Chapter Seventeen
Apocalypse Now
Super-senior CDOs: “The greatest triumph of illusion in twentieth century finance.”—JANET TAVAKOLI,
STRUCTURED FINANCE AND COLLATERALIZED DEBT OBLIGATIONS (JOHN WILEY & SONS, 2008)
OUTSIDE PERSHING SQUARE’S offices on Seventh Avenue in Manhattan, Bill Ackman, Pershing analyst Mick McGuire, and Roy Katzovicz, the firm’s chief legal officer, piled into a taxi. All three were wearing suits on a hot and sticky first day of August for a 9:30 a.m. meeting with New York State Insurance Superintendent Eric Dinallo.
They were running late after the usual last-minute debate over cutting pages from the presentation. “For every page of one of Bill’s presentations, you can be sure there were two or three that were cut,” McGuire remembers. “If it was up to Bill, every presentation would be an eight-hour seminar.” Katzovicz carried a box filled with copies of their latest presentation: “Bond Insurers: The Next S&L Crisis?”
After a few minutes, the taxi slowed in the crawl of rush hour traffic. “We shouldn’t have taken a taxi,” Ackman fretted. As they reached Houston Street, Ackman insisted they get out and take the subway: “It will be faster.” The subway left them several blocks from the insurance department on Beaver Street in lower Manhattan, and they closed the remaining distance at a high-speed walk in muggy Manhattan heat, Katzovicz struggling with the box of presentations. The pace was nothing unusual for Ackman. “Bill walks faster than anyone I know,” McGuire says.
Dinallo had been appointed to the top insurance post by New York Governor Eliot Spitzer in January 2007. A New York University- educated lawyer, Dinallo worked under Spitzer during his crusading days as the state’s attorney general. Dinallo masterminded the use of the Martin Act to go after Wall Street fraud and stood on the podium along with his boss at press conferences when Spitzer announced settlements with some of the country’s largest financial institutions. Since taking up his post at the insurance department, Dinallo had already pushed through a long-stalled insurance settlement to cover the September 11, 2001, destruction of the World Trade Center. On that hot August morning, new problems were looming.
The group took seats around a conference table and Ackman delivered the “Who’s Holding the Bag?” presentation he had given at the Ira Sohn Investment Conference in May. He described how the incentives to securitize and sell mortgages created enormous moral hazard in the mortgage market, how faulty structures allowed billions of dollars of doomed securities to be built out of the riskiest parts of bonds, and how small losses on $100 billion portfolios of collateralized-debt obligations (CDOs) could wipe out a bond insurer’s entire capital base.
He also reviewed other issues specific to the insurance department’s role in overseeing the bond insurers, such as how bond insurers were engaging in prohibited credit-default swaps (CDSs) and how MBIA’s growing fixed-income arbitrage business amounted to a disguised dividend from its regulated insurance subsidiary. Ackman argued that Dinallo couldn’t stand by and allow the credit-rating companies to usurp the department’s role as the de facto regulator of bond insurers. The ABX index referencing triple-B-rated subprime mortgage bonds indicated investors expected to recover just 65 cents on the dollar for those bonds before the credit-rating companies began to downgrade the debt, he said. Wait for the rating companies to “regulate” the market and it will be too late.
Ackman made the case that the insurance department should stop dividends to the holding companies of bond insurers and halt holding-company share buybacks because those funds would be needed to pay claims at the insurance subsidiaries. Pershing Square’s short interest in the holding companies had aligned the hedge fund’s interests with those of policyholders, Ackman argued. “There’s a huge crisis on the horizon, and it’s going to come sooner than you think,” he told the assembled group.
When the Pershing Square group got back to the office, others at the fund were eager to hear how things went. “Everybody would pile into Bill’s office for a recounting of events,” McGuire remembers. It was more than an investment-team event. Everyone was eager to hear about it: the investor-relations group, the traders, the tech guys, the assistants. “People appreciated the position, its significance to the firm and to Bill personally.”
“It was an incredible meeting,” Ackman told the group. Regulators were going to see that MBIA shouldn’t be taking any more money out of its insurance unit because policyholders are in jeopardy. “They’re toast,” Ackman concluded of MBIA.
