Commutations

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See also AIG, bond insurance and Goldman Sachs.

Contents

Overview

Main Entry: com·mu·ta·tion Pronunciation: \ˌkäm-yə-ˈtā-shən, -yü-\ Function: noun

Etymology: Middle English commutacion, from Anglo-French, from Latin commutation-, commutatio, from commutare Date: 15th century

  1.  : exchange, trade
  2.  : replacement; specifically : a substitution of one form of payment or charge for another
  3.  : a change of a legal penalty or punishment to a lesser one <commutation of a death sentence>

Bond insurance commutations

AIG - 100 cents on $

“Abus de biens sociaux”

...The French law that the Commission Bancaire may have cited is called “abus de biens sociaux,” or misuse of company assets, said David Chijner, a partner with Fried, Frank, Harris, Shriver & Jacobson LLP in Paris who specializes in corporate restructuring and mergers.

The law prohibits company executives from making decisions they know to be contrary to the interests of the company. Violators can be jailed for up to five years and fined as much as 375,000 euros ($545,000).

“It could be considered an ‘abus de biens sociaux’ in extreme circumstances,” Chijner said.

‘Bunch of Hooey’

James D. Cox, a professor of corporate and securities law at Duke University School of Law in Durham, North Carolina, said it is “preposterous” that reaching a settlement for less than 100 cents “could be a criminal act in a developed Western country in the depths of a financial crisis.”

“Even if you concede the point, it was not a crime for Goldman Sachs to take less than 100 percent,” Cox said. “Treating all the banks the same is a bunch of hooey.”

New York Fed spokeswoman Deborah Kilroe declined to comment. William C. Dudley, who took over as president of the New York Fed after Geithner became Treasury secretary, told PBS last week that the Fed didn’t want to choose who would be hurt by an AIG bankruptcy.

“When we made the decision to intervene to prevent the bankruptcy, we were protecting everybody,” Dudley said...

...“If Ambac had nobody’s backing and was in a near insolvency situation, then indeed the prudent French director would have a duty to try to maximize recovery,” Chijner said.

Even with government support, AIG had a greater chance of going under than Ambac did, according to credit-default swap pricing at the time. On Sept. 21, 2008, five days after the U.S. loaned AIG $85 billion and agreed to take a 79.9 percent stake in the insurer, then-Treasury Secretary Henry M. Paulson told the NBC-TV interview program “Meet the Press” that the action would “allow the government to liquidate this company.”

AIG had an implied 87 percent chance of missing debt payments on Nov. 7, 2008, the day the New York Fed negotiated the repayments, according to CMA DataVision, a London-based information provider. The chance of an Ambac default that day was an implied 77 percent. Credit-default swaps pay the buyer of the insurance face value of a security if a borrower fails to make a payment. In exchange, the buyer hands over the security or the cash equivalent.

AIG’s insurance contracts differed from Ambac’s because they required AIG to send collateral to counterparties when certain events, called triggers, occurred, said Jim Millstein, the Treasury Department’s chief restructuring officer.

The agreements required the insurer to post collateral when the assets it guaranteed, such as home loans, declined in value or when AIG’s credit rating was downgraded, Millstein said. Ambac guaranteed assets without triggers, so no payments were required until the assets matured, he said.

“It was just AIG’s pure arrogance that led them to do this,” Millstein said. “But they did it, and that was what the federal government inherited.”

Buying the assets underlying the credit-default swaps at face value and ripping up the guarantees to AIG’s counterparties stopped calls for collateral and staunched the bleeding from AIG’s balance sheet, Millstein said. It also may have prevented a run on AIG’s insurance business, he said.

Maiden Lane

Maiden Lane III, an off-balance-sheet entity created by the Fed, purchased $27.1 billion of underlying securities from AIG’s counterparties, according to the inspector general’s report. That money, combined with $35 billion in collateral funded in part by the government’s original bailout, equaled the $62.1 billion value of the assets, the report said.

