Whitney Tilson’s Response on the Monolines

Includes: AMBC, MBI
by: Whitney Tilson

I always enjoy a healthy debate with a friend, so I was pleased to see that Tom Brown took the time to share his thoughts on why he’s long Ambac (ABK) and MBIA (MBI).  We welcome contrary points of view about any of our positions, especially from someone as smart and experienced as Tom.  Thus, we carefully considered Tom’s arguments, but ultimately we were not persuaded and stand by our analysis (and continue to hold bearish positions on both Ambac and MBIA). 

MBIA’s $900 Million: To Downstream or Not To Downstream?

Tom’s article was triggered by one of my emails that questioned MBIA’s recent announcement that because the “landscape has changed”, it would not, contrary to its previously announced intentions, take $900 million of equity capital that it had raised and downstream it from its public holding company to its insurance subsidiary.  Tom argues that MBIA’s

...management only expressed an intention [emphasis added] to downstream the $900 million, and didn’t do so right away so it could receive more clarity on future actions by the rating agencies…[It is] simple, above-board capital allocation.

In other words, Tom argues, MBIA’s change of plans regarding this money is little different from, for example, a company that announces a share repurchase program and then doesn’t follow through on it. 

Our view is not so benign.  First, a little context.  While MBIA’s management insists that its insurance subsidiary “has substantially more claims-paying resources and liquidity than it will need to satisfy fully all policyholder obligations on a timely basis”, this assertion has been increasingly questioned by investors, analysts, ratings agencies and regulators, so in order to assuage all of these parties, MBIA has raised money in a number of different ways.  In particular, it raised in two transactions $1.6 billion in equity capital, half of which was from Warburg Pincus, which MBIA trumpeted multiple times as a critical element of its plan to ensure that MBIA’s insurance subsidiary retained its AAA rating.   

Obviously, for the capital to benefit the insurance sub, it has to get there, so on numerous occasions late last year and early this year MBIA’s management said that it “expects” to downstream “most” of this equity capital ($900 million it turns out) to its insurance subsidiary – an assurance that was relied upon by investors, analysts, ratings agencies, regulators, purchasers of MBIA’s guarantees during this period, and investors in MBIA’s $1 billion surplus note offering (a debt obligation of MBIA’s insurance subsidiary).  All of these parties have reason to be concerned about MBIA’s change of plans regarding the $900 million. 

In particular, it is the investors in the surplus notes offering, which closed in January, who should be especially aggrieved.  While there was no ironclad guarantee in the surplus notes offering document that most of the equity to be raised in the near future would be downstreamed, how else would a reasonable person interpret this paragraph, which was on page 1 of the offering document:  

On December 10, 2007, MBIA Inc. entered into an investment agreement (the “Investment Agreement”) with Warburg Pincus Private Equity X, L.P. (“Warburg Pincus”), pursuant to which Warburg Pincus has committed to invest up to $1 billion in MBIA Inc. through a direct purchase of MBIA Inc. common stock and a backstop for a shareholder rights offering. Most of the net proceeds of the Warburg Pincus investment are expected to be contributed to MBIA. [emphasis added]  

In addition, it is our understanding that at the road show for the surplus notes, investors were repeatedly assured by MBIA’s management that most of the equity capital would be downstreamed.   

Thus, the downstreaming of the equity capital was not a minor issue, such as whether a company fulfills its share repurchase intentions.  Instead, it was among the most important selling points of the surplus notes offering (not to mention the importance regulators, analysts, stock investors and the ratings agencies surely attached to this).  MBIA’s numerous emphatic assurances on this point were critical to getting the surplus notes offering completed, as we think few investors would have bought the surplus notes without the belief that most of the new equity money to be raised would be downstreamed to the insurance subsidiary, junior to the surplus notes. 

By making this assurance, MBIA was able to successfully complete the $1 billion surplus note offering, which was highlighted by MBIA and led the ratings agencies to reaffirm the AAA rating of MBIA’s insurance subsidiary, as evidenced by the headline and opening paragraph of MBIA’s press release on January 16th

MBIA Announces Successful Closing of Its $1 Billion Surplus Notes Offering; Fitch Reaffirms MBIA's Triple-A Ratings with a Stable Outlook 

ARMONK, N.Y.--(BUSINESS WIRE)--Jan. 16, 2008--MBIA Inc. (NYSE:MBI) today announced that its subsidiary, MBIA Insurance Corporation (the "Company"), has successfully closed its previously announced private offering of $1 billion Surplus Notes, which the Company has issued as part of its comprehensive plan to strengthen its capital. In connection with the completion of MBIA's Surplus Notes offering, Fitch Ratings announced today that it has reaffirmed the Company's Triple-A ratings with a "Stable Rating Outlook." 

"We are very pleased with the completion of our Surplus Notes offering," said Gary C. Dunton, MBIA Chairman and Chief Executive Officer. "The sale of the Surplus Notes is a key element of our capital plan as is the previously disclosed $500 million equity commitment from Warburg Pincus, which we currently expect to close by the end of January, and their commitment to backstop a $500 million rights offering. We are continuing to implement the capital strengthening plans we have in place. In addition, we are pleased that Fitch has reaffirmed our Triple-A ratings and restored our "Stable Rating Outlook."  

Given the obvious importance of how the proceeds from MBIA’s equity offering would be used, we find it very troubling that MBIA is now trying to welsh on its oft-repeated promise.  I suppose, however, that there’s an argument to be made that MBIA’s board and management are doing what they have to do and that those who relied on MBIA’s stated “intentions” were suckers and, in being foolish enough to believe MBIA, got what they deserved. 

