Thursday, December 20, 2007

Monolines-End of the Line?

"The forest issues is simple: a business ... that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place. ... Here we have instead an industry that would go bankrupt as soon as its AAA rating is lost: by definition this is not an industry that can deserve a AAA rating. ... There is a fundamental and conceptual flaw in a business model that is conditional on a AAA rating and that is a business that insures assets and firms that do not have a AAA rating. This is analogue to the voodoo finance of taking subprime and BBB mortgage backed securities and turning them into AAA by the black magic of CDO tranching. ... [M]onoliners collectively insure $3,300 bn of principal and interest ... with only a $22 bn capital base. ... But these risks cannot be an excuse for not admitting that the monoliners don't deserve an AAA rating. ... So enough of wasting time on dissecting the assets and liabilities and capital of individual monoliners; their business model is conceptually flawed in the first place; and their actual business practices have been even more flawed as they have now insured for years toxic RMBS, CDOs, CDOS of CDOs and in some cases even holding these assets on their portfolios such an AAA rating does not make any sense. ... But the current charade ... is another example of rating agencies supporting a rotten business model. ... So it is time to stop this charade of rating forebearance and admit that the emporer has no clothes: a business model that cannot survive without an AAA rating is conceptually a business model that cannot deserve under any circumstance an AAA rating; period! Arguing otherwise is believing in voodoo black magic", Nouriel Roubini (NR) at, 20 December.

"My contention is that the entire US financial engineering contraption is being dissolved, a crumbling pile of wreckage, with evidence of fraud throughout the structure. It is an historically unprecendented failure in innovation, a reckless extension to develop the inflation-based system", Jim Willie (JW) at, 20 December.

"It is unclear how much capital it would take to shore up ACA. Another solution the banks are discussing would relieve ACA of having to post collateral against its insurance contracts if the company is downgraded. ... Investment banks, hedge funds and insurance companies often use credit default swaps to bet on or against bonds without trading the underlying securities. ... At the heart of many insurance contracts issued by the company is a popular transaction known as the negative basis trade. For example, a bank holding a bond that paid interest at 0.50 percentage point over [LIBOR] would pay ACA 0.30 percentage point to insure it, pocketing the 0.20 point difference for the life of the contract. Accounting rules allow the banks to book that entire amount as income when the contracts are written ... 'It's a zero-sum game', [Sean Egan at Egan-Jones] said, noting that the gains at the investment banks buying the protection have to eventually result in losses for the firms they hedged with, 'If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades'," Vikas Bajaj and Gretchen Morgenstern at the NYT, 19 December.

Way to go NR! Right on! Welcome back! I have said in the same words, the monolines business model made no sense since late 2002 when I learned of them! The "emporer has no clothes". What don't the rating agencies understand? The monolines should never have existed! I agree, JW, this may be this round of financial innovation's end. Yes, this a zero-sum game.

From 1988 to 2005 I was a member of a Los Angeles financial professionals group which met monthly. We discussed the monolines in one late 2002 meeting and said what NR is saying here, in the same words, concluding their business model made no sense. Our discussion was spurred by a WSJ article in late 2002 about a dispute between MBIA and Gotham Partners (GP). We concluded GP was right: the monolines should not exist. GP shorted MBIA then showed the world its proof, that MBIA should not exist, as Hershliefer suggested, see my 10 December post. That the monolines have survived since 2002 amazes me.

There's more. "The key to MBIA is that the credit-rating agencies--such as [S&P]--give its insurance arm the rare and coveted rating of triple A. ... At MBIA's request, Eliot Spitzer's office launched an investigation of Gotham over possible market manipulation. ... The questions surrounding MBIA are critical ones not just for the millions of investors who own MBIA-guaranteed bonds but also for everyone who wonders whether the watchdogs of our financial system--the analysts, the accountants, and most critically in this case, the credit-rating agencies--can be trusted. ... To believe Ackman is right, you have to believe all these people are wrong. It's almost impossible. Almost. ... Look beneath the surface of this business, though and you find the potential for conflicts of interst. ... On July 17, 2002, he placed a bet against MBIA using credit-default swaps that would pay off in the event of MBIA's bankruptcy. On July 24, he shorted the stock. Then he released his report. ... MBIA's executive are particularly outraged about Ackman's allegations regarding the special-purpose vehicles. ... Ackman and others say it simply defies common sense to say that the SPV debt--which after all is on MBIA's corporate balance sheet ... doesn't belong to it. ... Morgan Stanley analyst Alice Schroeder wrote, ... 'In addition, the rating agencies are an explicit participant in the guarantor's business model and in effect are now in the awkward position of passing judgment on themselves'," my emphasis. Who wrote this? Bethany McLean in Fortune, 2 May 2005, 2.5 years ago! This article is titled, "MBIA-The Mystery of the $890 Billion Insurer", and is at in the May 2005 archive.


AlbertM said...

When you say they have no business model or right to existence, please back up that statement. Bonds have been insured for he past 40 years. Buffett recently applied for a license to insure municipal bonds.

Independent Accountant said...

The monolines had a right to exist, but shouldn't have. My point is: the insurance was economic garbage. Muni bond buyers would have been better off not having the insurance and buying uninsured munis. That Buffett wants to go into this business shows the product is overpriced. He wouldn't want to sell it otherwise. It's a zero-sum game, what the monolines get, the muni bond holders lose. More and more municipalities are foregoing insurance now because they figured out it is overpriced. The monolines business model was simple: selling a public relations story to frightened old people who do not understand expected value. The monolines typically paid out about 30% of their muni bond premiums to claimants. Who needs such insurance? Self-insure.