Confidence Game - Christine Richard [11]
CDOs were Wall Street’s favorite new asset class. The securities are built out of pools of securities rather than pools of loans. Otherwise, CDOs work on the same waterfall principle as simpler asset-backed bonds. MBIA was backing lots of CDOs at what it called “super-senior levels,” the most senior or highest levels of a CDO securitization. These super-senior exposures were considered better than triple-A because they had a greater cushion to absorb losses than what the rating companies believed was necessary to achieve triple-A performance.
Gold gave Ackman a history of the CDO business, including a description of a groundbreaking transaction called “BISTRO.” The CDO was created by JPMorgan as a way to lay off the credit risk of a pool of loans it held on its balance sheet.
In his notes, Ackman took down the nickname Gold told him people in the industry gave to BISTRO: “Bank for International Settlements Total Rip Off.” The Bank for International Settlements is an organization headquartered in Basel, Switzerland, that was created to promote global financial stability. One of its ongoing projects has been to create bank capital guidelines. BISTRO gamed those guidelines by converting long-term lending risk into a series of credit-default contracts that required less capital.
These CDS contracts had become the preferred way for banks to hedge their exposure to CDOs. Most of the CDOs MBIA guaranteed were insured through CDS contracts. In doing his research, Ackman found that insurance companies were prohibited from dealing in derivatives such as credit-default swaps. He asked Gold about this restriction during their meeting.
“Financial guarantors can’t write swaps,” Gold agreed. That’s why MBIA had set up LaCrosse Financial Products, which Gold called “an orphaned subsidiary.” LaCrosse, a shell company with nominal assets that was owned by an apparently unaffiliated charity, sold credit-default swaps, and MBIA guaranteed LaCrosse’s obligations. The orphaned subsidiary allowed MBIA to indirectly participate in the CDS market apparently without breaking the law. Ackman had asked Neil Budnick about LaCrosse, which was disclosed in a footnote in MBIA’s annual report, during their meeting earlier in the day, and he was surprised when the chief financial officer said he’d never heard of LaCrosse. Ackman found this particularly striking when Gold said later in the day that the company had seen “huge growth” and “remarkable volume” in its super-senior CDO business through LaCrosse.
Gold told Ackman that the performance of the CDO guarantees had been disappointing. MBIA wasn’t paying claims on its super-senior guarantees, but CDOs weren’t proving as stable as the financial models had predicted. Because the contracts were in derivative form, accounting rules required that the guarantees be marked to market, or valued each quarter based on the current market price. Because the CDOs were considered even safer than the highest-rated securities, the premiums MBIA received to insure the securities were tiny. That made the volatility of super-senior CDOs even more of a concern, Gold explained.
Ackman ended his visit to MBIA with his suspicions confirmed. In the car on the way back to the city, he called his business partner, David Berkowitz. The pair had started Gotham together nearly 10 years earlier after graduating from Harvard Business School. “It’s even worse than I thought,” Ackman told him.
AFTER THE MEETING AT MBIA, Ackman wanted to increase his wager on MBIA. He called Lehman Brothers in August 2002, looking to buy huge amounts of CDSs on MBIA, Michael Neumann, the CDS salesman at Lehman, later told the New York attorney general’s office when it investigated Gotham’s activities in 2003. “We’re very interested in this trade,” Ackman told him. “We’re really interested