Confidence Game

MBIA holds itself out to the investing public as a company that does not risk significant losses on the insurance it writes. In fact, MBIA’s winning streak came to an end in 1998.

—NEW YORK ATTORNEY GENERAL’S COMPLAINT AGAINST MBIA, JANUARY 2007

ON THE LAST FRIDAY in January 2007, word began to circulate that MBIA was about to announce a settlement with the New York attorney general’s office and the Securities and Exchange Commission (SEC). The settlement had been expected any day for more than a year. Now it appeared that the probe into the Allegheny Health, Education, and Research Foundation (AHERF) reinsurance transactions would end with MBIA paying $75 million, the amount it had taken as a charge more than a year earlier in anticipation of the settlement.

After more than two years, the regulatory cloud was about to lift. The stock surged in heavy volume in the final hour of trading after Bloomberg News reported the upcoming announcement. “We would view settlement as a huge relief,” Citigroup analyst Heather Hunt wrote in a research note to clients. “Expect short covering to drive up stock near term.” MBIA was, after all, the third-most-shorted stock in the Standard & Poor’s (S&P) 500 Index, she reminded investors.

After reading the news, Bill Ackman walked over to the firm’s trading desk to check prices on MBIA shares and credit default swaps (CDSs). For more than two years, Ackman had been waiting for regulators to take sweeping actions on MBIA. He had spent hours at the SEC and attorney general’s office describing what he believed were multiple offenses. It was not supposed to end this way, with a slap on the wrist for the AHERF transaction.

The investment team’s offices faced the trading desk, and through the glass partitions members of the team watched in amazement. Phones were put down. Eyebrows were raised. Within a few minutes, the team was standing around the trading desk, trying to figure out what on earth Ackman was thinking. Scott Ferguson, the first analyst to join Pershing, took the lead. He and Ackman had been sparring over the MBIA position for years. It was a loser for Pershing among a field of winners, and it had absorbed huge amounts of Ackman’s time and attention.

“Yes,” Ackman insisted. There was no more upside in the stock, Ackman said. The shares were fully valued even under the flawed models used by Wall Street analysts. The only reason for the stock rise was that everyone believed the short sellers would be forced to cover. He was not going to cover.

He also wanted to buy more CDSs. The premium on 5-year MBIA CDS contracts was 16 basis points, indicating that for $16,000 per annum, Ackman could buy protection against default on $10 million of debt. He had never seen the price that low. There was just no downside. It didn’t really matter if regulators had decided to let MBIA off easily. The company was overleveraged, and eventually that would take it down.

Mick McGuire, another Pershing analyst, remembers fearing that the MBIA short position was suffering from “investment analysis creep.” “First it was AHERF, Capital Asset, then Katrina. Was the reason for MBIA’s demise going to keep changing to support the idea of being short?” McGuire wondered.

No one doubted that MBIA was vulnerable, remembers Paul Hilal, Ackman’s longtime friend who joined Pershing Square’s investment team a year earlier. It wasn’t a matter of if but when the stock price would fall, Hilal says. But would MBIA blow up in a reasonable time frame? Did it make sense to keep putting money into a position if there was no catalyst? For years, the investment team had watched Ackman put his faith in the regulatory investigation. The regulators seemed to get it. After every meeting with the SEC, Ackman had been optimistic. Clearly, they didn’t get it. So, why add to the position now?

“Is Bill Ahab? Is he in denial?” Hilal recalls wondering, in a comparison of Ackman to the obsessed and doomed captain in Moby Dick. “We were operating on faith and out of respect for the guy. No one else had done the work on MBIA.”

All of Pershing Square’s other investments were analyzed by Ackman and at least one other analyst. Jonathan Bernstein, who had left the firm in 2006, had spent time on it, but MBIA had always been Ackman’s baby. No one had stepped into Bernstein’s shoes since he left the firm to go to business school, and no one wanted to. “It was complicated. It was personal,” says Ali Namvar, who joined the investment team in early 2006 from Blackstone Group, where he had met Ackman while working on the Wendy’s International transaction for Pershing Square.

