MBIA’s volatile credit protection

By Felix Salmon
February 17, 2011

It’s rare that prepared official testimony moves markets. But that’s what happened when MBIA CEO Jay Brown appeared in front of the New York State Assembly Standing Committee on Insurance yesterday — a body which, it’s fair to say, rarely appears in the news.

Brown’s testimony would be well worth reading even if it hadn’t moved prices on MBIA’s CDS substantially — they opened the session at about 45 points up front, which means you have to pay 45 cents to insure MBIA’s debt against default, and rapidly rallied to 38 points. The move is even more impressive when you note, as Zero Hedge does, that they’d already tightened in from 55 points a couple of weeks ago.

There are three things going on here, which it’s worth trying to separate: the news from MBIA, the effect that news has on MBIA’s creditworthiness, and the implications for markets.

The news is the most important thing. Brown explains in his testimony that MBIA, having guaranteed a number of mortgage bonds, has paid out substantial sums of money as those bonds have failed, including $2.5 billion on Countrywide-sponsored transactions and $1.3 billion on transactions sponsored by what is now Ally Bank. But Brown is not happy about this: he reckons he was lied to by the banks in question, and so he’s pursuing them to get his money back.

In a typical transaction with a bond insurer, the sponsor of a transaction would make a series of representations and warranties in the governing documents to provide assurance that the loans in the pool met certain criteria – and recourse in case they did not. These reps and warranties were critical to us, as these criteria were a key determinant of the quality of loans eligible to be included in the loan pool – and consequently, how the pool could be expected to perform…

MBIA accepted the risks that the collective pools of loans – having the characteristics represented and warranted by the sponsors – would not perform as anticipated and perhaps lead us to have to satisfy the trusts’ obligations to its note holders. MBIA insured only the risks for which we bargained and for which insurance was solicited. Notably, we did not accept the risk of loss on loans that should never have been in the transaction in the first place…

In the second half of 2007 we began to observe increased delinquency rates in some of our insured transactions. The delinquency rates were highly inconsistent with the purported quality of the loans, so we hired law firms and forensic diligence firms to investigate why this was happening. Their results were stunning. We learned that over 80% of the loans in the pools we insured were in fact not eligible to be included in the transactions, because they violated the guidelines and other terms of the contracts.

MBIA, then, is in a big fight with Countrywide (now owned by Bank of America), Ally Bank (now majority-owned by US taxpayers) and others. It’s trying to get those banks not only to reimburse MBIA’s losses on loans which violated the banks reps and warranties, but also to take back all loans which didn’t meet advertised standards, whether they’ve defaulted or not. If it succeeds, it will look much more creditworthy than it does right now.

Brown’s testimony is reasonably compelling: he explains that MBIA’s losses on prime mortgages are much bigger than its losses on subprime, which are actually zero to date. With subprime, he says, he knew what he was insuring; with prime, MBIA placed too much trust in those reps and warranties. And it’s fully entitled to hold the originating banks to the representations they made when the deals got done.

On top of that, rumor has it that MBIA is commuting deals, most recently with a UK fund called Protium. Essentially, Protium held about $4.5 billion of debt which was insured by MBIA, and on which MBIA was making occasional payments as and when they came due. It negotiated with MBIA and got the monoline to make one big payment, in return for wiping out any future obligations. The deal’s good for Protium, which gets lots of money up front and which no longer needs to worry that MBIA won’t be around to make the payments it’s obliged to make. And it’s good for MBIA, too, which pays out much less, in total, than it would if it left the agreement untouched. What’s more, if MBIA manages to put back bonds to the originating banks, it could actually make a substantial profit on the transaction, with the loss being transferred to the banks.

All of this is doing wonders for MBIA’s creditworthiness. At 39 points up front, the cost of insuring against an MBIA default is still high, and prices in a significant probability that the company will not be able to pay its obligations. But the price is much lower than it was just a couple of weeks ago, and anybody who had bought protection on MBIA is facing significant margin calls and mark-to-market losses. (Zero Hedge reckons Morgan Stanley might be one such player, and that the price on MBIA’s credit default swaps could go even lower if Morgan Stanley is forced to close its position.)

This is all a prime example of the kind of volatility that happens in the CDS markets. It’s called “jump risk”: credit derivatives are qualitatively different from, say, interest rate swaps, in that they can exhibit equity-like levels of price volatility. If you trade such things on margin — and pretty much everybody in the market does trade on margin — then you can be faced, overnight, with demands for very large amounts of collateral indeed. That’s one reason why exchanges don’t particularly want to try to implement central clearing of such instruments: if a big player finds itself unable to meet a large and sudden margin call, the exchange itself could lose billions of dollars.

I don’t know how much credit protection has been written on MBIA, but I suspect it’s a lot. Like much of the derivatives business, it’s a dangerous and volatile business to be in. And that’s one reason it’s important that government oversight of the derivatives market be beefed up — it simply can’t be allowed to continue on in an unregulated manner. There’s far too much tail risk in the market for that.

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