A few weeks ago I set out to learn more about MGIC (yes, MGIC (MTG) not MBIA (MBI)). MGIC is a monoline insurer whose primary business is insuring residential mortgage bonds. Needless to say, MGIC has had its troubles over the past few years and the stock price has been hammered down from over $70 in 2006 to a little over $2 right now. I had spent some time investigating MGIC at Christmas and had gotten frustrated by the opaqueness of the company. It was very difficult for me to determine the true risk of default of the loans it had insured and I couldn't figure out how I could invest in the company without getting a better handle on this. I thought that in taking a second look at the company I might come to a better understanding of the business and whether it was about to go bust (which it is certainly priced for) or whether there is unrealized value.
What does this have to do with MBIA?
Well, as it happens, MGIC and MBIA have very similar names and they operate a similar business. It's quite understandable that someone may get the two companies mixed up. And in fact someone did get the two companies mixed up and in the course of my research I ended up following a link to a message board that was purportedly a discussion of MGIC but was actually a discussion of MBIA.
It took reading only one message before I clued in that this was a different company than I had been researching before. The discussion was focused around the separation of the structured finance insurance wing (not very different from the residential mortgage insurance provided by MGIC) and the municipal insurance wing (different from MGIC).
In retrospect I was lucky that the message board began with what was an excellent synopsis of both of the businesses that MBIA is involved in, and a solid description of the investment case. If it had been your typical message board, full of quips and rants, I probably would have moved on without giving it a second thought. But instead I saw a company that sounded intriguing and potentially quite undervalued.
What's the idea?
Below is a quote from Jay Brown, CEO of MBIA (taken from the Q4 2008 conference call transcript via Seeking Alpha):
…are MBIA Corp and National separate with respect to the contributions that they make to enterprise value? The answer to that is yes. So to the extent that the value of one of them were to turn out to be zero, the remaining value of the consolidated firm [MBIA Inc] would be the value of the other.
In 2008, when all hell was about to break loose in the financial markets, MBIA decided to split its two primary insurance businesses (a structured finance division (called MBIA Corp) which insures mortgage backed securities (MBS), collateralized debt obligations (CDO) and some foreign government and corporate bonds, and a municipal insurance division (called National), which insures the debt of public municipalities and their infrastructure projects) into two separate holding companies.
The reason for the split was because the structured finance insurance business was looking tipsy, and this was impinging on the ability of MBIA to write municipal insurance. The direct cause was downgrades to MBIA's credit rating due to the uncertainty at the time with respect to all things structured finance. At any rate, by splitting apart the municipal insurance business from the structured finance insurance business, the municipal business would have the strength to continue to underwrite municipal bonds.
The municipal insurance business was seen as an important business to preserve at the time, not only from the perspective of MBIA but from the perspective of the regulators and the government. With the credit crisis reaching full bloom, it was necessary to insure that municipalities would be able to continue to raise funds and roll over expiring debt at reasonable rates. Part of that depended on their ability to have their debt insured by a third party like MBIA.
The split was approved by the New York Insurance Department in February 2009.
Why MBIA is a play on the outcome of court cases
Not everyone was happy about the split. In particular, the banks that had originated the CDOs and MBS that MBIA had insured did not like the idea of Structured Finance not having recourse to the parent or to Municipal. Moreover, MBIA transferred $5B from the Structured Finance division to the Municipal division. This transfer was done to shore up the capital requirements of the Municipal side, but of course it left the Structured Finance side with less capital at a time when the eventual capital requirements were very much in question.
There has been a lot written about the $5B that MBIA transferred out of the structured and into municipal. On the face of it, it seems a little strange that they were able to shuffle money out of one division and into another at the same time they were establishing walls on the recourse between these divisions. However, after reading through some of the conference call transcripts I found this explanation in the Q4 2008 call:
All of the $5.2 billion invested assets transferred to National came from a portion of the accumulated retained earnings produced by the US public policy holders over the past 35 years and the remaining deferred revenue for the $553 billion in municipal finance net par that National assumed from MBI Corp.
It certainly sounds like the money transferred was earned by National and therefore is National's to take. The New York Insurance Department seemed to agree because they approved the transfer as part of the transformation of the company into separate non-recourse subsidiaries.
