Confidence Game - Christine Richard [125]
WHEN NEWS OF the meeting between New York State Insurance Superintendent Eric Dinallo and representatives from the Wall Street firms was leaked later in the afternoon of January 23, 2008, the stock market soared. The Dow Jones Industrial Average rose more than 600 points, erasing an earlier drop of 300 points, as financial shares rallied. Ambac ended the day 72 percent higher, and MBIA gained 33 percent.
The rally continued in Asia. “Whether investors can sustain their confidence in the U.S. economy’s stability is the key,” Juichi Wako, a strategist at Nomura Securities Company, told Bloomberg Television News. It seemed a big part of that confidence rested with the triple-A ratings of the bond insurers.
It seemed that Dinallo had become more important to the market than the Federal Reserve.“The prospect of a rescue caused a far bigger stock market rally than the Fed’s biggest rate cut in a quarter of a century the day before,” the Economist magazine later noted. “There may be no better example of how a dull province of finance, when snared by complex risks it barely understands, can become terrifyingly unboring.”
Despite the upbeat tone of the market, the bad news kept coming. After the market closed, Security Capital Assurance Limited said it wouldn’t raise new capital. The “unprecedented uncertainty and instability affecting our industry make it impractical to consider raising new capital at the present time,” the company said in a statement. Fitch Ratings, which had warned that the company needed an additional $2 billion in capital to justify a triple-A rating, took the company’s insurance rating down five levels to single-A and left it under review for further downgrade.
THE NEXT DAY, January 24, Bill Ackman and Fiachra O’Driscoll, the head of synthetic CDO trading at Credit Suisse, met with Wilbur Ross. The billionaire investor was rumored to be considering a stake in Ambac. Unlike Marty Whitman and the principals at Warburg Pincus, Ross was willing to hear what Ackman had to say.
Ackman and O’Driscoll described how the companies were going to be destroyed by their exposure to collateralized-debt obligations (CDOs) and other securities backed by home loans.
“If you decide to invest, I’d steer clear of MBIA and Ambac,” Ackman said. “We haven’t analyzed Assured Guaranty, but the company is coming through this the best so far.”
The reason Assured Guaranty never took a single CDO backed by mortgages to committee was because it couldn’t review the underlying risk, Sabra Purtill, head of investor relations at Assured Guaranty, once explained to me. What were the FICO (Fair Isaac Corporation) scores on the underlying loans? How much was being borrowed compared with the value of the house? What was the borrower’s income?
One of the ironies of the bond insurers’ demise is that they were aware by 2005 that subprime loans had become riskier, yet the risk premiums on subprime mortgage-backed bonds were continuing to shrink. The bond insurers stepped back from the subprime market only to stumble into a magnified version of that risk in the CDO market.
When insuring CDOs, the bond insurers became reliant on someone else to do the work on the underlying securities, and it turns out that work didn’t get done. The CDO managers who had become major buyers of subprime mortgage-backed securities were interested only in credit ratings and yield. They didn’t pull the files on mortgages. Besides, Purtill says, reviewing the underlying loans simply wasn’t possible.
Purtill estimated that it took a single employee about one month to spot-check the files on the approximately 1,000 loans behind a mortgage-backed bond. Consider the amount of work necessary to complete the due diligence on a CDO backed by subprime-mortgage bonds—that’s assuming it was even possible to get access to information on all the underlying loans. If the CDO referenced 100 mortgage-backed bonds, then it would take one person 100 months, or a little more than eight years, to complete loan-level due diligence.
And what if the