Confidence Game - Christine Richard [150]
The downgrades also left a slightly unsettling feeling of “What’s next?” Bond insurers had been pillars of predictability. Not any longer. When Moody’s Investors Service downgraded CIFG in May, it took the rating down seven notches. Moody’s said CIFG—a company rated triple-A just a few months earlier—was close to breaching its minimum regulatory capital levels, which could cause regulators to take it over. That, in turn, could trigger termination payments like those ACA Capital faced and couldn’t meet.
Credit-default-swap (CDS) contracts had changed the rules of the game for bond insurers. Bond-insurance policies obligate a company to cover interest and principal when due on a bond if the issuer defaults. CDS contracts subjected bond insurers to a number of conditions that were poorly understood but potentially lethal.
“Depending on the language in the credit-default swap [contracts], [a termination event] can set off a chain of events that creates a complete unwind of the company,” Thomas Priore, chief executive officer of hedge fund Institutional Credit Partners LLC in New York, told me.
The bond insurers guaranteed hundreds of billions of dollars of CDS contracts, including $127 billion on CDOs backed by subprime mortgages. The riskiest hedge fund that sold protection through the CDS market was required to put up cash if the cost of protecting the underlying security rose. Because the bond insurers were triple-A rated when they entered into these contracts, they were deemed so creditworthy that they didn’t need to post collateral. Now the companies faced an immediate and overwhelming call on all of their capital in the event they were taken over by regulators.
On June 11, 2008, several days after the S&P downgrade, Jay Brown wrote to MBIA shareholders telling them not to be distracted by the inevitable “articles and reports” that would opine on everything from the company’s decision to keep the $900 million at the holding company to the mark-to-market value of its CDS contracts. “Please stay focused on this as the current difference between our estimates of ultimate economic losses (approximately $2 billion) versus the current market estimates reflected in our stock price ($10 [billion to] $14 billion) is really what this story is all about.”
Bill Ackman thought there was more to the story than that.
ON JUNE 18, ACKMAN MADE a presentation to a group of attorneys and hedge fund managers at the law firm Jones Day. That presentation, called “Saving the Policyholders,” was his last on the bond insurers.
He told the audience that most of the bond insurers, including MBIA, were already insolvent. Insolvency in New York state was measured in two ways: The first trigger is hit when a company has reported so many expected claims that it has essentially flagged for regulators that it won’t be able to meet all its obligations.
There is a second test of solvency, however, that asks an insurer to show it has sufficient assets to reinsure all its liabilities. In other words, could the firm pay another insurance company to take on its existing obligations? The answer to that question for MBIA was absolutely not.
The mark-to-market losses—which the companies insisted were no more than a reflection of an irrational market and should be ignored—were critical. In fact, the complicated formulas used to determine mark-to-market losses on CDS contracts sought to answer this very important question: How much more would an insurance company want to be paid—above the premiums already collected—to take on another insurer’s obligations?
If the bond insurers couldn’t reinsure their obligations with their existing assets, then the New York state insurance department should take them over, Ackman argued. If that happened, the CDS counterparties had the right to terminate their contracts and be compensated for the loss in the market value of their CDOs. It was a fatal sequence of events that began with the mark-to-market losses bond insurers were insisting everyone should ignore.
Investors were unaware of the risk