Because the transaction was approved by the regulators, the only legal recourse of the banks who don't agree with the transaction is to claim that the New York Insurance Department was negligent in their decision. The case was taken to court in April, and it just finished wrapping up a couple of weeks ago. The judge is expected to rule in the next couple of months and from there it will likely go to appeals.
Because of the almost certain appeal process, the case is likely to drag on quite a bit further before it is settled. Nevertheless, the upcoming ruling will be important to MBIA as it will be the first ruling on the matter, and because the judge residing over the case is not known to be overturned on appeal very often.
As I have said, the banks only have recourse to annul the transformation by proving that the New York Insurance Department acted in a manner that was negligent. The terms that are used to describe the behavior that the banks must prove of the regulator are "arbitrary and capricious". These are strong terms. Moreover, having to prove that the regulator acted with ill-intent a lot different than simply having to prove that MBIA acted in a manner that was improper or not in the best interests of all its policy holders.
Indeed, after having read through a number of the summaries of the court hearings, it appears that the Bank of America lawyers have consistently tried to change the frame of the trial to an evaluation of whether MBIA hid or misled information rather than whether the New York Insurance Department acted reasonably in their decision. I wonder if they are trying to redirect the issue because they know the real question before the courts will be difficult to prove.
As I mentioned, the pretrial was wrapping up at the beginning of June. The judge (Judge Kapnick) is expected to rule on the case in the next couple of months, perhaps not until August. The opinions of the trial that I have read (two good ones are here and here) suggest that the odds favor that the ruling will be on the side of MBIA.
As I also have already mentioned, the odds are also that there will be an appeal and that this case will drag on in one form or another for some time yet.
More specifically, it is likely that the case will drag on until there is some sort of resolution between MBIA and Bank of America (BAC) in all of their court disputes. Because you can't really understand what is going on between MBIA and Bank of America and the conflict over the transformation of MBIA without looking at the other disputes between the two parties. The transformation case is really just one leg of what appears to be a high-stakes game of chicken between the two companies, with the other leg being the fraud case that MBIA has against Countrywide.
The other court case
The reason that Bank of America is so intent upon challenging MBIA and its split is not only (or likely even primarily) that they are concerned about their claims on MBS insured by MBIA. It is instead because MBIA is litigating against Bank of America (more specifically litigating against Countrywide, of whose legal losses Bank of America would be responsible for) in a case concerning mortgages originated by Countrywide, and insured by MBIA, that have since gone sour. MBIA is trying to recoup claims it has had to pay out on Countrywide originations by claiming that there were misrepresentations and breaches of warranties in the insurance contracts (basically that the originators at Countrywide made up numbers, overstated incomes, or lied about the employment status, net worth etc) that were signed.
The fact that the two court cases are linked is made pretty obvious by the history. Originally the case against the MBIA transformation was being made by about a dozen banks and other entities. Those numbers have been whittled down to two (Bank of America and Societe Generale). In most instances where a bank dropped their case against MBIA's transformation there was a concurrent resolution of the breaches of representations and warranties that MBIA was claiming against the bank.
I think that the reason Bank of America is one of the last to have not settled with MBIA is because the numbers involved are bigger. In the suit against Bank of America for breaches, MBIA is looking to recover in the neighborhood of $3B, which it the amount they have paid to investors in claims on bonds backed by Countrywide mortgages. MBIA has often said that most of its losses, and most of its recourse, has been aimed at three parties: Countrywide, ResCap, and IndyMac and that of those three, Countrywide was "by far" the largest.
This second court case is really the first court case. By that I mean that it went to court first, and that it has already been ruled upon in some respects. The case was heard in pre-trial towards the end of last year. The hearing was aimed at resolving the burden of proof that MBIA had to meet to claim a breach of representation and warranties. The judge (Judge Bransten) made a few significant rulings. First, it was ruled that MBIA only had to prove that there was indeed a breach involved, but that MBIA did not have to prove that the breach was responsible for the eventual default. Specifically, the judge concluded that MBIA and Syncora "need only show that Countrywide materially misled them at the time they agreed to write insurance on Countrywide mortgage-backed notes, not that the alleged misrepresentations led directly to MBS defaults and subsequent insurance payouts".
