Confidence Game - Christine Richard [110]
CDOs can create a more devastating outcome once bond insurers begin to pay claims. The insurer might start paying claims on a CDO guarantee once losses in underlying mortgage pools hit 30 percent, just as it would on the straight mortgage-backed bonds. But the insurer may find itself paying off 100 percent of the value of the entire CDO it has insured by the time underlying pool losses reach just 35 percent.
The slicing, dicing, and repackaging of securities can concentrate risk. Mortgage-backed bonds are supported by payments on thousands of mortgages; everyone has to default before there’s a complete loss. CDOs, however, rely on the cash flow from hundreds of mortgage-backed securities. Recall that mortgage-backed securities have different ratings depending on where they reside in the payment waterfall. Lower-rated securities are completely shut off from the cash flow as losses increase. If all the securities backing a CDO are rated triple-B, they may be completely starved of cash as losses on underlying mortgage pools move from 30 percent to 35 percent. That means the entire CDO is cut off from cash even though most people whose mortgages are in the pool continue to make their payments.
The speed with which losses can burn through a mortgage-backed bond versus a CDO is akin to the difference between a fireplace log burning over the course of an evening and a newspaper incinerating within seconds. “We told Moody’s that ABS CDOs don’t meet our credit criteria,” Sabra Purtill, head of investor relations at Assured Guaranty, once related to me. “We told them ABS CDOs are dangerous. They never asked why. It was like we were talking to a tree.”
ON NOVEMBER 28, 2007, Ackman took the stage at the Value Investors Conference in Manhattan.
For the first time, Ackman had hired security guards to accompany him to a presentation. Many people believed Ackman was fanning a dangerous fire with his criticism of the bond insurers. During a Barclay’s Capital conference call on the financial guarantors earlier in the month, one caller prefaced his question by stating that he believed those writing and speaking negatively about the bond insurers were “financial terrorists.”
For years Ackman had asked regulators, reporters, and just about everyone he spoke to about MBIA to see no contradiction in shorting a company and being a decent person. It is an idea that many people simply can’t accept.
When Ackman had testified at the Securities and Exchange Commission in 2003, this issue of doing good by short selling had come up. Ackman had said it was one reason he decided to short Farmer Mac. “I prefer investments where I’m not fighting against the country. You know, where there’s public policy on my side instead of against me,” Ackman had told the investigators.
But the SEC attorneys had been skeptical. Wasn’t he really interested in Farmer Mac because he was seeking to profit from the company’s collapse?
“I’m a bit idealistic so it isn’t only a profit motive, but there was a profit motive, absolutely,” Ackman had responded.
Now Ackman asked the packed auditorium of investors to believe that he had devised a plan that would both hasten the collapse of a company he was betting against and do some public good in the process. Not many people would try to pull that off, but Ackman had his unrepentant idealism.
Ackman’s 146-page presentation was titled “How to Save the Bond Insurers,” and it laid out his plan for conserving capital within the insurance subsidiaries of MBIA and Ambac. Holders of insured bonds and the Wall Street firms that had sold credit-default swaps to MBIA would benefit from the additional capital, Ackman said. “The holding companies are the problem,” he told the audience. The holding companies wanted to take as much capital as possible out of the regulated insurance subsidiaries, but the policyholders were going to need that capital. Take back improper dividends, said Ackman. Void the inter-company guarantees that allow MBIA to run what is effectively a fixed-income hedge fund. Void the transactions