From the outside, Ackman was the ultimate skeptic, the guy who didn’t believe in the most trusted company on Wall Street. Around the office, however, he could be seen as hopelessly idealistic for believing he would be able to convince the world he was right about the bond insurers. After every meeting it was as if the same regulators and credit-rating company analysts, who hadn’t acted yet despite years of presentations, finally got it. Scott Ferguson, with the investment team, was much more the in-house skeptic.
“Really? What did they say?” Ferguson asked.
“They’re regulators,” Ackman told him, “so, of course, they can’t really say anything.”
Eventually, one of Ackman’s phrases for describing the success of his MBIA meetings was adopted around the office as shorthand for Ackman’s optimism. “Bill’s meeting? Ten out of ten?” “Yep. Ten out of ten.”
MBIA HAD SCHEDULED a conference call for the next day, August 2, to allay concerns about its CDO and subprime exposure. MBIA management put in place a new protocol for the call. All questions were required to be submitted in advance by e-mail. Mick McGuire, figuring questions from Pershing Square wouldn’t make the cut, messaged Jordan Cahn, on the credit-default-swap desk at Morgan Stanley, with some thoughts.
“The company, and much of the analyst community, speaks to the idea that the MBIA guarantees attach at super-senior levels of the capital structure and have a large cushion below them, making it highly unlikely that they suffer a loss,” McGuire wrote. “Yet it appears to me that every one of their high-grade CDOs has subprime exposure that exceeds the cushion protecting MBIA. If the subprime collateral is A-rated or lower and losses reach 15 percent, then the collateral is worthless and MBIA will begin to incur losses on its guarantees.
“The Holy Grail question relates to cumulative losses,” McGuire continued. “What would the cumulative losses within the 2006 subprime universe need to be for MBIA to incur a loss in its CDO portfolio?”
The company received hundreds of questions in advance of the call, Greg Diamond, the head of investor relations, told listeners as the call got under way. Diamond warned listeners to try to keep up with the slides because the presentation provided some “challenging and detailed information.”
“Bottom line, there may be downgrades in this portfolio as a result of the unprecedented housing crunch,” said Chuck Chaplin, MBIA’s chief financial officer, “but our subprime-mortgage exposure does not appear to pose a threat to the company’s balance sheet.”
At some point in the long queue of questions, McGuire’s got asked: “What would be the cumulative losses within the subprime universe needed for MBIA to incur a loss in its direct and CDO portfolio?”
The question elicited a long response but not an answer. If 100 percent of the collateral rated A and below defaulted with no recovery, “certainly the CDOs of high-grade mezzanine collateral would be materially impacted,” said Anthony McKiernan, head of MBIA’s structured finance. But he didn’t say what level of losses would trigger that scenario. Ten percent? Fifteen percent? Fifty percent?
The scenario—hundreds of A-rated securities all defaulting—sounded far-fetched. But as Deutsche Bank’s Greg Lippman had pointed out to the investment team at Pershing Square just a few months earlier, it was not. In a good housing market, with double-digit annual gains in home values in many markets, losses on subprime loans had run about 6 percent. Deutsche Bank figured that if home-price appreciation fell to 4 percent a year, subprime losses would jump to 8 percent. A market in which home prices remained flat would completely wipe out triple-B-rated bonds. A triple-B rating is a low investment-grade-rated security. A decline in home values would cause the damage to move up the rating scale, putting even single-A-rated bonds in jeopardy.
The subprime market contained the hallmark of every Ponzi scheme. It worked only as long as more money was put into the scheme. When home prices were rising, overextended borrowers usually could pay off their first mortgage—and often a home-equity loan and credit-card bills on top of that—by selling their house in a rising market. Once home prices stopped rising, the game was over, and home prices would plummet.
The mortgage market may have become perilous in many places, but MBIA executives said the company remained open for business. There was strong demand for bond insurance, and the premiums that insurers could command in the current market had improved, said Patrick Kelly, head of CDOs and structured products at MBIA. “We want to take advantage of the current situation where we can, even in the ABS CDO market,” Kelly said. “We also want to avoid getting stuffed with the risk that people are just looking to get off their own books.”
