Confidence Game - Christine Richard [103]
By the time Merrill executives left Armonk on that August afternoon, Gary Dunton, MBIA’s chief executive officer, agreed to back another $5 billion of CDOs.
Merrill Lynch wasn’t the only institution terrorized by collapsing asset values during the summer of 2007. At UBS, the chairman and chief executive officer (CEO) of the Swiss banking giant got a crash course in super-senior CDOs during the first week of August 2007. The lessons were shocking. UBS had ballooned its super-senior CDO exposure to $50 billion by September 2007, up from virtually zero just 19 months earlier.
Later, in the spring of 2008, UBS issued a report to Swiss banking regulators and to its shareholders explaining how the bank lost $18.7 billion on U.S. subprime mortgages. The risk management group “relied on the AAA rating of certain subprime positions, although the CDOs were built from lower-rated tranches of residential mortgage-backed securities,” the report said. Banks built models to predict the future performance of mortgages using just five years of data, and data taken from a period of strong economic growth, no less. Meanwhile, no one at the top imposed any limits on how much of this super-senior exposure the bank could hold. “The balance-sheet size was not considered a limiting metric,” the report said.
About the only thing UBS could say in its defense was that it believed “its approach to the risk management and valuation of structured-credit products was not unique and that a number of other financial institutions with exposure to the U.S. subprime market used similar approaches.”
RATING CAPITAL REQUIREMENTS PER $100 OF EXPOSURE
AAA 0.56
BBB 4.80
BBB- 8.00
BB+ 20.00
BB 34.00
BB- 52.00
As the summer of 2007 wound down, the heads of major financial institutions were coming to grips with a terrifying scenario: Severe credit-rating downgrades of super-senior CDOs were going to wipe out their capital. Banks and brokerages around the world were moving toward implementation of BASEL II guidelines, under which capital charges are minimal at high ratings but escalate dramatically as securities are downgraded (see figure above).
A bank with $50 billion of AAA-rated CDOs on its books would have to hold about $280 million in capital against the position. If those securities were downgraded to triple-B, then the bank would need $4 billion of capital. A further downgrade to double-B would increase the bank’s capital need to $26 billion, or nearly 100 times the capital it needed when the securities were rated triple-A. This steep increase in capital requirements turned the collapse in the value of CDOs into a global banking crisis. Financial institutions were relying on credit-rating companies to determine how much capital to hold against trillions of dollars of securities. That meant every time the credit-rating companies stamped a security with a triple-A rating, more capital was sucked out of the financial system. Triple-A-rated securities—considered the safest of safe investments—actually posed enormous risk to the financial system. The risk of a triple-A rating was that it was wrong.
As banks watched CDO ratings collapse, they saw one way to get those ratings back to triple-A: get the securities wrapped by bond insurers. Pressure was building for the credit-rating companies to rethink the triple-A ratings on bond insurers. Credit-default-swap contracts on the bond insurers were trading at levels that suggested the companies were rated far below triple-A.
The time was ripe. Ackman sent a note to Chris Mahoney, the chief credit officer at Moody’s Investors Service. “There is still time for Moody’s to revisit its analysis and our numerous presentations to you on MBIA and the bond-insurance business,” Ackman wrote in an e-mail. “The notion that these companies are triple-A is as much an absurdity as the triple-A ratings Moody’s has placed on subprime mezzanine CDOs and other highly rated structured finance vehicles on which investors have