Confidence Game - Christine Richard [122]
There was plenty to be concerned about. The stock market was lurching lower every day. Experts were talking about recession. Home sales, manufacturing, and employment were all weakening.
Then the Federal Reserve stepped in, slashing its benchmark rate by 75 basis points to 3.5 percent from 4.25 percent. It was the biggest cut in 23 years and the first time since the days after the September 11, 2001, terrorist attacks that the Fed had acted between meetings. Despite the move, stocks ended the day down.
IN THE WINTER OF 2008, the New York State Insurance Department became an unlikely hub for Wall Street power brokers. The department, with its narrow hallways, fluorescent lights, and suspended ceilings—from which cockroaches occasionally dropped onto the heads of employees—is a far cry from the plush offices of the investors and Wall Street executives who came regularly to meet with Dinallo about the bond insurers. On January 23, 2008, the CEOs and chief financial officers of the largest banks on Wall Street arrived en masse.
By the time the meeting got under way at 11 a.m., nearly 20 bankers were assembled from virtually every firm on Wall Street including Citigroup, Lehman Brothers, Merrill Lynch & Company, and Morgan Stanley. Some crowded around the conference table in the main meeting room. Others took up seats along the wall, and more called in and listened on the speaker phone.
Framed photos of more than 100 years of New York state insurance superintendents stared down at the assembled group. They had debated some difficult problems over the years—floods and fires, war and terrorism—but the issue on the agenda that day was unlike any other: a Wall Street-made catastrophe that threatened to bankrupt an entire class of insurance companies. The bankers were there to figure out what to do about more than $100 billion of contracts they had entered into with bond insurers to protect the value of CDOs backed by mortgages.
The question on everyone’s mind was whether a downgrade of the major bond insurers would cause the markets to seize up. If what had been happening in the market in recent days was any indication, there was good reason to be concerned.
Banks were counting on the bond insurers to keep their triple-A ratings so that the value of their hedges could remain intact.
Downgrades of bond insurers would create a growing hole in banks’ balance sheets, according to a Barclay’s Capital research report. Banks that already had raised $72 billion of capital could need another $143 billion if the bond insurers’ ratings were cut to low investment grade, the report warned. Even a downgrade of just one letter grade—to double-A from triple-A—would leave the banks $22 billion short of capital.
Because the bond insurers were rated triple-A, they weren’t required to post collateral against their credit-default-swap contracts. In the case of ACA, the company got a free pass on posting collateral as long as it stayed above triple-B. The arrangement set up a catastrophe, however, because ACA was not required to post collateral until its portfolio was so devastated by mark-to-market losses that a downgrade was unavoidable. Once that happened, collateral-posting requirements went from zero to billions of dollars in an instant, and ACA did not have the money.
MBIA, Ambac, and FGIC had more leeway on posting collateral than ACA Capital. They had to be considered insolvent before that became an issue. But how close were they to insolvency? The decline in the market value of the CDOs suggested that the bond insurers were going to have to make billions of dollars of payments. Surely, the banks had the upper hand as counterparties on contracts that, from the banks’ perspective, were worth billions of dollars.
“It’s a different world we’re in,” Dinallo recalls telling the group. “This is insurance.” The insurance