On January 11, bond insurer MBIA (MBI) won another victory in its ongoing series of court battles with an array of Big Banks and Smart Money investors. The shares, which were just under 10 in late December, spiked to as high as 14.96 on the news. The press release was brief and to the point:
MBIA Inc. today announced that the Appellate Division of the New York State Supreme Court has reversed an earlier decision by a lower court and granted MBIA’s motion to dismiss the plenary lawsuit brought by a group of banks challenging the Company’s Transformation. In its decision, the Appellate Division agreed with MBIA’s position that the lawsuit was an improper collateral attack on the New York State Insurance Department’s approval of MBIA’s Transformation. The Court also dismissed all of the other causes of action stated in the banks’ complaint.
“The banks have continuously sought to obstruct National’s goal of providing much needed insurance capacity to the municipal market and to undermine the determinations made by the New York State Insurance Department. So we are gratified by the Appellate Division’s decision and are now looking forward to a prompt resolution of the Article 78 proceeding, in which we fully expect to prevail,” said Jay Brown, MBIA CEO.
The company makes a copy of the decision available on its website. The legal issues involved are complex and outside the circle of competence of the average retail investor.
Savvy investors Bruce Berkowitz and Whitney Tilson have a Clash of the Titans going, with Berkowitz long and Tilson short. Resorting to simplification in the face of mind boggling complexity, the whole thing is about the meaning of the word "fair," which is used repetitiously (and in quotes) within the decision and related documents. My opinion is that the banks don't play fair and that's how I'm playing the situation.
Options Strategies around Litigation
Litigation naturally lends itself to the use of options as an investment vehicle. Options price theory assumes that share prices move continuously and randomly in small increments, while wins and losses in litigation make stock prices move rapidly and in one direction. Being properly positioned when a legal decision creates a gap up or down can be extremely rewarding.
Late last year, encouraged by a lull in the market and CEO Jay Brown's November purchase of 1 million dollars worth of the company's stock, I elected to drop an MBI January 2012 5/15 vertical call spread in favor of a pair of bullish reversals. The new trades were short Feb and May 10.0 puts and long 8 times as many 15.0 calls for the same months. With the shares trading just under 10, the premiums were more or less a wash.
The thinking was, with the year end coming along and the banks under pressure to reduce the uncertainty about their putback exposures, one or more settlements were possible and it could be anticipated that shares would jump in response. The out of the money options can rapidly gain value under these circumstances, and as the shares move above the strike delta increases rapidly, so that the options behave more and more like shares.
Further, earnings will be announced in February. If MBIA has made but not publicized any substantial amount of commutations, the range of possible outcomes on solvency will be much reduced, and may permit a conclusion that MBIA Insurance (the structured finance subsidiary) is clearly able to meet all its obligations to remaining policyholders. With 20/20 hindsight conferred by subsequent events, it will then be possible to determine that the restructuring was "fair" to all concerned.
Because a rapid move on the earnings was also a possibility, it was desirable to set up options positions that would benefit more from an upward move than from a downward one. On 12/27, I posted the following stocktalk:
- Back to playing MBI with bullish reversals, short 10 MBI May 2011 10.0 puts, long 80 MBI May 2011 15.0 calls, premiums a wash.
The short puts are treated as if they were cash secured when computing rate of return, which is the purpose of the two entries for 10,000. Broker/customer arrangements vary in their requirements for cash security on naked puts.
The resulting profits can be ephemeral - they consist entirely of extrinsic value - time premium - and unless the stock closes well above 15 in May there is nothing further to be gained here, and much to lose. I am unwilling to spend large premiums on out of the money calls, and would never make an opening trade to be in this position. As a rule of thumb, if you wouldn't make the trade today, you should undo it. Based on that line of thinking, I closed out the whole position.
Swapping between Time, Volatility and Directionality
The bullish reversal, as originally constructed, was time neutral - over the period of time involved, the time premium on the short puts would offset the time premium on the calls purchased. With the rapid change, time was no longer neutral. Instead, time was the enemy, insidiously eating up profits. A fair sized directional move, from 13.53 to 16.46, would be required just to break even on the May 15.0 calls. A decrease in volatility would also have adverse effects.
With that in mind, I went back to a vertical call spread - in this case, the MBI Jan 1012 10/20. The time value on the 20.0 calls sold is more or less equal to the time value on the 10.0 calls purchased. In the meantime, directional moves will be captured, reflecting an opinion that the shares will be making their way toward 25 over the course of the next several years. This trade is more directional in nature, and is far less dependent on or subject to the passage of time or changes in volatility.
If the stock heads back down and an opening develops, another ratio bullish reversal might be attempted, along the lines of what has been working.
Back in the meltdown post Lehman, I suffered large losses on MBIA. The whole thing was a learning experience, at best, and the tuition involved was high. Warren Buffett has counseled that you don't have to get it back the same way you lost it. But if difficult experience with a situation gives added insight to how it works, there is every reason to apply the knowledge so gained. At the same time, part of the lesson learned was the importance of position size limits. Buffett is a poor mentor on that topic, since his published remarks suggest he is sufficiently confident in his judgment to disregard position limits when it suits his purposes.
From a philosophical point of view, the gains I've made by applying what I learned during MBIA's near-death experience can be considered as tuition reimbursements. If you master the material presented, you get some of your tuition back. I don't expect to get it all back where I lost it, because I intend to apply the lesson learned on keeping position size within appropriate limits.
Bill Ackman demonstrated extreme patience in his studious stalking of MBI, and a fine understanding of the principle of risking a little to gain a lot with his CDS tactics. In my opinion much of what he did was illegal and I filed a written complaint with the SEC accordingly. Ackman has donated the proceeds to charity, and I have moved on.
And the lessons learned can be applied to other situations. Patience, doing one's homework, and creating attractive risk/reward profiles can yield fine results. And the humble option is a derivative, and an effective weapon when properly applied.
Disclosure: I am long MBI.
Additional disclosure: Long MBI Jan 21 2012 10.0 calls, short MBI Jan 21 2012 20.0 calls