Confidence Game - Christine Richard [106]
This time, there was no disguising the fact. MBIA reported mark-to-market losses of $342 million to reflect the decline in the value of collateralized-debt obligations (CDOs) it had insured. Still, not everyone was convinced that the company was coming clean. “I’m trying to understand how the guarantors can take such low levels of mark-to-market losses relative to what the rest of the Street is taking on these securities,” Ken Zerbe, an analyst with Morgan Stanley, said during the company’s conference call.
The day before, Merrill Lynch had reported the largest loss in its 93-year history, taking $7.9 billion of writedowns mainly on super-senior CDOs backed by subprime mortgages. The writedowns reflected a discount of 19 percent to 57 percent of the face value of various types of securities Merrill held. “Bottom line is we got it wrong by being overexposed to subprime,” Merrill’s chief executive officer (CEO) Stan O’Neal told listeners on the firm’s October 24, 2007, conference call.
Then O’Neal did something extraordinary. He apologized for having been too slow to lay off the firm’s exposure to other firms and investors. As the subprime mortgage market collapsed during the first quarter, Merrill Lynch faced a desperate scramble to get mortgages, mortgage-backed securities, and CDOs off its balance sheet, O’Neal explained.
Unfortunately for MBIA shareholders, Merrill Lynch had succeeded in getting MBIA to assume more than $5 billion of its CDO risk. MBIA and Merrill had exposure to very similar securities. Yet if MBIA had taken writedowns of the same magnitude on securities it guaranteed as Merrill took on securities it held, then MBIA would have reported $3 billion, rather than $342 million, of losses, the equivalent of more than 45 percent of its insurance company capital.
MBIA chief financial officer Chuck Chaplin gave Zerbe an answer as to why Merrill and MBIA were taking such different markdowns on super-senior CDOs, but it was not easy to follow: “The vast majority [of CDOs] are marked using market quotes for the collateral in the deals and then the subordination of the deal as inputs into an analytical mode that then incorporates assumptions about correlation and the relationship between collateral spreads and financial guarantee premiums to calculate an implied premium for the deal,” Chaplin said. “And then the present value of the difference between the implied premium and the premium that we receive is the balance sheet value at period end,” he added.
The explanation left many peplexed and unsatisfied. MBIA’s shares, already under pressure, began to drop.
Zerbe wasn’t the only equity analyst raising questions. Heather Hunt, who covered the bond insurers for Citigroup, asked why all of these super-senior CDOs were getting insured in the first place. Was it because the market is just at a standstill and having insurance is the only way of getting the deal done? Hunt asked.
“Heather, these are assets that are sitting on the balance sheets of the banks,” Chaplin explained.
“These are assets the banks already held?” Hunt asked.
“Those assets could be there for a variety of reasons,” Chaplin offered.
So the insurance was put on after they bought the CDOs? asked Hunt.
“Right,” Chaplin replied. “So as the banks and investment banks faced growing notional balance-sheet size, this was an opportunity to hedge some of that.”
“Got it. Okay,” said Hunt.
Equity analysts had cheered MBIA’s move into the CDO business, yet it seemed they had a poor understanding of what was driving that business. This wasn’t the bond insurance business anymore. MBIA was providing a service that allowed banks to make huge amounts of securities disappear from their balance sheets. This disappearing act was known as a “negative basis trade.” It allowed financial institutions to book all their profits on vast CDO holdings up front while assuming away the risk of default. As the risk seemingly disappeared, so did the