That MBIA doesn't have to prove the cause of the default is a big win. In 2008 a lot of mortgages went bad, and trying to prove the exact cause of each default would have been a difficult and time consuming task. The ruling should make it easier for MBIA to rescind insurance that they had written and recoup the losses.
Perhaps the only negative thus far is that the judge wouldn't produce a summary judgment that if fraud could be proven on an individual loan, all mortgages within the MBS securitization of which that loan was a part of could be put-back to Countrywide. While I'm a little fuzzy on why the ruling here would be different than the above described judgment, it apparently it has to do with the language of the insurance contract versus the language of the securitization.
This was aspect of the judgment was clearly in favor of Bank of America but it is less important to MBIA directly than it is as a weapon in the cat and mouse game taking place between the two companies. If Judge Bransten would have assented to this summary judgment, it would have created, at least based on my understanding, some big problems for Bank of America. While the rulings in MBIA's favor makes it easier for the insurers to get out of paying claims, the summary judgment on MBS as a whole could initiate a process that would eventually lead to the put-back of untold billions of mortgage backed securities by investors who could prove fraud.
MBIA is not a direct investor in MBS securities, so from the perspective of direct exposure, this aspect of the ruling seems somewhat irrelevant to them. But what makes it more relevant is that MBIA can pursue this aspect in order to keep the fear in the heart of Bank of America, giving them further enticement to settle the whole thing and be done with it.
Indeed, MBIA has appealed this aspect of the verdict, and that appeal sounds like it could have some legs. Since the time of the verdict MBIA has dug up Countrywide's internal fraud tracking database. They also have a line of former Countrywide employees ready to give depositions about the fraud.
I have little doubt that there is much fraud to be found. I've read a number of books on the housing crisis as I've struggled to learn how to best play its recovery, and more than one of those books has described in detail the shenanigans of Countrywide. In particular. All the Devils are Here, written by Joe Nocura and Bethany Mclean, laid out a nice couple of chapters on how Countrywide went from a stand-up lender to out-and-out fraudulent behavior in its pursuit of market share and Angelo Mozilla's obsession with being the biggest and best at whatever they did. If the only question becomes whether fraud has occurred, I can't see there being much doubt about the answer.
If MBIA can get the summary judgment on appeal, the result would be a big win for investors looking to recoup losses on Countrywide mortgages. Until the matter is settled, it remains a big risk to Bank of America.
Bank of America should settle
This is strictly my opinion on the subject, but I do not see why Bank of America continues to take the risk of letting this appeal against Countrywide, an appeal that could affect a lot of mortgages and result in a big loss for the bank, go to its final judgment. The rulings against Countrywide on the issue of breach of representations and warranties have all gone against them. If this appeal goes the same, it will not only be easy for MBIA and other insurers to rescind the insurance that it wrote for Countrywide, but it will be much easier for all investors of mortgage backed securities to do the same.
Why would Bank of America take that risk?
To up the ante just a little bit further, Bank of America has already reached an $8.5B settlement on much of their exposure to first lien mortgages. I read a lot of commentary about the settlement, and more than some of it suggested that the deal was far below what had been expected. The settlement, after all, reflects $106B in defaulted loans, meaning that it covers less than 10% of all defaults.
The settlement is already opposed by some of the smaller creditors and will be going to court to settle its validity. Its been going through appeals to determine whether it should be settled in state court or federal court.
Remember that the summary judgment that MBIA has asked for is that if a single loan is in default in a MBS security, the entire security should be able to be put-back on Countrywide. If the judge agrees to the summary judgment on appeal, you are looking at put-backs of a substantial percentage of those $106B in defaults. To take MBIA as a case study, in the Q2 2010 conference call, before the put-back litigation was announced and therefore at a time when MBIA was still speaking freely on the matter, the company said that "sometimes as low as 75% and some cases as high as 90% of the loans in the securitization are in violation of reps and warranties".
The other point here is that by letting the put-back trial with MBIA progress through its discovery process, you are providing opportunity for MBIA to unearth more evidence and uncover more issues. By doing so you are putting the much larger $8.5B settlement at risk. Would it not be better to settle with MBIA and close the books on their investigation into Countrywide?
