Confidence Game - Christine Richard [6]
Blythe Masters, a 26-year-old Trinity College graduate working at JPMorgan in 1995, is often credited with having invented CDS contracts. The contracts were created as a way for commercial banks to reduce their exposure to corporate borrowers. By purchasing protection against a default, the bank took on a position that would offset losses if a borrower defaulted.
The market for CDS contracts, which didn’t exist before the mid-1990s, totaled $2.2 trillion by the end of 2002. Outstanding contracts hit $62 trillion by the end of 2007. Ackman was not seeking protection against MBIA filing for bankruptcy; he was betting that the chance of the company defaulting on its bonds was more likely than the market believed. In addition to shorting tens of millions of dollars of MBIA stock, Ackman bought protection against a default on $2 billion worth of MBIA debt. He had also set up two additional funds, Gotham Credit Partners I and IA, to hold CDS contracts on MBIA. Investors in these funds could earn nearly 40 times their money, or a 4,000 percent return, if MBIA filed for bankruptcy. Of course, investors would lose their entire investment if perceptions about MBIA’s triple-A rating remained unchanged and unchallenged.
Ackman’s bet was spectacularly contrarian. He was wagering on the collapse of a company that the rating companies had awarded their highest triple-A rating and that everyone else was counting on.
Indeed, MBIA’s reason for being was to take the worries out of the debt market. MBIA’s president, Gary Dunton, summed it up in the company’s 2001 annual report: “In our minds, our franchise is the ultimate money-back guarantee, the ‘Good Housekeeping Seal of Approval.’ ”
The company was started in the early 1970s by a young man named Jack Butler, who had worked on Wall Street for Franklin National Bank, picking municipal bonds for the bank’s portfolio. One winter afternoon in 1967, as Butler was driving back from a ski weekend in Vermont with Jim Lopp, an investment banker, the pair hit on an idea: If you took the time to understand how the municipal bond market really worked, you could find plenty of municipal bonds on which the risk of default was practically zero. Butler bought such bonds all the time. Selling insurance on bonds that would never default sounded like a good business.
Butler and Lopp had worked together on a deal in Omaha, Nebraska, several years earlier that became their blueprint. The mayor of Omaha wanted to raise millions of dollars to build a sewage-incineration plant. The process was experimental, however, and taxpayers didn’t want to foot the bill if the project didn’t work. The sewage-incineration plan was designed to blast the sewage into a solid substance, which could then provide fuel to blast the next batch of sewage into more fuel. To finance the plan, the mayor, Lopp, and Butler came to an agreement. Lopp would underwrite the bonds, Butler would buy them, and the mayor would see to it that the project was bailed out if something went wrong.
In fact, the plant didn’t work. As Butler remembers it, the headline in the local Omaha newspaper read “Ten Million Dollar Toilet Doesn’t Flush.” But the mayor made good on his promise, and the taxpayers bailed out the bondholders.
The municipal bond market was less risky than it appeared, Butler realized. The credit ratings on many municipal bonds didn’t take into account the understanding between investors and public officials, such as Omaha’s mayor, that bonds used to fund public projects wouldn’t default.
Then came the spark of inspiration. If a smart investor could find bonds that were safer than they appeared, an even more astute businessperson could create a business guaranteeing these bonds. The bond-insurance business was simple: In exchange for receiving an upfront insurance premium, the bond insurer agreed to cover all interest and principal payments over the life of the bond if the issuer defaulted. As long as the bond insurer maintained its triple-A rating, the bonds remained triple-A. The beauty of bond insurance, Butler saw, was that