First, it is expected that Justice Bransten will issue her opinions on motions for summary judgment on Countrywide's primary and BAC's successor liability with respect to MBIA's insurance fraud and mbs putback (fraud) case within the next two months. While any settlement of this action also involves the commutation of commercial mbs cds that MBIA wrote in favor of BAC, this is still a two-party negotiation.
What makes this a three-party negotiation is the presence of the BAC Article 77 hearing seeking judicial approval of the reasonableness of BNYM's (Trustee) $8.5 billion settlement of mbs putback claims against BAC on behalf of institutional investors, which is not expected to commence until after Justice Bransten has issued her decisions on summary judgment.
For reasons discussed in Linsanity and the Bank of America Article 77 Settlement Valuation Experts, an adverse decision on BAC's successor liability would be the second of two unfavorable legal precedents for BAC (the first being causation) that has occurred during the interval between the date the Trustee entered into the settlement agreement and any actual performance of the transactions contemplated by that settlement. The actual Trustee release of claims against BAC and $8.5 billion payment by BAC are expressly conditioned in the settlement agreement on court approval of these transactions in the Article 77.
The reasonableness of the $8.5 billion settlement with institutional investors is premised on, among other things, the absence of BAC's successor liability. So a settlement by BAC of MBIA's fraud litigation would serve double-duty by not only eliminating MBIA's approximate $5 billion fraud claim, but also by increasing the likelihood that BAC would gain Article 77 approval of its $8.5 billion settlement with institutional investors. See Bank of America Successor Liability, the Article 77 Case, and Settlement Game Theory.
Second, as MBIA recently disclosed in its annual report, MBIA doesn't expect MBIA Insurance, its securitization guaranty subsidiary, to have sufficient liquidity to remain a going concern for the entirety of 2013, absent a settlement of MBIA's fraud litigation against BAC. If MBIA Insurance cannot pay its claims because of a liquidity shortage, the New York Department of Financial Services (NYDFS) will place MBIA Insurance in rehabilitation (equivalent to a bankruptcy proceeding, but conducted under New York state insurance law and supervised by the NYDFS). MBIA expects the fraud litigation settlement to occur before any rehabilitation proceeding for MBIA Insurance commences because it is in the financial interest of both MBIA and BAC to reach such settlement prior to any rehabilitation. Both MBIA and BAC would suffer an adverse economic result, as discussed below, if a rehabilitation proceeding for MBIA Insurance commences as compared to their settlement outcomes prior to any rehabilitation.
The presence of the NYDFS makes this a second three-party game of strategic negotiation. The timing of any rehabilitation proceeding involving MBIA Insurance is entirely within the discretion of NYDFS as insurance regulator. As well, the conduct of any such rehabilitation proceeding, such as whether (i) BAC's cds claims (which are not regulated by NYDFS) against MBIA Insurance will be subordinated to MBIA's outstanding insurance policies (which are regulated by NYDFS), and (ii) MBIA's fraud case against BAC, continued by MBIA Insurance in rehabilitation and under NYDFS supervision, will be pursued through trial and appeal or will be settled earlier, is all up to NYDFS acting within its broad grant of statutory discretion.
Because the effect of MBIA Insurance's potential rehabilitation transforms the BAC/MBIA settlement negotiation into another three party game that involves NYDFS, it is time for NYDFS's chief Lawsky to step up to the table and do his job to prevent an easily avoidable insurance rehabilitation. Any rehabilitation proceeding will create easily avoided losses not only for BAC and MBIA, but also for the New York insurance market and insurance policy holders. As an insurance regulator, Mr. Lawsky should have a keen interest in making sure that an easily-avoided rehabilitation does not occur so as to inflict potential losses on MBIA Insurance policy holders.
An analysis of possible pre- and post-MBIA Insurance rehabilitation settlement outcome scenarios for BAC and MBIA, and a possible game-plan for Mr. Lawsky to pursue, follows after the jump.
In order to see how NYDFS's Lawsky might play a gains-enhancing third party role in the BAC/MBIA settlement negotiation and preserve the integrity of the New York insurance market, let's first see how the two-party game between BAC and MBIA might play out in terms of anticipating settlement outcomes in the alternative cases of settlement before and after a rehabilitation proceeding involving MBIA Insurance.
Scenario 1. The settlement prior to MBIA Insurance rehabilitation case.
Let's assume hypothetically that BAC wants to receive $1.3 billion (BAC's carrying value) for commutation of its cmbs cds written by MBIA Insurance. Let's also assume that the market chatter is correct, that MBIA Insurance has been paying about 15 cents on the dollar of par cds coverage for its prior dozen or so commutations of cds coverage with BAC's prior co-defendants in the recently-decided Article 78 action. This translates into an MBIA bid to commute BAC's cds for a payment of $900 million.
Let's also assume hypothetically that MBIA wants to receive $3.5 billion in settlement of its fraud action against BAC, which is an approximate $1 billion discount to the current value MBIA would receive if it prevailed in its claims through appeal. If MBIA obtains $3.5 billion and pays out $900 million in commutation payment, MBIA receives a net payment from BAC of $2.6 billion. This permits MBIA Insurance to repay the $1.5 billion secured loan received from MBIA Insurance's sister subsidiary, National Finance (National's secured loan), leaving $1.1 billion net proceeds to enhance the residual value of MBIA Insurance.
Let's also assume hypothetically that BAC is willing to pay $2.8 billion in settlement of the MBIA fraud action, which after netting against the $1.3 billion it wants in commutation, leaves MBIA $1.5 billion net, only just enough to repay the National secured loan without additionally enhancing MBIA's residual value.
