Confidence Game

There’s not likely to be a man left standing in the bond-insurance industry. This thing is over already; the market just doesn’t know it yet.

—BILL ACKMAN, JUNE 2008

WHEN STANDARD & POOR’S (S&P) downgraded MBIA and Ambac to double-A on June 5, 2008, the world didn’t end, the stock market didn’t crash, the dollar didn’t collapse. In fact, MBIA’s share price rose a few cents. After all, confidence had been unraveling for more than a year. There had been plenty of warning. Still, it was the end of an era in the bond market. Rob Haines, the bond insurance analyst at CreditSights, summed it up this way: “For those of us who follow the monoline industry, last week was akin to the fall of Rome.”

The downgrades also left a slightly unsettling feeling of “What’s next?” Bond insurers had been pillars of predictability. Not any longer. When Moody’s Investors Service downgraded CIFG in May, it took the rating down seven notches. Moody’s said CIFG—a company rated triple-A just a few months earlier—was close to breaching its minimum regulatory capital levels, which could cause regulators to take it over. That, in turn, could trigger termination payments like those ACA Capital faced and couldn’t meet.

Credit-default-swap (CDS) contracts had changed the rules of the game for bond insurers. Bond-insurance policies obligate a company to cover interest and principal when due on a bond if the issuer defaults. CDS contracts subjected bond insurers to a number of conditions that were poorly understood but potentially lethal.

“Depending on the language in the credit-default swap [contracts], [a termination event] can set off a chain of events that creates a complete unwind of the company,” Thomas Priore, chief executive officer of hedge fund Institutional Credit Partners LLC in New York, told me.

The bond insurers guaranteed hundreds of billions of dollars of CDS contracts, including $127 billion on CDOs backed by subprime mortgages. The riskiest hedge fund that sold protection through the CDS market was required to put up cash if the cost of protecting the underlying security rose. Because the bond insurers were triple-A rated when they entered into these contracts, they were deemed so creditworthy that they didn’t need to post collateral. Now the companies faced an immediate and overwhelming call on all of their capital in the event they were taken over by regulators.

On June 11, 2008, several days after the S&P downgrade, Jay Brown wrote to MBIA shareholders telling them not to be distracted by the inevitable “articles and reports” that would opine on everything from the company’s decision to keep the $900 million at the holding company to the mark-to-market value of its CDS contracts. “Please stay focused on this as the current difference between our estimates of ultimate economic losses (approximately $2 billion) versus the current market estimates reflected in our stock price ($10 [billion to] $14 billion) is really what this story is all about.”

ON JUNE 18, ACKMAN MADE a presentation to a group of attorneys and hedge fund managers at the law firm Jones Day. That presentation, called “Saving the Policyholders,” was his last on the bond insurers.

He told the audience that most of the bond insurers, including MBIA, were already insolvent. Insolvency in New York state was measured in two ways: The first trigger is hit when a company has reported so many expected claims that it has essentially flagged for regulators that it won’t be able to meet all its obligations.

There is a second test of solvency, however, that asks an insurer to show it has sufficient assets to reinsure all its liabilities. In other words, could the firm pay another insurance company to take on its existing obligations? The answer to that question for MBIA was absolutely not.

The mark-to-market losses—which the companies insisted were no more than a reflection of an irrational market and should be ignored—were critical. In fact, the complicated formulas used to determine mark-to-market losses on CDS contracts sought to answer this very important question: How much more would an insurance company want to be paid—above the premiums already collected—to take on another insurer’s obligations?

If the bond insurers couldn’t reinsure their obligations with their existing assets, then the New York state insurance department should take them over, Ackman argued. If that happened, the CDS counterparties had the right to terminate their contracts and be compensated for the loss in the market value of their CDOs. It was a fatal sequence of events that began with the mark-to-market losses bond insurers were insisting everyone should ignore.

Investors were unaware of the risk of these termination payments because the bond insurers had not properly disclosed the risk, Ackman said. He read MBIA’s disclosure regarding the contracts: “There is no requirement for mark-to-market termination payments, under most monoline standard termination provisions, upon the early termination of the insured credit-default swap. However, some contracts have mark-to-market termination payments for termination events within MBIA Corp.’s control.”

