Regulation: Good cop, bad cop

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Tough talk by the regulators might bear fruit for the monolines.

When superintendent of insurance for New York Eric Dinallo first proposed a rescue plan for the monoline guarantee companies this was viewed by many in the market as a much-needed piece of good news. At last someone was prepared to do something proactive to sort out the mess that these firms have found themselves in. But the regulator’s approach seemed to have moved from carrot to stick when the financial market’s favourite bogeyman, New York governor Eliot Spitzer, subsequently announced that the firms had just five business days to raise fresh capital or face being broken up.

Spitzer’s move must have been designed to try to bounce the banks into action. And on February 23, when news broke of a potential $3 billion capital injection for Ambac from Citi, UBS, RBS, Wachovia, Barclays, SocGen, BNP Paribas and Dresdner Bank, it looked as if the good cop/bad cop approach might have paid off. The preferred route for all concerned is to have the monolines recapitalized by the banks, and the suggestion that they should be split along good bank/bad bank lines must be something that the latter should be very keen to avoid.

The reason for this is stark. Unhedged CDO exposures have so far generally been marked down by 30% by the banks. This would imply that were the $100 billion notional monoline CDS on super-senior CDOs outstanding written down in a similar way the banks would take a $30 billion hit. However, Merrill and UBS took 100% and 90% write-downs respectively on their exposure to monoline ACA when it was downgraded to triple-C – effectively the hedge became worthless. And if the plan to split the monolines in two is carried out, the "bad bank" entity left holding the ABS CDO exposure could well have a rating below investment grade as well – leaving the banks staring at similarly aggressive write-down levels.

One less drastic suggestion is that the guarantors could be recapitalized to the double-A rather than triple-A level. Analysts at Bank of America estimate that in this situation the write-downs on monoline exposure by the banks could be limited to 5% – or $5 billion. Keeping the firms at double-A is crucial for 2a-7 money market funds, which are limited to holding less than 5% of their portfolios in sub-double-A rated instruments. If the entities wrapping their municipal exposure are downgraded below this level, $200 billion forced sales will be the result.

The proposed Ambac recapitalization cannot, therefore, happen too soon, and is a sign that the banks that have been directly drawn in to the monoline industry’s problems have grasped the magnitude of the gun barrel that they are staring down.