Insurance Claims And Issues

Collateralized Debt Obligations, Credit Default Swaps, And Credit Insurance, Continuation ....

.... Part 3:  What Is The Prognosis?

     Merrill Lynch's recipe for settlements of CDO indemnity obligations may be "a template for Wall Street, Bank of America Corp. analysts said."  John Glover, "Merrill CDO Deal May Be Model, Bank of America Says (Update 1)" (Bloomberg.com, Friday, August 1, 2008).  

    Another description from a different analyst is that Merrill may have set a "benchmark".  John Glover, "Merrill Gives Up Gains, Is 'On Hook' For CDO Losses (Update 2)"  (Bloomberg.com, Wed., July 30, 2008).

    Yet a third description of this conduct is that Merrill Lynch has ushered in "a sea change in the way banks are approaching their holdings of troubled investments."  Jenny Anderson, "An Investment Firm That Prospered From Past Crises Turns to Mortgages" Business Day Section, p. C1, col. 3 (New York Times Nat'l Ed., Wed., July 30, 2008).

    Here is what Merrill arranged.  It held Collateralized Debt Obligations.  It sold them to Lone Star Funds.  The sale price was in the neighborhood of 22 cents for 100 cents or 22 cents on the dollar.  Merrill loaned Lone Star 75% of the 22 cents-for-100 cents purchase price.  Glover, "Merrill Gives Up Gains, is 'On Hook' for CDO Losses (Update 2)", supra.

    To fully understand the potential significance of this transaction, it is reported that some accounting information will help.  "Investment banks [like Merrill Lynch] can book a gain if an insurer is willing to pay more to terminate its liability on a default swap contract than the amount at which the bank has it on its books, Bank of America said."  Glover, "Merrill CDO Deal May Be Model, Bank of America Says (Update 1)," supra.  [Emphasis added.]  Unknown, unnamed "analysts" say:  "'Monetization of these gains, we feel, would follow.'"  Id.

     I think this means that right now, no-one can honestly say what these paper accounting "gains" are worth.  They do know enough to know, apparently, that an insurer shedding liability on "a default swap contract" is a postiive gain.  Insurance regulators will otherwise "probably" take over the Insurance Companies "and pay the holders of municipal bonds they guaranteed before the banks," according to "the analysts".  Id.

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Collateralized Debt Obligations, Credit Default Swaps, And Credit Insurance, Continuation ....

.... Part 2:  Devalue, Destroy, or Divest.

    Ambac Financial Group Inc., a Bond Insurance Company that ventured into the dangerous land of Collateralized Debt Obligations and hoisted packages of subprime mortgages in exchange for real money, agreed with Citigroup Inc. that Ambac would get out from under a guarantee of CDOs.  Christine Richard & Jody Shenn, "Ambac to Pay $850 Million in Citigroup CDO Settlement (Update 7)" (Bloomberg.com, Friday, August 1, 2008).   Here is how the Ambac-Citigroup deal has been reported.  Recall that a very broad definition of Collateralized Debt Obligations is that they "package pools of securities," including subprime mortgages, "and slice them into pieces of varying risk."  Id.

    Not long ago, Ambac guaranteed a Collateralized Debt Obligation of $1,400,000,000.00 or $1.4 Billion.  After the subprime collapse and the credit crunch began, Ambac wrote down the value of the CDO by $1,000,000,000.00 or $1 Billion.  (Could this have been accurately reported instead as written down the value of the CDO to $1 Billion?  See below.)

    Next, Ambac paid $850,000,000.00 or $850 Million to Citigroup to get out from under Ambac's guarantee of the CDO.  By an accounting charade, Ambac reported that it gained $150,000,000.00 or $150 Million on the transaction.  See Christine Richard, "Ambac Posts Record Net Income on Accounting; New Business Falls" (Bloomberg.com, Wed., August 6, 2008).

