MBIA: Can Litigation Create Shareholder Value?

Bond Insurer MBIA (MBI) is suing Merrill Lynch, now part of Bank of America (BAC), over 5.7 billion of insured CDOs, alleging fraud. According to the complaint, Merrill Lynch knew that much of the collateral included in the CDOs it sponsored was not “high grade,” and in point of fact was already developing losses that should have been disclosed. As became evident when Andrew Cuomo investigated the rating agencies, S&P and Moody's (MCO) did not do due diligence before providing ratings. Merrill, which had access to information at the level of individual mortgages, took advantage of this fact to avoid revealing what it knew about the quality of the collateral.

The simple fact is that Merrill had material information about the risk involved which it knew would cause MBIA to decline coverage if revealed. Failure to reveal the information is fraud, no different than buying insurance on a house which is already on fire, or being used as a warehouse for fireworks. It doesn't matter whether anyone asks if the house is on fire or used to store fireworks - claims will not be covered. Where Merrill is the insured, coverage should be rescinded. In cases where Merrill does not own the bonds, the bondholder should be paid and Merrill should make MBIA whole.

At this point MBIA is involved in five suits that will have a material effect on shareholder value

• as plaintiff, against Merrill Lynch

• as plaintiff, against Residential Capital (GMAC)

• as plaintiff, against Countrywide (now part of BAC)

• as defendant, against Aurelius Master Capital

• as defendant, against Third Avenue Trust

The first three cases taken together cover most of the claims they have incurred since the onset of the financial crisis. MBIA is claiming it was induced to issue its policies by fraud. If the company's suits are successful, their claim liabilities will be substantially reduced, perhaps by more than half.

The last two are cases where they are being sued over the transformation by which MBIA was split into separate structured finance and municipal bond insurance companies Aurelius holds numerous MBS and other structured finance products insured by MBIA and opposes the transformation on the grounds that they should have access to the assets of the municipal bond subsidiary in order to be paid for their claims against the structured finance company. Third Avenue holds surplus notes issued by the SF sub and likewise wants the security of having access to the funds of the muni-only. MBIA did the split under the supervision of the NY State Insurance Department, so proof of fraudulent conveyance will be difficult. A loss on either case would be a setback to the company's efforts to resume writing municipal bond business.

The litigation by Aurelius and Third Avenue would be less important if MBIA prevails against any of Merill, Countrywide or ResCap, because more funds would be available to pay debts or claims.

Capital raise – MBIA hoped to be able to raise capital to get the muni-only sub incontrovertibly up to a level consistent with past requirements for triple A. The target date was April 1^st. Marty Whitman, when discussing Third Avenue's suit, mentioned that MBIA had been out in the capital markets, as if that had anything to do with his surplus notes. There was a connection: Marty would like to see these notes, issued to yield something like 15%, and some of them bought in the secondary market for less than par, priced well above par to yield a rate similar to what MBIA is looking for on their new capital raise. A desirable outcome from his perspective but really not so important as to ruin old friendships.

A capital raise will be much easier when the courts have spoken.

Investment Implications – MBIA has been trading around 5.00 and under lately, well below its nonGAAP adjusted book value. That stands at 40.06 per share and would be a long-term best outcome target value. Successful resolution of the litigation would go a long way toward monetizing the difference. As a shareholder, I think the company is right in all of these cases, but the outcome is uncertain and may not be known for a long time. In any event, the market and options pricing place very little value on the possibility of prices anywhere over 7, although 10 to 20 would not be illogical in the event of success in the legal arena.

Options Strategy – with the above in mind, I have been playing the case in options, along the following lines:

Short 10 MBI May09 5 Puts @ 1.25

Long 80 MBI May09 7 Calls @ .1875 (average)

Short 10 MBI Jun09 5 Puts @ 1.20

Long 80 MBI Jun09 7 Calls @ .15

The objective is to control 8,000 shares in case it pops, while owning no more than 2,000 if it tanks. Sometimes there will be two months open, sometimes only one. If the stock is between 5 and 7 at expiration, both options expire worthless and there is little or no cost to the position. If the stock is under 5 at expiration, I will be assigned to buy 1,000 shares at a cost of 5.00, which I am willing to pay on the grounds it is 1/8 of the possible 40 per share best case target. Depending on luck and skill, it may be possible to keep rolling this position forward at a cost that compares favorably with other methods of taking this much exposure to the company. Meanwhile funds that would have been tied up watching MBI wobble up and down between 2.50 and 5.50 have been put to more productive uses.

