on any of the outstanding litigation, the payout will be substantial.

It's difficult to know to what extent today's action created a short squeeze. MBIA has about 10% of its shares sold short, and there have been a number of savvy value investors that have been accumulating positions. In the past, it has always been possible for short-sellers to cover without undue suffering, but I wonder how long that will continue.

I continue to invest in MBIA on the basis that shares will be worth $25, perhaps sooner than my original time frame.

Disclosure: Author long MBI