So, at the end of the day in the case of settlement prior to MBIA Insurance rehabilitation, MBIA is seeking a net receipt payoff from BAC of $2.6 billion, while BAC is seeking a net payment payoff of $1.5 billion. This translates into a $1.1 billion delta that needs to be bridged through settlement.
While BAC and MBIA negotiate to bridge this settlement delta, rehabilitation day for MBIA Insurance approaches with adverse consequences for both BAC and MBIA.
Scenario 2. The settlement after MBIA Insurance rehabilitation case.
Let's assume hypothetically that if MBIA Insurance is placed into rehabilitation by NYDFS, BAC's cmbs cds are classified as class 6 claims, subordinated to outstanding MBIA insurance policies regulated by the NYDFS, which are classified as class 2 claims. See Are Bank of America's CMBS CDS Insurance Policies? for the legal argument why subordination of cds claims can be expected, as well as this recent post from MKM Partners' insurance analyst Harry Fong Is BAC's back up against the wall? with respect to the possibility of massive dilution of BAC's cds claims by other cds holders (analyzing the ability of cds counterparties to assert market value impairments in the event of rehabilitation) (This assertion by cds couterparties of market value impairment, which would be much greater than credit risk impairment, depends upon the enforceability of ipso facto clauses contained in the cds documentation, as well as their interpretation under Section 560 of the federal bankruptcy code, which is beyond the scope of this blogpost. For general legal discussion of cds claims in bankruptcy, see Credit Derivatives and Bankruptcy).
While it is pure speculation to consider what BAC's recovery on subordinated cds claims in rehabilitation would be, there is every reason to assume that it would be zero, especially since the National secured loan ranks senior to BAC's unsecured subordinated cds claims. So in the MBIA Insurance rehabilitation case, BAC stands to lose between $.9 billion-$1.3 billion in respect of its cmbs cds recovery, when compared to scenario 1.
Let's assume hypothetically also that if MBIA Insurance is placed into rehabilitation by NYDFS, MBIA's recovery on its fraud litigation will be reduced, as NYDFS has no financial incentive to seek the largest recovery possible against BAC, which would redound to the benefit of MBIA's shareholders, but simply enough to pay off the National secured loan (which enhances creditworthiness for National to pay its municipal financial guaranty claims) and MBIA Insurance's regulated insurance policies. So let's assume that MBIA's fraud recovery will be limited such that MBIA Insurance will be able to pay off the $1.5 billion National secured loan, but result in no additional proceeds to enhance the residual value of MBIA Insurance.
So in the MBIA Insurance rehabilitation case, MBIA stands to lose $1.1 billion compared to its best case before rehabilitation under scenario 1.
3. Splitting up the surplus achieved by settling prior to rehabilitation, and NYDFS Lawsky's role
Assuming that the above scenarios bear some resemblance to the settlement negotiation reality as understood by BAC and MBIA, we can readily see that both BAC and MBIA do better by settling before the commencement of a MBIA Insurance rehabilitation. BAC does better by as much as $1.3 billion (the amount BAC is seeking with respect to commutation of its cmbs cds), while MBIA does better by as much as $1.1 billion (the amount that MBIA is seeking in settlement to increase MBIA Insurance's residual value).
So, we can anticipate that both BAC and MBIA believe that scenario 1 provides a surplus recovery for them as compared to scenario 2. We might also anticipate that they disagree as how to split this surplus between them.
One can see how during settlement negotiations, BAC might say to MBIA: "You should pay us (all of) (most of) that $1.1 billion surplus that accrues to you in scenario 1 over scenario 2, since you don't get to scenario 1 without our agreement to settle!"
One can see also how during settlement negotiations, MBIA might say to BAC: "You should pay us (all of) (most of) that $1.3 billion surplus that accrues to you in scenario 1 over scenario 2, since you don't get to scenario 1 without our agreement to settle!"
And so, Mr. Lawsky can play the role of referee in this settlement game of chicken by inserting himself not only as a neutral observer (at least certainly more neutral now that Justice Kapnick has ruled in NYDFS's favor in the Article 78 case, notwithstanding BAC's decision to appeal), but also as what a commercial mediator might call an "equal-opportunity head-knocker".
As an equal-opportunity head-knocker, Mr. Lawsky can tell: (i) BAC, out of earshot of MBIA, that BAC can certainly expect in a rehabilitation case that NYDFS will supervise that its cmbs cds will be subordinated to the conventional insurance policies, and that BAC can expect NYDFS to continue the prosecution of MBIA's fraud case against BAC until the bitter end, as every dollar BAC pays is another dollar of potential recovery for a regulated insurance policy holder; and (ii) MBIA, out of earshot of BAC, that MBIA can certainly expect in a rehabilitation case that NYDFS will supervise that NYDFS will settle MBIA's fraud case against BAC for the minimum amount necessary to make sure that regulated insurance policies are paid, without any concern for producing any residual value to MBIA Insurance.
NYDFS has a role to play in seeking to avoid the unnecessary commencement of a rehabilitation proceeding involving MBIA Insurance, and if BAC and MBIA can't agree on a division of the surplus between them that results from a settlement before rehabilitation, Mr. Lawsky should certainly intervene in furtherance of NYDFS's regulatory mandate to preserve the integrity of the New York insurance market. Plus, it can be rather pleasant to act as an equal-opportunity head-knocker.
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.