By GRETCHEN MORGENSON and VIKAS BAJAJ
June 18, 2008
SourceThe risks associated with the vast, unregulated market for credit default swaps played a crucial role in the bailout of Bear Stearns. Now these financial instruments are taking center stage in another Wall Street drama: whether regulators will let MBIA, the big bond insurance company, renege on a promise to shore up a crucial unit with $900 million in capital.
MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.
But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.
In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit.
Mr. Dinallo confirmed last week that the swaps written by MBIA and other financial guarantors were a big factor in his dealings with the weakened bond insurers.
“It is a concern that possibly if one of the companies filed for rehabilitation or if we move to rehabilitate, the holders of the credit default swaps could move to get preferential treatment,” he said.
Mr. Dinallo said he could refuse to honor acceleration demands if he took over a bond insurance firm, but such a move would almost certainly prompt investors who hold the credit default swaps to press their cases in court. The acceleration clause is a standard feature in credit default swaps written by many bond guarantors, including Ambac and the Financial Guaranty Insurance Company.
MBIA, which insures $670 billion in municipal bonds and mortgage-related securities, has been hit hard by the credit crisis. It recorded a $2.4 billion loss in its most recent quarter and lost its prized AAA rating from Fitch Ratings and Standard & Poor’s; its shareholders have watched their holdings plummet 67 percent since the beginning of the year.
Wall Street is worried that rising losses on the $230 billion in mortgage and related securities that MBIA has guaranteed will burn through the company’s capital in the coming years. The company has said it expects total losses of $2 billion, while other analysts believe the number could be as high as $14 billion.
MBIA’s woes have raised concerns that its insurance unit is on shaky ground and that policyholders may be at risk. To allay such fears, MBIA raised $2.6 billion in capital and twice committed to contributing $900 million to its insurance unit.
On May 12, for instance, MBIA promised to contribute the money to the subsidiaries within 30 days. “This contribution is consistent with our previously announced capital strengthening plan and is intended to support MBIA Insurance Corporation’s triple-A ratings and existing and future policyholders,” the company said.
But the 30 days have come and gone with no contribution from MBIA. Last week, the company noted that “the landscape has changed,” and said it instead wanted to use the $900 million to start a new insurance subsidiary, letting the existing unit wind down its operations. The company said it had changed its thinking because S.& P. and Moody’s Investors Service, another rating firm, recently have indicated that a $900 million injection into its existing insurance subsidiary might not be enough for the unit to maintain its current high ratings.
“We have stated from the beginning that we believe MBIA Insurance Corporation has substantially more claims-paying resources and liquidity than it will need to satisfy fully all policyholder obligations on a timely basis,” C. Edward Chaplin, the company’s chief financial officer, said in a statement last week. “A high priority is pursuing opportunities to support the bond insurance market as a whole.”
But Joshua Rosner, an analyst at Graham-Fisher in New York, said, “It seems to me that if Jay Brown insists on putting the money anywhere other than at the insurance subsidiary or through a new subsidiary directly under it, he is making a very clear statement that he no longer believes in the viability of the insurance company to meet its obligations.”
The swaps’ acceleration clauses appear to be a factor in this bit of brinksmanship, although MBIA does not advertise their existence. In a presentation about its first-quarter results, for example, MBIA said its “insurance contracts are not subject to acceleration.”
Asked about this discrepancy, MBIA said the presentation language meant that holders of its swaps have no acceleration rights “as long as the company continues to operate in its current manner,” which it believes it will do.
“Fortunately, for us it’s not something that we have to be concerned about,” said Greg Diamond, director of investor relations for the company.
Mr. Dinallo said he would consider allowing MBIA to put the $900 million into a new company if it reinsured the municipal bonds in MBIA’s existing insurance unit.
“I am trying to think carefully of what is the right use from a regulatory perspective for that $1 billion,” he said. “If they intend to take the billion and do some cut through reinsurance for the municipal side, I’d be very open to it.”
MBIA said it was working closely with Mr. Dinallo’s office and “would consider selected reinsurance opportunities” for its new subsidiary.
But others are not so sure. John Miller, chief investment officer at Nuveen Asset Management, a big municipal bond fund manager in Chicago, voiced skepticism about MBIA’s plans to start a new insurance subsidiary that could reinsure its existing portfolio.
“It would be surprising to me if it would be successful,” Mr. Miller said. “It will still be an MBIA-insured bond and then reinsured also by MBIA, but MBIA as a new company.”
As the negotiations between MBIA and the state insurance commissioner continue, a bill is moving through the New York State Legislature that would put restrictions on financial guarantors that insure credit default swaps. For example, a financial guarantor could insure a swap only if the buyer owns the underlying bonds and is using the swap as a hedge.
Mr. Dinallo said his office was also working on new rules for how and when bond guarantors can write credit default swaps. “When we rewrite the rules of the road we have to make sure this doesn’t happen again,” Mr. Dinallo said.
For its part, MBIA said it would no longer write credit default swaps.