Saturday, February 2, 2008

A bond insurer bailout is likely to put policyholders interests ahead of shareholders

During Markel Corporation’s recent conference call, Tom Gayner , Chief Investment Officer, explained why Markel had sold off their positions in the mono-line insurer/financial guarantors, Ambac and MBIA.

“In the financial guarantee companies (our portfolio position) is zero. There is too broad a case of dispersions and risk and reward and things that can happen that are way beyond just what you can analyze with numbers. I mean there's political issues involved that are well beyond our circle of competence. That is a battle we're going to sidestep.”(Tom Gayner 4Q 2008 Markel Corporation conference call)

Gayner’s comment on the “political issues” would likely refer to Insurance regulators interest in protecting muni-bond policyholders and ensuring the smooth running of the capital markets for municipal bonds. These political considerations are likely to come before the interests of financial guarantor shareholders.

The man charged with saving the day is Eric Dinallo, NY Insurance Commissioner. Dinallo has already moved to raise insurance capacity in the municipal bond market by inviting Berkshire Hathaway to insure municipal bonds for New York.

Dinallo has also discussed capital raising initiatives with major banks. According to a FT article Jan 28 2008, Dinallo convened with the major banks and told them that $15 billion would be needed to fix the bond insurers and protect their ratings. Various measures discussed included extending credit lines and capital raising initiatives to strengthen their balance sheets.

Dinallo’s current focus is on organizing a bailout of Ambac. As well as capital raising initiatives, a reinsurance plan has also been discussed, according to a recent Bloomberg report. Under this arrangement banks and brokerages, would offer to reinsure losses Ambac suffers on bonds and securities over an agreed upon limit in return for a fee. Any such reinsurance arrangement would involve a number of considerations such as ensuring financial institutions are not reinsuring their own exposures, calculating what the reinsurance loss provisions will be for each bank or brokerage and deteriming how much Ambac will have to pay for any reinsurance.

Bill Ackman, ardent critic of MBIA and Ambac , who is shorting the stock of both companies, believes regulators must act now if they want to protect policy holders. Ackman explained why he is still short MBIA and Ambac in a recent WSJ article

"The reason why we're still short the holding companies of MBIA and Ambac is because we believe the regulators and the banks are working to help policyholders, and not holding-company shareholders," (“Bond Insurer foe soldiers on” Feb 2 2008)

Ackman also mentions in this WSJ article that Banks, who have billions in off-balance sheet investments in CDOs and subprime mortgage securities that are insured by Ambac and MBIA, would see an arbitrage opportunity in helping the ailing bond insurers keep their triple A ratings. According to some estimates up to $70 billion of subprime investments would be written down by investment banks and others if the bond insurers failed. Paying the $15 billion price tag as suggested by Dinallo would be a small price to pay to protect the value of these securities.

Ackman is supportive of a plan to protect muni-bond holders but says” if the bailout is a mechanism for banks to continue to hide losses off balance sheet, then we think it's very bad for the capital markets." (“Bond Insurer foe soldiers on” Feb 2 2008)

What form the eventual bailout of Ambac or potential capital infusions for MBIA will take remains an open question , however this is a precarious time for financial guarantor shareholders. Political considerations such as protecting policy holders as well as ensuring the solvency of insurers are likely to dominate the thinking of Insurance regulators who are intent on stabilising the municipal bond markets.

Disclosure: I own shares in Markel Corp(MKL) and Berkshire Hathaway (BRKB) but no other positions in any securities discussed.

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