If there is a news item that makes the stock gap upward to over 7, the position will pay off well. The thinking is, eventually these cases will be concluded and that would lead to a sudden increase if the resolution is favorable.

Does Litigation create shareholder value? That's not really a fair question. In point of fact, fraud destroys value for shareholders and society as a whole: it has very nearly brought down the nation's financial system. MBI CEO Jay Brown, commenting on the most recent case, said

Today’s action is consistent with our intention to pursue all available remedies against those parties whose improper actions have directly resulted in substantial losses for MBIA and its shareholders.

Perhaps there will be suits on other issues. Bill Ackman comes to mind - he needs suing. Years ago I felt that litigiousness was wrong and something to be avoided, but now I think differently. Litigation is an uncertain remedy, but in today's business world the morality of the jungle prevails and those who are not proactive in asserting their rights have none.

Earnings and Conference call – scheduled for May 12^th. 4Q 2008 featured an increase in shareholder value, fueled primarily by share buybacks at bargain prices. That is unlikely this quarter, although some debt buybacks or commutations are a possibility – certainly management has been actively exploring all avenues to create value. Direct RMBS should hold fairly steady since the California situation is stabilizing at a high foreclosure rate. CDOs, to judge by what the complaint said about Merrill's contribution, are going to see more impairments, toxic stuff oozing out from inside CDO^3s, etc.

The revision to FAS 157 on mark to market will not make much difference – MBIA marks its liabilities up to reflect market expectations of what losses will be, then it marks them down to reflect the market's belief they won't be able to pay their claims. Management was not previously intimidated into refraining from using judgment, so there won't be that much change here.

I look for adjusted book value to come in at around 40.

Disclosure: long MBI, no positions in other stocks mentioned

Comments

[Steven Hansen:]

interesting. i assume there would be a knock-on effect if they are successful (there will be more litigation).

May 04 01:18 AM

[Tom Armistead:]

Most of the suits mention an implied warranty of good faith and fair dealing. Obviously any legal victories based on such a doctrine would totally destabilize Walll Street. One more thing to worry about.


On May 04 01:18 AM Steven Hansen wrote:

> interesting. i assume there would be a knock-on effect if they are
> successful (there will be more litigation).

May 04 08:04 AM

[Sean Farina...:]

Tom, there are other factors at word besides the litigation.. Such as the large losses on MBIA OldCo's ABS CDO portfolio that have not been recognized as impairments and are in excess of statutory surplus.

Reading MBIA's published "CDO Strategy" on their website would lead one to believe they were not so hapless as to guarantee billions of dollars of deals that turned so horrifically bad. I'm sure ML will cite the in-depth description of the arduous due diligence performed by MBIA before wrapping a CDO. Nowhere in that document does it state that low premium rates mean less due diligence is feasible, and no where does it say that it does less scrutiny of deals with longstanding partners.

MBIA's paid 2nd-lien claims in '08 relative to '09 reserves show the farce here. Transformation amounted to looting precarious insurance sub and leaving it definitively undercapitalized to try to establish a legally distinct firm to write new business.

Ambac's approach (direct ownership of NewCo by OldCo, not like MBIA where National is owned by an intermediate holding co which is held by MBIA HoldCo) is more equitable.

Insolvency at OldCo accelerates debt and would force HoldCo into bankruptcy. 5/12 should be interesting and you do make good points -- I have no position but am watchign closely.

Good luck.


On May 04 08:04 AM Tom Armistead wrote:

> Most of the suits mention an implied warranty of good faith and fair
> dealing. Obviously any legal victories based on such a doctrine would
> totally destabilize Walll Street. One more thing to worry about.
>

May 06 12:02 PM