Help for the Guarantors - From an Unexpected Source

Here’s an irony: one of the very instruments the bears have been using to beat up the financial guarantors, credit defaults swaps on the companies themselves, could provide the guarantors with a surprise tool they can use to help commute certain CDS on CDO  agreements with investment banks on very favorable terms.

In particular, the ballooning prices of the CDSs on the guarantors have some very interesting, and lucrative, effects on the economics of commutation. Let me walk you through a hypothetical example, and you’ll see how:

Step 1:  A financial guarantor [FG] writes a CDS on the super-senior tranche of a CDO composed largely of residential mortgage back securities [RMBS]. Its counterparty: an investment bank [IB] that owns the super-senior tranche.

Step 2:  The CDO blows up, and its market value sinks. Initially for the IB, this market value decline is offset by a rise in the value of its CDS contract with the FG. So far, the credit enhancement has worked as planned. The FG, meanwhile, estimates the net present value of the impairment of the CDO it wrote at, say, $1 billion. (All numbers are illustrative.)

Step 3:  The rating agencies downgrade the FG amid a relentless negative commentary by certain high-profile bears. The price of CDS on the FG zoom, to the point that their prices imply a 60% chance the FG will default.

Step 4:  The quarter ends. The IB reports a positive mark of $1 billion on the CDS it owns, but by accounting rules has to net that against $600 million to reflect the wild market on CDS on the FG. So it can only show a $400 million positive mark, against the $1 billion it’s lost on the CDO. IB not happy now with enhancement!

Step 5:  FG also reports earnings. It recognizes an impairment of $1 billion (the net present value of expected loss) on the CDS it wrote on the CDO. But the FG will make cash payouts against that loss only gradually, in the form of principal and interest payments over the life of the defaulted bonds. The payouts will last for as much as 40 years, with principal payment at the end. In tallying the NPV of the CDO loss, the FG assumes a discount rate of 5%, to reflect the yield of its investment portfolio. Also, the FG, which intends to regain its triple-A rating, holds $1.3 billion in capital against the impairment, in line with the agencies’ requirement for triple-A.

Step 6: The FG approaches the IB with a proposal to commute the contract. Suggested deal: FG will pay $500 million in a single payment if IB terminates agreement. Benefits to IB: it gets $500 million up front rather than waiting for a dribble of cash that will last for decades; in addition, it no longer has to worry about the financial health of the FG, which the CDS market says is sinking fast. Best of all, remember that the IB has only been able to show a $400 million positive mark on its CDS on the CDO, since it had to net it against the sky-high market value of the CDS of the FG. Five hundred million dollars is more than $400 million. A good deal!  Also, the IB can earn 15% (or whatever its ROE is) on the $500 million it gets from the FG, rather than the 5% discount rate the $1 billion was returning as a liability of the FG.

Benefits to the FG, meanwhile: In return for its $500 million cash payout, it recognizes a $500 million reduction in impairments, and frees up the $800 million in capital it had set aside under the rating agency model!

Would it make sense to commute every CDS agreement? Of course not. It only works for agreements between selected guarantors and selected investment banks. But as you can see, a big driver of the benefit is the high price of CDS on the guarantors, which, ironically, the bears on the guarantors and those wacko rating agencies have helped bring about. In this case, both the guarantor and the investment bank have strong economic incentives to come to some sort of agreement. It’s been made possible largely by the excessive fear and panic about the health of financial guarantors led by Bill Ackman.

I certainly hope commutation agreements are announced soon, before Bill Ackman covers his short and CDS positions with respect to the financial guarantors.

Tom Brown is head of BankStocks.com.

Comments

[vittello]

Top notch explanation. This is exactly how the crisis can be unwound without leaving too many bodies in its' wake. I hope congress/the president grant the $300B for central bank loans as it will make this strategy much easier to digest for the banks. Mr. Brown's coverage of this situation is always spot on and backed up by facts rather than emotion. The shorts in this stock just don't have a strong enough grasp on macro-economics to justify what they are doing. So far, collusion, conflict of interest and fraud have allowed them to profit-those days are numbered.