    This accounting sleight of hand works on Wall Street.  After Ambac reported its settlement agreement with Citigroup, the shares of Ambac rose 50% to $3.79 a share.  The share price of its rival Bond Insurance Company MBIA also rose, by 29% to $7.67 a share.  Associated Press Report, "Stocks & Bonds/A Rough Week With a Sedate Conclusion," Business Day Section, p. B7, col. 2 (New York Times Nat'l Ed., Saturday, August 2, 2008).

    This is suddenly the preferred way of shedding exposure by shedding previously given guarantees of Collateralized Debt Obligations.  "Somehow, $4.4 billion just evaporated at Merrill Lynch."  Louise Story, "A Sale of Troubled Mortgage Assets Raises More Questions Than It Settles," Business Day Section, p.C1, col. 1 (New York Times Nat'l Ed., Wed., July 30, 2008), published Online as "A Deal at Merrill Puts Spotlight on Others".  Once again, CDOs are described in this newspaper report as "toxic mortgage investments".  Not long ago, Merrill Lynch assigned a value of $11,100,000,000.00 or $11.1 Billion to the "toxic" CDOs on its books.  At this time, it is selling those CDOs for the lesser value of $6,700,000,000.00 or $6.7 Billion.  That is not all.

    Merrill Lynch is loaning the buyer, Lone Star Funds, most of the purchase price.  It wrote down the value, and put it back on the balance sheet as a loan.  This arrangement is reportedly all about the corporate balance sheet.

    As reported in the newspapers and other media, Merrill Lynch's arrangement removes the iffy valuation of CDO ownership from its books.  It is replacing ownership of a likely low value asset on its books, with a loan.   However, as noted in the linked newspaper article, the risk of the CDOs remains.  That said, however, something else may have been gained besides a balance sheet balancing better.

    If CDOs are the new Credit Insurance, then not owning nor guaranteeing the payment of CDOs may mean that the party that sold them, even if it devalued them, no longer runs the additional risk of issuing an Insurance Policy without the authority of any State to do so.  That exposure means potential penalties.  It is generally unknown how to accurately calculate that unwanted exposure.  Dumping the CDOs may dump that additional "toxic" exposure, too.

    Merrill Lynch is not only moving its CDOs to Lone Star Funds, however.  It also reportedly settled recently with a Reinsurance Company, XL Capital Assurance, "which had insured some of the firm's C.D.O.'s."  Merrill is writing down those CDOs' value in the 3Q 2008.  Merrill Lynch's settlement agreeement with XL Capital will cost Merrill a reported $500 Million, while other settlements with "other reinsurance companies" will add another $800 Million in Merrill's obligations.  Louise Story, "Write-Down Is Planned At Merrill" p. C1, col. 5, Business Day Section (New York Times Nat'l Ed., Tuesday, July 29, 2008).

    What is not necessarily understood in all these stories, and what the linked article does not mention, is that reinsurance is insurance purchased by an Insurance Company.  If a Reinsurance Policy was issued to "insure some of Merrill's C.D.O.'s," that means that the Reinsurance Company and Merrill both implicitly viewed the CDOs as insurance for which Reinsurance was a good idea in their judgment.

    CDOs, the New -- and unauthorized and, so far, unregulated -- Credit Insurance.  The next post in the Continuation of this subject, Part 3, will address the Prognosis.

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Collateralized Debt Obligations, Credit Default Swaps, And Credit Insurance, Continuation ....

.... Part 1 -- What Are These Things?

      Collateralized Debt Obligations and Credit Default Swaps belong to a group collectively labeled "toxic securities" in the media.  See "Merrill CDO Sale Not As Good As It Looks:  Analyst," a Reuters report published online at washingtonpost.com, Wed., July 30, 2008.  A more polite name that they go by is "structured finance revenue," meaning revenue from "structured products" like CDOs and other securities backed by mortgages on peoples' houses or commercial properties, "and credit derivatives."  Jonathan Stempel, Reuters report, "Moody's Profit Tumbles, To Be Sued By Connecticut" (washingtonpost.com, Wed., July 30, 2008).

