Bond Insurers Step Up Efforts To Cancel Insurance Deals
June 23, 2008: 03:59 PM EST
CHICAGO -(Dow Jones)- As bond insurers' financial condition deteriorates, they and their bank clients are facing some ugly choices. Often, it's a choice between bad and worse.
One such option some bond insurers are seeking is to try to renegotiate some of the contracts that have gotten them in trouble. These contracts, called credit default swaps, obligate the insurers to guarantee payments on collateralized debt obligations. They are some of the worst exposures that bond insurers face.
Security Capital Assurance Ltd. (SCA) and Financial Guaranty Insurance Corp., or FGIC, are already seeking to commute, or cancel, their exposures to these contracts. After big credit ratings cuts last week, MBIA Inc. (MBI) and Ambac Financial Group Inc. (ABK) have also explored such commutations, according to a Monday report in the Financial Times. All told, the bond insurers are said to be exploring commutations on $125 billion of insurance policies they wrote in the form of credit default swaps.
A commutation would mean that the investment-bank counterparty to the contract would release the insurer from having to make guarantee payments on these risky securities.
This outcome potentially carries as much risk for both parties as just holding on to the contract.
For investment banks, the benefit is getting a payment from bond insurers, some of which may eventually face insolvency and be unable to pay anything on securities that default. But the risk for investment banks means bringing the CDO's risk onto its own books - possibly leading to more unwelcome write-downs if the securities continue to decline in value.
For bond insurers, commuting its guarantees could mean getting out from under obligations to make such high payments on a defaulting CDO that the insurer could go into insolvency. The risk, though, is that the insurers will find it harder to drum up business in the future, having demonstrated their guarantees to be unreliable.
Banks are likely to drive a hard bargain with bond insurers, if they consider commutation at all, said David Veno, an analyst with Standard & Poor's. "No one is going to do this to be a good citizen."
Up to now, bond insurers have gotten nowhere in their efforts to get banks to renegotiate credit default swap contracts that guarantee payments on exotic securities called collateralized debt obligations.
"The banks don't want to do it as they are all hurting for capital and their funding costs are way up," said Janet Tavakoli, president of Tavakoli Structured Finance Inc. If banks release bond insurers from their financial guarantee contracts, the investment banks will have to account for the securities on their own books, and set aside reserves for potential losses.
But the argument to cancel some deals may be more compelling as the bond insurers considered to be the strongest and best-capitalized see their credit ratings plunge, too, which makes the overall situation more stark.
Tavakoli said rising defaults in securities that were packaged as investment- grade debt could give bond insurers an argument that investment banks mislabeled the deals.
"I would only fork over the amount of capital they would have reserved against" a triple-A rated deal as a cancellation fee, said Tavakoli of a potential bond insurer offer.
Investment banks, for their part, might be more willing to consider commutation now, particularly as some of the smaller insurers have been downgraded into junk status.
Security Capital, which first lost its triple-A rating in December and is now rated B2, or junk, by Moody's Investors Service, said in May that it had organized key members of its bank counterparties to its derivatives deals to " explore the potential for us to commute, restructure, or settle certain of our guarantees," President and Chief Executive Paul S. Giordano said during an investor conference call in May.
Security Capital recently lost a key battle in a dispute with Merrill Lynch & Co. (MER) over Security Capital's attempted cancellation of seven contracts, with a face value of $3.1 billion, and a spokesman said Monday the company was still evaluating whether it would appeal.
Merrill changed how it accounts for the disputed contracts and now counts them as securities it will hold to maturity, which allows it to avoid taking market- value write-downs as value fluctuates.
FGIC is suing IKB Deutsche Industriebank (IKB.XE) of Dusseldorf, Germany, to cancel credit default swap contracts that expose FGIC to potential liabilities of $1.875 billion. Moody's cut FGIC to B1 on Friday.
ACA Capital Holdings Inc. (ACAH), which is currently in forbearance on obligations to post collateral for some of its deals, said in May that it had closed out three credit swap policies for a payment of $28.4 million, which included $9.5 million for losses incurred, $18.3 million in return of unearned premiums and the rest as a reduction of interest income. ACA didn't give other details about the cancelled deals.
After Moody's Investors Services cut its rating to A2 from triple-A last week, MBIA said it will require a total of $7.4 billion in new payments related to the downgrade: $2.9 billion for termination payments and $4.5 billion in collateral under its guaranteed investment contracts or GICs. The GICs are part of MBIA's asset-liability management business, which is separate from its troubled derivatives business. A spokeswoman Monday said she couldn't address the issue of whether MBIA is discussing commutation with its counterparties.
MBIA said it has capital on hand or in liquid investments to post the necessary collateral, but the payments could restrict MBIA's capital flexibility.
Ambac, which has a smaller GICs portfolio, said its downgrade, to double-A from triple-A, won't have a material effect on the amount of capital it will have to put up as collateral. An estimate by CreditSights Inc. put the amount Ambac will have to post as a result of its downgrade at $556 million. An Ambac spokeswoman didn't return a phone call asking for comment.
But even if the insurers do cancel some deals and free up capital, that doesn't necessarily win them an upgrade, said Standard & Poor's Veno. "We are putting weight into other things such as damage to reputation and damage to franchise," he said. "Will investors accept a financial guarantee from a bond insurer that is tainted?"
MBIA recently traded down 12.3% to $4.90, Ambac traded down 6.3% to $1.91, and Security Capital traded down $9.5% to 38 cents.
-By Lavonne Kuykendall, Dow Jones Newswires; 312-750-4141; lavonne.kuykendall@ dowjones.com
(Jed Horowitz contributed to this report.)
(END) Dow Jones Newswires
06-23-08 1559ET
Copyright (c) 2008 Dow Jones & Company, Inc.
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