Confidence Game - Christine Richard [22]
“Thank you for the report,” Rutherfurd wrote back. “I will read at least the executive summary over the weekend.”
On December 16, a week after the publication of the Gotham report, Morgan Stanley issued its second report relating to MBIA since the firm’s analysts met with Ackman. This one was titled Gotham’s Concerns—Warranted or Not?
Analysts Alice Schroeder and Vinay Saqi also make a surprising point about MBIA and its competitors. “Ultimately to invest in this industry, we believe investors need to address the business-model question for themselves,” they wrote. Morgan Stanley had concerns about the model, they added, “however, our rating and valuation, of necessity, reflect the fact that investors (not to mention those whose paper is being guaranteed) have been willing to accept financial guarantors as a viable business model, because only those who do will buy the stocks and, therefore, set a price for them.”
Morgan Stanley’s response to the Gotham report laid out a dilemma that would have far-reaching implications not just for MBIA but also for the credit markets and the U.S. economy. Could the models being employed across Wall Street—not only to establish MBIA’s triple-A rating but also to set the ratings on trillions of dollars of securities—be relied on to safeguard the financial system?
From the perspective of a stock market investor, the answer was simple: “The business model question is one investors must take a position on and move on,” the analysts wrote. The answer wasn’t as simple for the credit-rating companies. By assigning the bond insurers triple-A ratings, the rating companies ultimately determined whether or not the bond insurers had a business. “We do not expect the rating agencies to do an immediate 180-degree as the result of a report such as Gotham’s,” wrote the analysts. One reason: “The rating agencies are an explicit participant in the guarantors’ business model, and, in effect, are now in the awkward position of passing judgment on themselves.”
Ackman’s startlingly high estimates for MBIA’s mark-to-market losses on CDOs were cited in the Morgan Stanley report. “Because of the gap between MBIA’s mark-to-model loss and the loss estimate other market participants have cited, this is the area that concerns us the most,” the analysts wrote. Growth in MBIA’s business of guaranteeing CDOs “has been explosive,” they noted.
MBIA responded to the Morgan Stanley report the same day. For the company to pay a single dollar covering a loss on a CDO, defaults on investment-grade bonds would have to be more than 2.5 times historical maximum default rates, the company said. Such a situation would be “an extremely unlikely catastrophic event, approaching a global meltdown of corporate credit.”
GOTHAM PARTNERS FACED a meltdown of its own in the days after the MBIA report was issued as Ackman and Berkowitz worked frantically to save the First Union deal. In a series of meetings, some lasting late into the night, Ackman and Berkowitz tried to come up with a settlement offer for First Union preferred shareholders. In the end, the preferred shareholders would not settle. Ackman and Berkowitz were not able to salvage the deal with First Union.
The decision to wind down Gotham’s main funds followed a meeting with Paul Roth, one of the top hedge fund attorneys in New York, and Joel Press, then a senior partner at Ernst & Young LLP, who was considered by many to be the dean of hedge fund accounting. The alternative to winding down the funds was to redeem the investors who asked for their money back in November. That would leave the remaining investors with a disproportionate amount of their capital in illiquid investments. Roth advised against it. The funds had experienced a material event with the halted merger of First Union and