THREE WEEKS LATER, on August 24, 2007, Merrill Lynch’s head of fixed income, Osman Semerci, along with three other executives from Merrill, boarded a helicopter for the short flight to MBIA’s Armonk headquarters.
Janet Tavakoli, a CDO guru who runs her own structured finance research firm in Chicago, later dubbed Merrill Lynch’s last-ditch effort to dump toxic securities on MBIA the “Apocalypse Now helicopter ride,” a reference to the scene in the Francis Ford Coppola movie in which U.S. helicopters level a Vietcong village while blaring Wagner’s highly dramatic “Ride of the Valkyries.” These CDOs were so loaded with toxic subprime mortgages that Tavakoli expected the bond insurer to take losses on this so-called “super-senior” exposure.
In her book on CDOs, Structured Finance and Collateralized Debt Obligations (2008), Tavakoli calls super-seniors “the greatest triumph of illusion in twentieth century finance.” A major motivation of creating super-senior tranches of CDOs, she says, is that this layer of risk is very difficult to price. Investors know what the going rate is for a security rated A or triple-A, but what yield should an investor earn on something that’s rated higher than triple-A?
Over the last several years, Merrill Lynch, known as the “Bullish on America” stockbroker to millions of retail investors, had become a huge player in the mortgage business. The firm hired Christopher Ricciardi, a Credit Suisse trader, in 2003 to ramp up its presence in the CDO business. Ricciardi turned Merrill into what the Wall Street Journal later dubbed “the Wal-Mart of CDOs.” In 2006 and 2007, Merrill underwrote 136 CDOs, raking in $800 million in underwriting fees on the business, according to Thomson Financial. To assure a steady supply of raw material for these CDOs, Merrill in late 2006 bought First Franklin, a subprime-mortgage originator.
When the music stopped in the housing market in late 2006, Merrill Lynch’s balance sheet was loaded down with exposure to risky borrowers. “By September 2006, Merrill Lynch carried on its books inventory that included at least $17 billion in RMBS CDO securities, as well as an additional $18 billion in mortgage-backed bonds, and a further $14 billion in subprime loans,” according to a complaint MBIA later filed against Merrill Lynch.
By the time Merrill executives left Armonk on that August afternoon, Gary Dunton, MBIA’s chief executive officer, agreed to back another $5 billion of CDOs.
Merrill Lynch wasn’t the only institution terrorized by collapsing asset values during the summer of 2007. At UBS, the chairman and chief executive officer (CEO) of the Swiss banking giant got a crash course in super-senior CDOs during the first week of August 2007. The lessons were shocking. UBS had ballooned its super-senior CDO exposure to $50 billion by September 2007, up from virtually zero just 19 months earlier.
Later, in the spring of 2008, UBS issued a report to Swiss banking regulators and to its shareholders explaining how the bank lost $18.7 billion on U.S. subprime mortgages. The risk management group “relied on the AAA rating of certain subprime positions, although the CDOs were built from lower-rated tranches of residential mortgage-backed securities,” the report said. Banks built models to predict the future performance of mortgages using just five years of data, and data taken from a period of strong economic growth, no less. Meanwhile, no one at the top imposed any limits on how much of this super-senior exposure the bank could hold. “The balance-sheet size was not considered a limiting metric,” the report said.
About the only thing UBS could say in its defense was that it believed “its approach to the risk management and valuation of structured-credit products was not unique and that a number of other financial institutions with exposure to the U.S. subprime market used similar approaches.”
| RATING | CAPITAL REQUIREMENTS PER $100 OF EXPOSURE |
|---|
| AAA | 0.56 |
| BBB | 4.80 |
| BBB- | 8.00 |
| BB+ | 20.00 |
| BB | 34.00 |
| BB- | 52.00 |
As the summer of 2007 wound down, the heads of major financial institutions were coming to grips with a terrifying scenario: Severe credit-rating downgrades of super-senior CDOs were going to wipe out their capital. Banks and brokerages around the world were moving toward implementation of BASEL II guidelines, under which capital charges are minimal at high ratings but escalate dramatically as securities are downgraded (see figure above).
