Bank of America Settlement With Assured Guaranty a Plus for Financial System

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Includes: AGO, BAC, CS, JPM, MBI, MS
by: Tom Armistead

Assured Guaranty (NYSE:AGO) has just announced a settlement with Bank of America (NYSE:BAC) on the R&W (representations and warranties) issue. From the press release:

The cash settlement of $1.1 billion will be paid in full by March 31, 2012. The initial payment of $850 million was paid on April 14, 2011. In addition, Bank of America and Countrywide have agreed to a reinsurance arrangement that will reimburse Assured Guaranty for 80% of all paid losses on the 21 first lien RMBS transactions until aggregate collateral losses in those transactions exceed $6.6 billion. Cumulative collateral losses on these transactions were approximately $1.3 billion with no paid losses by Assured Guaranty as of December 31, 2010. As of December 31, 2010, Assured Guaranty’s gross economic loss on these RMBS transactions, which assumes cumulative projected collateral losses of $4.6 billion, was $490 million. The total estimated value of the settlement is expected to be accretive to shareholders’ equity and adjusted book value, a non-GAAP financial measure.

This outcome is a triumph for Assured Guaranty CEO Dominic Frederico, who has exerted an extraordinary amount of patience in making a determined effort to resolve R&W issues without resorting to litigation. He had previously described working with BAC on the issue as similar to "Chinese water torture." Again from the press release:

We are pleased to have reached a settlement with Bank of America that puts this legacy issue behind both of us,” said Dominic Frederico, President and Chief Executive Officer. “This settlement significantly strengthens our balance sheet, allowing us to more effectively assist municipal issuers. We hope that this settlement—negotiated outside of litigation—encourages other R&W providers including JPMorgan Chase, Deutsche Bank and Flagstar Bank to accelerate the R&W claims settlement process.”

The implications for other players in the R&W area are clear. MBIA (NYSE:MBI) CEO Jay Brown has been resolute in his determination to enforce compliance with R&W rights, and has been less patient than Frederico, launching litigation against the responsible parties as soon as it became clear that they had no intention of performing their contractual obligations.

BAC CEO Brian Moynihan, discussing the settlement in an interview on CNBC, was taking the approach that the company will now be making strong efforts to put this issue behind it. Bank of America, according to its last 10-K, was unable to establish reserves for a portion of R&W liabilities because it had difficulty communicating with "certain mono-line insurers." That would be MBIA.

It is entirely possible that the Fed suggested to BAC that it would be appropriate to resolve its legacy mortgage related issues prior to increasing the dividend.

Investment Implications

Shares of AGO and MBI were up in pre-market trading, 19.7% and 14.2%, respectively. Both companies have substantial short interest outstanding, and short-sellers would be well-advised to cover. It is unlikely that they will find a better exit point. A serious squeeze is possible.

I'm long MBI and AGO, and plan to monitor developments. Both companies are trading well below recent highs and well below nonGAAP ABV (adjusted book value). AGO has said that the settlement will be accretive to ABV. I do not expect to take profits until I have had time to do a thorough review of the settlement and its implications for mono-line balance sheets.

Valuation

This settlement validates the published book values of both AGO and MBI. The amounts they have been claiming as recoverable under R&W are correct, if not understated. Their prospective ability to write new business on favorable terms is greatly enhanced.

After studying pre-crisis multiples applicable to ABV, I have reached the preliminary conclusion that both companies may eventually trade at about 70% of ABV. For MBI, that would be 36 X .7 = 25. For AGO, that would be 49 X .70 = 34.

These targets require that remaining R&W issues be resolved along the lines of what the companies have been reflecting in their financials, and that the issues created by S&P's proposed modifications of its standards for rating bond insurers be resolved - with or without the cooperation of that rating agency.

A Brief Summary of the R&W Issue

From Jay Brown's testimony before the NY State Assembly Standing Committee on Insurance:

In our structured finance business, we believed that by doing business with large, well-capitalized and highly reputable loan originators, servicers and sponsors, we would limit our exposure to loss, let alone fraud. We believed that working with such reputable institutions would ensure that the reps and warranties written into the transactions were backed by an entity financially capable of meeting them. What we did not count on, and could not have foreseen, is that these institutions would willfully ignore both written underwriting guidelines and prudent lending practices on a massive scale and then subsequently refuse to honor the reps and warranties they made to us. As a result of their actions, we have paid out over $4.2 billion in claims through September, including $2.5 billion on Countrywide-sponsored transactions, $1.3 billion on transactions sponsored by what is now Ally Bank, $333 million on a Credit Suisse-sponsored transaction, and $76 million on a Morgan Stanley-sponsored transaction.

Bank of America was a leader in opposing R&W claims. The settlement with Assured Guaranty suggests that a majority of these claims can now be settled out of court and on a factual basis. Ultimately that will be good news for the entire financial system, as it will result in losses caused by a lack of integrity resting with the perpetrators. That will restore confidence. It will remove uncertainty. It will help maintain viable markets for Municipal bonds and eventually for RMBS.

Disclosure: I am long MBI, AGO.

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