Posted by February 16, 2008
This is getting kind of creepy. I actually dreamed I had a conversation with FRBNY President Timothy Geithner. I don’t remember what we actually talked about but I felt like the conversation went OK. The dream freaks me out a little bit but other than that, it seems like a typical Saturday morning. When I eventually get around to opening the weekend edition of the WSJ – always nice to get the paper delivered – I can’t help but notice an article about how the NYS Insurance Commissioner is considering splitting financial guarantor insurance companies in two in a move to “save” the insured municipal bond market. The article really concerns me and it notes that a financial guaranty insurance company, MBIA, just replaced their CEO, and the new CEO stated that he would like to split the company in two. Another financial guarantor, FGIC, has also made the same request. The problem with splitting the insurers into parts, a “good insurer” (the one who only receives premium from underwriting virtuous municipal bonds) and a “bad insurer” (the one who writes, I mean used to write, protection from loss in nasty, subprime CDO tranches) is that there is a good chance that the combined company is already insolvent. The argument is that once “fixed”, the chastened good insurer, having learned valuable lessons, will now behave as an extraordinary corporate citizen and will provide needed credit support to the struggling municipal bond market while yielding appropriate returns on equity. However, it’s likely there isn’t enough capital now for the insurance company to pay all of its existing obligations. Once the capital is allocated appropriately, there would be nothing left for the good insurer. Perhaps the implicit intent of “splitting in two” is for the stockholders of the financial guarantors to benefit if the insurer can easily renege on just a portion of their obligations. This benefit society, how?
I’m usually pretty chill on the weekends and I’ve had years of training / practice in how to detach from work. On this particular Saturday, however, I was legitimately scared by what I read in the morning paper. I was so pissed off that I sent an email out to about 15 people at work including the highest levels of FRNY bank management, just to tell them that New York State should not be inappropriately seizing assets and deciding who wins and who loses without some sort of bankruptcy proceeding. So now it’s official, I am a dork… a dork, who sends work emails out on Saturdays. I included my cell phone number at the bottom of the email in case someone else at the bank was working over the weekend AND they thought I could be helpful. Did I already say, dork?
I did not receive any work cell phone calls, but I checked my email about six hours after I sent it out on Saturday. There was a lengthy reply from someone at the executive office saying they agreed with me and the bank should consider whether or not a response might be appropriate. Needless to say, I was delighted to read the email and maybe happier yet that no one called me over the weekend.
February 19, 2008
Price action in the financial markets is fairly calm on this first day back to work after the long Presidents Day weekend, although Treasury did yields rise about 12 twelve basis points across the curve. The calmness didn’t really find the municipal bond market though, where stress continued unabated.
ARS auctions continue to fail and investors in another major short term structured municipal bond product, known as Variable Rate Demand Notes (VRDNs), are also starting to pull back and request their money bank. The big difference between ARS and VRDNs, however, is that VRDNs have back-up bank credit lines. So, with VRDNs, the risk of funding suddenly out-of-favor borrowers lies with banks (where it belongs), for ARS this risk is with individual investors. To make matters worse, there really are individual retail investors in the muni bond market, classic “mom and pop” investors. Probably very few of this type of investor understood the liquidity risk they assumed when purchasing the ARS. For example, if auctions were to continue to fail, these investments effectively become long term securities. This would upset many investors who thought they were holding short term securities and presumably have a need to get their money back fairly quickly.
February 20, 2008
OK, so the municipal bond market is about as f****d up as it can get characterized by: very little new issuance, high rates relative to Treasury securities, and a panic mindset in the short end of the market. VRDN and ARS rates are all over the place while the number of ARS securities that are experiencing failed auctions continues to increase. The short-term benchmark index, known as the SIFMA Index, reset today at 2.37%, up from 1.24% last week and 1.73% the week prior. So what is fair value for these securities? Who knows?
At the four pm executive briefing today, it was suggested that a major financial guarantor may split in two with an equity infusion. Of course the devil is in the details, but this could be just what I feared. The concept is to isolate the problematic assets, can you say ‘Collateralized Debt Obligation, or CDO’, from the healthy book of business, which is exposure to the municipal bond market. The trouble is, the structured finance policy holders may get screwed in the process because they would no longer have access to the healthy part of the business. If we consider capital to be the loss bearing capacity of the company as it now stands, how will the capital be allocated between the “good” and “bad” financial guaranty insurer? Not sure where new capital comes from either since this looks like a lawsuit waiting to be filed. As if that wasn’t enough…wait, there’s more. Split up a financial guarantor before midnight tonight and see the credit derivative market convulse, absolutely free! Perhaps it’s not surprising that a lot of people wanted protection from these financial guarantors going poof so they bought protection from this event in the Credit Default Swap (CDS) market. Who knows how big that market is, I think it’s in the $ trillions, and the CDS market may soon experience its own nascent crisis of confidence. Would splitting in two, by itself, be a claim event in CDS contracts? Who knows? Nothing like making up the rules of the game as you go.