A bank with $50 billion of AAA-rated CDOs on its books would have to hold about $280 million in capital against the position. If those securities were downgraded to triple-B, then the bank would need $4 billion of capital. A further downgrade to double-B would increase the bank’s capital need to $26 billion, or nearly 100 times the capital it needed when the securities were rated triple-A. This steep increase in capital requirements turned the collapse in the value of CDOs into a global banking crisis. Financial institutions were relying on credit-rating companies to determine how much capital to hold against trillions of dollars of securities. That meant every time the credit-rating companies stamped a security with a triple-A rating, more capital was sucked out of the financial system. Triple-A-rated securities—considered the safest of safe investments—actually posed enormous risk to the financial system. The risk of a triple-A rating was that it was wrong.
As banks watched CDO ratings collapse, they saw one way to get those ratings back to triple-A: get the securities wrapped by bond insurers. Pressure was building for the credit-rating companies to rethink the triple-A ratings on bond insurers. Credit-default-swap contracts on the bond insurers were trading at levels that suggested the companies were rated far below triple-A.
The time was ripe. Ackman sent a note to Chris Mahoney, the chief credit officer at Moody’s Investors Service. “There is still time for Moody’s to revisit its analysis and our numerous presentations to you on MBIA and the bond-insurance business,” Ackman wrote in an e-mail. “The notion that these companies are triple-A is as much an absurdity as the triple-A ratings Moody’s has placed on subprime mezzanine CDOs and other highly rated structured finance vehicles on which investors have incurred large losses.”
Mahoney wasn’t the only one fielding questions about triple-A-rated securities. American International Group (AIG), the world’s biggest insurance company, was also faced with questions about its massive amounts of guarantees on super-senior CDOs during its second-quarter conference call on August 9. Investors and analysts were concerned about a unit called AIG Financial Products (AIGFP), a small operation headquartered in London, which specialized in guaranteeing CDOs using credit-default swaps. AIG, like the bond insurers, guaranteed these securities at the super-senior level and, also like the bond insurers, it insisted that it did not foresee making any payments on these exposures.
On the call, Goldman Sachs analyst Thomas Cholnoky asked just how bad things would have to get before AIG would take losses on these super-senior exposures. “It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of those transactions,” answered Joseph Cassano, who ran AIG Financial Products.
“That’s okay,” Cholnoky replied.
“Just okay?” AIG’s Cassano shot back.
“I agree with you,” Cholnoky said. “I tend to think that this market is overreacting.”
But was it?
In testimony before Congress a year later, Joseph St. Denis, a former SEC enforcement officer and the vice president of accounting policy at AIG Financial Products, reported that the process of valuing super-senior CDOs turned contentious in the summer of 2007. The problems intensified over an off-balance-sheet entity called Nightingale, St. Denis said. Nightingale was a structured-investment vehicle (SIV) created by AIG Financial Products. SIVs are intended as stand-alone entities, much like asset-backed commercial-paper programs such as Rhineland Funding. They finance themselves by selling short-term debt and using the proceeds to purchase securities with longer maturities such as super-senior CDOs.
St. Denis was vacationing in Puerto Rico in the summer of 2007 when he began receiving e-mails from the credit traders in London wanting to know if AIGFP would have to shift Nightingale onto AIG’s balance sheet if AIG Financial Products purchased all of its outstanding debt. That might become necessary, the traders told him, because the market was rejecting the commercial paper. When St. Denis returned from vacation, he discovered that the group had already bought the debt. He immediately scheduled a call with the firm’s Office of Accounting Policy (OAP) in London to discuss the problem of the company’s massive super-senior exposure. The instant the call was over, Cassano burst into the conference room. “He appeared to be highly agitated,” St. Denis later told Congress. His statement was cleaned up to remove objectionable language before being released to the public.
“What the [expletive deleted] is going on here?” Cassano asked.