Both the bond insurers and the credit-rating companies had “misled the investing public by ignoring and not disclosing CDS mark-to-market termination risk in determining the ratings for bond insurers,” Ackman said.

Ackman had a second bombshell to drop that evening. Financial Security Assurance (FSA) and Assured Guaranty still had triple-A ratings with a stable outlook. The fact that two of seven bond insurers still had credibility gave the industry a glimmer of hope. Bonds—even structured finance bonds—could be insured if a company was careful enough. As municipalities shunned the other bond insurers, FSA and Assured had seen business surge in recent months.

“The market has not woken up to FSA,” cautioned Ackman. “FSA is AAA stable, but don’t look too closely.” FSA had steered clear of guaranteeing CDOs backed by mortgages, but it insured billions of securities backed by home-equity and Alt-A loans. It was under-reserving against those losses, Ackman said. The insurer also had a problem with its investment-management business. Like MBIA, FSA issued billions of dollars of guaranteed-interest contracts (GICs) for municipalities. The proceeds were invested in subprime securities, which had tumbled in value, leaving FSA’s asset-management business with assets valued at $16.2 billion and liabilities of $20.4 billion. Ackman predicted that Dexia, FSA’s European parent company, wouldn’t support FSA. The capital hole was too deep.

Summing up his view of the bond-insurance business, Ackman told the audience, “There’s not likely to be a man left standing” in the industry. “This thing is over already; the market just doesn’t know it yet.”

The next morning, risk premiums on FSA credit-default-swap contracts surged. That same day, Dexia announced it was providing a $5 billion credit line to help FSA. The commitment “is a reaction to the attack of Pershing,” chief financial officer Xavier de Walque told Bloomberg News. The move was intended “to avoid any doubt and to stop any speculation.”

On June 19, the day after Ackman’s presentation, Moody’s followed through on its threat to strip MBIA and Ambac of their triple-A ratings. MBIA was cut further than Ambac, all the way down to single-A, a rating at which MBIA was obliged to post collateral and terminate guaranteed-investment contracts.

Ackman was certain MBIA’s holding company would have to file for bankruptcy. Its asset-management unit had left it with a gaping hole in its balance sheet that probably couldn’t be filled even with the $900 million Brown had decided to keep at the holding company.

Meanwhile, the insurance unit was insolvent under one of two New York state tests of solvency, in which case the company’s CDS counterparties could force it to terminate contracts and absorb billions more in losses.

On June 27, Ackman wrote to MBIA’s board of directors, including Kewsong Lee and David Coulter from Warburg Pincus, telling them that they should seek advice about the solvency of MBIA Inc. and MBIA Insurance Corporation. He followed up a few days later with an e-mail, which he made public: “You don’t, of course, have to rely on our analysis in determining MBIA’s solvency, but we caution you in relying solely on management’s statements or financial statements prepared by management,” Ackman wrote. Even if the companies were not insolvent but were approaching insolvency, directors had expanded fiduciary duties. They had to assure that shareholders were not favored over creditors and that one class of creditor wasn’t favored over another.

“Don’t take our word, but do yourself a favor,” Ackman wrote. “I encourage you to hire investment banks of the highest caliber to complete a solvency analysis. If you are unable to engage one or more investment banks to provide an appropriate solvency opinion, you already have your answer as to the company’s solvency.”

ON JULY 15, 2008, Roy Katzovicz sat in his apartment, waiting for Ackman to appear on CNBC’s Squawk Box. The show’s producers had been badgering Ackman for several months to come on the show to talk about the bond insurers. Katzovicz had repeatedly expressed his views on how TV and complicated financial ideas don’t mix. In his most recent e-mail to Ackman on the topic, Katzovicz said simply: “TV = Bad.”

But Ackman couldn’t be dissuaded from making the appearance. He had a plan for recapitalizing Fannie Mae and Freddie Mac, the giant government-chartered mortgage companies, which many investors feared were now insolvent. Ackman also had a short position in Fannie Mae’s stock and in both government-sponsored enterprises’ subordinated debt, which would rise in value if Ackman’s plan was implemented.

Ackman told the anchors on CNBC that it would be a mistake for the government to put equity into Fannie Mae and Freddie Mac. The companies needed to be recapitalized, and taxpayers shouldn’t be the ones to do it, he argued.

