Shares of formerly beleaguered bond insurer MBIA (NYSE:MBI) have rallied strongly this week, joined by competitor Assured Guaranty (NYSE:AGO) on the strength of a two notch downgrade from Standard & Poor's. The monolines have a history of gapping up and down on news, raising the question, is there more to come, or is it time to trim positions?
The move started with an article in the WSJ, soon echoed by Reuters, reporting rumors that NY's financial services regulator was pressuring the remaining parties to resolve the transformation litigation against MBIA's restructuring, which split the structured finance and municipal bond insurance operations into separate subsidiaries.
Then BTIG initiated coverage on MBIA at a buy, citing the potential for a resolution of the transformation litigation to ignite a severe short squeeze, fueled by large short interest coupled with extremely concentrated ownership. ZeroHedge has a copy of BTIG's report, and has previously written up the possible short squeeze.
Finally, S&P announced rating actions on the monolines, downgrading AGO by two notches to AA-, outlook stable. NPFG (National Public Financial Guaranty), MBIA's municipal bond insurance subsidiary, was affirmed at BBB, outlook developing, and MBIA Insurance Corp, the structured finance sub, was affirmed at B, outlook negative.
AGO's ratings are expected to remain unchanged for two years, barring an unforseen reduction in capital adequacy, which is a positive, as the company has a stable hold on a rating in the double A area. AGO was up 13.3% on the day, while MBI extended its previous gains by another 5.26%, bringing its three day move to about 33%.
Waiting For a Ruling on Causation
On October 5th, Judge Eileen Bransten of the NY State Supreme Court heard arguments from MBIA and Bank of America (NYSE:BAC) on the issue of causation, and is expected to deliver a decision shortly. If the decision favors MBIA, the amounts collectible on putbacks will increase significantly. This could have a favorable impact on the company's capital, not to mention the perceived risk going forward for the RMBS it insures.
For readers who are interested in a good write-up of this issue, very well-informed and articulate, I recommend this article from Barry Ritholz at The Big Picture.
Briefly, the big banks, and Bank of America in particular, have attempted to interpret the contracts containing the representations and warranties which create the putback obligation to include a requirement of causation. They don't think they should have to accept the putbacks unless (1) a loss occurs and (2) it is directly and proximately caused by faulty underwriting. They see the passage of time, and the intervening occurrence of the financial crisis, as sufficient reason to deny putbacks.
Meanwhile, MBIA relies on the plain unadorned language of the contract, which specifies putbacks as the remedy for breaches of representations and warranties, and specifically allows for the putback of loans where no loss has occurred.
The contracts generally require that the breach have a material adverse effect on MBIA's interest. As an insurance company, the risks that they contemplated insuring did not include negligence or malfeasance on the part of the bank issuing or selling the mortgage - hence the representations and warranties, included at their request. As such, anything that increases the risk of default has a material adverse effect, whether a loss has occurred or not, and whether there was anything that could be interpreted as an intervening event.
A Combustible Mixture
The combination of high short interest, concentrated ownership, and potential wins and losses in litigation is highly combustible. Any investment that depends on outcomes in litigation is speculative. Both the monoline insurers and their big bank adversaries are trading at discounts to book value, occasioned by the same uncertainties. I believe the monolines are a better bet, but the banks are just too cheap to be attractive shorts.
Adjusting My Position
I've been holding a long position by means of deep in the money LEAPS, supplemented by occasional low cost, short-term bets, mostly by means of bullish reversals.
Holding MBI January 2012 5.0 calls, I rolled out and up to the May 2012 8.0 calls, for a net credit of $1.74. The thinking was to take some money off the table and define my downside risk in the event the stock retreats. I devoted a small part of the proceeds to buying some MBI December 2011 12.0 calls, at a cost of 21 cents, similar to buying lottery tickets. MBI has made a $2.50 move in three days, and could easily hit $12 if something favorable develops on the litigation front.