AIG and Ambac wrote insurance on mortgage-linked securities, and losses piled up when U.S. borrowers began to miss monthly payments at a faster pace at the beginning of 2007. Delinquencies of all home loans have doubled since then, to 9.6 percent of all homeowners in the third quarter of 2009 from 4.8 percent in the first quarter of 2007, according to the Washington-based Mortgage Bankers Association.

Neither Ambac nor AIG has ever filed for bankruptcy. Neither Societe Generale nor BNP Paribas has been prosecuted for accepting a discounted payment from Ambac."


"In the months leading up to the September 2008 collapse of giant insurer American International Group Inc., Elias Habayeb and his colleagues worked nights and weekends negotiating with banks that had bought $62 billion of credit-default swaps from AIG, according to a person who has worked with Habayeb.

Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar, according to people familiar with the matter.

Among AIG’s bank counterparties were New York-based Goldman Sachs Group Inc. and Merrill Lynch & Co., Paris-based Societe Generale SA and Frankfurt-based Deutsche Bank AG.

By Sept. 16, 2008, AIG, once the world’s largest insurer, was running out of cash, and the U.S. government stepped in with a rescue plan. The Federal Reserve Bank of New York, the regional Fed office with special responsibility for Wall Street, opened an $85 billion credit line for New York-based AIG. That bought it 77.9 percent of AIG and effective control of the insurer.

The government’s commitment to AIG through credit facilities and investments would eventually add up to $182.3 billion.

Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the swaps -- insurance-like contracts that backed soured collateralized-debt obligations.

Subprime Mortgages

CDOs are bundles of debt including subprime mortgages and corporate loans sold to investors by banks.

Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.

The New York Fed’s decision to pay the banks in full cost AIG -- and thus American taxpayers -- at least $13 billion. That’s 40 percent of the $32.5 billion AIG paid to retire the swaps. Under the agreement, the government and its taxpayers became owners of the dubious CDOs, whose face value was $62 billion and for which AIG paid the market price of $29.6 billion. The CDOs were shunted into a Fed-run entity called Maiden Lane III.

Habayeb, who left AIG in May, did not return phone calls and an e-mail.

Goldman Sachs

The deal contributed to the more than $14 billion that over 18 months was handed to Goldman Sachs, whose former chairman, Stephen Friedman, was chairman of the board of directors of the New York Fed when the decision was made. Friedman, 71, resigned in May, days after it was disclosed by the Wall Street Journal that he had bought more than 50,000 shares of Goldman Sachs stock following the takeover of AIG. He declined to comment for this article.

In his resignation letter, Friedman said his continued role as chairman had been mischaracterized as improper. Goldman Sachs spokesman Michael DuVally declined to comment.

AIG paid Societe General $16.5 billion, Deutsche Bank $8.5 billion and Merrill Lynch $6.2 billion.

Ambac

*28 cents on $

Ambac Financial Group, Inc. (NYSE: ABK) (Ambac) today announced that it has commuted two CDO of CDO of ABS (commonly referred to as CDO-squared) exposures and two high grade CDO of ABS exposures. The four transactions, with an aggregate of approximately $3.5 billion notional outstanding at September 30, 2008, were settled with counterparties in exchange for a total cash payment by Ambac Assurance Corporation (AAC) of $1.0 billion.

The two CDO-squared transactions originally comprised collateral consisting of A-rated CDO of ABS tranches, and the two high grade CDO of ABS exposures originally comprised collateral consisting of asset-backed securitizations rated A- or higher. Most of the collateral had been downgraded to below investment grade since the inception of the transactions. All four of the transactions had been internally downgraded to below investment grade.

As a result of the settlements, Ambac expects to record positive adjustments to its aggregate mark-to-market and impairment reserves. In addition, the stress case losses in the rating agency capital models for these transactions combined exceeded AAC’s final payments; therefore, the settlements will result in an improved rating agency capital position for AAC.