“We’ve just finished a call with OAP,” St. Denis replied. “They agree with our approach . . . ”
Cassano let loose with a string of expletives. Then Cassano said, “I have deliberately excluded you from the valuation of the super-seniors because I was concerned that you would pollute the process.”
St. Denis resigned from AIG shortly thereafter.
DURING THE SECOND WEEK of August 2007, three issuers of asset-backed commercial paper (ABCP)—American Home Mortgage Investment Corporation, Luminent Mortgage Capital, and Aladdin Capital Management—opted to extend the maturity of their commercial paper. Under the terms of the debt, the issuer was permitted to do this as an alternative to arranging a bank liquidity line. It was a clever idea, allowing holders of the commercial paper to earn a small additional yield by granting this option to the issuer. Unfortunately, when the option was exercised, it triggered a panic. Investors didn’t buy commercial paper to find out that they’d lent their money to an issuer undergoing a crisis of confidence. “The subprime tsunami has come to the beach, as it were, to the safest of the safe,” Lee Epstein, CEO of Money Market One, told Bloomberg News.
For years, Wall Street had been expanding this market, using it to finance all types of loans—including high-risk subprime mortgages. The key had been to diversify the risk, to elevate the ratings to the highest-possible level and wipe away any perception of risk. But investors now feared the $1.5 trillion market was contaminated. Subprime and CDOs had turned the ABCP market into a field strewn with land mines. Investors tiptoed toward the fringes, hoping their commercial paper matured without a problem. Once they were out, they stayed out, leaving no one to provide funding for more than a trillion dollars of mortgages, credit card balances, and auto loans.
Some market commentators later pointed to August 9 as the official beginning of the credit crisis, the point at which isolated problems turned into systemic failure. The next day, central banks around the world coordinated a massive intervention for the first time since the September 11, 2001, terrorist attacks. The U.S. Federal Reserve System added $43 billion to the banking system, the European Central Bank flooded the interbank market with $215 billion, and the Bank of Japan added $8.4 billion.
On August 14, 17 Canadian ABCP sellers couldn’t roll over their commercial paper. It appeared the banks had an “out” for providing liquidity support in the event of a market disruption. They decided that what was happening qualified as a market disruption. Simon Adamson, an analyst with CreditSights in London, told Bloomberg News that the situation was developing “a frightening momentum.”
Ackman wrote to Pershing Square investors the same day: “In 2006, our short position in MBIA’s stock and our investment in credit-default swaps were a source of significant mark-to-market losses,” Ackman said. “We have more than recouped our previous mark-to-market losses on this investment.” Investors seeking to protect $10 million of MBIA debt against default for five years would have agreed to pay $16,000 a year in premiums on the day MBIA announced its settlement with regulators in January. That same insurance now cost $250,000 a year. “We believe that we are still in the early innings,” Ackman wrote.
As the summer drew to a close, Ackman attended the U.S. Open as a guest of JP Morgan. He made his way through the crowd at the Arthur Ashe Stadium in Flushing Meadows to the bank’s court-side suite. Inside, JP Morgan CEO Jamie Dimon and his wife chatted with guests. Dimon shook Ackman’s hand and mentioned that he’d seen the “Who’s Holding the Bag?” presentation. “Very interesting,” he told Ackman.
Guests milled around the open bar and dug into a buffet of filet mignon and Caesar salad. Several people gathered in front of the plate glass window to watch the action below. The event, a favorite entertainment venue for Wall Street clients, was packed. For all the problems in the credit markets, stocks were still on the way up and wouldn’t peak until October 9, 2007, when the Dow Jones Industrial Average would hit an all-time high of 14,164.
By the end of August 2007, the collapse of Wall Street was nevertheless well under way. The financial system was breaking down in places unfamiliar even to those who worked on Wall Street: the asset-backed commercial paper market and the world of off-balance-sheet entities like SIVs. It deteriorated as investors struggled with how to price billions of dollars of super-senior CDOs and as investors came to realize that sometimes it isn’t good enough to be 99.99 percent certain about the future.
“Make sure you don’t have any bond-insurer exposure,” Ackman told Dimon as the matches played on.
