I've spent a lot of time talking about what I consider Bank of America's risky gamesmanship in its multi-pronged litigation
with the bond insurer MBIA, but it may be that I've
underestimated that risk by focusing on the downside for the
bank in MBIA's breach of contract and fraud suit. Under a
not-implausible scenario, BofA faces serious risk in its
regulatory challenge to MBIA's transformation that's going to
trial on May 14. And ironically, the risk comes not from losing
the case -- but from winning it.
According to a sophisticated and well-advised MBIA
institutional investor that has devoted serious resources to
analyzing the issue -- trust me, even though the investor
doesn't want to broadcast its involvement, this is a seriously
savvy player -- if Bank of America and two French banks succeed
in overturning MBIA's 2009 split into separate muni bond and
structured finance businesses, there's a reasonable likelihood
that BofA could wind up at the back of the line of MBIA
claimants, waiting years for whatever scraps are left over from
payouts to municipal bond insurance policyholders.
Here's why. For all sorts of reasons, bond insurers can't
write policies directly backing credit default swaps, which
often function as bets by one investor on the other party's
failure. Instead, in the economic boom years, monoline parent
companies would create special purpose vehicles to engage in
credit default swap deals. The insurer would then write an
insurance policy backing the special purpose vehicle. The
monoline essentially issued insurance on a product it
technically couldn't insure; the CDS counterparty would end up
with a hedge on its CDS risk. It's widely believed that Bank of
America is the counterparty in more than $1 billion of
MBIA-backed credit default swaps. Indeed, it's part of the bank
group suing MBIA over its restructuring because (according to
many statements over the years by the banks) BofA and its allies
are concerned that MBIA's structured finance spinoff doesn't
have the money to pay what it owes policyholders, including
whatever it owes through these CDS deals.
Let's assume that BofA, Societe Generale, and Natixis are
correct and New York regulators improperly approved the MBIA
restructuring in 2009. (New York State Supreme Court Justice
Barbara Kapnick, who is presiding over the case, has said her
determination will turn on the reasonableness of the state's decision, but the banks insist MBIA's solvency is a crucial part
of the analysis.) Bank counsel Robert Giuffra of Sullivan &
Cromwell said at a recent hearing before Kapnick that if the
banks prevail, MBIA could merely return to the Department of
Financial Services and reapply for restructuring "in open
daylight." But there's a good argument to be made that if
Kapnick undoes the restructuring, DFS Superintendent Benjamin
Lawsky will feel compelled to put MBIA into receivership, the
insurance equivalent of Chapter 11. His overwhelming interest is
in protecting municipal bondholders with MBIA insurance
policies, especially since most of the major structured finance
policyholders have commuted their policies through settlements
in the bank litigation. Lawsky has to make sure that MBIA has
sufficient reserves to back long-lived muni bonds, which argues
for state control of the insurer's limited assets.
So if MBIA enters receivership, what happens to credit
default swap counterparties in deals with MBIA-backed SPVs?
There's no direct precedent to answer that question. No New York
bond insurer has gone into receivership, and when Wisconsin
insurance regulators put Ambac into rehabilitation, they
segregated its structured finance business from its muni bond
business, so the relative ranking of their claims wasn't a
That said, New York regulators have hinted that they will
treat CDS counterparties as "general creditors," rather than
insurance policyholders in a monoline receivership. (Here's a
prescient 2008 Financial Times story raising the issue, written
in connection with the near-failure of the monoline SCA.) The
CDS counterparties, remember, don't have direct policies, but
merely contracts with insured special purposed vehicles. And,
again, it's in the interest of the Department of Financial
Services to be perceived as protecting the ordinary folks who
invest in municipal bonds rather than the financial tightrope
walkers who entered CDS deals.
If the Department decides to classify CDS investors as
general creditors, BofA goes to the back of the line, behind
muni bond investors. Even if the bank challenges the
classification, it could take a half-decade to get to New York's
highest court and win a reversal.
In other words, in the receivership scenario posited by the
MBIA institutional investor, BofA risks walking away with
nothing -- or, at best, waiting years to collect -- if it wins
the Article 78 proceeding.
Granted, the scenario rests on a series of hypotheticals.
But they're reasonable hypotheticals, and the MBIA investor who
explained them to me took careful steps to inform itself. At the
very least, the scenario illustrates the leverage Lawsky will
have over BofA if Kapnick returns MBIA's fate to his department.
Lawsky has made it clear that he wants the banks to resolve
their claims and let MBIA get back to the business of insuring
bonds. It's hard to believe he'll be less inclined to use his
leverage against BofA if he loses the regulatory challenge.
Spokesmen for Bank of America and the three-bank coalition
in the Article 78 case declined comment. I left a request for
comment with a spokesman for the DFS but didn't hear back.
(Reporting by Alison Frankel)
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