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What is the Fallout of the Ambac Bankruptcy on the Investment Banking Industry? Robo-signing Conspiracy Theory Grows Some Balls

Submitted by Reggie Middleton on 11/15/2010 15:20 -0400

We have an updated view of Ambac’s bankruptcy effects on the
investment banking industry- actually, two banks in particular. All
paying subscribers are urged to download the summary – File Icon Investment Bank Exposure to monolines. Professional
and institutional subscribers should download the accompanying addendum
which actually illustrates the hundreds of insured securities in
inventory of the banks in question, complete with CUSIP numbers: Ambac-MBIA Insured Model

I have taken the liberty to summarize parts of the subscription
report for BoomBustBlog readers who don’t subscribe. While I will not
reveal the most exposed banks, I will show how this is far from a
non-event for the investment banking industry, and more to the point –
how the post “The
Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks
Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf
2008!” will be even more prophetic than Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billionn in Equity. After all, the smart money should view Banks, Monolines, and Ratings Agencies As The Three Card Monte (Wall)Street Hustlers, particularly since the Shadow Inventory System in the US is Disguising the Equivalent of a Dozen Ambac Bankruptcies!

The Fallout of the Ambac Bankruptcy and Its Likely Effects On the US Investment Banking and Broker/Dealer Industry

The majority of the exposure at risk is that of AMBAC towards the
investment banks, which is significantly (as of 2008) the US taxpayer
through the government’s backing of the Maiden Lane assets as part of
sterilized sale of Bear Stearns to JP Morgan. That is, the securities
referenced in the accompanying subscription model and $31bn exposure
referred to therein are the securities that were issued by investment
banks, sold to other investors and backed by AMBAC and MBIA. If the
investment banks offerings were to default (and given that there is no
protection due to AMBAC bankruptcy), there would be loss to the holders
of these securities that relied on AMBAC’s protection. This is not
direct exposure to the investment bankss, but I do believe there is
material indirect exposure due the very distinct possibility that the
banks are now open to greater warranties and representations clause
risks, as well as the impetus for investors to go after the banks
directly as a result of (now uninsured) losses as a result of the
purchase of these securities – many of which would most assuredly fail
to pass the sniff test!

Perspectives on Exposure

There are several distinct areas that raise concern regarding
investment bank exposure to the monoclines. Direct credit counterparty
exposure related to hedges on ABS CDOs and CDS is the area that offers
the obvious concern. Banks and broker dealers used mononlines, and Ambac
in particular as CDS protection on a wide variety of other assets.
Fitch writes that banks are thought to have actively engaged in
‘negative basis trades’ with CDS purchased from the financial
guarantors. With the poor and increasingly deteriorating performance of
underlying assets and securities upon which protection was purchased,
substantial and material gains on CDO hedges have been booked by banks.
These gains are likely reflected in the public reporting of banks as
accounting profits. Referencing Why the Case Shiller Index, Although Showing Another Downturn Coming, is Overly Optimistic and Quite Misleading! and The Truth Goes Viral, Pt 1: Housing Prices, Economic Sales and the State of Depression you can get an idea of the depth and breadth of value destruction on a real, economic basis…

By perusing “The
3rd Quarter in Review, and More Importantly How the Shadow Inventory
System in the US is Disguising the Equivalent of a Dozen Ambac
Bankruptcies!” you can see that this problem will be persistent for the balance of this decade, at a minimum…

We estimate that it would take about 6.2 years
to clear the shadow inventory if foreclosure sales account for 25% of
sales (7.8 years and 5.2 years if foreclosure sales account for 20% and
30% of existing home sales, respectively).

It is important to note that these
figures only encompass loans that are already delinquent and does not
includes loans which are current now but will go delinquent in the
future and REO’s held by banks.

All paying subscribers can download the full shadow inventory report here: Foreclosures & Shadow Inventory. Professional and Institutional subscribers should also download the accompanying data and analysis sheet in Excel – Shadow Inventory.