The MBIA job wouldn’t be about analyzing and predicting cash flows, Namvar remembers thinking. In fact, it seemed to be turning into a letter-writing campaign more than anything else as Ackman tried to get others to see the risk he saw in MBIA. “As an analyst, it’s just not what you want to do,” Namvar says.

THE FOLLOWING MONDAY, January 29, 2007, MBIA formally announced the settlement. The company neither admitted nor denied any wrongdoing. The SEC and attorney general’s complaints made public the full story of the AHERF reinsurance contracts. MBIA engaged in a “fraudulent scheme” to mask the earnings effect of the default by the Allegheny Health, Education, and Research Foundation, the attorney general’s complaint said. The scheme guaranteed that the three reinsurers who covered the AHERF loss got back “every cent of their money plus a profit.” To pull off the scheme, MBIA lied to its investors, its auditors, the credit-rating companies, and its reinsurers, according to the complaint.

Without the improper use of reinsurance, MBIA would have reported its first quarterly loss ever in 1998, the complaint stated. Instead, it preserved the appearance of an unbroken track record of strong earnings. “MBIA holds itself out to the investing public as a company that does not risk significant losses on the insurance it writes,” the complaint said. “In fact, however, MBIA’s winning streak came to an end in 1998.”

These details didn’t dampen analysts’ enthusiasm for the company’s prospects. “We reiterate our ‘buy’ rating,” Bank of America analyst Tamara Kravec wrote, increasing her target for the share price to $85 from $78.

“Let the Repurchases Begin,” Merrill Lynch analyst Rob Ryan headlined his report. With the investigation behind it, MBIA was clear to restart its stock buyback program, Ryan wrote. He reiterated his “buy” rating.

“Settlement Finally Announced, Shares Benefiting from Short Squeeze,” JP Morgan told clients in a research note. “Shares have rallied about $4 since late Friday following the news alerts, which we believe has largely been driven by short covering.” The negative overhang had been removed from the stock, the report added.

During a conference call to discuss fourth-quarter earnings, MBIA chief financial adviser Chuck Chaplin explained that MBIA’s dealings with Capital Asset would be reviewed by an independent consultant as part of the settlement with regulators. “We don’t expect any further enforcement action,” Chaplin, who had replaced Nick Ferreri, reassured listeners on the call.

Geoffrey Dunn, the insurance analyst from Keefe Bruyette & Woods, asked the first question on the call. “Good morning and congratulations on getting past all that regulatory stuff,” he told Chaplin.

A few days later, MBIA’s board approved a $1 billion stock-buyback plan. The timing would depend on receiving approval from the New York State Insurance Department to take further dividends out of the insurance unit, MBIA said.

In early February 2007, Ackman attended the funeral of longtime family friend James Williams. A Michigan attorney, Williams had invested early on with Ackman in Gotham and later served on the board of First Union Real Estate. A reception was held after the funeral at the Bloomfield Hills Country Club. Ackman walked over to say hello to Williams’s daughter, who was standing with another woman. When he put out his hand to introduce himself to the other woman, she said: “I know who you are. You’re Bill Ackman.” She introduced herself as Heather Hunt and said she had reason to know him well because she was the equity analyst who covered the bond insurers for Citigroup.

Ackman had read her reports and considered her to be the most upbeat of the analysts following MBIA. “Any friend of the Williams family is a friend of mine,” he said, shaking her hand. Then he added, “This isn’t the time or place, but I think you’ve got it wrong on MBIA.” He suggested that they should get together and talk about it back in New York.

Hunt seemed amenable to the idea, even though it looked like the short sellers had been wrong about MBIA. Even where the short sellers had been right in their criticism, it seemed MBIA was going to get the last laugh. On February 13, 2007, a judge ruled against the plaintiffs, a group of shareholders who were seeking to sue MBIA after its share price fell in the wake of the AHERF restatements. The reason for the ruling: The plaintiffs waited too long to begin questioning whether the company had committed fraud. Shareholders had a duty to begin investigating the AHERF transaction after it was described in Gotham’s report, the judge said. “When the circumstances would suggest to an investor of ordinary intelligence the probability that she has been defrauded, a duty of inquiry arises,” he wrote.