[Ishortyou]

In respect to AMBAC and MBIA, they need to keep and save all the cash possible including stop paying dividends, deleverage from all their risky liabilities specially those CDS, CDO's, RMBS-ABS of uncertain value, in order to remediate their book values, once their book values are sound they need to reinstate their triple A rating again to write new low risk public bond insurance business. They can also open or extend a line of credit to make sure to continue operations and dissipate doubts.

They are already doing these, so it will take some time to deleverage their books from uncertainties and rewrite new business again. This coming back will be the best advertisement to recruit new clients.

[crashof2008]

Er, this is a little cute, but it is WAY off the mark. Obviously you haven't taken any math beyond college algebra. Oh well.

Did it ever occur to you that one of the key reasons MBI is tanking today is because of their 8-K they filed with the SEC yesterday?

It's a felony to lie to the SEC, so they are usually more accurate in their filings with them than with what they tell their bloggers acting in their behalf.

READ THE 8-K FILED WITH THE SEC yesterday.

Looks like the fallout from the initial stages of implementation of FASB 163 is REALLY starting to bite!

[Ishortyou]

This is the chance for AMBAC and MBIA to remediate their books!

[oldlures1]

crashof2008 - You have every right to disagree and express same here, but a personal attack on Mr. Brown is uncalled, inappropriate and, in my opinion, childish.

Mr. Brown - thank you for your insight and information. It's good food-for-thought. Personally, I'm grateful to read a perspective that differs from the predictable gloom-n-doom rhetoric from the "crash" camp. Such differing views are hard to come by these days, so again, thank you!

[Ishortyou]

thank you!

[howling wolf]

Mr. Brown,

the point you raise has been mentioned in previous analyses -- insurer
payments will occur over a long timeline and MTM accounting can disconnect from reality esp in these panicked markets. But other factors can easily come into play -- regulators and those holding the guarantees are apt to get more concerned as capital declines and could force events. Over reliance on the fact that payments are deferred across a very long period is akin to stating my O2 requirements for a week -- all very interesting but becomes irrelevant if I'm denied air for an hour..

[oldlures1]

*fingers crossed*

[take a guess]

In step 6, to make up for the sinking value of CDS on FG, IB can sell the CDS to FG as part of the deal. The FG will get the $0.5B in cash or maybe even more for the sale of CDS. The IB can sell the CDS acquired from IB if the rating doesn't go up. Whoever causes the manipulated price of the CDS on IB will lose for sure.

[oldlures1]

Crash - I read the 8-K as you suggested. I didn't see anything that wasn't previously disclosed in Moody's report or, for that matter, MBIA. Am I missing something? It was the June 25th filing that you suggested be read, correct? Also, I'm going to plead ignorance here, but could you elaborate on what you think FASB 163 is going to do?

[bondboy]

Tom,

Interesting analysis, but why have we yet to witness a single such transaction? Are the financial/reporting incentives in your example large enough? What are the possible impediments to getting a deal done?

[fxtrader07]

@crashof2008: you are a poor heavily biased guy who obviously goes to sleep every night hoping the world will have come to an end by the time he wakes up next morning. And over the course of the day you are seemingly absessed to get all the bad news there is.
Enjoy the money you make that way while it lasts (if you make any money, that is) but it's a pretty miserable way of living. The money you make (if at all, longer term) is a lousy compensation for a life full of negativity and friction.

[fxtrader07]

@Tom brown: thanks for another very insightful piece on the financial sector

[scrog]

I'm no expert, but it seems to me that many players sitting on big unrealized, but marked, losses are hoping for them to reverse so they can get big unrealized, marked, gains back to where they started. Surely there is plenty of bad paper, but some babies are being tossed with the bath water. Unwinding the deal now means turning possible (probable?) paper loses into certain realized losses. Hope springeth eternal.