The two companies had all the capital they needed, Ackman said. It was just in the wrong form. They had too much debt and not enough equity. The company could be recapitalized by wiping out the equity holders, giving the junior debt holders warrants and giving the senior debt holders equity in the company.

“I woke up on Thursday morning with an idea,” Ackman said. “The more I thought about it, the more logical I thought it was and that it would be implemented.”

Ackman made no apologies for his view that the company’s equity holders should be wiped out and that he should be able to profit from it. “Investors made a bet and allowed the institution to become too levered over time,” Ackman said.

Later that day, the Securities and Exchange Commission (SEC) announced a plan to clamp down on those shorting the shares of Fannie Mae, Freddie Mac, and a number of other financial firms. Short sellers had become—in the eyes of many people, including government officials—the enemies in a battle to stabilize the financial system.

That stability remained elusive, however. A week later, on July 22, 2008, Moody’s warned it might cut FSA’s and Assured Guaranty’s triple-A ratings. Shares of FSA’s parent, Dexia SA, plummeted 16 percent to 8.06 euros in early trading. Assured shares plunged 40 percent, or $7.43, to $11.32.

Shortly after the announcement, Moody’s held a conference call to discuss the state of bond-insurance ratings. Investors were furious. There was not a single triple-A-rated bond insurer that hadn’t lost its top rating or been threatened with a loss of the rating. When the call was opened to questions, the first caller wondered just how devastating the meltdown of bond insurers’ credit ratings had been to Moody’s credibility. The caller jumped in with his own answer: “The metaphor of Frankenstein’s monster comes to mind, with the guarantor in the title role—escaped from the lab and running loose in the rating-agency village!”

MEANWHILE, IT WAS NOT just Katzovicz who wished Ackman would stay off CNBC. “I’ve been reflecting on your high-profile strategy concerning Fannie Mae and Freddie Mac,” one of Ackman’s investors wrote to him shortly after his appearance on CNBC. While Ackman’s “exposé” on MBIA had benefited all Pershing Square’s investors, he was now creating a “perception that a self-interested short seller is attempting to meddle in public affairs,” the investor wrote.

To make his point, he quoted James de Rothschild of the famous banking family, circa 1816: “As soon as a merchant takes too much part in public affairs, it is difficult for him to carry on with his banker’s business.” The investor concluded, “I thought I’d share with you this quote, which reflects our general philosophy on the focus desired for investment managers.”

Others echoed the criticism of Ackman’s high profile role. Marty Whitman, MBIA’s second-largest shareholder and a holder of nearly $200 million of the surplus notes sold earlier that year to save the triple-A rating, dedicated a long section of his letter to investors in the summer of 2008 to discussing Ackman. “William Ackman appears to be disingenuous when he writes and talks about saving MBIA’s policyholders,” Whitman said. “Why does he care about policyholders? Ackman’s objective is to drive down the market price of MBIA securities.”

Whitman continued: “Bear raiders seem to tend very much to engage in nefarious activities, whether legal or not.” Until the SEC began to investigate some of this activity, short sellers were free to say or write whatever they liked, Whitman said. “There is no apparent downside for being a loose cannon.”

WHILE ACKMAN WAS DETERMINED to show that the bond insurers were insolvent, Eric Dinallo at the New York State Insurance Department was doing everything in his power to prevent a regulatory takeover of the companies.

On July 31, he wrote to the Financial Times: “Rumors that can destroy the stock price of banks and investment banks have been the focus of the media and have now attracted the attention of regulators.” Insurance companies are also vulnerable, he wrote.

New York state law provides for “civil and criminal sanctions for spreading false rumors or making statements ‘untrue in fact’ about an insurance company’s solvency,” he warned. “Recently, some individuals have asserted that some of the bond insurers are insolvent—a far more serious, far-reaching, and risky allegation than claims that the insurer’s holding company stock is overvalued,” he added, without naming names. “Rumor mongering and inaccurately disparaging insurance-company solvency cross a line,” Dinallo concluded.

Several months earlier, Dinallo had worked the phones with Eliot Spitzer to convince the banks to participate in Ambac’s equity offering and save its triple-A rating. Now, as confidence in both the bond insurers and the banks continued to collapse, raising more capital wasn’t possible.

