Confidence Game

IN THE FALL OF 2005, Oliver White arrived at Pershing Square. He had spent the summer working as a fishing guide in Jackson Hole, Wyoming, and reading the investment books Bill Ackman had sent him. White had also searched the Internet for information about Ackman. Most of what he found was from the Gotham Partners era: the investigation, the pump-and-dump allegations, the suggestions of market manipulation. “It was all about how bad Gotham was,” White says. “I chose to go anyway. He was different from the person I was reading about.”

The first thing Ackman did after White arrived was drop the report Is MBIA Triple-A? on White’s desk. “Bill never doubted that he could possibly be wrong,” White recalls. “It was never that [MBIA’s] stock was going to go down and we were going to make money that way. It was that the whole business model was going to come apart.”

Not everyone at Pershing Square was so convinced. Other members of the investment team weren’t as eager to talk about MBIA as they were about some of the fund’s other positions. Often, when White followed up with someone in the office about some MBIA issue Ackman had raised in a meeting, he was told, “Look, it just doesn’t matter.”

Members of the investment team believed Ackman was right about the company, but the problem was that the market just didn’t care. Unless the market reacted, Pershing Square’s investment in MBIA credit-default swaps would be a drag on performance.

By all indications, that drag was going to continue. On November 2, 2005, the Wall Street Journal reported that an MBIA settlement with regulators was expected by the end of the week. According to unnamed sources, the bond insurer would pay less than $100 million to settle the probe into its handling of losses related to the Allegheny Health, Education, and Research Foundation (AHERF), wrapping up the year-long inquiry as soon as the end of the week.

MBIA stock soared $5, or nearly 9 percent, to close the day at $62.49. It was the biggest gain for the shares in more than three years. “The real concern has been that regulators would find broader issues that would implicate current management or threaten the ratings,” Mark Lane, an analyst at William Blair & Company in Chicago, told Bloomberg News. The article “is reducing anxiety about broader issues,” he added.

The article was titled “MBIA Nears Civil Settlements—Investors Hope the Pacts Will Silence Bearish Critics.” Though the article didn’t quote any of these hopeful investors, it did note that an unusually high percentage of MBIA’s shares had been sold short.

If the story was leaked to the Wall Street Journal to silence further negative articles, the strategy was successful. I’d been pushing my editor to let me write again on the Caulis Negris transaction. I had even proposed taking a short unpaid leave of absence so I could dig into the story without the distractions of day-to-day market reporting.

The response was not positive. The managing editor, who oversees bond coverage at Dow Jones, told me I was obsessing over a story that was too complex and didn’t interest our readers. Look at the Wall Street Journal’s article on MBIA and its pending settlement, he suggested. That story moved the stock. “That’s the kind of story you should be breaking.” My story on MBIA and its complicated Caulis Negris transaction had been completely ignored, he added.

“If taking a leave of absence to write about bond insurance is what you really want to do,” he continued, “you should think about whether Dow Jones is the right place for you.” By the end of 2005, I was thinking about a new job.

Meanwhile, the Wall Street Journal article predicting a settlement lit a fire under Ackman. He wouldn’t let regulators drop the investigation. Several months earlier, Ackman had been contacted by David Farner, an executive at the University of Pittsburgh Medical Center (UPMC). Farner had followed the AHERF situation closely throughout the 1990s because its health-care operations in Pittsburgh, including the group’s flagship facility, Allegheny General Hospital, were a direct competitor of UPMC. Long before AHERF filed for bankruptcy, Farner had seen red flags in Allegheny General Hospital’s financial statements. In a 14-page report sent to both MBIA and the credit-rating companies, Farner, a former Arthur Anderson accountant, had taken apart the hospital’s disclosure. He flagged problems with arrows and notations all through the financial statements: “Investment income included in operating revenue.” “Cash transfers to AHERF exceed $14 million.” “Statements and footnotes for 1996 financials do not allow comparison with 1995 numbers.” But no one responded, and AHERF collapsed into bankruptcy the following year.