Bruce Berkowitz, of Fairholme Funds, was quoted as saying as much last year at a Morningstar Investment Conference:
While Fairholme's stake in MBIA may seem schizophrenic given the latter's legal dispute with Bank of America, Berkowitz thinks this a false problem. A win for MBIA, as he sees it, will mean little to Bank of America and a great deal to MBIA. The lawsuit's unequal impact on the two parties, as well as the high likelihood of MBIA's eventual triumph, has moved him to take a stake on both sides of the argument.
By continuing with the transformation case against MBIA, Bank of America seems to be betting it can do one of two things:
- It can win the case and annul the split of the two businesses
- It can wait out MBIA until the middle of next year, at which time MBIA will run out of resources for claims and have to go into receivership
Now they may be able to achieve one of these two ends but the rulings thus far aren't painting a particularly rosy picture of the future. Moreover, in the process Bank of America runs the risk of opening up a far larger can of worms by putting in jeopardy their MBS settlements.
The Investment case for MBIA
Part of what makes MBIA a compelling investment idea right now is that these court cases are likely to come to resolution in the next 6-9 months. The potential of a negative outcome occurring seems to me to be outweighed by the potential negative (for BofA) consequences of the fraud case if Bank of America allows MBIA to move ahead with it. And the evidence thus far suggests to me a ruling is more likely to be in the favor of MBIA.
The other part of the investment idea is, of course, valuation. The value to be realized in MBIA if the litigation goes their way seems to be enough to justify the risk.
On this write-up I hoped to focus on the court cases. I am going to do another write-up that provides a more detailed run-through of the value of MBIA. But for the purposes here, there are a number of analyses that have been done by others that can be leaned upon to get a ballpark feel for the upside.
First of all, as I already alluded to, Bruce Berkowitz and Fairholme Funds own a large position in MBIA bonds and in their common stock. In particular, the Fairholme Allocation Fund owns a little over 6 million shares of MBIA common stock, which makes up a rather enormous 25% of the assets in the fund.
Though written a couple of years ago, the following quote summarizes what Berkowitz thinks about MBIA post transformation:
"Once it becomes clear that National is walled-off, you have a tremendous amount of uncertainty gone," Berkowitz said.
More recently, Fairholme gave investors a glimpse into the valuation range they saw. In the 2011 annual report Fairholme said:
MBIA common stock is The Allocation Fund's largest position. Recent legal settlements paid and reserves taken by defendants are convincing skeptics of the company's ability to more than just survive. Following GAAP, the company reports a book value of about $12 per share. Following Statutory Accounting Principles (SAP) utilized by insurance regulators, book adjusts to $16. Assuming an orderly run-off, the company calculates an adjusted book value of $35. Each method has its strengths and weaknesses and does not include a value for new business.
Another value fund, Fernbank Partners, recently published their valuation range for MBIA here. Fernbank puts the range at between $3.2B and $6B. That is between a 50% and 200% appreciation from the current stock price.
BTIG initiated MBIA with a buy rating and a target price of $22 last November. Perhaps worth pointing out is that the valuation BTIG came up with is based purely on the value of National (the municipal insurance business) less the holding company debt. No value is attributed to the structured finance arm, and no value is attributed to the future business that National may be able to write once the lawsuits are settled.
Just like all of these folks, I think that the upside to a settlement with Bank of America is compelling. The company trades at a fraction of adjusted book value, and the basic business of insuring municipal bonds looks to be worth at least double the current stock price in the event that the business can begin to write insurance again. The structured finance division may be worth nothing, though that is very dependent on the size of the eventual settlement with Bank of America. A full recovery of the amount that MBIA has booked ($3.2B) would give the structured finance division an adjusted book value of around $14 per share. So it remains to be seen whether structured finance is a write-off, or more of a call-option that becomes far in the money if the litigation goes right.
I originally bought a small position in MBIA at $9. But have since added to it in at a little under $10. I wish that MBIA had not risen so soon after I first discovered the idea. I would have liked to have had a larger position. As it is, MBIA currently makes up about 4% of my portfolio.