Confidence Game

MBIA projects an image of financial health and rectitude. Woe to executives—and investors—if regulators prove it’s a facade.

—JONATHAN LAING, BARRON’S, APRIL 2005

TWO YEARS AFTER BILL ACKMAN wrote to his investors that he would wind down Gotham Partners, he was signing up many of those same investors in a new fund. Leucadia National Corporation had agreed to let Ackman take on outside investors a year ahead of schedule. The Leucadia-only fund had returned 29 percent over the first three quarters of 2004. Many of Ackman’s previous investors were eager to sign on again.

When the newly opened fund began operations on January 1, 2005, Ackman was far from Wall Street, angling for giant sea trout at a fishing lodge in Tierra del Fuego, at the southernmost tip of South America. He had bid for the stay at the Kau Tapen Lodge along the Rio Grande at a charity auction. The trip was a chance to celebrate the successful launch of his fund and to kick back—except that Ackman isn’t very good at kicking back.

“He’s so technical and inquisitive that he drove everyone crazy,” remembers Oliver White, the fishing guide assigned to work with Ackman. “It wasn’t enough to know how something was done. He always wanted to know why—why is it done that way,” White says.

For six days, Ackman and White, a philosophy graduate from the University of North Carolina at Chapel Hill, talked and fished. White explained technical details to Ackman about fly selection, casting the line, and luring the fish. Meanwhile, Ackman spotted the next member of Pershing Square’s investment team.

“At the end of his stay, he asked me—no, he told me—I should come to New York and work for him,” White says. It wasn’t uncommon for guides to be offered jobs by visiting executives and entrepreneurs. Camaraderie was easily kindled while fishing. “But usually you could just tell it wasn’t sincere,” White recalls. This time it was. Several months later, White returned home to North Carolina and found a box had arrived from New York in his absence. It was from Ackman and filled with books: Graham and Dodd’s Security Analysis, Peter Lynch’s One Up on Wall Street, Benjamin Graham’s Intelligent Investor, Lawrence Cunningham’s The Essays of Warren Buffett, and Thornton O’glove’s Quality of Earnings.

These were Ackman’s favorite books on investing, and he wanted White to read them all. Ackman made his reputation on Wall Street as an activist investor, a high-profile role that requires a knack for showmanship. But those who know Ackman well say he is an analyst at heart.

“He is the smartest analyst I’ve ever met,” says Rafael Mayer, managing director of Khronos LLC, a family office and fund of funds investor, and a friend of Ackman’s. “He looks at something and he just decomposes it.”

That process began with questions, lots of questions, including the one Ackman had badgered White with so many times while they were fishing: “Why?” It was also the question Ackman had tried to answer when he looked at the MBIA reinsurance transaction now being investigated by regulators. “Most investors have no clear conception of how companies can report earnings that are partially illusory; to them, numbers are numbers,” O’glove wrote in his 1987 book. Meaningful analysis requires one to understand the quality of earnings numbers, he stressed. And the reason so few investors do this kind of work, he added, is that “such research is usually negative. Most investors would rather kill the messenger than think about the message.”

SEVERAL WEEKS AFTER he returned from South America, Ackman, along with Marty Peretz, and Eliot Spitzer were huddled around a small table in the attorney general’s office, eating pressed turkey sandwiches. Peretz had arranged the lunch meeting. Ackman wanted to point Spitzer toward the important issues at MBIA, including its use of bogus reinsurance in 1998.

This was an important transaction. It showed how MBIA could not tolerate the perception that it sometimes made mistakes. In fact, Ackman insisted, the bankruptcy filing of the Allegheny Health, Education, and Research Foundation (AHERF) threatened MBIA’s zero-loss business model. As the hospital cracked under the weight of too much debt, its management raided charitable endowments it controlled for cash and propped up earnings by understating the amount of uncollectible hospital bills it carried on its books. In July 1998, when the city or any other government entity failed to come to its rescue, AHERF’s Philadelphia subsidiaries filed for bankruptcy protection.

