For those willing to look deeper than company press releases, publicly available information suggests that investors should avoid MBIA (NYSE:MBI) like a plague.
As important as it is for investors to analyze MBIA’s current economic position, however, the more important MBIA story lies in the lapses by those responsible for safeguarding policyholders of MBIA Insurance Corporation, MBIA’s principal insurance subsidiary until February of this year when its assets were stripped.
Parts 1 and 2 of this discussion focus on issues that should concern MBIA investors. Part 3 raises questions about what appear to be disturbing oversight failures.
PART 1: MAJOR RISKS
Despite the large losses reported to date, MBIA’s loss reserves appear to remain disconnected from economic reality and deficient by conservatively $5B, easily enough to wipe out MBIA Insurance Corporation’s capital. Here are the main problem areas.
- Second lien securitizations – MBIA paid approximately $600M on second lien securitizations during the first quarter, 75% of the year-end net reserves for these exposures. Servicer reports reveal that delinquencies on these deals increased to $2B during the first quarter. Therefore, payments are likely to continue at a similar pace through the end of 2009. MBIA’s net reserves decreased to approximately $600M ($1.2B minus $600M in anticipated recoveries from servicer lawsuits) as of the end of the first quarter, an amount that could easily be exceeded next quarter. If loan performance does not improve, MBIA’s future payments could exceed $8B. If loan performance improves gradually, investors should expect around $4B in future payments (over six times MBIA's current net reserve).
- Multi-sector high grade CDO impairments – Slide 44 of the first quarter earnings presentation illustrates cash flow projections for MBIA’s high grade CDOs which imply about $3.2B of ultimate principal payments. By comparison, recent loan performance for the RMBS securities in MBIA’s high grade CDOs suggests that losses will significantly exceed Pershing Square’s Open Source Model projections from a year ago. Realized collateral losses in excess of subordination levels are likely to surpass MBIA’s ~$3.2B estimate within the next six months, then grow to a low end ultimate estimate of approximately $6B, assuming steady improvements in loan performance. If loan performance does not improve or improves more gradually, ultimate principal losses could easily exceed $10B.
- Discount rates – The cash flows and present value impairment figure for high grade CDOs on slide 44 indicate that MBIA will consistently earn a significant spread above LIBOR, probably around 150 basis points, for the next 40+ years. The discount rate is discussed in MBIA’s 2008 10-K, which suggests that the New York Insurance Department allowed MBIA to artificially inflate the rate by using a portfolio yield calculated excluding low-yielding money market investments and including intercompany loans under repurchase agreements. Discounted at LIBOR would more than double the present value impairment numbers.
- Guarantees of MBIA’s investment management business – As of the end of the first quarter, the book value of liabilities of MBIA’s investment management business exceeded the book value of assets by $500M. The market value shortfall was $2B. It is difficult to imagine how MBIA Insurance Corporation, which guarantees these obligations, can avoid a liability for the book value shortfall, at a minimum. MBIA Insurance Corporation’s Statutory financials do not reveal any such a liability.
- Mezzanine CDOs – $500M is a reasonable estimate of losses on US and European mezzanine CDOs based on the ratings of the underlying collateral and subordination levels shown in MBIA’s first quarter CDO disclosure. MBIA's public disclosures do not provide any indication that a liability has been established for these exposures.
Commercial Real Estate
If commercial mortgage performance deteriorates to the extent anticipated by CMBS pricing, MBIA will realize losses well in excess of $10B on structured CMBS pools and commercial real estate CDOs (this estimate is based recent CMBX pricing and MBIA’s November 8, 2008 commercial real estate presentation). Loan losses large enough to wipe out CMBS securities originally rated BBB or lower from 2005 through 2007 would result in losses in the neighborhood of $5B. SEC filings state that MBIA would make payments once realized losses breach subordination levels for most structured CMBS pools, so it would be impossible to suppress these liabilities using steep discount rates. MBIA Insurance Corporation has established no reserves for structured CMBS pools and commercial real estate CDOs.
PART 2: MBIA LITIGATION
MBIA has filed lawsuits against originators responsible for roughly half of MBIA’s known losses, Merrill Lynch, Countrywide, and Residential Funding. The Merrill lawsuit alleges Merrill deceived MBIA into assuming credit risk on four CDOs. The Countrywide and Residential Funding lawsuits allege that loans supporting second lien securitizations breached these originators’ representations and warranties, and therefore need to be repurchased.
MBIA’s complaint against Merrill argues that MBIA did not perform adequate due diligence and Merrill knew this. This lays a shaky foundation for a claim because most people believe that it is incumbent on large financial institutions to diligently review relevant information before assuming credit risk on large transactions. In addition, most of the key allegations in the complaint are false or irrelevant. Here are a few examples.
- MBIA’s lawsuit claims that Merrill exploited an advantage due to detailed analyses of loan level data that Merrill performed, but MBIA did not. This contradicts MBIA’s February 11, 2008 response to Pershing Square Capital’s Open Source Model, where MBIA describes a “loan by loan analysis” much more detailed than Pershing Square’s analysis. At the time of this letter, both MBIA and Pershing Square had access to much better and more current information than Merrill had at the time the deals were closed, yet MBIA was projecting no impairments on the disputed CDOs.
- Page 27 of the complaint states that collateral losses had wiped out all or most of the subordination as of the closing date for each disputed CDO. This is obviously false, as it would have made it impossible for these deals to carry even spurious AAA ratings when they were closed. In addition, MBIA disclosures showed that subordination levels remained largely intact through year-end 2007.
