I have discussed a mail the keys to Securitization Sub scenario here, whereby MBIA can substantially improve its negotiating position, and substantially worsen Bank of America's (BAC) negotiating position, with regard to settling their fraud and Article 78 litigation by threatening to invite the New York Department of Financial Services (NYDFS) to take over Securitization Sub and place it into rehabilitation.
The only event that now needs to take place before MBIA can embark on the mail the keys scenario is for Justice Kapnick to render her decision in the Article 78 proceeding brought by BAC, and for that decision to be adverse to BAC.
Or does Justice Kapnick even have to announce her decision before MBIA mails the keys, after all?
We already know that MBIA and BAC each expect Justice Kapnick to render the Article 78 decision in favor of MBIA and NYDFS. BAC was willing to buy $170 million of MBIA notes at a 20% premium to their trading value to frustrate the MBIA consent solicitation. Would BAC do this if it believed it would win the Article 78? Likewise, MBIA just spent $170 million in repurchasing these notes at a premium after it first received consents from the sellers. Would MBIA do this if it thought it would lose the Article 78?
(As a side note, given the litigiousness of BAC, one might expect BAC will bring some action claiming that MBIA either conducted an illegal tender offer, or made material misrepresentations in its consent solicitation materials (BAC might need to round up a noteholder to assert these claims, as it is not clear how BAC has standing to assert these claims). Any such action is going to fail, as MBIA was dealing with institutional investors and knew where the bonds were. It did not need to conduct a tender offer to find the bonds, and the noteholders knew how to protect themselves when they read in the consent solicitation materials that MBIA might buy bonds during the pendency of the solicitation.)
(As another side note, shame on BAC for faulty due diligence. Why wasn't BAC aware, before MBIA announced its consent solicitation, that it could put the squeeze on MBIA if it had bought up half of the 5.7% notes before hand. BAC's whole litigation strategy has been to delay the litigation long enough to push MBIA into a liquidity squeeze in order to obtain a favorable settlement. Buying a blocking position of the 5.7% notes should have been the first thing they did in pursuing this strategy. Well, this is the same BAC that thought it had done careful due diligence in connection with the Countrywide acquisition.)
So, how can one expect BAC and MBIA to view their settlement positions post-consent solicitation? First, one can posit that the reason that no settlement has been reached to date is because MBIA wants too much (in BAC's view) to settle its fraud action against BAC, and BAC wants too much (in MBIA's view) to commute (or collateralize) its cmbs credit default swaps (cds) that MBIA issued to BAC.
How would a rehabilitation of Securitization Sub affect this settlement dynamic, given that MBIA has successfully completed its consent solicitation and both parties expect the Article 78 action to be decided adverse to BAC?
BAC indicates in its latest 10Q that it carries cmbs cds from a monoline counterparty at $1.35 billion; let's assume this refers to the MBIA cds. BAC is likely seeking at least this amount in a settlement with MBIA, in order to avoid recognizing a loss.
These cmbs cds are derivative contracts, not financial guaranty insurance policies. While cds accomplish the same objective as financial guaranty insurance, they are not treated as insurance policies for insurance regulatory purposes, and there is every reason to believe that the NYDFS will treat the cds as unsecured general claims of Securitization Sub in any rehabilitation. NYDFS has much discretion in setting up a repayment plan for obligations of Securitization Sub in rehabilitation, and there is no reason to believe that it would place mere derivative contracts at the same repayment priority as insurance policies, especially with respect to a derivative holder such as BAC, which has been litigating against NYDFS for the past 4 years in the Article 78.
MBIA's municipal finance sub (National) has provided a $1.6 billion secured loan to Securitization Sub, principally to finance cmbs cds commutations with parties other than BAC. If NYDFS subordinates BAC's cds in a Securitization Sub rehabilitation, as one would expect, National's secured loan should be ranked senior to BAC's cds, and National's loan would receive payment in full prior to any payment to BAC in respect of the cds. Remember, NYDFS specifically approved the secured loan from National to Securitization Sub, and NYDFS wants a financially secure National to emerge from any rehabilitation of Securitization Sub; indeed, this was NYDFS's reasoning in approving MBIA's transformation that is the subject of the Article 78.
So if MBIA mails the keys of Securitization Sub to NYDFS (especially after Justice Kapnick announces her decision), MBIA will have effectively crushed BAC's expectation that it would receive its carrying value of $1.35 billion dollars, and BAC would be hard-pressed to avoid recognizing a writedown on its carrying value of the cds. BAC would be holding subordinated cds from an insurance company in rehabilitation that are junior to a $1.6 billion secured loan to MBIA and BAC would have no recourse to National once, as expected, Justice Kapnick renders an adverse decision in the Article 78.
Does MBIA give up any upside by mailing the keys to Securitization Sub to NYDFS? It is hard to see how. Securitization Sub's sole business purpose at this point is to obtain maximum recovery on its fraud suits, principally against BAC, but also against other mbs issuers. NYDFS as rehabilitator has the same incentive to maximize the litigation recovery, and the management of the litigation is essentially on cruise control, and something that NYDFS is more than able direct to the extent it needs to. So, MBIA would find a willing and accomplished surrogate in NYDFS with respect to the maximization of litigation recoveries. Indeed, since NYDFS will likely slow or no pay Securitization Sub's obligations while in rehabilitation, Securitization Sub will have greater ability to see the litigation through to the end while in rehabilitation than not.
Remember, MBIA will likely view repayment of National's $1.6 billion without any additional residual recovery from Securitization Sub to be a very successful result. Financial commentators have expressed the view that National's value (assuming such loan repayment) is over $20/share to MBIA shareholders.
Perversely, once Securitization Sub is in rehabilitation, the only way BAC can maximize its recovery in respect of its subordinated cds is to lose the case and suffer as large a damage award as possible in the MBIA fraud action against it. So, BAC has now exposed itself to a strategy whose logic is not just perverse, but self-defeating. I wonder what the board of directors of BAC is thinking of when they consider this?
Does MBIA need to wait for Justice Kapnick's decision to mail Securitization Sub's keys to NYDFS? Hard to see why. Justice Kapnick's decision rests on whether NYDFS was arbitrary and capricious in approving MBIA's transformation in 2008-9. No facts happening after that determination is relevant to Judge Kapnick's analysis.
NB: this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice. Investing is a tough game, and everyone must do and own their own work, because you will certainly own your investments.
Disclosure: long MBI. Follow me on twitter.