“We did not understand that while most hospitals are essential, not all hospitals are essential,” Jay Brown had explained to Ackman in August 2002. MBIA’s guarantee of hundreds of millions of dollars of hospital bonds had been a miscalculation, and it came back to bite the bond insurer at the worst possible time.

Russia had recently defaulted on more than $30 billion of debt and severed the ruble’s link to the U.S. dollar. Asia’s year-old currency crisis was morphing into political and social chaos in Indonesia and Malaysia. Long Term Capital Management, a hedge fund run by a team of Nobel Prize-winning mathematicians, was unraveling and threatening to take the financial system with it.

Almost immediately after the AHERF bankruptcy filing, MBIA sought to reassure investors by stating that it had $75 million of reserves that would be adequate to absorb the loss. Yet confidence in the bond insurer continued to falter that summer on a combination of AHERF concerns and the Asian financial crisis. For the first time, investors were asking whether MBIA’s triple-A rating was at risk. MBIA’s shares had been sinking all summer, dropping from a high of around $53 in April to $43 by late summer and then tumbling precipitously in early September.

On September 11, 1998, the company held a conference call to set the record straight. “I understand that we have exhausted the phone line capacity of the provider, and I think we have something like over 250 participants on this conference call,” MBIA’s then chairman and chief executive officer (CEO) David Elliott said.

Elliott told listeners that MBIA was in the process of making arrangements in the reinsurance market, which—at very little cost—would double its reserves, ensuring that even if the loss was larger than $75 million, the company could cover the loss and eliminate an impact on its earnings.

The only problem, Ackman told Spitzer seven years later, was that MBIA didn’t really use reinsurance. It borrowed the money to pay for the loss and accounted for it improperly as insurance.

Spitzer called in the head of his investor-protection unit, David Brown, to join them. A former Goldman Sachs attorney who attended Harvard Law School with Spitzer, Brown had coordinated his boss’s assault on corrupt Wall Street research, improper trading by mutual funds, and kickbacks by insurance brokers. Brown seemed a bit stressed, Peretz recalls. “I had a dim foreboding that the attorney general’s office couldn’t confront another big scandal.” But Brown heard Ackman out, starting with the AHERF deal.

Ackman took the attorneys through the particulars of the deal: Three reinsurers—AXA Re Finance S.A., Converium Reinsurance (North America) Incorporated, and Muenchener Rueckversicherung-Gesellschaft (Munich Re)—agreed to make a payment to MBIA of $170 million in the fall of 1998. In exchange, MBIA agreed to reinsure $45 billion of bonds with the three reinsurers in the future. Converium reimbursed MBIA $70 million and was promised reinsurance business for which MBIA would pay it $102 million in premiums. Munich Re and AXA Re reimbursed MBIA $50 million each under the same type of policy. AXA was promised $98 million in future premiums; Munich Re would receive $97 million.

The transactions allowed MBIA to net the gains on its reinsurance contracts against its future AHERF claims payments, erasing the loss from its earnings statement. The reinsurance allowed MBIA to meet analysts’ expectations that it would earn $433 million in 1998 rather than report the first quarterly loss in its history.

“One simple question will enable you to determine whether reinsurance accounting is appropriate,” Ackman wrote in a follow-up e-mail to the attorney general’s office. “Ask the reinsurers whether they would have agreed to cover the $170 million in cash to MBIA to absorb the AHERF loss without some kind of offsetting arrangement—verbal, written, or otherwise.”

The answer would, of course, be no, Ackman wrote. The reinsurers took a $170 million cash loss the day they signed the AHERF reinsurance contract. “If you interview executives at Munich Re and they say that they would have agreed to cover the $170 million loss without a commitment of future premiums or some other form of reimbursement from MBIA, they are lying. The same, of course, holds true for the executives at the other reinsurers.