If the bond insurers couldn’t find outside investors willing to put up more capital, then the only alternative was for them to reduce their expected claims. That meant convincing the banks to tear up CDS contracts on the worst of the CDOs. Under these agreements, known as commutations, the banks accept a fraction of the payment they expected to receive had they waited for the CDOs to default. The agreements allowed banks to trade a potentially larger but uncertain payment in the future (after all, the bond insurer might run through all its capital) for a smaller but certain payment today.

Among the first deals announced was one between Ambac and Citigroup over an unnamed CDO. Ambac paid Citigroup $850 million in exchange for tearing up a CDS contract on a $1.4 billion CDO. During a conference call shortly after the deal was announced, a caller asked David Wallis, Ambac’s chief risk officer, what the projected payout on the CDO would have been without the commutation. “Pretty damn close to $1.4 billion,” Wallis replied.

Dinallo says he chose not to play the role of inflexible regulator. “We could have slammed down the gate, not allowed any money to leave the insurance companies,” Dinallo tells me as we sit in his office in early 2009. The result would have been an immediate collapse of the company’s shares on the expectation that the holding companies would file for bankruptcy. That may have been what Ackman wanted, but there were important people who believed it was absolutely necessary to do more. Among them were officials at the Federal Reserve who told Dinallo that they were getting calls from foreign banks. The world’s bankers wanted to know if U.S. financial institutions were going to stand behind their contracts. “This was becoming a geopolitical issue,” Dinallo remembers.

Dinallo, the son of a Hollywood script writer who penned episodes of The Six Million Dollar Man, kept a collection of superhero action figures and comic books on a shelf in corner of the conference room. And in the summer of 2008, every day seemed to bring another opportunity to save the world.

At the end of July, Dinallo had just managed to pull XL Capital Assurance back from the brink. The threatened collapse of the company was reverberating across the insurance sector. The bond insurer had been spun off from XL Capital Ltd., a catastrophe reinsurer based in Bermuda, which protected other insurance companies against losses in the event of hurricanes and other natural disasters. XL Capital Ltd. was on the hook to cover some of its former unit’s CDO and subprime losses. The stock market was punishing the catastrophe reinsurer over the uncertainty created by this obligation. Other insurance companies were worried about the coverage they had purchased from XL Capital Ltd.

Negotiations took place over several tension-filled weeks at the offices of Fried, Frank, Harris, Shriver & Jacobson, where lawyers from more than two dozen banks, two insurance companies, and the insurance department hashed out a plan to disentangle the bond insurer, its former owner, and scores of bank counterparties. The meetings, held simultaneously in a series of conference rooms, lasted late into the evening. Hampton Finer, the deputy superintendent of the insurance department, recalls weeks of raised voices and boxes of cold pizza. The lawyers were up against a tight deadline; XL Capital Assurance needed to file its first-half regulatory statements before the end of July to show that it was solvent.

Finally, on July 28, Dinallo announced an agreement. XL Capital Ltd. would pay $1.78 billion to its former bond-insurance unit, and Merrill Lynch would tear up $3.7 billion of contracts on CDOs in exchange for a $500 million payment, saving the company from insolvency. “This agreement gives a light at the end of the tunnel,” Dinallo said during a conference call with reporters. “Even a distressed bond insurer can be brought out of a dire situation.”

JUST AFTER 11 P.M. ON AUGUST 7, 2008, Mick McGuire was finishing a review of MBIA’s second-quarter earnings statement. Pershing Square had issued press releases with questions for MBIA management ahead of MBIA’s last two earnings conference calls. McGuire assumed they would do the same this time and was in the process of drawing up a list. There were questions on the fairness of bond insurers canceling CDS contracts. Questions about MBIA’s off-balance-sheet debt and when it came due. Questions about the effect on MBIA of its reinsurers being downgraded. “I believe those are probably the issues worth calling out,” McGuire e-mailed to Ackman. “I can think of others, but I would guess that other investors might also already be focusing on them.”

The most obvious question in Ackman’s mind was whether MBIA was insolvent. This time, Ackman was going to leave it up to investors and equity analysts to ask the questions.