But this argument falls apart when one considers that in its Q1 earnings release on May 12th (and concurrent 8-K and 10-Q filed with the SEC), MBIA said:  

After consultation with the New York State Insurance Department, MBIA Inc. has decided [emphasis added] to contribute $900 million of the proceeds of the offering to its insurance subsidiaries in the next 10 to 30 days. This contribution is consistent with our previously announced capital strengthening plan and is intended to support MBIA Insurance Corporation's Triple-A ratings and existing and future policyholders. 

In this statement, there’s no use of words like “intends” or “expects”, behind which MBIA and its defenders can hide amidst contorted wordsmithing – “the company has decided” couldn’t be more clear.  Thus, Tom is simply incorrect when he writes that “Management only expressed an intention to downstream the $900 million”. 

MBIA’s definite commitment, with a timetable, to downstream the $900 million has important implications.  For a month after May 12th, MBIA’s surplus notes traded at approximately 90 cents on the dollar, as investors in those notes were now certain of having an additional $900 million of capital subordinate to them.  But after MBIA announced on June 11th that it would no longer downstream that capital, the notes fell to 65 cents – that’s a $250 million loss suffered by the surplus notes holders!  Methinks these investors, especially those who purchased the notes in the open market after May 12th, might have quite a lawsuit against the company – and that the SEC and NY State Attorney General Cuomo might have an interesting investigation here… 

Dinallo’s Role

I agree with Tom that NY Insurance Commissioner Eric Dinallo only has formal oversight over MBIA’s insurance subsidiary, not the holding company, but disagree with Tom’s implication that Dinallo or other regulators are powerless to do anything if they determine that MBIA has acted wrongly in failing to downstream the $900 million.  As Attorney General Eliot Spitzer demonstrated, New York’s Martin Act gives regulators enormous power to bring charges against executives who make false statements in connection with security offerings. 

Even without the Martin Act, Dinallo has immense power over MBIA.  I can imagine a phone call from him (who we’ve never met or spoken with, by the way) to Jay Brown in which Dinallo might say: 

In an SEC filing a month ago, you promised in no uncertain terms to downstream that $900 million.  If you’re right that MBIA’s losses will not be as great as the market expects and therefore your insurance sub doesn’t need the extra capital, then I’ll allow you to upstream the money back to the holding company at that point.  But right now, given the level of uncertainty about what future claims might be, the insurance sub and its policyholders (my sole concern) might need that money, so I want you to downstream it.   

If you don’t, my next phone calls will be to the SEC and Attorney General Cuomo to ask them to investigate your actions.  In addition, I will hold a press conference to publicly blast you for your actions. 

Finally, Dinallo could also go after MBIA for $1 billion of capital that was upstreamed to the holding company.  In December 2006 and again in April 2007 (when the mortgage crises was well underway), MBIA affirmed that its insurance subsidiary was overcapitalized and, based on this, the NY State Insurance Department approved a dividend of $500 million on each occasion to be paid from MBIA’s insurance sub to the holding company.  Now that we know the insurance sub was not, in fact, overcapitalized, why can’t Dinallo ask MBIA to give that $1 billion back? 

Duties of MBIA’s Board

Tom points out that “Jay Brown and the other members of MBIA’s board of directors have a fiduciary obligation to their shareholders.  It is very, very simple.”  By this, I assume Tom means that if it’s in the best interests of the shareholders of the holding company to keep the $900 million at the holding company level and use it to benefit MBIA’s shareholders by, for example, paying out a big dividend, buying back stock or, most likely, start a new bond insurance company that is walled off from the liabilities of the current one, then the board and management of MBIA not only should do so, but have a fiduciary responsibility to do so.   

Fair enough – heck, if I were in their shoes, I might be tempted to act the same way – but one reason why insurance companies are so carefully regulated is so that regulators can protect policyholders of the insurance subs from self-interested actions by managers and boards of insurance holding companies.  The deal that insurance holding companies have with regulators is that they are junior to all claimants of the insurance sub, namely the policyholders and debt holders.  Only when regulators are satisfied that there is no doubt that the insurance sub can meet all of its obligations is capital allowed to be upstreamed to the holding company. 

In this case, MBIA raised equity with the stated “intention” of increasing the financial strength of the insurance sub and this was in fact guaranteed by management in a press released and filings with the SEC, so it’s not so simple to now say, “Ooops!  We changed our mind” and deny policyholders and debt holders of the insurance sub that $900 million that they were counting on. 

MBIA’s Ultimate Losses

Tom concludes his article, correctly, by focusing on the only thing that really matters: what MBIA’s losses will ultimately be.  He argues that MBIA is “overcapitalized,…its risk exposure is declining…[and that] neither MBIA or Ambac have capital or liquidity shortfalls.”  If he is right about this, then the stock might well be a buy. 

But we don’t think he’s right and I did not, as Tom wrote, “let the following comment stand: ‘we continue to feel comfortable with our economic loss estimates embodied in the reserve and impairment figures we provided to the market in our last earnings call.’” Rather, my email was focused on MBIA’s decision not to downstream the $900 million, not on rebutting every assertion Jay Brown made in his letter. 

We have laid out in numerous other venues our case for why we believe MBIA’s (and Tom’s) loss estimates are likely to prove to be far too low, most recently in pages 104-129 of our presentation on the mortgage crisis entitled “Why We Are Still in the Early Innings of the Bursting of the Housing and Credit Bubbles – And How to Profit From It”, which we’ve posted on our site.