Good News for Monolines Wanting To Settle Their CDO Obligations

| About: Merrill Lynch (MER)
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Whenever a debt issuer runs into distress, it's a safe bet that there will be legal tussles between holders of junior and senior notes. CDOs are no exception, as Aline van Duyn reports today in the FT. But it turns out there's a silver lining here for the monolines:

The billions of dollars worth of hedges that banks bought on the CDOs they held on their books from bond insurers like Ambac and MBIA often involved handing over the voting rights on the CDO.

With hindsight, this was an extremely unwise move. An estimated $100bn of such CDSs on CDOs were written by bond insurers. The underlying CDOs are essentially worthless without these rights. The rights which allow holders to decide whether or not a structure is liquidated is what will determine whether it has any value at all. Now, as more banks seek to sell their CDOs to hedge funds - like Merrill Lynch (MER) did recently - they need these rights back. Hence the desire to reach deals with the bond insurers to tear up the CDSs on the CDOs, even if they are potentially losing out by doing so.

If a bank has insured its CDO tranches with a monoline and wants to sell those CDO tranches, it will have to settle up with the monoline first. Unless and until it does so, the monoline will retain the voting rights, and no one has any interest in buying any kind of distressed debt instrument sans voting rights. In other words, the monolines are in a strong negotiating position, and the banks have an incentive to settle with the monoline for substantially less than the mark-to-market present value of the insurance contract.