The transaction, announced on September 29, 1998, solved all of the company’s problems in one fell swoop—$170 million of reinsurance would cover the AHERF claim, allowing MBIA to avoid taking a loss and leaving its entire unallocated reserve intact for possible future claims.

Yet Ackman believed that the deal had created conflict behind the scenes. The company’s chief financial officer, Julliette Tehrani, left her post 10 days after the September 11, 1998, conference call to become an adviser to Elliott. Then both executives left the company a few months later and Brown stepped into the role of chairman and chief executive. Ackman found the explanation for these changes unconvincing. “I would like a little time to do various pursuits that are crazy, I realize, to most people,” Elliott told a reporter. “But I like to work outdoors—raking the leaves and mowing lawns—which I have had very little time to do.”

“I always suspect management is trying to hide something,” O’glove wrote in the introduction to Quality of Earnings, one of the books Ackman sent Oliver White. “What is it they are trying to do cosmetically? I ask. And I start out by assuming the worst.”

ON MARCH 8, 2005, MBIA announced that it would restate its financial results for the last seven years to account for one of the AHERF reinsurance contracts as a loan. MBIA did so because, based on an internal investigation, it appeared there might have been a side agreement made by an executive at MBIA to reassume almost all of the AHERF risk that was transferred to Converium Re. The other two contracts, covering $100 million of losses, were not restated. The next day, MBIA said federal prosecutors had joined the attorney general’s office and SEC in seeking information about the reinsurance transactions.

Ackman returned to the attorney general’s office several weeks later. He had more to tell about MBIA’s disclosure, its accounting, and its derivatives business. He described the investment-management business as an abuse of its New York state-regulated insurance unit. MBIA Inc., the publicly traded holding company, sold securities that received a triple-A rating because they were guaranteed by MBIA’s regulated insurance subsidiary. MBIA Inc. then invested the funds in higher-yielding securities, pocketing the difference between its cost of funding and the return on the securities, Ackman explained. The insurance unit would not offer guarantees to other companies to engage in this business because the risk was too high, he argued. In effect, Ackman said, the transaction was a disguised dividend from the insurance company to its parent company.

The story Ackman presented was complex. He was deconstructing MBIA’s entire business, and regulators had no idea how to deal with that. Just getting everyone in the group up to speed on bond insurance was hugely time consuming, as one person involved in the MBIA investigation recalls. Insurance is mind-numbingly complicated even before one considers the municipal finance, asset-backed securities, collateralized-debt obligations, and credit-default swaps (CDSs) that made up MBIA’s business. “Ackman,” he says, “had been marinating in it.”

“He comes across as very smart, with an unusually intense affect,” explains the person who attended a number of Ackman’s presentations. “He’s leaning in, staring fixedly, talking for long periods of time. He’s bright. And he knows he’s bright.”

At his best, Ackman had a way of making others in the room feel like they were as smart as he was. At his worst, he came across as the only one smart enough to get it. Then there was the sheer volume of information he presented. “He had a tendency to throw in everything including the kitchen sink,” the person says.

ON MARCH 30, 2005, MBIA received a second round of subpoenas from the Securities and Exchange Commission and the attorney general’s office. Regulators wanted to know more about many of the issues Ackman had raised during their most recent meeting. They wanted more information on how the bond insurer accounted for advisory fees and determined how much to set aside as reserves against future possible losses. They wanted details about a company called Channel Reinsurance, which MBIA had set up to reinsure billions of its guarantees. The next day the stock tumbled $4.36 to $52.28, its biggest drop in more than two years.

Despite the investigation, the New York State Insurance Department allowed MBIA to take special dividends out of its insurance unit for the first time in its history. The dividends were approved in both the fourth quarter of 2004 and the first quarter of 2005. MBIA used the cash to buy back shares, helping to boost its share price. A few days after the announcement that it had received a second round of subpoenas, MBIA issued a press release saying it had purchased more than 3.4 million shares in the first quarter and planned to continue purchasing shares whenever market conditions permitted.