“The Gotham Partners report, in conjunction with the earlier disclosures regarding the 1998 transactions, effectively put the market, including plaintiffs, on notice of the probability of misrepresentations and deception,” the judge wrote. The plaintiffs argued that they were thrown off track by management’s immediate denial of allegations raised in the report, but the judge had no sympathy. “Plaintiffs could not have reasonably relied on MBIA’s December 9, 2002, vague and general press release to allay the concerns raised by the Gotham Partners report and the series of prior disclosures,” the judge decided.

“Remarkable development,” Aaron Marcu, the outside attorney who represented Gotham when it was investigated by the New York attorney general, wrote in an e-mail to Katzovicz and Ackman after a Bloomberg News article ran describing the ruling. “The chutzpah is stunning.”

The subprime mortgage market had become an increasingly important part of the U.S. mortgage market. In the mid-1990s, only 5 percent of mortgages were considered subprime; in early 2007, that number grew to 20 percent. Outstanding subprime mortgages rose from $35 billion in the mid-1990s to $625 billion in 2005 and $1.7 trillion by 2007.

Most of these mortgages had been used to back trillions of dollars of supposed safe securities. A research report making the rounds in early 2007 reminded investors that it had yet to be seen whether the securitization market was sufficiently regulated, transparent, and stable to entrust with the funding of the U.S. mortgage markets. Josh Rosner, a consultant, and Joe Mason, a finance professor at Louisiana State University, warned that lenders had become far more aggressive in recent years, making it very difficult to predict default rates and losses on mortgages. If those losses exceeded expectations, then the deterioration in mortgage-backed securities could be dramatic.

To complicate matters, many of these subprime mortgage-backed securities had been purchased by collateralized-debt obligation (CDO), shrouding the risk of the underlying mortgages in one more layer. “Risk that is more difficult to see, by virtue of complexity, is risk just the same,” Rosner and Mason warned.

These rumblings did little to dampen spirits as more than 6,000 people descended on the Venetian Hotel in Las Vegas for the annual American Securitization Forum conference in the winter of 2007. Participants were guardedly optimistic that the concerns about the subprime mortgage market would blow over. Between gambling, golfing outings, and dealmaking, panelists batted around a number of troubling issues.

Mark Adelson, a structured finance analyst with Nomura Securities, took notes during the conference and shared them in a research report. “One panelist feels strongly that BBB subprime ABS [asset-backed securities] are lousy investments because they exhibit cliff risk,” Adelson’s notes rather ominously read.

Adelson labeled one section of his notes “Scary Topics.” It included this idea: “A slowdown in housing can create a feedback loop in the labor market as construction, mortgage lending, and real estate industries contract.” And then there was this observation: “Borrowers may start to behave differently than they have in the past in deciding whether or not to default on their loans.”

Still, the mood was upbeat. One panelist suggested that the structured finance market was on track to turn out an astounding $1 trillion of CDOs during 2007. Countrywide Financial Corporation, one of the largest providers of credit to the housing market, sponsored a cocktail party networking event. Citigroup executives held court in the Tao bar. Tonight Show host Jay Leno headlined the group’s annual dinner.

“Looking toward the horizon, one sees the telltale signs of a possible storm,” Adelson concluded in his notes. “It could blow over and amount to nothing. Or it could develop into a tornado.”

One particularly fateful meeting at the Las Vegas conference was between executives from Financial Guaranty Insurance Company (FGIC), a bond insurer that for years had shunned structured finance in favor of the stodgy, predictable municipal bond business, and IKB Deutsche Industriebank AG, a bank that had lent to middle-sized manufacturing companies in Germany since the 1920s.

In 2001, IKB began to use more of its capital to invest in CDOs. In 2002, it created an off-balance-sheet SPV called Rhineland Funding to purchase these exotic securities. By holding the CDOs in an SPV rather than on its own balance sheet, IKB needed less capital. The CDOs purchased by Rhineland were highly rated: mostly triple A, or super senior, and supposedly better than triple-A risks.