“My immediate focus as Ambac’s new CEO is to restore confidence in our balance sheet through aggressive risk reduction,” said David Wallis, Ambac’s Chief Executive Officer, “Ambac has consistently emphasized that in this period of extreme uncertainty in the capital markets, the de-risking and de-leveraging of our balance sheet is our highest priority. These settlements represent positive and tangible steps towards that goal. We have now successfully commuted five CDO transactions representing $4.9 billion of notional exposure including three of the CDO-squared transactions that had been widely perceived to be the riskiest segment of our CDO portfolio. I am confident that further progress towards remediation of our book will be achieved.”

*60 cents on $

Source: New York Fed’s Secret Choice to Pay for Swaps Hits Taxpayers Bloomberg, October 27, 2009

" ... Citigroup Inc. agreed last year to accept about 60 cents on the dollar from New York-based bond insurer Ambac Financial Group Inc. to retire protection on a $1.4 billion CDO..."

Assured Guaranty Corp.

CIFG

" ... New York insurance commissioner Eric Dinallo said CIFG was the department's top priority following that deal. In previous comments, he had said both CIFG and FGIC were in binary positions: they needed to either make deals with counterparties or face insolvency. FGIC also announced it had commuted $1.875 billion in structured finance exposure in a deal with Calyon, a French bank..."

DB - OeBB 48 cents on the $

Deutsche Bank AG and OeBB-Holding AG, Austria’s state-owned railroad company, reached a settlement in a dispute regarding 613 million euros ($882 million) worth of derivatives.

Germany’s largest bank is receiving 295 million euros in return for dissolving the contract on collateralized debt obligations between the parties, the two companies said yesterday in an e-mailed statement. The CDOs will revert to Frankfurt-based Deutsche Bank.

OeBB bought the derivatives from Deutsche Bank in 2005 and 2006 to boost returns on its investments. The securities were hurt by the credit crunch that followed the collapse of the U.S. mortgage market, forcing Vienna-based OeBB to write down the entire value of the securities.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or weather. Credit-default swaps are derivatives used to protect against debt losses or speculate on credit quality, and pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to meet its obligations.

OeBB’s CDOs package credit-default swaps tied to debt including asset-backed securities and company bonds. They expire from 2013 to 2015. OeBB made provisions on the securities of 420 million euros in 2008, and 157 million euros the year before, the company said in April, when it reported a record 966 million-euro loss.

OeBB had appealed a February court ruling dismissing a claim that Deutsche Bank didn’t disclose the risks associated with the derivatives. Yesterday’s settlement ends all legal disputes connected to the case, according to the statement.

FGIC 74 cents on the $

Sellers of protection on bond insurer Financial Guaranty Insurance Corp's credit default swaps will need to make payments of 74 percent the sum they insured, after an auction was held on Thursday to determine the value of the company's credit default swaps.

BONDS

FGIC's CDSs were valued at 26 cents on the dollar, said auction administrators Creditex and Markit. That means protection sellers will need to pay out $7.4 million per $10 million of insurance they sold.

CDSs are used to insure against a borrower defaulting on debt or to speculate on their credit quality. For bond insurers, the contracts are backed by debt the company insures.

Payments on the contracts were triggered after The New York Insurance Department told the bond insurer to suspend paying claims in November because it was in violation of the state's minimum capital requirements.

Net volumes of around $900 million are outstanding in CDSs referencing FGIC, according to the Depository Trust & Clearing Corp.


"... Traders are speculating the swaps on the insurers may be worth less than anticipated after an auction to settle contracts on FGIC’s Financial Guaranty Insurance Co. set a value of 26 cents on the dollar for the mortgage and home-equity loan debt backed by the company.

The price “came in notably above the high-teens recovery rate expected by the market,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.

Recovery Expectations

The auction value means buyers of swaps on FGIC will be paid 74 cents on the dollar, at least 6 cents less than the market had been pricing in. The market had been anticipating a recovery of about 18-20 cents the day before the auction, according to Barclays Capital prices.