Although New York State insurance regulators clearly weren’t worried about the creditworthiness of the company, the market was growing more skeptical. News of the regulatory investigation had pressured CDS spreads wider on both MBIA Inc. and its insurance unit. On April 26, it cost $55,000 a year to buy protection against a default on $10 million of MBIA debt compared with $33,000 to buy the same amount of protection on its largest competitor, Ambac Financial Group. In a letter during the last week of April, Ackman told Pershing’s investors that the fund’s short position on MBIA was its second most profitable investment during the first quarter of 2005.

The regulatory attention on MBIA generated lots of press, with articles appearing in the New York Times and the Wall Street Journal, and this time MBIA was on the defensive. Fortune magazine revisited the arguments Ackman made in his original report on MBIA. MBIA’s chief executive officer, Gary Dunton, bristled at Ackman’s criticism. “Think about what we do. We build infrastructure around the world. We enable countries to build markets. We do good. I don’t know why anyone would question the legitimacy of this business,” MBIA CEO Gary Dunton told Fortune’s Bethany McLean. “My mom says there are evil people out there,” Dunton added.

The investment weekly Barron’s wrote about MBIA after the firm received a second round of subpoenas. “MBIA projects an image of financial health and rectitude,” columnist Jonathan Laing wrote. “Woe to executives—and investors—if regulators prove it’s a facade.”

Success inspired Ackman to try again with Moody’s Investors Service. “Mr. Rutherfurd, two years ago we had an e-mail dialogue concerning a research report I wrote on MBIA,” his message began. He explained that since his last contact with Rutherfurd, the Gotham investigation had ceased, MBIA had restated six years of earnings, and the bond insurer had received more subpoenas related to issues raised in the Gotham report. “It is clear that you did not take me seriously two years ago, I guess because of all of the negative publicity,” Ackman wrote. “I would be willing to meet with you, your chief risk officer, and anyone you would like to attend such a meeting.”

But in the early summer of 2005, Chris Mahoney, Moody’s chief credit officer and vice chairman, contacted Ackman about setting up a meeting. Roger Siefert, the Kroll accountant, accompanied Ackman, along with Scott Ferguson and Jonathan Bernstein from Pershing’s investment team, to Moody’s downtown office.

“It was the first time that a third party had come in and lobbied for a rating downgrade,” says a person who attended some of Moody’s many subsequent meetings with Ackman. “It was unprecedented.” And in many ways, it was unappreciated. “He made so much noise, ran it as high up the org chart as he could. So we said, ‘Okay. Let’s just humor him,’” the person recalls.

Ackman delivered what was becoming a well-practiced monologue. He talked about MBIA’s move into insuring structured finance, what he described as MBIA’s misleading track record of losses, and its unique vulnerability to a downgrade because it relied on its triple-A ratings to survive.

One of the Moody’s analysts stopped him there. If the bond insurer were threatened with a downgrade, then it could go out and raise more capital, he said. Ackman disagreed. The need for capital would undermine management’s and the business model’s credibility, Ackman said. No one would want to put money into a company that had just proven its business model was broken, he added.

“It was a little victory, and there weren’t many victories with Moody’s,” Bernstein says. Siefert remembers the comment, too. It was a moment when he thought someone at Moody’s saw the huge paradox of a company being triple-A rated even though the only thing that stood between the company and its collapse was a triple-A rating.

And maintaining that triple-A rating was only going to get harder. Ackman noted that MBIA faced a nearly impossible task of increasing its earnings and guarantees without venturing into riskier lines of business. In fact, the company had already stumbled. That’s why MBIA engaged in the AHERF transaction and others that helped it bury losses. “Management integrity has been compromised to uphold the ‘no-loss illusion,’” he said.