Confidence Game - Christine Richard [20]
MBIA was ballooning its exposure to CDOs—adding $30 billion of guarantees in nine months—and underestimating the risk, the report said. Bonds referenced in CDOs are more likely to suffer from adverse selection because banks may use CDOs to offload risk to credits they’re worried about, Ackman wrote. As a result, CDOs are more likely to be packed with higher-risk credits than a random portfolio of bonds, he explained.
The credit-rating companies also were underestimating correlation risk, the report said. Although an earthquake in California doesn’t increase the chance of an earthquake occurring in Florida, bond defaults tend to be contagious and closely correlated in times of economic stress. That makes CDOs, which mingle various types of loans across different geographic regions, vulnerable to the same pressures.
In fact, the whole bond-insurance industry might be vulnerable to faulty statistical models that rely on the past to predict the future, Ackman argued in the report. These models estimated that MBIA faced just a 1-in-10,000 chance of confronting a scenario that would leave it unable to meet all its claims. Yet historical data-based models considered the 1987 stock market crash an event so improbable that it would be expected to happen only once in a trillion years, Ackman explained. “The recent stock market bubble and its collapse are good reminders that the ‘unthinkable’ and the ‘unpredictable’ occur more often than expected,” Ackman wrote.
Ackman also pointed out that MBIA was dangerously reliant on its own triple-A credit rating. Without the top rating, MBIA wouldn’t be able to write new business, Ackman said. MBIA’s investment portfolio would fall in value after a downgrade because it was packed with bonds guaranteed by MBIA itself. The assets in the SPVs, some of which were insured by MBIA, would fall in value while investors—who provided financing to the SPV through the commercial paper and medium-term note markets—would demand a higher yield or perhaps shun the securities altogether if they carried a lower rating. “An actual or perceived downgrade of MBIA would have fairly draconian consequences for the company and create substantial drains on the company’s liquidity,” Ackman concluded. “The self-reinforcing and circular nature of the company’s exposures makes MBIA a poor candidate for a triple-A rating.”
The report sent MBIA’s shares tumbling nearly 4 percent on the day it was released.
MBIA issued a press release within minutes of the report’s publication. The report “is not independent, objective research but rather a negative advocacy piece by a hedge fund that has shorted MBIA stock and has also taken a speculative position in derivatives on MBIA-insured debt,” the statement said. “Many of the points raised in the Gotham report are patently wrong and demonstrate a clear lack of understanding.”
The Gotham press release landed on my desk at Dow Jones. I called Ackman to request a copy of the report. It was rare to find anyone on Wall Street willing to publicly criticize a company. But Ackman was bursting with comments: “The more I looked, the more I found,” he told me.
Equity analysts rushed to discredit the report. “We believe the Gotham report mixes and matches in such a way to as to prey upon post-Enron fears,” Joshua Shanker, an analyst with Blaylock & Partners, said in a report.
Not everyone, however, was critical. Several days after the report was released, Ackman received an e-mail from a former senior MBIA executive. “I commend the authors of the December 9 research on MBIA,” the e-mail began. “It is extremely well documented for the arcane sector of the financial-guaranty insurance and hopefully has been well received for its many revelations.”
The following day, Brown took the podium at a Keefe Bruyette & Woods insurance conference at Le Parker Meridien