Farner had recently drafted another report. This one addressed events that followed the AHERF bankruptcy, and it had been inspired in part by a reading of Ackman’s report Is MBIA Triple-A? “This document describes the actions that we believe MBIA was willing to take to conceal another AHERF-related loss,” UPMC’s report began. The report wasn’t about the reinsurance transactions regulators were investigating but about how MBIA dodged additional losses related to AHERF.

One year after the AHERF properties in Philadelphia filed for bankruptcy in 1998—and MBIA arranged its reinsurance transac tions—AHERF’s Pittsburgh properties were teetering on the verge of collapse. Those facilities avoided bankruptcy after the Pittsburgh group’s creditors agreed to write down some of its debt and refinance the rest. Banks, including JP Morgan and PNC Bank, took a 33 percent writedown. MBIA, however, did not report any losses or writedowns.

Farner believed the bond insurer embedded its losses in the complicated refinancing transaction that took place in 1999. The refinancing of Allegheny General Hospital’s debt “represents a particularly egregious example of the claims in the Gotham Report that MBIA’s practice is to defer losses by restructuring troubled credits,” Farner wrote.

Here’s how it worked, according to the report. MBIA charged just $500,000 to insure the hospital’s new bonds even though the insurance lowered the hospital’s borrowing costs by what Farner estimated was $25 million. Bond insurance was supposed to be priced to reflect credit risk, and the hospital had below-investment-grade ratings. Farner believed that the cheap insurance policy was a disguised writedown. In fact, MBIA effectively took the same 33 percent writedown as some of the hospital’s other lenders. MBIA had originally insured $68 million of Allegheny General bonds, so a 33 percent writedown would have amounted to just about $23 million or the approximate savings from the bond insurance that was essentially given away. “We can only conclude that MBIA’s management valued the ability not to admit any additional AHERF-related losses,” the report concluded.

Ackman wanted regulators to see the document. He called Farner’s office, leaving him a voice-mail message at 9:15 a.m.: “I don’t know if you saw the Wall Street Journal today, but it says that MBIA is close to a settlement with the regulators. It could come as early as next week. We are meeting with the [Securities and Exchange Commission] tomorrow at the SEC’s request. It may be the last time that we have an opportunity to present information to the SEC. I am certainly aware of the West Penn situation, but I do not know the details as well as you do. I appreciate the fact that you want to speak with them without your being perceived as being influenced by us. I don’t think there will be any harm in having a conversation.”

Farner was traveling, so his secretary sent him a message about Ackman’s call, but before Farner could respond, Ackman called again, shortly after 10 a.m. “There are real issues out there on what MBIA did. You know better than anyone else. I don’t want to have to do this, but I will have the SEC and [the attorney general] send you a subpoena. We are at the 11th hour now, and I do not want to see MBIA get away with a crime. Let me know if you will be going voluntarily on this, or will I have to have the regulators subpoena you.”

Ackman hoped that if regulators could piece together what they knew about the AHERF reinsurance deal with Caulis Negris and the refinancing of Allegheny General Hospital’s debt, then they would see the truth about MBIA. The company had encountered serious problems in the late 1990s, and the only way it kept investors believing in its zero-loss business model was by using deceptive accounting and disclosure.

When Ackman and Farner finally spoke, Farner said he would be happy to get a subpoena. The requests for information arrived a few weeks later. Farner sent his report to the Securities and Exchange Commission and the New York attorney general’s office. Farner expected regulators to have questions about his analysis of the transaction, but he never heard from them again.

A SETTLEMENT WAS PROVING elusive, too. When MBIA announced third-quarter earnings on November 8, 2005, there was no news about a resolution. Instead, the company took a $75 million charge to account for its best estimate of what it expected eventually to pay in order to settle the regulatory investigation. MBIA had managed to “beat the numbers,” coming in below the $100 million amount leaked to the Wall Street Journal.

