With the monoline industry continuing to struggle for survival, albeit with a weak pulse, and the ABS CDO sector almost flatlining, CDO hedge agreements with the monoline industry have been a cause for concern within the structured finance market.
But recent decisions allowing the monolines to deliver up-front payments on CDOs are receiving industrywide praise, and it is believed more of these agreements are in the works.
"We believe it is in the best interest of the CDO market to commute these contracts," said Brian Yelvington, senior macro strategist at CreditSights. "Doing so keeps the monolines out of regulatory seizure, and thus what little protection there is for the structured finance market is still viable."
Indeed, many of these financial institutions have already written down their exposure to the monolines through negative basis trades on super senior tranches of CDOs.
The monolines are not necessarily benefiting from maintaining these agreements either. While the monoline companies are still collecting periodic premiums from these transactions if they keep the deals alive, the premium income they are getting doesn't offset the drag on their balance sheets, said Joel Telpner, partner at Mayer Brown. This is because of the hefty amount of capital reserves that need to be set aside by these insurers for the probability of a default on their guarantees.
Late last month, Merrill Lynch announced that it had agreed to terminate ABS CDO hedges with monoline guarantor XL Capital Assurance (XLCA), now Syncora Guarantee. The hedges with XL will be terminated in exchange for an up-front cash payment to the bank of $500 million. These contracts had a carrying value of approximately $1 billion at June 27, 2008. The bank also said it is in the process of negotiating settlements on certain contracts relating to CDO hedges with MBIA and other lower-rated monolines.
Outlook Is Up
The elimination of the Merrill Lynch ABS CDO transactions, as well as potential commutations with financial counterparties on other ABS CDOs, is "significantly capital accretive from the standpoint of Syncora and a positive for the credit profile," said Fitch Ratings, which changed Syncora's outlook to positive from "evolving" earlier this month. Moody's Investors Service put the monoline on review for a possible upgrade.
An increase in termination agreements is also widely expected. "You will, no doubt, see more of this," Yelvington said. "No structured finance player wants to see a monoline
get seized."
Earlier this month, Citigroup terminated a contract with Ambac Financial that hedged AA Bespoke, a $1.4 billion AA-rated CDO-squared transaction made up primarily of MBS, most of which had been downgraded below investment grade. As part of this agreement, Ambac will pay Citigroup $850 million and record a $150 million positive pretax adjustment.
With these up-front payments, banks can lock in some guaranteed payment loss, perhaps forgoing a large (uncertain) payment from monolines at a later date, said JPMorgan Securities in a recent report.
Indeed, a lump sum paid out to the banks that bought protection on these deals may be more than they would have received if a monoline were to become insolvent.
Many market participants believe that these agreements would not be adhered to if a monoline were seized. Thus, letting the monoline out of its obligations keeps the rest of the system intact by keeping the firms out of regulatory hands, Yelvington said.
In 2Q08, Citigroup said it had $9 billion in ABS CDO-related hedges, including $6.8 billion, or 76%, with Ambac, a recent report from CreditSights pointed out. As a result of the payout, Citigroup's net CDO exposure could increase by $250 million to $400 million. But the deal should reduce Citigroup's ABS CDO-related monoline exposure by nearly 16% and its CDO exposure to Ambac by 21%, CreditSights said.
Tough to Unravel
But unwinding these deals is not so easy. Often, a bank cannot just unilaterally walk away, even if it thinks that the protection is worthless. Because of the way these deals are structured, the bank could end up having to make a termination payment to the monoline, Telpner said.
"Even if it may be beneficial for both sides, it may require both parties coming together to negotiate," he said. "The party that wants to terminate may end up having to make a payment to the other party, even though the other party is happy to let them out."
What also delayed these termination agreements from happening sooner was the industry's wait-and-see mentality. Market participants were not only trying to understand their exposure, but they were waiting to see if the monolines were going to put in different, additional capital or, if possible, the monolines were going to break up, market sources agreed.
Furthermore, there is still some value placed on monoline protection, and if there is a way to restructure the deal and keep the monoline exposure there, it could be beneficial, Telpner said. For example, there are CDO transactions that have experienced market value-triggered defaults but which are, nevertheless, still cash-flow positive. Although the junior classes have been wiped out, there may be enough cash flow to ultimately repay the monoline-wrapped super senior class. In those situations, monolines and super senior holders are exploring restructuring alternatives that might avoid their having to liquidate collateral, which would, in turn, trigger an immediate payment obligation on the part of the monoline.
Secondary wraps on existing transactions - which improve balance-sheet positions and re-hedge exposure - are one of the other available options in the market to reduce the counterparty risk in bank CDO exposure to the monolines.
There is also talk about a private equity-type of transaction. In these scenarios, investors would approach banks that have bought protection from a monoline and offer to buy out that exposure. These investors would then aggregate exposure to the monoline by buying up a portion of these positions, enabling them to do a significant restructuring with a monoline that may involve becoming a capital holder in the company.
While one investor said he had not seen any of these deals being done, he thought it was a very complicated play to accomplish in this type of market environment.
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