- Subsequent to closing the deals with MBIA, Merrill reported losses on CDOs multiples larger than what was hedged through MBIA. If Merrill knew that these structures would generate massive losses that nearly led to the firm's collapse, as the complaint alleges, other CDOs would have been sold or hedged in 2007.
Page 7 of the complaint argues that the disputed transactions threaten MBIA Insurance Corporation’s ability to maintain minimum capital and solvency requirements. If these transactions threaten MBIA Insurance Corporation’s solvency, how could management possibly justify the February restructuring that further weakened this capital position?
The Countrywide and Residential Funding lawsuits and MBIA’s forensic analysis of loan files will almost definitely yield future recoveries in cases of very clear breaches. However, the prospectuses for these deals may make it difficult to obtain sweeping recoveries, because these documents clearly highlight their extraordinary credit risk, and in fact disclose many of the problems identified in the complaints as contributing to the claims for damages. In other words, the loans were bad, but they were clearly advertised as being bad.
In addition, the Countrywide and Residential Funding deals have performed similarly to other second lien securitizations that MBIA wrapped, including CSFB, Morgan Stanley, and IndyMac deals. This will make it difficult to argue convincingly that these companies’ underwriting was generally substandard.
A fundamental problem with MBIA’s lawsuits against originators derives from MBIA’s access to superior information and unique perspective to anticipate the mortgage crisis. Instead of withholding capital and voicing concerns about the erosion in credit quality, MBIA leveraged its balance sheet with credit risk. MBIA’s lawsuits allege that MBIA was an unwitting victim, when in reality MBIA was part of the problem.
Complaints by Aurelius and Third Avenue seek to reverse or modify MBIA’s February 2009 restructuring, which diverted over $5B away from MBIA Insurance Corporation to fund another subsidiary. These lawsuits mention that rating agencies slashed MBIA Insurance Corporation’s ratings, and CDS pricing on MBIA Insurance Corporation obligations spiked to 70% up-front (which implies almost a 100% probability of default) immediately following the restructuring announcement. These two facts provide compelling evidence that the restructuring left MBIA with inadequate capital, a key ingredient in a constructive fraudulence claim.
However, plaintiffs’ strongest ammunition in these lawsuits may have come from MBIA managers, who claimed that the restructuring would motivate insureds to terminate MBIA’s obligations at a discount. This implies that there was intent to hinder creditors, a requirement in showing intentional fraudulent conveyance. These comments might also convince a court that MBIA breached its duty to negotiate fairly and in good faith, as the complaints allege.
The restructuring was designed to allow MBIA, which has effectively been in run-off for the past year, to write new public finance business. However, the uncertainty introduced by these lawsuits makes it unlikely for MBIA to generate significant new business for the foreseeable future.
This leaves long-term investors with the likelihood that toxic legacy assets will wipe out shareholders’ equity, without the upside that would come with new revenue generation.
PART 3: OVERSIGHT LAPSES
A Low Down Dirty Shame
The views expressed in Parts 1 and 2 of this discussion are shared by a variety of investors. Therefore, if it distorts the truth, MBIA management or any other interested parties should seize the opportunity to disabuse the investing public of any misconceptions, and turn critics into advocates.
If the facts and conclusions are basically correct, the situation raises numerous questions for individuals charged with protecting policyholders’ interests.
- How could the New York Insurance Department allow over $5B to be extracted from MBIA Insurance Corporation, leaving it at best drastically undercapitalized, and at worst insolvent? And why would regulators allow the restructuring to place the interests of policyholders below the interests of MBIA management and shareholders?
- Why have insurance regulators been so willing to facilitate transactions that transfer needed assets from insurance operations to other holding company operations? Examples include loans to investment management affiliates of monoline insurers, and an offer to allow AIG’s insurance subsidiaries to assume credit risk on risky securities insured by the financial products division of AIG. These types of transfers clearly increase risks to policyholders, the group that insurance departments are charged with protecting.
- How have regulators and auditors allowed monolines to recognize large anticipated litigation recoveries given that the likelihood of such recoveries is highly questionable?
- How have insurance regulators justified the reduction or elimination of Statutory contingency reserves in the face of unprecedented credit risk?
- Why would the New York Insurance Department allow creative calculations to boost the rate used to discount MBIA’s losses?
- What has prevented the National Association of Insurance Commissioners or other agencies from investigating or at least questioning the New York Insurance Department’s decisions to repeatedly facilitate large transactions that place the interests of shareholders and management ahead of monoline policyholders? In addition to MBIA’s restructuring and an offer to prop up AIG’s financial products unit, NYID allowed XL Capital to commute its obligations to XLCA, a transaction that voided valuable protection for many policyholders and reduced the pool of assets available to protect all policyholders.
- Why haven’t one or more attorneys general investigated MBIA’s restructuring, which effectively confiscated assets from insureds and gave it to shareholders and management?
- How could MBIA’s auditors and actuaries allow MBIA to record such optimistic loss estimates in the face of data that supports much larger losses?
- How does S&P justify an investment grade rating for MBIA Insurance Corporation? MBIA Insurance Corporation is extremely leveraged and assumes credit risk on highly correlated below investment grade credits many multiples of Statutory Surplus.
- Regardless of the notional capital available to support MBIA Illinois, how does S&P justify the AA- rating despite numerous lawsuits that threaten the operation and a management team that recently raided the assets of a company it manages?
Disclosure: Short MBIA