Almost unnoticed this week was the demise of Ambac’s non-municipal monoline bond business. In the fourth quarter of 2008, though, the monoline bond insurers’ commitments to MBS, CDOs and all sorts of other high-falutin financial instruments was one of the principal systemic-risk drivers that precipitated TARP and other government-market interventions. Does the fact that this huge business now could go bust without a blip on the systemic-risk radar mean that there doesn’t need to be any resolution framework for non-banks? We don’t think so – Ambac got to go bye-bye without wreaking market havoc only because of all the supports – many of them flat-out bail-outs – that went before. And, given all this support, the insurance regulator got almost two years to think about what to do with Ambac. Thus, Ambac is a poster child for all that went wrong before, not an example on which policy now should be based. First, some facts, Ambac is a monoline bond insurer. Like MBIA – another basket case – it once upon a time principally provided its insurance – regulated by the states – for municipal bonds. This was a tidy business, but not a big earner. So, as the financial boom accelerated, these firms succumbed to temptation and attached their vaunted AAAs to a wide array of complex securitizations they didn’t fully understand. When the market collapsed, they had far more risk to honor than they could ever afford to pay, contributing in no small way to the systemic crisis in private-label MBS. At the height of the crisis, the monoline bond insurers went desperately to Treasury in hopes of a bail-out. Treasury said no, but used its $700 billion in TARP authority, as well as the conservatorship of the GSEs, to absorb the indirect cost of the bond insurer’s collapse. The insurers were left hanging, but their customers were so insulated from any loss that this didn’t matter. This gave MBIA and Ambac the intervening year in which they and their state regulators sought ways to restructure themselves so that municipal claims – Treasury’s critical concern – could be paid without another bout of systemic risk in the MBS arena.
State insurers permitted the most troubled of the monoline bond insurers to restructure into “oldco/newco” firms – that is, the muni-bond business became a new company backed by whatever capital was left in the insurer and the non-traditional claims were relegated to the oldco, where hope was about all that was left.
Unsurprisingly, litigation is pending on these restructurings, which puts the screws hard to all of the firms that invested based on the bond insurers’ AAA. Even as some sued, though, many counterparties have simply written off risk backed by the bond insurers, meaning that the insurers’ failure now has far less contagion effect. Thus, with regulators’ blessing, the restructuring bought the firms some time and the financial system some peace.
Not, though, enough. This week, the Wisconsin insurance regulator for Ambac seized $64 billion in risky insurance to permit an orderly liquidation, instead of what he feared would be a mad scramble for coverage. Now, MBS investors will get about 25 cents on the dollar for claims, with the excess – expected to be lots – converted to “surplus notes” with which investors can, we think, paper their bedrooms.
Now, to the systemic-risk policy impact of the Ambac case. In one sense, it proves that regulators can handle complex insurers under current law without the resolution authority in the pending legislation. This might lead one to assume that AIG could have been handled like Ambac – that is, regulators would have hived the CDS into an oldco and put the traditional insurance business into a newco to go merrily on its way. This scenario, though, is hindsight at its clearest.
In our view, there was simply no way to treat AIG like Ambac. First, the size difference is orders of magnitude, meaning that the complexity of a market-driven regulatory resolution like Ambac’s was far more difficult, especially taking into account not just AIG’s size, but also all of its cross-border exposure. And, then, there’s the time factor. Perhaps with lots of time, all of AIG’s complexities could have been addressed and AIG could have been liquidated like Ambac. But, of course, there wasn’t anytime because regulators didn’t expect AIG’s collapse and had no process ready to ensure an orderly liquidation.
That’s just what the pending legislation aims to do. Ambac shows why the bill is necessary – it demonstrates that, with forethought, even systemic situations can be liquidated at cost to shareholders, creditors and counterparties. AIG might have been similarly resolved if the agencies had seen it coming and had orderly liquidation tools in hand, but they didn’t then and can’t be counted on to do so in the future absent the proposed statutory directives. The resolution regime is designed to buy that time and, even more importantly, make regulators and firms think ahead of the crisis what to do should one occur.
On a side note, Ambac’s case is important not only in the systemic-risk context, but also in the debate over credit default swaps. The insurance-regulator’s seizure isn’t technically a default, although Ambac said it is now considering a pre-packaged bankruptcy. Of course, whatever the legalities of what happened, holders of Ambac-backed MBS aren’t going to get paid as anticipated. If this is a “default,” then CDS must be honored; if it isn’t, they don’t. Who decides? A trade association. Stay tuned.