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In an attempt to strengthen its balance sheet and remove the vestiges of the financial crisis, Morgan Stanley (MS) announced a comprehensive plan to settle its legal fight with MBIA Inc. (MBI). The 2-year-old legal dispute involved conflict over guarantees on commercial mortgage-backed securities (CMBS).

Terms

As a part of the settlement agreement, Morgan Stanley will close the outstanding credit default swap (CDS) protection deal (worth $4.9 billion approximately), which was purchased from MBIA. In addition to that, all the pending litigations between the two parties would be resolved with the payment of cash consideration to Morgan Stanley.

The agreement also states that Morgan Stanley will pull out from the lawsuits challenging MBIA’s restructuring. Similarly, MBIA has agreed to withdraw charges against the company related to the quality of bonds underlying the guarantees on CMBS.

Some people familiar with the deal stated that MBIA will pay $1.1 billion to settle the legal claims as well. This amount would be borne by MBIA Insurance, MBIA’s structured finance division.

The Back Story

It all started before the financial crisis in 2008. Though MBIA mainly focused on municipal bonds, it guaranteed and sold a large number of credit-default swaps (CDS) on CMBS and other structured financial products when the U.S. real estate market was booming.

Following the financial crisis, MBIA’s CDS started defaulting and there were huge amount of claims that threatened its profitability. Hence in 2009, MBIA decided to split itself in to two units – a municipal guarantee business and a structured finance unit. However, a group of 18 banks including Morgan Stanley objected to the restructuring and claimed that MBIA’s ability to pay its policyholders will get reduced if the division in its business occurs.

With Morgan Stanley withdrawing its objection for restructuring and settling the legal charges, a total of 13 banks have reached an agreement with MBIA. Now only UBS AG (UBS), Bank of America Corporation (BAC), Societe Generale Group, Natixis and BNP Paribas (BNP) remain as a part of the original lawsuit.

A Win-Win Situation

For MBIA, the settlement will bring down large amount of obligations to guarantee regular principal and interest payments on commercial real estate related bonds, which could again default under the present economic scenario. The deal also clears the big obstacle that was standing in its way of restructuring.

By removing the MBIA exposure from its balance sheet, Morgan Stanley will be able to free $5 billion of capital. Additionally, this will improve its Tier 1 common ratio by 75 basis points under Basel III requirements by the end of next year. The agreement would diminish a huge volatile factor from the company’s quarterly results.

Morgan Stanley will write off the entire value of the investment, thereby leading to $1.8 billion of pre-tax charge in the current quarter. This charge would reflect the difference between the cash that the company received in the settlement and the contracts' market value.

Since 2007, the company has lost about $3 billion from its exposure to bond-insurance companies, including MBIA. As of September 30, 2011, Morgan Stanley had net exposure to MBIA’s derivative contracts worth $2.7 billion.

Since last year, Morgan Stanley has been shedding and divesting risky trading businesses. The company had spun off its derivative hedge fund unit, FrontPoint Partner last year. Earlier this year, the company also amended its ties with Mitsubishi UFJ Financial Group Inc. (MTU), which resulted into Mitsubishi UFJ converting about 7.8 million Morgan Stanley preferred shares into 385.5 million shares of common stock. This also enhanced the company’s capital ratios.

Morgan Stanley’s decision to de-risk its balance sheet will allow it to comply with the various new regulatory requirements. Additionally, the current agreement would free up the additional capital that can be invested in its core businesses.

Currently, Morgan Stanley retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating.

 
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