Tom A's Stock Picks

When Hedges Go Awry

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Several weeks ago I did a post on the extreme cost of CDS protection on Ambac and MBIA, guessing that much of the premium price paid for this protection arises from its popularity as a hedge on bonds they insure. Lately there has been speculation that Ambac and MBIA may be able to resolve many of their pending claims at terms that will be favorable to both them and the policyholders under current market conditions. How would this work and what are the implications for hedged positions?

An article in the Financial Times quoted "sources" to the effect that Ambac and MBIA have been pursuing the possibility of commutation of many of their policies. The scenario is that an investor, perhaps an investment bank, owns a mortgage backed security backed by sub-prime collateral that is insured by one of the monolines. Because the monoline's credit is deeply discounted by the market, the investment bank has to mark the bond to market, creating an unrealized loss. To hedge this loss, the investment bank buys CDS protection on the monoline, which offsets the unrealized mark to market loss on the bond. Or, alternatively, they buy credit protection on the ABX, an index of sub-prime bonds. I believe that this index overstates the severity of future losses, and the protection is accordingly over-priced, in sync with the bond, which is under-priced.

The monoline, meanwhile, has been doing surveillance, recognized that they will be making payments, and booked a loss. The rating agencies have been doing stress case analyses and requiring that the monolines have capital equal to 1.3 X the stress case losses in order to qualify for triple A status. Suppose the bond is 1 billion, and a realsitic loss estimate is 500 million. A stress case estimate could be 700 million, so the monoline would need 910 million (700 X 1.3) capital to carry the policy and loss on its books and maintain a triple A capital level. Paying the loss of 500 million would free up 410 million of capital. The investment bank, if they are agile, cashes the claim check and unwinds the CDS position at a profit. The mark to market losses, which are grossly in excess of reality, go away. The monoline is suddenly over-capitalized, even by rating agnecy standards. Everybody is very happy.

Paying the claims in advance sounds a lot like compromising liabilities, but given the shared knowledge of the participants and the distorted economic realities around these transactions, it makes a lot of sense.

In some cases there might be some warranties and representations liability to discuss. When mortgages are bundled and sold, warranties and representations as to the quality of the mortgages are made. Both MBIA and Ambac have been going through their insured books to look for any misreprentations or breaches of warranty that may have been made in connection with the transactions. Merril Lynch and Coutrywide Financial both have material liabilities on their balance sheets against warranties and representations claims. Sometimes lies work best on a willing listener and the two parties are really in it together. There might be some situations where items of this type could be swapped back and forth, netted out, and swept under the carpet, avoiding much embarassment and hard feelings.

This whole thing is like a hall of mirrors: reality is distorted in a multitude of twisted images. But the investment bank and the monoline insurer, both of which have been diligently studying the servicer reports on the underlying collateral, and putting their projections into industry standard software, can probably develop a realistic value of the claim, reach an agreement, and settle. There is a question as to how many holders there are on some of these instruments - the more holders, the harder to unwind the whole deal. I tracked a few of them via SEC filings, it looks like most issues wound up spread among an average of 15 holders. That seems a little unwieldy to me but everybody has got to be well-motivated and they should be able to work something out.

As these grossly exagerated and multiply hedged positions are unwound, values will revert to reality very rapidly. The agile will reap large rewards: the slow and clumsy will incurr crushing losses.

Meanwhile, Tom Brown (at bankstocks.com) has likened Moody's to a referee that throws out the rule book. He uses basketball, I like soccer: the referee (Moody's), comes up behind the player (MBIA), trips him up, then shows him a yellow card. MBIA, noting that the rules no longer apply, will no longer play by them. Maybe it was a red card and MBIA is no longer in the game - if so, they will take their ball (capital) and go home. They will act in their shareholder's best interests and spend the capital in excess of double A requirements to buy back their shares at a fraction of their intrinsic value. This will not be hard to do as the short-sellers are shovelling them out as fast as they can borrow them. Moody's calls this "capital extraction," at least when MBIA does it. I call it justice for shareholders.

Ambac and MBIA, if you think about it, have been hedging their stress case hypothetical losses with a combinaton of cash and investment grade securities, at a 1.3 X level. There is no need for them to be particularly agile as the cash and investment grade securities are stable in value. The magnitude of the actual losses wil become clearer each month, and they can unwind at any time the other players want to and it will be to their advantage. The other hedgers have problems: the mis-priced bonds, the mis-priced CDS, the mis-priced shares of Ambac and MBIA, the ABX index, the overstated mark to market losses - the whole mess will unwind in chaos, and somebody will be slow, clumsy, or just unlucky, trampled as the herd panics and runs for the exits.

I am long the shares of Ambac and MBIA, and neither position is hedged. .