Rhineland obtained funding through the commercial paper market. To attract the risk-averse investors who bought commercial paper, Rhineland needed to reassure those investors that someone stood ready to buy the commercial paper in an emergency. This was known as liquidity support. For awhile, IKB provided the liquidity support guarantee, agreeing to buy the paper if the market boycotted it for some reason. But as Rhineland Funding’s outstanding commercial paper grew to 12 billion euros, it was clear that the bank wouldn’t have the cash if it was called on to buy Rhineland Funding’s commercial paper. IKB had come to Las Vegas pitching a structure it called “Havenrock II” to solve that problem.

The German bank had developed a complicated plan. French bank Calyon had agreed to buy $2.5 billion of CDOs from Rhineland Funding if Rhineland couldn’t roll over its commercial paper. The proceeds would give IKB the cash or liquidity it needed to pay back some commercial paper investors. Calyon, however, sought to protect itself from any loss on that contract by entering into two credit-default-swap contracts with Havenrock II, a Jersey-registered SPV created by IKB.

Havenrock II was essentially a shell company that lacked the assets to meet its obligations. This is where FGIC came in. IKB executives Winfried Reinke and Michael Braun explained to FGIC executives that they were looking for someone to provide a backstop on Havenrock’s obligations. They assured FGIC officials that the bank had never drawn on its liquidity facilities and wouldn’t do so in connection with Havenrock II, according to legal documents filed in a later suit over the transaction. Comforted, FGIC agreed to pursue the idea of doing the swap with Havenrock II.

At each step in the chain, an entity agreed to assume the risk that the CDOs could fall in value, but that entity immediately contracted to offload the risk to someone else. FGIC agreed to be the last in the chain only because it believed the ultimate risk resided in the first link of the chain back at IKB.

FGIC officials later met with Stefan Ortseifen, the head of IKB in Dusseldorf. In court documents, they recalled Ortseifen’s stressing the importance of Rhineland to IKB. The bank would always stand behind Rhineland and had in the past taken 10 CDOs out of Rhineland when they performed poorly, though the bank had no obligation to so. And although Rhineland had liquidity contracts with banks, it would be unthinkable for IKB to draw on those contracts and to shift distressed assets to third parties, the FGIC employees remember being told. The risk came full circle back to IKB, or so IKB seemed to be saying. On paper, FGIC assumed much of the risk, although the company’s business model called for assuming essentially zero risk. Somewhere in between IKB’s assurances that FGIC would never have to cover losses and FGIC’s promises to cover any and all losses, the risk vanished.

Bill Gross, manager of PIMCO, one of the world’s largest bond funds, might have been poking fun at the goings-on in Las Vegas that year when he wrote about the market’s dangerous reliance on the triple-A ratings assigned to securities backed by subprime mortgages:

“AAA? You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels, and a ‘tramp stamp.’ Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.”

WHEN ACKMAN WROTE to investors in the early spring of 2007, he had never been more enthusiastic about the fund’s MBIA position. “For some time, I have believed that our investment in MBIA credit-default swaps offers the most attractive risk/reward ratio of any investment I have come across in my investment career,” Ackman wrote in a March 5, 2007, letter to investors. It cost the fund about $10 million a year to have a bet on MBIA in the credit-default-swap market. The potential payout in the event MBIA filed for bankruptcy was $2.5 billion.

“The price of CDS on MBIA today continues to imply that the market assesses the probability of the company defaulting to be nominal,” Ackman wrote. “We believe otherwise.”

On the same day, Ackman sent an e-mail to his investment team: “I think we should short some Ambac.” He had been reading Ambac Financial Group’s 10-K filing, and the second-largest bond insurer had “larger mortgage-backed securities and home-equity exposure than MBIA, at around $60-plus billion, or approximately 10 times shareholders’ equity.”

The e-mail raised concerns for the team. Now Ackman was looking to short a second bond insurer. Scott Ferguson countered Ackman’s suggestion by saying that the shares of both MBIA and Ambac traded at around 10 times earnings per share. “I’m not bullish on multiple contraction from here,” said Ferguson, “unless we have a view that the market thinks ‘fair’ for these guys is eight times earnings.”

Someone else noted that virtually every analyst had upgraded MBIA in the last two or three months, “which seems to indicate that the stock price is just going to go right back up to the mid-70s.”