     Perhaps a little more sharpness in definition will aid in understanding.  Perhaps not.  It is worth a try.  CDOs are securities.  They "repackage pools of bonds and loans and divide" the cash flow from these pools of bonds and loans "into notes of varying risk and returns that are sold to investors."  John Glover, "Merrill CDO Deal May Be Model, Bank of America Says (Update 1)" (Bloomberg.com Friday, August 1, 2008).

     CDOs "package pools of securities, including those backed by subprime mortgages, and slice them into pieces of varying risk."  Christine Richard & Jody Shenn, "Ambac to Pay $850 Million in Citigroup CDO Settlement (Update 7)" (Bloomberg.com, Friday, August 1, 2008).  More simply put, "CDOs repackage bonds, loans and credit-default swaps and use the income to pay investors."  John Glover, "Merrill Gives Up Gains, Is 'On Hook' For CDO Losses (Update 2)" (Bloomberg.com, Wed., July 30, 2008).  [Emphasis added.]  

     So, then, "Collateralized Debt Obligations" include "Credit Default Swaps," it appears.  CDSs have been defined by the same financial reporter as "contracts conceived to protect bondholders against default, [they] pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements."  John Glover July 30, 2008, supra.  CDSs, in addition, are defined by their use "to speculate on a company's ability to repay debt."  John Glover, August 1, 2008, supra.  See also Christine Richard & Jody Shenn, August 1, 2008, supra.

     If this is confusing, try wrapping your mind around what the media describes simply as "complex European products known as constant proportion debt obligations (CPDOs)".  Jonathan Stempel, July 30, 2008, supra. 

     There is no present need to venture into the world of CPDOs.  It is enough to recognize that reporters, through no fault of their own, do not appear to understand what Collateralized Debt Obligations and Credit Default Swaps are all about, how they function, what they actually do.  They function like Insurance.  Although it is the job of reporters to report to the public what these things are all about, it is not at all the fault of reporters that they do not understand financial vehicles backed by or involving packages of subprime mortgages.  People and particularly regulators were never supposed to understand that CDOs and CDSs are really Insurance.  They function just like Insurance, and they insure credit obligations every bit as much as regulated Credit Insurance.  They are called seemingly impenetrable names for a reason, which is that their makers do not wish them to be understood for what they are:  Insurance.

     The title of this post reflects that it is a Continuation.  In many posts in this space, see, e.g., the post here of July 10, 2008, the similarity between these seemingly mystical securities and Credit Insurance was found to be identical.  The disguise worn by these securities has so far deflected closer examination and prevented any kind of regulation.  The damage done by this deception is the subject of the next post in this series, Continuation Part 2, Devalue, Destory and Divest.

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Securitization and the "New" Insurance, No Assurance.

     "Securitization" includes, in basic terms, bundling securities and selling them.  Previous posts in this space have addressed one of those "securitization" vehicles, collateralized debt obligations, which are not regulated as "Insurance," and their virtually identical resemblance to regulated Credit Insurance.

    Other features of "securitization" besides the avoidance of regulation, include that borrowers and lenders are not likely to know much about the other, even their identity in at least some cases.   "[T]oday the holder of the note securing the property is a faceless investor represented by a trustee, like the Bank of New York."

     Further, loan servicing companies stand in the middle between lender and borrower.  It is the job of a loan servicing company to obtain for the lender all the money from the borrower that can be obtained.  "And because the foreclosure process can generate lucrative fees, servicers have an incentive to drag out the process, experts say."

     In particular, plaintiffs attempting to foreclose on residential housing are at a loss in many cases to present the actual note given by the borrower as evidence that the plaintiff owns the "securitized" debt or otherwise has the right to foreclose on the security, i.e., the borrower's home, in the event of nonpayment of the loan.  This evidentiary disability is a growing disadvantage as more Judges require evidence of authority to foreclose.  A "consumer lawyer at Jacksonville Area Legal Aid in Florida" is quoted in this regard in Gretchen Morgenson, "How One Borrower Beat the Foreclosure Machine" p. 1, col. 2 "Sunday Business" Section (New York Times Nat'l Ed., Sunday, July 27, 2008).  The consumer lawyer points out that this is an issue of whether the plaintiff has standing to sue, and the answer to that question may well determine whether the same plaintiff has standing to settle.