Now, with even the potential for the idea of residential real estate
significantly rebounding any time soon empirically dismissed, we can
revisit the concept of what happens when the financial wherewithal of
one of the major CDS hedge counterparties in the monoline relationship
is no longer simply questionable (see our warning in 2007 that Ambac was insolvent)
but its insolvency is actually guaranteed and its ability to fulfill
its obligation is unquestionably impaired if not totally eliminated. The
result is that any accounting gains on these hedges would have to be
reduced and reduced significantly – not merely reserved against,
exposing banks and broker/dealers to real economic losses versus the
accounting gains that they took against these relatively small companies
with relatively (and literally/economically) huge and highly levered
exposures.

Having said that, we have identified banks that have material
exposure to monoline insurers, but far less that originally anticipated –
at least on a direct basis.

Potential for direct investment bank losses

The AMBAC bankruptcy will have several repercussions on the financial markets

It would hurt the ability of financial institutions and governments to issue new debt.
Trigger wave of losses since now double-default protection is now effectively single-protection
Increased mark-to-market losses

As implied in the previous page, we believe that investment bank’s
securities investor exposure can and probably will translate into actual
bank exposure upon loss due to the economic equivalent of warranty and
representations clauses (if not directly from those clauses themselves).
Ambac and MBIA has actually successfully sued many originators and
issuers on this basis and the ability (as well as the impetus) to do so
will easily fall into the investors lap with the collapse of the
protection on these devalued securities which will invariably spur a
multitude of realized and unrealized losses. If this is the case then
investment bank’s exposure and liability is now very similar to
commercial and mortgage banking originators known to be in the hot seat,
ex. JP Morgan, Bank of America, Citibank, etc.

1. According to S&P, the top U.S. banks could face up to
$31bn of losses from mortgages repurchases while the FBR Capital Markets
expects Financial Institutions industry to face $44bn of total losses

2. According to FBR Capital, the five largest banks – Bank of
America, JP Morgan, Citigroup, Wells Fargo, and Sun Trust Banks are
expected to roughly 55% of total industry losses with Bank of America
amongst the most exposed

3. Bank of America had sold $1.2 trillion of loans to Fannie Mae
and Freddie Mac between 2004 and 2008 and has received repurchase
requests on $18bn and has recorded $2.5bn of losses from mortgage
repurchases. The implied loss rate on these repurchases is 13.88%. As of
the time of the afore-referenced report, Fannie and Freddie have only
requested repurchases of 1.5% of the loans sold by BofA. To put this
into perspective, insiders at Citibank are on the record as saying that
up to 80% of the Citibank loans were sold, knowingly containing
defective underwriting criteria (BoomBustBlog is of the belief that B of
A, through their Countrywide and Merrill Lynch acquisitions, has the
worse loan book of size in the country, and this assumption is justified
in linked anecdotal articles towards the end of this report).

4. If Freddie and Fannie were to simply attempt to put back half
of that amount (40% x $1.2 trillion), and succeed on only half of those
demands (20% of $1.2 trillion), we are talking over $33 billion of
losses for B of A alone. Now, of course, this is a gross
oversimplification of the matter, but we believe the logic is sound and
ratings agencies (as has been customary over the last decade or so) have
materially and significantly underestimated the extent, depth and
breadth of the problems at hand.

5. Testimony of Richard Bowen, Senior Vice President and Chief Underwriter for Correspondent Acquisitions for Citigroup Mortgage, in front of the Financial Crisis Inquiry Commission. In early 2006, he was promoted to Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group.

The delegated flow channel purchased approximately $50 billion of prime mortgages annually… In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets. This
situation represented a large potential risk to the shareholders of
Citigroup…I started issuing warnings in June of 2006 and attempted to
get management to address these critical risk issues. These warnings
continued through 2007 and went to all levels of the Consumer Lending
Group…We continued to purchase and sell to investors even larger volumes
of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.

6. All interested in this space should investigate the
accounting and economic treatment of liabilities arising from warranties
and representations, as well as the legal treatment as such, for there
is significant potential for fraud in creating securitizations. The SEC,
as demonstrated by their actions with Goldman Sachs, has a point to
prove and word has it that FHFA is issuing subpoenas, powers unavailable
to private concerns (ex. the monolines) who have to sue and access such
information through discovery. FHFA and similar government entities
will undoubtedly seek to recover and maximize any amounts available to
reduce taxpayer losses in an election year.