“Can you tell us what changed with respect to the other two reinsurers on AHERF that required you to restate earnings?” asked Ken Zerbe, the bond-insurance analyst from Morgan Stanley, during the MBIA’s earnings call. “I thought these were—these other two—were true risk arrangements.”

“I don’t want to be too specific in terms of the regulatory matters,” replied Nicholas Ferreri, MBIA’s chief financial officer. “But going through the investigative process and going through all of the risk transfer requirements . . . and based on all of the information that has come through, it’s appropriate at this time to correct and restate the financials on those contracts.” MBIA had managed to turn the settlement into old news without actually coming to an agreement with regulators.

By the end of 2005, it seemed clear that Spitzer’s office had lost interest in everything except the AHERF transaction. It fit nicely into Spitzer’s high-profile pursuit of insurance giant American International Group (AIG) and his headline-grabbing takedown of the company’s CEO, Maurice “Hank” Greenberg. Spitzer showed that AIG used “insurance” contracts to make itself appear financially stronger while also entering into reinsurance arrangements with others, such as Brightpoint and PNC, to help them conceal losses.

Ackman’s other issues with MBIA weren’t as easy to pin down. “There was a lot of interesting stuff,” one person involved in the investigation recalls. “But it was a swamp, a morass.” Regulators couldn’t rely on Ackman’s accusations and analysis, he explains. Everything had to be checked out.

Still, Ackman pushed on. He and Jonathan Bernstein, the Pershing Square analyst assigned to cover MBIA, made frequent trips to Moody’s offices. For the most part, the meetings were professional and cordial, but things got a bit emotional on one occasion, Bernstein remembers. Ackman had been telling Moody’s analysts that he felt MBIA management had responded disingenuously to some of his criticisms in a posting on the company’s Web site.

“These are people who challenged my reputation,” Ackman said. “Do you understand what it’s like to have a company try to destroy you? To see your children’s friends shy away from them because their parents read lies about you in the Wall Street Journal?” Ackman was visibly angry.

Bernstein remembers it as his least favorite moment. It was detrimental when their arguments were seen as personally motivated. And they were up against enough resentment already, Bernstein felt. “They (the Moody’s analysts) were there because Bill had complained to their boss’s boss’s boss,” Bernstein says.

One Moody’s executive who attended a number of the meetings with Ackman recalls his reaction to the hedge fund manager. “He was persuasive, organized. He came off as a bit crazy.” And, yes, he agreed, “it seemed like a personal crusade.” Ackman, he felt, “was emotionally vested and obviously financially vested.” That was always a big issue: the huge gains that Ackman would make if Moody’s downgraded MBIA. “Were we there to make him wealthy or to do the right thing?” the Moody’s executive asked.

As far as many in the market were concerned, a downgrade of MBIA remained unthinkable. When the Wall Street Journal asked James Lebenthal, chairman emeritus of municipal bond broker Lebenthal & Company and a former MBIA board member, what would happen if MBIA were to lose its top rating, he summed up the view held by many people. “You’re asking me to speculate on the divinity of the emperor,” Lebenthal said. “The emperor is divine.”

Ackman’s frustration with Moody’s boiled over at the end of 2005 when he wrote to the credit-rating company’s board of directors. “I am writing to bring to your attention two inaccurate Moody’s ratings that threaten the reputational integrity of Moody’s and potentially create personal liability for you as a director of Moody’s Inc.,” the letter began. Among those receiving the letter were Raymond McDaniel, Moody’s chief executive officer and chairman of the board; Robert Glauber, president of the National Association of Securities Dealers in Washington, DC; and Ewaldus Kist, the former chairman of ING Groep NV in Amsterdam.

Ackman explained that he was sending the letter to the board because Moody’s had failed to act on MBIA even though Pershing Square and Roger Siefert, one of the top forensic accountants in the country, had met three times with high-level Moody’s executives and analysts, providing evidence of aggressive and fraudulent accounting and “poor management character and candor.” Despite an ongoing investigation that had led to MBIA’s having to restate its results twice, he continued, Moody’s had not even placed MBIA’s ratings under review. There were many other issues that Moody’s was missing, which Ackman wanted to explain to the board.