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Credit Default Swaps: The New Credit Insurance.

Ask the Bond Insurers.

     Credit default swaps are "financial instruments" of a special nature.  They "are privately traded insurance contracts that let people bet on companies' financial health."  Gretchen Morgenson & Vikas Bajaj, "MBIA Debt is Setting Up a Quandary" p. C1, col. 5 "Business Day" Section (New York Times Nat'l Ed., Wed., June 18, 2008).

     According to the Wikipedia Online Encyclopedia, "Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes."  Wikipedia Encyclopedia entry for "Credit Default Swap".

     The workings of credit default swaps are illustrated by what many had assumed is the precarious financial condition, and the apparently glaring need for an infusion of capital, at the Bond Insurance Company MBIA.  MBIA reportedly wrote $137,000,000,000.00 or $137 Billion of credit default swaps which provide that their purchasers can demand immediate payment if the Bond Insurance Company either (1) becomes insolvent or (2) is taken over by state regulators.  Morgenson & Bajaj, supra.  This is reportedly a huge hammer for MBIA in the face of calls by such as the New York State Insurance Superintendent to raise some $900,000,000.00 or $900 Million for the Bond Insurance Company; if MBIA defaults on the credit default swaps, in basic and simple terms, MBIA arguably does not need the additional capital if all its money is going to pay off the credit default swaps.

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Bond Insurance Companies Ratings Drop.

     As previously posted here, MBIA was the No. 1 Bond Insurance Company.  Ambac Financial stood in at the No. 2 position.  Until recently, perhaps.  Their respective credit ratings have both been downgraded below the rating that has always been necessary in order to sell Bond Insurance.  The developments are reported in several places including Reuters Report, "Moody's May Downgrade Ratings of MBIA and Ambac Units," p. C2, col. 1 (New York Times Nat'l Ed., Thursday, June 5, 2008), available online at www.nytimes.com; and Associated Press Report, "Stocks & Bonds/Investors Fret Over Financial Sector," p. C10, col. 4 (New York Times Nat'l Ed., Thursday, June 5, 2008), available online at www.nytimes.com.

     In the meantime, three of the Credit Ratings Companies reportedly have reached or are negotiating a deal with the New York State Attorney General to change some of their business practices -- although not the source of their income, which when they began in that business was the person asking to find out a rating but now is, and would remain, instead the business that is being rated.  The reported deal would also leave unchanged the opportunity for the business purchasing the services of a Credit Ratings Company to go to another Credit Rater if it did not like the rating, which it would not be compelled to disclose even as it shops for a better rating.  See, for example, "Moody's, S&P and Fitch Agree to Deal on Fees," published on Friday, June 6, 2008 by the Los Angeles Times Online "From Times Wire Services", available online at www.latimes.com;  Jenny Anderson & Vikas Bajaj, "Rating Firms Seem Near Legal Deal on Reforms," p. C1, col. 5 (New York Times Nat'l Ed., Wed., June 4, 2008), available online at www.nytimes.com.

     "The deal with [the New York State Attorney General] applies only to debt backed by U.S. subprime and other so-called non-prime loans."  "Moody's, S&P and Fitch Agree to Deal on Fees," supra.

As soon as the web log host, TypePad, provides again the opporunity to hyperllink directly to these sources, the author will try to make that happen but it is not possible to do so at the time of this post.  Instead, the websites of the sources should work and for that reason are made available here in the interim.

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Credit Default Swaps: The New Credit Insurance?