Additional observations on investment bank Ambac Exposure through Reps and Warranties

From the Ambac 3^rd quarter 2010 conference call:

Total incurred losses for the quarter
were $459.2 million, primarily related to a handful of asset-backed
securitization credits and a public finance transportation transaction.
All the transactions had been previously reserved but had deteriorated
over the past few months.

The RMBS incurred losses were negative $259 million during the quarter, favorably impacted by increased estimates for remediation recoveries in the second lien portfolio, partially offset by additional deterioration noted in certain segments of portfolio.

While initial delinquency rolls are
steadying somewhat, large later stage buckets are driving continued poor
performance especially in loss severities across both first and second
lien transactions. Ambac increased its estimate of remediation
recoveries on RMBS transactions due to breaches of representations and
warranties by approximately $738 million during the third quarter.

As of September 30th, RMBS reserves are net of approximately of $1.9 billion of estimated remediation recoveries. The
increase in the estimate of remediation recoveries is a result of
additional breaches discovered during the quarter, the addition of two
more transactions to the scope of our review and an enhancement to our
estimation process of certain transactions to include an extrapolation
of breaches across the population that is based on a statistically
significant sampling of loan files.

Given the scale of the losses in the RMBS portfolio, the
evidence of pervasive breaches noted to date and recent performance
addressing these contractual breaches, Ambac believes limiting
remediation credit to the loan amounts where actual breaches have been
discovered under-staged the amount Ambac is expected to recover from
institutional sponsors.

As a result, the number of
transactions where random samples were extrapolated to estimate the
amount of subrogation recovery increased from one as of June 30, 2009 to
seven as of September 2009. Correspondingly, the number of transactions
where an adverse sample was used decreased from ten to six. We are
actively working these transactions to resolve these breaches through
litigation or otherwise and continue to believe our assumed recovery time of three years is appropriate.

Although Ambac’s management is not the most disinterested party
through which to get unbiased information, it is evident that they are
more confident, and probably justifiably so, in their ability to ramp up
recoveries by putting losses back to the originators. They have been at
this since before 2008.

As excerpted from the Subprime Shakeout blog: AMBAC Sues Bear Stearns Subsidiary For Shoddy Underwriting November 17, 2008

Mortgage insurance company Ambac
Assurance Corp. has become the latest plaintiff to bring a lawsuit
against a mortgage originator for improper underwriting, suing Bear
Stearns subsidiary EMC Mortgage Corp. in the United States District
Court for the Southern District of New York. The lawsuit (available here)
alleges that mortgage originator and “aggregator” EMC, under the
control and behest of Bear Stearns, made loans that it knew borrowers
could not afford to repay and sponsored securitizations that created a
market for such defective loans. It further alleges that EMC made
specific representations to Ambac to induce it to provide insurance for
four separate securitizations, maintaining that the loans were
underwritten without fraud, errors or omissions and that EMC would
repurchase any loans that were found to be defective.
Interestingly, while Ambac brings several claims based on EMC’s eventual
breach of these representations and warranties, it does not bring a
claim for fraud or negligent misrepresentation.

This has a direct correlation with investment banks’ exposure, of
which we have illustrated potentially $31 billion worth in the
accompanying model for professional subscribers, complete with CUSIP
numbers (I-bank Ambac-MBIA Insured Model).

…But, what’s most interesting about
this action is the lengths to which Ambac goes to create a distinction
between the poor performance of the loans stemming from the downturn in
the housing market and the overall financial crisis, and the poor
performance engendered by EMC’s irresponsible lending. For example, in
paragraph 25, Ambac alleges that “EMC assumed the risk that the loans
did not conform to its representations and warranties, while the
insurers agreed to assume the risk that loan pools conforming to EMC’s representations did not perform as anticipated.” (emphasis in original) Ambac explains this concept further in paragraph 58:

The ability to evaluate the risk of the
Transactions and adequacy of structural protections therefore depended
on the ability to assess and control for the risk of default on the
securitized loans. Certain default risk – e.g., due to changes in
interest rates, changes in borrowers’ creditworthiness over time,
adverse macroeconomic developments, and geographic concentration – is
not subject to the control of the originator or sponsor, is measurable
and quantifiable to an acceptable degree, and is the type of risk that
Ambac knowingly assumes when it insures these types of transactions in
exchange for a premium. Other default risk – e.g., due to misrepresented
loan attributes, fraud or abject failures in origination and
underwriting practices – depends directly on the controls, protocols,
and practices of the originators and sponsor, and is not reasonably
measurable or quantifiable by their counterparties.

