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Wednesday, February 06, 2008


the coming monoline bailout

surely one of the hot-button issues in this market has been the status of the monolines and their triple-a rating. any time news about ambac or MBIA hits the wire, it seems shares and treasuries jump this way or that depending on the jist of the news. the first rumors of the monoline bailout helped put a bottom in, whereas the first monoline downgrade (following many weeks of forbearance) and speculations on an unfolding potential credit default swap disaster had helped throw the market off a cliff in the first place.

via the financial times, s&p has estimated that the monoline bond insurers are counterparty to credit default swaps held by commerical banks against just their CDO portfolios valued at something like $125bn, and the need of loss reserves at the banks as they reassume default risk would be considerable. and of course failure would have knock-on effects in the muni bond market as well, which could roil the risk-averse capital pools (such as money market funds) that invest heavily in munis.

in spite of this, it is speculated that any bailout may not come soon enough to prevent further ratings downgrades, and the event may give the markets another reason to sell off.

``Given the number of competing interests and levels of commitment of participants involved, we think it is unlikely that an agreement sponsored by Dinallo could be hammered out within the appropriate timeframe,'' CreditSights analysts Rob Haines, Craig Guttenplan and Joe Di Carlo in New York wrote in a report. ``In the offchance that any deal could be solidified, the rating agencies are likely to have already taken action.''

some thoughtful commenters have even implied that a deal may be difficult to arrive at due to the conflicting interests of the parties to the bailout.

but an insightful posting from accrued interest on the detail of what is happening sheds considerable light on why a bailout of some kind is certainly in the cards well before the bitter end of a terrifying CDS market unwind.

No one is claiming that the monolines are actually running out of cash today. The actual cash paid out on structured finance deals to date has been small. In fact, based on the way the insurance contracts were structured (called a pay-as-you-go credit default swap), its likely that actual cash payments would occur slowly over time.

I'm not dismissing the impairments in Ambac or MBIA's portfolio just because little cash has actually been paid out. The write downs are real. But if the AAA rating were not so key to their business, if it were merely a cash flow business, the situation would be vastly different.

And that's just the thing. If a group of banks could put enough cash into Ambac and MBIA to maintain the AAA, then it really would become a cash flow issue. The write downs today would turn into in real cash losses over many years. The banking system would have time to absorb those losses, rather than suffer large write downs right now.

No wonder regulators are pushing such a plan. The question for any bank considering involvement is how big the capital infusion has to be. I've heard numbers ranging from $3 billion to $15 billion. One of those numbers would be easy for Wall Street to take on. The other would be tough given today's capital constrained environment.

in other words, a relatively small capital infusion will keep money center banks from having to confront a massive problem in the immediate future, allowing them instead to spread larger (bloomberg cites estimates of up to $65bn in the long run) losses over several years in a manner that will allow them to be offset by future income. wall street can certianly cut off its nose to spite its face, but with so much on the line one has to expect better.

there's no doubt these companies have been greedily and disastrously managed. that's the only way for a company like MBIA to end up with $8bn in CDO-squareds. but a bailout should come and very likely will come.

UPDATE: via housing wire, more on the bond insurers.

Back in the States, New York Insurance Superintendent Eric Dinallo has been trying to orchestrate a rescue of some of the troubled insurers, and media reports suggest he may be having more success now than when he first started the effort.

Bloomberg reported Wednesday that Ambac Financial Group, Inc. — who already lost its AAA rating from Fitch — is being targeted for one bank-led bailout effort, including Citigroup Inc. and UBS AG. The Wall Street Journal also reported Wednesday that a unit of Credit Agricole SA is mulling a separate bailout of Financial Guaranty Insurance Co.

UPDATE: more from msn money on what the ramifications on the municipal bond side might look like -- more significant that i had considered, a run on the tendered option bond market could be a scary event for all kinds of muni holders, including money market funds.

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