Swaps on MBIA have dropped for five straight days. Contracts on Ambac have fallen six straight..."

FSA

MBIA

The International Swaps and Derivatives Association created a list of all the CDS contracts which reference MBIA.

SCA - ML 13 cents on $

"... Under its agreement with Merrill, SCA will pay $500 million in return for the commutation of eight credit default swaps backing $3.74 billion. The ongoing litigation on seven of those CDSs will also be dropped...."


"... Under the agreement approved by the Department, XL Capital Limited (XL), the former indirect parent of XLCA, will pay just under $2 billion – comprised of $1.775 billion in cash and 8,000,000 XL Class A ordinary shares – to SCA subsidiaries XLCA and XL Financial Assurance Limited (XLFA). In return, existing financial guarantee and reinsurance arrangements among SCA, XLCA, XLFA, and XL will be terminated, commuted or restructured.

The agreement also provides funding that will serve as the basis for restructuring or commuting insurance policies that XLCA provided to insure credit default swaps it sold to many of the world’s largest financial institutions.

As part of the transaction, there will be a commutation among Merrill Lynch International, Merrill Lynch & Co., XLCA, SCA and certain trusts. The Merrill Lynch entities will commute in whole eight ABS Credit Default Swap (CDS) agreements and dismiss related litigation in exchange for a cash payment of $500 million..."

Syncora Guarantee

As of June 30, 2009, Syncora Guarantee expects to report a policyholders' surplus deficit in the range of $3.9 to $4.1 billion. The comprehensive restructuring to remediate the Company's policyholders' surplus deficit included three primary components:

  1. the commutation and restructuring of substantially all of Syncora Guarantee's CDS portfolio;
  2. the remediation of expected losses on the Company's insured RMBS; and
  3. the creation of Syncora Capital Assurance.

The closing of the transactions related to the 2009 MTA effectively commuted or restructured all of Syncora Guarantee's $56 billion of CDS exposure.

The 2009 MTA provided for the effective commutation of the Company's financial guarantees of CDS relating to collateralized debt obligations of asset-backed securities ("ABS CDOs") and other structured products with an aggregate par approximating $15 billion and case basis loss reserves in accordance with statutory accounting principles as permitted by the NYID ("SAP") approximating $4.6 billion.

This represents all of Syncora Guarantee's CDS exposure for which the Company has reserves or expects losses with respect to ABS CDOs and substantially all of Syncora Guarantee's financial guarantee exposure to ABS CDOs with expected losses.

The RMBS Tender Offer closed on July 15, 2009 and, upon settlement thereof, Syncora Guarantee will effectively commute approximately $3.8 billion of insured RMBS and approximately $1.2 billion in loss and loss reserves associated with Syncora Guarantee's RMBS portfolio.

Syncora Guarantee achieved a total of 68.4 remediation points, or 95% of the target amount, in the RMBS Tender Offer. Along with the reinsurance of certain insured public finance and selected global infrastructure bonds by Syncora Capital Assurance, Syncora Guarantee has restructured or commuted in aggregate approximately $110 billion of par bonds insured.

On a SAP basis, after giving effect to the transactions contemplated by the 2009 MTA, the RMBS Tender Offer and related transactions on a pro forma basis as if they had been consummated on June 30, 2009, Syncora Guarantee would expect to report total policyholders' surplus at June 30, 2009 in the range of $150 million to $210 million, as compared to an expected policyholders' surplus deficit (unaudited) at June 30, 2009 in the range of $3.9 to $4.1 billion.

The policyholders' surplus of Syncora Capital Assurance, reflecting its initial capitalization and its assumption of certain business from Syncora Guarantee, is expected to be in the range of $265 million to $295 million.


"The New York State Insurance Department today announced that it has approved the restructuring of Syncora Guarantee Inc. (SGI), allowing the bond insurer to proceed with a series of transactions that will enable it to move from nearly a $4 billion deficit to a surplus of approximately $180 million.