     Credit default swaps are a hard thing to understand.  It almost seems as if those who use them benefit by not describing them in language that can be readily understood by other people.  The more a person learns about credit default swaps, the more they seem like unregulated Insurance, however.  See, for example, Gretchen Morgenson, "First Comes the Swap.  Then It's the Knives." p. 1, col. 2, "Sunday Business" Section (New York Times Nat'l Ed., Sunday, June 1, 2008), available online at www.nytimes.com.

     Parenthetically, a definition of the term, "counterparty," is given in this newspaper column.  A counterparty on a credit default swap is the insurer.

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Credit Raters Examined!

      Many specifics and lots of broad implications about the workings of credit rating corporations including their roles in Insurance are discussed in Roger Lowenstein, "Triple-A Failure," p. 36 (New York Times Sunday Magazine, April 27, 2008).  One thing is hardly mentioned but fairly clear:   While the credit rating corporations recognize that their models of evaluating subprime mortgages and collateralized debt obligations were inadequate if not counterproductive by providing a rating structure on paper or in theory, but not in reality, it does not appear that any of the credit rating companies ever declined even one opportunity to be paid large amounts of money to rate the credit of even one "asset-backed" financial product including Insurance.  Not one.

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Excess, Credit Conditions, and Insurance.

    "Like at the end of the Gilded Age and the Roaring Twenties, we are going the other way.  We are clearly in a period of excess, and we have to swing back to the middle or the center cannot hold."

William H. Gross, chief investor at a bond fund, quoted  by Jenny Anderson, "Wall Street Winners Hit a New Jackpot:  Billion-Dollar Paydays" p. A1, col. 3 (New York Times Nat'l Ed., Wed., April 16, 2008). 

    Credit conditions affect the purchase of Insurance and the regulation of Premium Increases.  Current reports concerning the availability and use of credit reflect:

• The Mortgage Bankers Association began tallying foreclosure actions in 1979.  The current number of foreclosures in the United States is the highest that the Mortgage Bankers Association has ever reported.
• Almost every State in the Union has experienced the effects of an increase in the number of foreclosure proceedings.  In 47 States, foreclosure totals increased by 20% or more in one year's time, from December of 2006 to December, 2007.
• In the State of Ohio for example, in 2007 over 80,000 foreclosure lawsuits were filed.  That is an increase of 40% from only four years ago.

    Yet States are taking steps to face the credit crisis from which the current Federal government always seems to flee.  Taking Ohio as an example again, the Ohio Supreme Court approved a new Mediation program in January, 2008.  When a lender files a foreclosure action in Ohio, the lender is allowed to obtain copies of the real estate closing documents only after the lender first tries "to work out payments with homeowners."  In other words, they have to mediate their dispute with the borrowers they are suing in the foreclosure action.  "'It slows down the process and gets everyone to the table,'" says the Ohio Treasurer.  Dina ElBoghdady & Renae Merle, "States Tackle Foreclosures in Absence of Federal Help" (washingtonpost.com, Wed., April 16, 2008).  This newspaper report is based on a study prepared by the Pew Charitable Trusts, as was this one:  John Leland, "Foreclosures Push States to Try a Mix of Solutions" p. A14, col. 6 (New York Times Nat'l Ed., Wed., April 16, 2008).   

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Subprime Insurance Claims Worldwide, Not Limited to U.S.

     Brit Insurance is reportedly the largest Insurance Company in Lloyd's.  Andrea Felsted, Insurance Correspondent of The Financial Times, "Companies - UK: Brit Insurance Sets Aside 60m to Cover US Subprime Claims" (ft.com, Tuesday, March 11, 2008).  Brit received "25 notifications of potential claims under policies written to protect financial institutions."  In response, Brit set aside an additional reserve on top of the reserves it set in the ordinary course of business "to pay for [these potential] claims arising from the collapse of the US subprime mortgage market."

     The amount of the reported additional reserve is 62.5 Million Pounds.

     A spokesperson for Brit Insurance is quoted as saying that the cost of Insurance Coverage for financial institutions is now rising.

     More to come.

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