The next morning, the stock was rallying as the conference call got under way. The news for investors was mixed: New business had completely dried up, but unlike other financial firms, including Ambac and Fannie Mae, MBIA didn’t increase its projections for losses during the quarter.

Ackman listened in on the call from his house in upstate New York, where he was setting up for Pershing Square’s annual staff party. The office was closed for the day, and all the employees—the investment team, the traders, the accountants, and the administrative assistants—were on their way upstate to spend the day sitting by the pool, barbequing, and playing tennis.

“Having lost our AAA ratings, it will be several quarters before we have a true sense of what exactly our company will look like in the future,” Brown told listeners. “The good news is the business models are functioning exactly as we designed them to under this type of stress.”

Part way through the question-and-answer session, Greg Diamond, the head of investor relations, read an anonymously submitted question. It was about the company’s views on Dinallo’s letter to the Financial Times: “Given your very vocal opponent who has put out several presentations and press releases containing precisely the type of allegations that Dinallo suggests are illegal under the law, does MBIA intend to file a lawsuit against Pershing Square for disparagement and for losses that Mr. Ackman created for the company’s shareholders?”

Brown took that question. “MBIA agrees that statements made by certain short sellers may have, in fact, violated New York insurance law, and we plan on cooperating with any investigation or action brought by the New York state insurance department or any other regulator who may wish to investigate these activities.”

He noted further, “MBIA is assessing all of its options and will take such actions as it determines are in the best interest of its shareholders, including any litigation that may be necessary if we believe that’s in the best interest of our shareholders.”

As the headlines hit the newswires, Pershing Square began receiving phone calls and e-mails from investors. A member of the investor-relations team e-mailed Ackman, asking if he was concerned about the threat of a lawsuit. “I think a lawsuit is very unlikely, but if so, it would be helpful to us because we get access to their books and records. As a result, the probability of their doing so is very low.”

The Pershing party continued. As the group gathered around the Ackmans’ pool, the mood was upbeat. Ackman manned the barbeque. His children played in the pool. The humidity had been building all day, and now flickers of lightning appeared on the horizon. Suddenly, thunder rumbled surprisingly close by, and the group retreated into the house.

LATE THAT AFTERNOON, ACA Financial Guaranty announced after months of negotiations that it had finally reached a deal with its bank counterparties. The bond insurer would tear up credit-default-swap contracts protecting $65 billion of CDOs and other structured finance securities against default. In exchange, ACA would pay the banks just 3 cents for every dollar of the $9 billion they owed.

David LeMay, a partner at Chadbourne & Parke, which represented ACA’s 29 bank counterparties, explained that no one bank could demand to be paid without triggering the same demand from the entire group. “There were 29 nuclear powers, any one of whom pushes the button and the game is over,” said LeMay.

Wall Street had trumpeted the CDS market as the ultimate hedge. What could be better than a contract that allowed a bank to lend money with the certainty of being paid back? But now the system’s fatal flaw had been exposed. All this risk transfer depended on extraordinarily creditworthy sellers of protection. ACA Capital, a bond insurer whose main business was to provide protection against default, had just been presented with a $9 billion bill and had only $698 million in the bank.

On that sleepy August afternoon, the event passed little noticed. The Dow Jones Industrial Average was hovering well above 11,000. Investors still believed that those in power could control the outcome: lower interest rates, raise capital, silence critics, restore confidence. Somehow, if everyone just kept hoping and pretending, the crisis could be kept at bay.

On Merrill Lynch’s final conference call held earlier that summer, chief executive officer John Thain was asked about the firm’s exposure to the bond insurers. Merrill had $20 billion of super-senior CDOs on its books, the majority hedged with counterparties, including bond insurers. Was it possible, a caller asked, that the bond insurers could survive to make good on those guarantees?

“In the case of MBIA, I think it is very unlikely that they will actually default because it’s not in their interest to do that,” Thain replied. “I think they will simply go into a runoff mode, and they will simply keep collecting their payments and making their payments and they’ll live for years and years and years and years.”

That would be the best outcome—if they could outrun the reality and wait for the economy to turn and for people to start making their mortgage payments again. But the crisis was coming anyway—for MBIA, for Merrill Lynch and John Thain, and for everyone else.