I spent most of the day talking to investment bankers trying to learn how difficult it might be for municipal entities to refinance out of their ARS liabilities. What a surprise, the consensus was that it won’t be easy. I hope I don’t read in tomorrow’s WSJ that a major financial guarantor insurance company has split in two.
February 21, 2008
The feared headline was not in today’s WSJ but there was a diagram of how such a plan might work. I was happy to see the legal term “fraudulent conveyance” mentioned in the article which gets at that lawsuit reference earlier, so I’m more hopeful now that this plan’s sponsors may back off. I couldn’t help myself and sent another email to the highest levels in the organization on the topic.
I did finish a memo on the current awful state of the ARS market AND I got invited to have lunch with next Monday with a Fed governor. As in one of the Board of Governors. That should be cool. At lunch I’m going to be, like, “Excuse me, governor, would you mind passing the bread?” I also had a conversation after the 4 pm meeting with a Trader Analyst on the Foreign Exchange staff and the head of the Research department. Big picture stuff. Unfortunately there is little on the horizon that looks positive. The only saving grace for me is that I still have a job. It won’t be in management anytime soon, though. I just found out that my posting for a first level manager position on the foreign exchange staff was unsuccessful. Oh and my boss is about to become my bosses’ boss. Great.
February 22, 2008
No remarkable headlines in today’s WSJ and I did not have to make any written contribution to the AM call for a change. Of course, I wasn’t so lucky with the PM call and the Weekly Markets Review product. I also managed to send an email to someone at the Board of Governors (BoG) responding to a question about Variable Rate Demand Notes and another e-mail to the head of FRBNY’s Research department updating prices at different maturities for a credit derivative index.
Not much market news to report today until 3:30 when CNBC reported that AMBAC, a large financial guarantor, is going to announce a recapitalization plan on Monday or Tuesday of next week which cause the DJIA to rally about 150 points – from down 75 to up 75 points in the last half hour of trading. I am keeping my fingers crossed that this plan does not put structured finance policyholders at a disadvantage. Just thinking about it scares me. However it plays out at least I feel I did my part – expressing my concerns to senior management, where it goes from there, who knows?
Just after I finished a draft email on the ARS market around 6 pm, I received an email from an EVP who was forwarding an email he received from the bank’s Chief Counsel. The email wanted to know if auction rate preferred securities were callable. My first reaction was “sure, why wouldn’t they be?”, but trying to play the role of a responsible central banker, I thought it best to run the question by some of my muni contacts to confirm. The first person I spoke to said “What are you doing working at 6:30 in the evening?”, so I asked him the same question. First thing he wants to talk about: it’s not callable securities, it’s the financial guarantor situation. As if I wasn’t scared enough, already. Anyway the contact confirms that these securities should be callable and says he’ll send me a quick email over Bloomberg to confirm. I have shared access to a Bloomberg terminal so that means now I have to log in to Bloomberg. While I’m doing that, my phone rings, it’s someone from the BoG, and what do they want to talk about? ARS, of course. So, while I’m chatting some more about ARS, I casually ask, “Hey, do you know any reason why closed end funds couldn’t call their outstanding ARS?” To which the person says, “ well they can call the securities, of course, but are you really asking about the potential conflict of interest between the fund’s board of directors, who are supposed to represent the fund’s common shareholders, and the fund’s management and sponsors who want to refinance?” (As long as the interest rates remain low on the ARS, they benefit the common shareholders of closed end funds. The fund’s management on the other hand would like to get out of the product BEFORE the fails start, hence the potential conflict). I replied, “ummm, sure that’s what I’m asking, I think”. I was then able to author a pretty detailed response to the General Counsel including a discussion of that conflict of interest that I just learned about. My email would have been totally different if I didn’t get that phone call just then. Am I a player or what 😉 ?
More thoughts about the issue of splitting up the financial guarantors. The de facto “approval” may come from rating agencies: will the “good insurer” be able to retain a “AAA’ rating? At that point, who cares what the “bad insurer” is rated, maybe only the bankruptcy judge when the bad insurer suspends claim payments. At least we have the independent, professional credit rating agencies to protect us, oh wait, there a major reason how we got in this mess in the first place! L The NY State Insurance Superintendent may be primarily focused on making headlines while the financial guaranty companies themselves resemble wounded animals. So, there’s not much expectation for rational behavior from either of those two camps. But at least we have Moody’s, S&P, and Fitch to protect the public. Oh, wait. ☹