“My understanding of the reason for being short MBIA is because we think it is a fraud. If no one is willing to pursue and punish them for it, should we still be shorting it?” Mick McGuire wrote.

The entire investment team was about to get a lesson on just what was going on in the subprime world. In April, Boaz Weinstein, the head of credit trading at Deutsche Bank, called Ackman to set up a meeting. He wanted to bring along Greg Lippman, a trader with the German bank, who helped to create the ABX Index, a benchmark for the performance of various securities backed by subprime mortgages. Among those who helped Lippman create the index, which would become a gauge for the market’s fear of subprime, was Rajiv Kamilla, a Goldman Sachs trader with a background in nuclear physics.

The idea behind the ABX Index was to create reference points that could be used as a proxy for the state of the mortgage market. The ABX was actually a series of indexes. Each index averaged prices on a basket of credit-default-swap contracts written on 20 mortgage-backed securities, all originated around the same time and with the same credit rating.

Lippman had come to pitch Pershing Square on betting against the BBB-rated ABX index. Spreads on these mortgage-backed bonds had widened in recent months, but there was more to come, Lippman said. That was because spreads on these bonds had been kept artificially low. The buyers of the securities had been mainly CDO managers—and they’d been overpaying, Lippman said. In some ways, that was not surprising because the same banks that were underwriting the mortgage securities were underwriting the CDOs. There was no real third-party investor involved in the market. As subprime losses worsened, there was potential for “devastation of the sector,” according to the presentation.

The trade wasn’t the type of investment Pershing typically put on, McGuire remembers. Ackman liked to take positions in large, publicly traded companies that he believed were under- or overvalued by the market. Deutsche Bank’s trade, using credit-default swaps to bet on the rising risk premiums on an index of asset-backed securities, was esoteric and seemed initially like “a bunch of witchcraft,” McGuire says. “Looking back, it was the playbook for everything that was going to happen [in the subprime crisis].”

It was stunning how vulnerable BBB-rated mortgage bonds—considered safe, investment-grade securities—were to losses. It would take only a minor downturn for the securities to be wiped out. And the housing market was headed for more than a minor downturn. Housing prices had surged for years, mortgage loans had become more aggressive, and borrowers had put down less money. The strong housing market kept default levels in check. But if home prices were to lose their momentum, there would be huge problems, Lippman explained.

In a good housing market, losses on subprime-mortgage pools were typically about 6 percent. Deutsche Bank’s models predicted that if home-price appreciation slowed to 4 percent a year, losses on subprime-mortgage pools would jump to nearly 8 percent. That would be enough to wipe out most bonds rated BBB-. If home prices remained flat, then the next level, the BBB-rated bonds, would be wiped out. If home prices actually fell, higher-rated bonds would be in jeopardy.

Pershing didn’t put on the trade Lippman pitched, but the presentation affirmed Ackman’s view that Pershing should be shorting not just MBIA but also the other bond insurers, including Ambac Financial Group and Security Capital Assurance. On the surface, the bond insurers appeared well insulated. They hadn’t guaranteed BBB-rated subprime mortgage- backed bonds. But they had guaranteed something called mezzanine CDOs. These securities were backed by mortgage bonds rated A and BBB, levels in between the AAA-rated front row and the B-rated bleacher seats.

If Lippman’s projections were right and it took only a small drop in home prices to wipe out BBB-rated securities, then the bond insurers were in deep trouble. MBIA and Ambac may have insured only the AAA-rated parts of the mezzanine CDOs, but if the securities backing those CDOs were worthless, there was no hiding in the highest-rated tranche. By shorting the bond insurers, Ackman could capture rising subprime defaults, the rating-company folly that allowed investment-grade securities to be vulnerable to flat home prices and complex CDOs that failed to structure away risk. Besides, at the time Ackman met with Lippman, it cost $170,000 a year to buy protection on $10 million of the BBB-rated ABX index, whereas the same amount of protection on MBIA cost just $30,000 a year.

The Lippman meeting had started a bit after 5 p.m., but the group was still in the conference room at 8:30 p.m. Several of the attendees canceled dinner plans as the meeting ran late and lights in surrounding office buildings clicked into darkness.