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Friday, February 15, 2008


moving to a monoline resolution

governor of new york eliot spitzer issued a five-day ultimatum to the bond insurers to raise capital or be taken over and broken up by the state of new york. FGIC, having been downgraded from triple-a earlier in the day by moody's, subsequently contacted new york commissioner of insurance (and spitzer appointee) eric dinallo and acquiesced to a state-managed breakup of the firm which will separate the original municipal bond insurance side of the company from the later structured credit underwriting side.

that latter fraction will likely need a bailout, as ft points out:

A break-up of the bond insurer model holds grave implications for financial institutions that face writedowns on insurance and derivatives contracts entered into with bond insurers.

MBIA and ambac were granted some more time by moody's -- two weeks, perhaps -- as the ratings agency believes them to be better situated.

spitzer and dinallo are likely accelerating the process at the development of illiquidity in the auction-rate securities (ARS) market. accrued interest here and here has explained the mechanics of what is going on.

Most commonly, a bank is brought in to provide liquidity support [for ARS auctions]. In general, the bank provides full credit support, assuming the issuer hasn't already defaulted. As a result of this, investors in ARS don't have to worry that the issuer will have enough cash on hand to handle sales of their bonds. As long as the issuer is current on its interest payments, the bank will provide cash for normal redemptions of bonds. Think of it like a line of credit.

Here is where things get a little weird. Sometimes the issuer of a ARS was a little more sketchy credit. The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We'll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven't seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank's liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

For most ARS buyers, that's not acceptable. ARS buyers tend to be money-market like investors, who have zero desire to take on credit risk. So what are those bond holders doing? They are selling the bond back to the remarketing agent!

that flood of sales in anticipation of monoline downgrades has driven the banks from their liquidity arrangement prematurely, resulting in failed auctions. this is a pure liquidity problem of contagion from the monolines, one which may result in issuers calling their ARS and refinancing into fixed-rate municipal bonds. this has forced spitzer into the fray and pushed the monoline problem closer to a state-managed resolution.

splitting the monolines, much as with the earlier berkshire hathaway pitch, is not the bailout wall street banks need to have in order to avoid writing down instruments to which the monolines are counterparty, such as credit default swaps. but dinallo thinks MBIA and ambac will be rescued before they are downgraded.

``I wouldn't view that as being an empty threat,'' Havens said of Spitzer's comments. ``I interpreted that comment as basically being a shot across the bow of the banks and other parties with skin in the game to come to the table and come up with a solution.''

New York's regulators last month organized banks to begin plans for a rescue and are talking to private-equity firms and sovereign wealth funds, Dinallo said. The companies probably need about $5 billion and a line of credit for $10 billion, he said.

``We are encouraging them to resolve these transactions quickly within a finite number of days,'' Spitzer said today. ``If they're not going to happen, then we need to act quickly'' to find other ways to offer capital relief.

... Banks, which bought protection for collateralized debt obligations, stand to lose $70 billion if bond insurers are stripped of their to ratings, Oppenheimer & Co. analyst Meredith Whitney in New York said last month.

... Moody's analyst Jack Dorer said yesterday that he plans to complete a review of Ambac and MBIA by the end of the month.

here's the video clip of dinallo. i personally find it impossible to believe that, if the monolines "probably need about $5 billion and a line of credit for $10 billion" in order to run off their obligations -- which dinallo clearly thinks they can do over time, if not perfectly -- that they will not get that provision.

yves smith with more. david merkel doesn't think splitting them can be done and forecasts lawsuits.

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