Wednesday, July 9, 2008

MBIA holding company credit default swaps

Warning: This post needs serious modification to be correct. Several errors are in it and (like most my opinions) should not be relied on. A follow up is here.

As regular readers know I have no opinion as to whether Ambac and MBIA are long-term insolvent at the insurance company level. I really have no idea whether losses will be 2 billion or 20 billion. [I am long the stocks as of a few days ago - but I have no opinion about long-term solvency and when I purchased them I thought there was a reasonable chance that the end-game for both companies was zero.]

I believe that losses will be lower than is implied in the market prices of mortgages, but higher than is indicated in the loss reserves of most banks. That is a very wide band – and for detail within that band you are reading the wrong blog.

I do have something to say about the insanity of the market at the moment. It is about MBIA parent company credit default swaps… I think people holding that parent company default swap are insane.


It is highly unusual in the US for the parent company of an insurance company to guarantee regulated subsidiaries. Fairfax Financial has guaranteed TIG in exchange for getting some Odyssey Re stock out. However that is the exception rather than the norm – and the (California) insurance regulator got the guarantee in response to a specific deal.

Most the time it is possible for the parent company to go bankrupt without the insurance subsidiary (as happened with Conseco) or for the insurance subsidiary to go bankrupt without the parent company (as happened with Freemont General).

It is possible after the bankruptcy of the subsidiary for the regulator to sue the parent company based on fraudulent conveyance or some other rule. But the regulator has no prima-facie right to go after the holding company. (The California Commissioner sued Fremont General arguing fraud. Fremont settled for a large sum of money - but the holding company is still not on the hook for the insurance company liabilities...)

So how is it with MBIA?

MBIA holding company to the best of my knowledge (and having read a few statutory statements) has never guaranteed the insurance subsidiary.

MBIA holding company has well over a billion in cash (including the recently raised money). It got this with its recent capital raising – and was originally going to inject that cash into the regulated subsidiary to maintain the AAA rating.

The rating agencies told MBIA that would not be sufficient to maintain the rating and so MBIA kept it at holding company. The insurance commissioner is peeved – but there is little he can do unless he can prove fraud.

So the MBIA holding company is loaded. Indeed the net cash holdings of the holding company is slightly larger than all holding company obligations. At some point (somewhat lower than here) MBIA becomes a Ben Graham stock.

The point however is that it is highly unlikely for the holding company to go insolvent. Moreover almost all of the holding company debt is due after 2012 – often quite a long time after 2012.

The credit default swaps on the holding company imply a very high chance (well over 50%) of holding company insolvency.

Is everyone mad?

How can MBIA holding company go bust?

I can think of a few ways the holding company can go bust:

  • Well the first way that the holding company can go bust is to inject the holding company money into the insurance company and not be able to get it back. That is what Whitney Tilson – a vocal short – wants to happen. It is also what the insurance commissioner wants to happen but the insurance commissioner motivations are different.
  • The second way is that MBIA uses its holding company loot to buy back lots of shares at the current price – and runs itself out of holding company cash. Certainly MBIA has indicated that it is interested in buy-backs – but I doubt they are that interested.

  • A third way is for the company to inject the money into a new (and hence AAA rated) subsidiary and not be able to get it out of the new subsidiary. Ambac is trying to do that with its existing subsidiary (Connie Lee). However that money is to come from the regulated insurance company and not the holding company.
  • A fourth way is that the insurance commissioner manages to successfully sue the holding company. That seems unlikely to me – but courts are a crap-shoot and anything is possible.

There are probably other ways that the holding company can go bust. I don’t know them all. But the holders of the credit default swap are awful sure that holding company insolvency is inevitable. Too sure.

Full disclosure: the position in Ambac is many times as large as the small position in MBIA. More so after yesterday's trading...


Huntington Hartford said...

(1) do insurance regulators hold grudges? If management screws the regulated insurance sub in favor of the holding company, will the insurance regulators never let management play in the insurance biz again?

(2) You should submit this idea to Value Investors Club. You might win $5000... even though it's hard for me to see much upside if what you say is true. How much value is that per share if the holding company gives it back to shareholders?

John Hempton said...

(a). Yes insurance regulators hold grudges. They are human. They also long for a quiet life. Its pretty rare that an insurance regulator takes over a company before it is long-gone.

(b). The value of the company is indeterminate. However this is a super cheap option with a five plus year life. So is Ambac.

If the shorts believed these companies would be here in five years they would cover. There is huge short interest. Then anything can happen. The world is a wierd place.

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