Thursday, January 24, 2008
Financial guranty industry bail-out
regulators and Wall Street view the industry as too critical to fail, hurdles likely remain in hammering out a deal. • Scenario 1: reinsurance. We believe that reinsurance would be the most palatable form of capital relief for the bond insurers as well as any investment bank providing the capital. Reinsurance would clearly weigh on earnings until the reinsurance capacity was no longer needed. However, current shareholders would benefit from no permanent dilution to book value (as would be the case with a straight equity raise). We also believe reinsurance would be favored by the investment banks, which are unlikely to want direct investment exposure to some of the more riskier assets insured, such as HELOCs/Closed-End Seconds, Subprime RMBS, or CDOs. Through reinsurance, the banks could target the credits that they feel most comfortable with while freeing up capital to the bond insurers at the same time. What would be left at the monolines, however, is a much riskier book of business. That riskier revenue stream could impair the companies' ability to win back confidence among bond issuers and investors. • Scenario 2: direct capital injection. While regulators may favor the more permanent nature of a straight equity raise for the bond insurers, we believe a direct capital infusion is not the most likely scenario. We would expect any Wall Street bank participating in a bailout could balk at a direct investment, which would increase their risk exposure to the bond insurers' at risk credits. Shareholders are likely to oppose a directed investment as well, as it would prove to be significantly dilutive to tangible equity. Agreement over pricing of an equity offering could also serve as a stumbling block. • Scenario 3: surplus notes. A surplus note offerings, similar to the one recently conducted by MBIA, would be a feasible solution as part of a larger capital plan. We believe it is unlikely that the bond insurers would favor capital relief entirely in the form of surplus notes, given the high cost of the debt that MBIA paid to get their deal off the ground. We note that MBIA's deal had an initial yield of 14% but has subsequently traded to a yield of over 20%. While the yield on a surplus note that was part of an orchestrated capital plan may be priced tighter than the MBIA deal, we believe the pricing disagreements between the insurers and the banks providing the capital would keep surplus notes as only a small portion of a larger solution.