Tuesday, May 01, 2012

How BofA could lose big if it wins MBIA regulatory challenge

I've spent a lot of time talking about what I consider Bank of America's risky gamesmanship in its multi-pronged litigation with the bond insurer MBIA, but it may be that I've underestimated that risk by focusing on the downside for the bank in MBIA's breach of contract and fraud suit. Under a not-implausible scenario, BofA faces serious risk in its regulatory challenge to MBIA's transformation that's going to trial on May 14. And ironically, the risk comes not from losing the case -- but from winning it.

According to a sophisticated and well-advised MBIA institutional investor that has devoted serious resources to analyzing the issue -- trust me, even though the investor doesn't want to broadcast its involvement, this is a seriously savvy player -- if Bank of America and two French banks succeed in overturning MBIA's 2009 split into separate muni bond and structured finance businesses, there's a reasonable likelihood that BofA could wind up at the back of the line of MBIA claimants, waiting years for whatever scraps are left over from payouts to municipal bond insurance policyholders.

Here's why. For all sorts of reasons, bond insurers can't write policies directly backing credit default swaps, which often function as bets by one investor on the other party's failure. Instead, in the economic boom years, monoline parent companies would create special purpose vehicles to engage in credit default swap deals. The insurer would then write an insurance policy backing the special purpose vehicle. The monoline essentially issued insurance on a product it technically couldn't insure; the CDS counterparty would end up with a hedge on its CDS risk. It's widely believed that Bank of America is the counterparty in more than $1 billion of MBIA-backed credit default swaps. Indeed, it's part of the bank group suing MBIA over its restructuring because (according to many statements over the years by the banks) BofA and its allies are concerned that MBIA's structured finance spinoff doesn't have the money to pay what it owes policyholders, including whatever it owes through these CDS deals.

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