Confidence Game - Christine Richard [94]
It was also the missing piece we did not have when we wrote the “Insurance Charade” article in the fall of 2006. Municipalities were publicly rated as if there was real risk they wouldn’t pay their debts. But on a second—largely undisclosed—scale that risk was assessed based on the track record of municipalities finding a way to avert default. The “moral obligation” that Jay Brown had spoken of in his meeting with Bill Ackman was factored into the second rating scale.
This second scale determined the capital charges applied by the credit-rating companies to the bond insurers when they guaranteed municipal debt.
The article struck a nerve. “Moody’s overrates MBIA and massively underrates municipals, thus generating this huge business of bond insurance,” one investor wrote me in an e-mail. “It is a racket that the taxpayers are subsidizing private bond-insurance companies. The ultimate irony is that the triple-A-rated bond insurers, who are rated on the corporate scale, are in fact riskier than the A-rated muni issuers, who are rated on the muni scale but are much less likely to default than the insurers. Who is insuring whom?”
ON MAY 23, 2007, Ackman joined the lineup of hedge fund managers making presentations at the Ira Sohn Investment Conference, an annual charity event held at the Time Warner Center in New York. Ackman made a presentation titled “Who’s Holding the Bag?” He answered this question by explaining that when the bond insurers were unable to meet their obligations on the billions of dollars of subprime securities and CDOs they had guaranteed, Wall Street banks and brokers would be left without the protection they were counting on.
Bond insurers presented a huge risk to the market, Ackman said. They had virtually no margin for error and yet financial institutions around the world were relying on them to maintain their triple-A rating. Investors trusted them so much, in fact, that bond insurers were one of the few counterparties in the credit-default-swap market that weren’t required to post collateral when the value of the CDOs they backed fell. “When losses hit, these guarantees will have no value, and the counterparties will be left holding the bag,” Ackman said.
Money had been flowing into the subprime mortgage market because CDO managers had been devouring all the mortgage-backed securities they could lay their hands on, Ackman explained. All that would be needed to halt this flow of money was for investors to get spooked about buying the lowest-rated tranche of a CDO. This piece of a CDO—the smallest, riskiest, and highest-yielding piece—had to be sold or the economics of the transaction didn’t work. If the CDO couldn’t be sold, then a huge source of demand for mortgage-backed securities would disappear. If the demand for mortgage-backed securities dried up, then originators wouldn’t be able to make as many mortgages. Every $1 invested in these lower-rated tranches of CDOs made it possible for the market to originate $111 of subprime mortgages, Ackman explained.
The demand for mortgage securities to create CDOs had made credit too easily available for subprime mortgages. Loan standards became shoddy. Buyers stretched their finances to get into homes they couldn’t afford. Adjustable-rate mortgages had become common, and now that loan rates had begun to reset in one giant wave that would continue for more than a year, borrowers would succumb in droves. Ackman used scatter graphs, flowcharts, and bar charts to tell a scary story: If the rating companies were wrong, as Ackman alleged, and the CDOs weren’t as safe as they seemed, then the subprime boom would turn to bust. Desperate borrowers wouldn’t be able to refinance into lower-rate mortgages. When losses on mortgage pools hit 9 percent, all mortgage-backed bonds rated triple B and below would become worthless. Moody’s was predicting losses of 6 percent to 8 percent, a recent upward revision.
Where did MBIA fit into this precarious picture? It had insured $22 billion worth of CDOs backed by subprime mortgages. Of those, $5 billion