Of course, the story gets worse. Let’s fast forward to this past September: Ambac sues BofA over fraudulent mortgages issued by Countrywide September 30th, 2010

Ambac Assurance Corporation, the guarantor of structured finance obligations for Ambac Financial Group Inc., is suing Bank of America Corporation over losses associated with fraudulent mortgages allegedly originated and sold as securities by Countrywide Financial.

Ambac claims it was mislead about the
quality of loans the monoline insured as securities between 2004 and
2006. Bank of America took over Countrywide in 2009.

According to the Ambac complaint
filed on Tuesday, the firm engaged in 12 transactions with Countrywide
consisting of more than 268,000 loans, which served a total collateral
of about $16.7 billion.

…Ambac has so far reviewed 6,533 Countrywide loans, 97% of which it found did not comply with the failed institution’s representations and warranties.

Just so this is not lost on anybody, Ambac is alleging (and I
certainly do believe them) that nearly ALL (yes, 97% is just about ALL)
of the loans pledged as securities behind the B of A securitizations
though Countrywide financial were bogus! The Countrywide portfolio makes
the 80% claim from the Citibank official look downright rosy in
comparison! Think about all of the potential repercussions if this
statement were just remotely accurate.

“Countrywide’s loans did not bear the
represented attributes or conform to Countrywide’s own underwriting
guidelines,” the filing said, “And in many cases were made to borrowers
with little or no ability to repay their loans.”

…Managing director for investor
relations at Ambac, Peter Poillon, said he couldn’t directly attribute
Ambac’s bankruptcy to the deals with Countrywide. He told HousingWire
“because of our exposure to those transactions and others, Ambac
Assurance is no longer able to issue those cash dividends to holding
company.”

Ambac Sues Credit Suisse

Ambac Assurance Corp, a unit of Ambac Financial Group Inc has sued Credit Suisse Group,
alleging the company misrepresented the risks of mortgage-backed
securities in a deal Ambac insured in 2007. Ambac claimed that many of
the loans involved were fraudulent, based on misstatements of income or
occupancy.

Ambac suits against Citibanks and Credit Suisse…

… Ambac Credit Products in a lawsuit
against Citigroup and Credit Suisse related to $2 billion of credit
protection that Citigroup obtained from Ambac on the super-senior
tranches of a CDO named Ridgeway Court Funding II Ltd. that was
structured by Citigroup during the first half of 2007. Credit Suisse was
hired by Citigroup to manage the CDO and was responsible for selecting
the collateral in which it invested. In order to induce Ambac to provide
credit protection on the deal, Citigroup and Credit Suisse made
specific false representations with respect to the value, nature and
credit quality of the collateral that was included in Ridgeway II’s
portfolio, which, in fact, included substantially deteriorated subprime
mortgage backed securities that Citigroup sold to Ridgeway II in order
to get off its own books. In August 2009, Ambac filed its action in New
York state court, asserting claims for fraud, negligent
misrepresentation, breach of fiduciary duty, and fraudulent conveyance.
Ambac seeks to rescind the credit default swaps or, in the alternative,
obtain damages.

While it is clear that Ambac will have limited resources to
aggressively pursue certain litigation, those entities that purchased
the insured securities from the investment banks now have significant
impetus to start looking under rocks and into dark crevices. With a 97%
fraudulent or misrepresented loan rated, I see the buyers of said
securities getting very rough with the investment banks, particularly
with the guaranteed losses in the pipeline due to a lack of CDS
coverage. You never know regulatory capture may even be damned in this
election year teeter tottering on the brink of a recession – see More on Lehman Brothers Dies While Getting Away with Murder: Introducing Regulatory Capture for more on this topic.