The agreement provides reinsurance for Syncora's municipal bond business by a newly-formed, well-capitalized subsidiary, Syncora Capital Assurance Inc. The restructuring also includes a $1.2 billion commutation payment to policyholders who entered into credit default swaps on collateralized debt obligations on asset backed securities. Finally, the deal reduces SGI's mortgage-backed security liabilities through a voluntary tender process that offered upfront cash payments to policyholders in exchange for their insurance claims. Nearly 70% of the tender offers were accepted.

"This agreement protects municipal bond and other policyholders and permits the reduction of company liabilities in a fair and equitable manner. The agreement also enables the company to avoid receivership and the disruption that it would cause," said Acting Insurance Superintendent Kermitt Brooks.

"The Insurance Department is pleased with this agreement because it represents the culmination of more than a year and a half of effort to stabilize the bond insurance market by working with each of the major bond insurers."

Completion of the Syncora restructuring means that substantially all New York domestic municipal bond insurance policies have been stabilized as a result of the Insurance Department's efforts since it announced a three-point plan to do so in late 2007. The plan called for alleviating problems facing bond insurers, attracting new capital into the market and developing new regulations.

The Insurance Department helped develop individual solutions to stabilize each of the major bond insurers, including Syncora, MBIA, FGIC, FSA and CIFG, and to attract new capital into the market with the licensing of Berkshire Hathaway Assurance Corporation and Municipal and Infrastructure Assurance Corporation.

In addition, the Department has issued an industry advisory, known as a Circular Letter, to bond insurers and has proposed state legislative action. The September 2008 advisory called on insurers to institute a series of "best practices," including expanded reporting requirements and written underwriting policies. The Department also has urged the Legislature to approve increased minimum capital and reserve requirements, as well as a number of other reform measures.

The Syncora restructuring was reviewed and evaluated by Gene Benger, Michael Campanelli, Jim Davis, Ken Gingrass, Paul Hannon, Larry Levine, Tim Nauheimer and Margot Small under the direction of Deputy Superintendents Hampton Finer, Michael Moriarty and Robert Easton."

Moody's on bond insurance commutations

Q9. How does Moody’s view the recently announced agreement between SCA and Merrill Lynch regarding credit default swaps on troubled ABS CDO exposures? What are the implications for other guarantors?

A: SCA recently announced that it has reached an agreement with Merrill Lynch to terminate eight credit default swaps on ABS CDOs in return for a $500 million cash payment to Merrill.

From a capital adequacy perspective, SCA’s commutation with Merrill is a clear positive because it eliminates a significant amount of estimated stress case losses from its portfolio. In our capital adequacy analysis, we are using stress-case losses, not expected losses, to benchmark capital adequacy. It is also important to remember that our target capital adequacy benchmarks include an additional 30% cushion on top of our stress-case modeled losses.

Depending on the particular circumstances surrounding these exposures, commutations can be in the business interest of both the guarantor and the bank counterparties. Guarantors benefit from reduced uncertainty regarding future losses and can free up significant amounts of capital to support other business. Bank counterparties can benefit by getting cash today and by eliminating the uncertainty related to the recoverability of a stream of payments that can stretch out over 30 years or more, as well as by de-leveraging the balance sheet. In some cases, commutations may also allow bank counterparties to record gains on positions relative to current marks.

Moody’s believes that most guarantors are involved in discussions with bank counterparties for the commutations of credit default swaps on ABS CDOs, although in many cases, there remain significant obstacles to reaching agreements – primarily related to settlement amounts.

In the case of SCA’s agreement with Merrill, the negotiated settlement has some elements that are typically associated with a distressed exchange. However, such a determination is ultimately a matter of judgment, and it depends on the specific circumstances of the guarantor, as well as the amount of the settlement compared to the economic value of the hedge..."

References

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