“Moody’s Aaa rating is so powerful and credible that investors don’t do any due diligence on the underlying credit,” Ackman pointed out. These MBIA-insured obligations were piling up at a rate of about $2 billion a week, he explained. “Every day that Moody’s incorrectly maintains an Aaa rating on MBIA, these extremely risk-averse investors unwittingly buy bonds that are not deserving of Moody’s Aaa rating.”

The board declined Ackman’s offer to meet. John Goggins, Moody’s general counsel, wrote to Ackman to say that board members were not permitted to engage in discussions about individual credits. The policy was designed to avoid “even the appearance of inappropriate influence,” he wrote.

ON FEBRUARY 6, 2006, Ackman wrote to investors with the good news that they had earned 40 percent, after fees, on their investment in Pershing Square in 2005. The return would have been better without the short position on MBIA, which contributed a negative 3.3 percent to the result. “MBIA was our largest loser for the year despite news flow which would make any short seller proud,” Ackman wrote.

Wendy’s International was the fund’s biggest winner in 2005. The fast-food company’s shares surged after it agreed to a plan proposed by Ackman to spin off its Tim Hortons coffee and donut unit. Ackman’s most recent activist campaign, directed at McDonald’s, landed him on the cover of Barron’s under the headline “Meet Mr. Pressure.”

Pershing Square moved its offices from the Bowery Bank building on 42nd Street to 888 Seventh Avenue with views of Central Park, where tenants included hedge fund manager George Soros and private equity investor David Bonderman. At the end of 2005, Ackman bought a $26 million co-op in the Beresford Building overlooking Central Park.

Ackman’s success elsewhere made Jonathan Bernstein’s job all the more frustrating. As the primary analyst on MBIA, Bernstein read every article and every credit-rating company report that mentioned MBIA. He helped Ackman organize vast amounts of material for presentations to regulators and rating companies.

When Bernstein met friends after work for drinks, they asked him what Pershing investments he was working on. He could never tell them that he’d been assigned to work on the profitable ones, the ones that were catapulting Ackman into the news as a successful activist investor. Bernstein recalls a few friends who worked for funds of funds, which invest in hedge funds, sharing their bosses’ views on Ackman: “It’s the MBIA obsession; that’s why our fund isn’t investing with Pershing Square,” they told Bernstein. The consensus on Ackman and his persistence about MBIA was that he was either “a genius or a lunatic,” says Bernstein.

Rafael Mayer, an early investor in Pershing Square, says that Ackman’s drive to bring people around to his way of thinking can backfire. His impatience can make people feel a bit used, and his thoroughness can be seen as obsession, Mayer says.

“Look at Markopolos,” Mayer says, referring to Harry Markopolos, the fund manager who tried for 10 years to warn the Securities and Exchange Commission in detailed letters and e-mails about Bernie Madoff’s Ponzi scheme. “Unfortunately, if you write long letters, people think you are crazy,” Mayer says.

Even Ackman’s friends poked fun at his relentless pursuit of MBIA. For his 40th birthday, Ackman’s wife Karen threw him a party, inviting more than 100 family members and friends to the Blue Hill at Stone Barns restaurant in upstate New York. Former Gotham colleagues David Berkowitz and David Klafter composed a song in Ackman’s honor set to the tune of the 1936 hit “The Way You Look Tonight.” The song—hitting as it did on Ackman’s well-known self-assurance—elicited laughter and applause from the crowd.

For those of Ackman’s investors who heard the song, some of the spoof lyrics would prove prescient. These were good times for investors—the Dow Jones Industrial Average was flirting with 11,000, and the rise in property prices seemed unstoppable. But the good times wouldn’t last forever. “Some day, when we’re awfully low, when the world is cold,” Klafter and Berkowitz sang, “we will get a glow just thinking of you, and the way that you were right.”