MBIA was down 26% this week -- and I'm surprised it wasn't more, given the news last Thursday and Friday.
In Bill Ackman's presentation last Wednesday (which is posted at www.valueinvestingcongress.com), he revealed an area of exposure for many of the bond insurers that I hadn't previously been aware of: Guaranteed Investment Contracts (GICs). I knew MBIA had an investment management division that sold GICs, but didn't fully understand their structure and how toxic this business can be in the event of a downgrade. It's really quite ironic that everyone (myself included) has been so focused on the company's structured finance exposure, but something out of left field like GICs might be what triggers a liquidity crisis that takes the company under.
Allow me to explain what a GIC is. Let's say a municipality like Wichita does a $100 million bond offering to build some schools (or bridges or whatever). Immediately after the offering, it has $100 million in the bank, but it doesn't need all of the money up front. Instead, as the schools are built, it pays the costs over time -- let's say $25 million per year.
MBIA (and many other bond insurers) of course have relationships with countless municipalities, so they set up investment management divisions to tap these relationships and help municipalities invest the money they raised so they could earn some extra return. (In many cases, the bond insurer offers a package deal in which it wraps the bonds and also invests the proceeds -- possible illegal tying, but that's another story.) The produce the bond insurers sold to the munitipalities was a guaranteed investment contract, which was of course marketed as 100% safe, secure, liquid, triple-A, blah, blah, blah (you see where this story's going, don't you? Think auction rate securities...).
A GIC would typically be structured to pay out over time -- in the case of the example above, Wichita would give MBIA the $100 million it had just raised and in return MBIA Asset Management would give Wichita a GIC that promised to pay out $25 million per year plus interest a tiny bit higher than what Wichita could have earned by putting it in Treasuries. MBIA Asset Management (part of the publicly traded holding company) would, in turn, have MBIA's insurance sub provide 100% financing, taking advantage of its AAA rating (and taking all of the risk; more non-arm's-length dealings...), and the MBIA holding company would simply pocket the spread. Finally, MBIA would invest the money in various securities, attempting to match their duration with the expected payout timetables of the GICs.
A nice feature of this set-up for MBIA was that it sold a steadily increasing amount of GICs, so it could pay off maturing GICs with incoming cash from new GICs -- not a Ponzi scheme, because there are assets backing it up, but the liquidity characteristics of the GIC business allowed MBIA, if it wanted (or if it got sloppy or greedy), to invest the GIC assets in illiquid and/or long-dated securities.
This was a wonderful business for everyone as long as markets were tranquil, assets were liquid and held their value, MBIA's customers continued to buy new GICs and, critically, MBIA maintained its AAA rating. None of these things are true today, however.
In particular, many GICs have a clause that says if MBIA is downgraded, it had to immediately repay or post "eligible collateral" on most or all of the GIC. Sure enough, MBIA was downgraded five notches by Moody's last Thursday and, as a result, on Friday after the close, MBIA released the following statement:
As a result of the downgrade to A2, MBIA expects that it will require $2.9 billion to satisfy potential termination payments under Guaranteed Investment Contracts (GICs). In addition, MBIA expects to be required to post approximately $4.5 billion in eligible collateral to satisfy potential collateral posting requirements under GIC's as a result of the downgrade. MBIA Inc. has total assets of $25 billion related to its ALM business, of which $15.2 billion is available to satisfy these requirements including approximately $4.0 billion in cash and liquid short-term investments; $1.0 billion of unpledged eligible collateral on hand; and approximately $10.2 billion of other unpledged diversified securities with an average rating of Double-A. In addition, MBIA Inc. also has available another $1.4 billion in cash, including the proceeds of its recent equity offering.
Translation: "Contrary to everything we've ever said about no accelerating liabilities in any part of our business, we now have to immediately come up with $7.4 billion of cash and eligible collateral (U.S Treasury or agency securities, with appropriate haircuts -- roughly 5%). But don't worry, we have $25 billion of assets..."
$25 billion of assets to cover $7.4 billion of liabilities sounds reassuring -- perhaps that's why the stock was up on the open Monday (giving us the opportunity to short more) -- but in reality MBIA is in big trouble because it never expected to have to come up with huge amounts of cash on short notice. Here's why:
When MBIA says that it has "$15.2 billion is available to satisfy these requirements", it means that $9.8 billion of its ALM (Asset/Liability Management) business assets are already collateralized. And there's not really $15.2 billion left to meet the collateral call -- that's based on MBIA's cost, but according to MBIA's own filings, this was impaired by $1.4 billion as of 3/31 -- and the actual impairment today is surely much greater, for two reasons: 1) prices of these securities have declined this quarter and 2) the estimated values are based on an orderly sale, not a rushed sale to meet a collateral call (speaking of which, I spoke with a senior fixed income trader today who said there are lots of sellers but absolutely no buyers for fixed income securities, as financial firms are looking to reduce their holdings going into the close of the quarter).
In reality, as MBIA admits in its press release, it has only $5 billion in cash or cash equivalents in its ALM business, plus the $1.4 billion recently raised by the holding company (no wonder it didn't downstream the $900 million!), so it needs to come up with another $1 billion from the "approximately $10.2 billion of other unpledged diversified securities with an average rating of Double-A" -- not an easy thing to do in this ghastly market.
Can MBIA come up with the $7.4 billion it needs to pay off a lucky subset of its creditors? Sure, but only by pledging all of its cash and selling its best, most liquid securities, which is exactly what it's doing right now according to the article below that just came out on the WSJ web site. But what about all of its other creditors -- the holders of GICs and medium term notes that come due next month (and the month after that and the month after that) -- which are secured by increasingly low-quality, illiquid assets?
This is the kind of liquidity crunch that has led many financial companies to file for bankruptcy. If MBIA were to do so, it would obviously wipe out the equity, but it would at least treat all creditors fairly rather than early ones getting paid in full and later ones left holding the bag (this is the same issue that exists for policyholders at MBIA's insurance sub as well, by the way).
When MBIA finally sinks beneath the waves, its management, board, analysts and defenders will surely cry that no-one could have predicted this perfect storm, yada, yada, yada, but in fact Bill Ackman spelled it all out five and a half years ago in 66 pages of excruciating detail in his original presentation on MBIA, Is MBIA Triple A? (attached), in which he concluded:
A two-notch downgrade could have catastrophic consequences for the company. It would likely create problems for the renewal of MBIA’s SPV commercial paper. It might also cause a reduction in the value of all of MBIA’s wrapped obligations including all of Triple-A One’s assets. The decline in values of these assets, in turn, could trigger covenant defaults in the SPV’s liquidity facilities, further exacerbating its immediate liquidity crisis.
Additionally, Moody’s reports that MBIA’s ISDA documentation contains increasing collateral requirements in the event of a downgrade of the company. The company’s municipal GIC portfolio also has rating downgrade triggers. 86 Perhaps most significantly, a downgrade could shut off a material percentage of the company’s cash flow, for MBIA may be unable to write new premium without a AAA rating.
A Barclays Capital research report which is available on MBIA’s website explains:
Spiraling down…down…and down?
In the event of a financial guarantor being downgraded, will a vicious circle lead to rapid rating deterioration and potential bankruptcy? This is a much-debated question in that a financial guarantor who relies on its credit ratings for its business franchise could face a rapid decline in new business in the event of a downgrade, which could precipitate further downgrades.
It appears to us that an actual or perceived downgrade of MBIA would have draconian consequences to the company and create substantial drains on the company’s liquidity. The self-reinforcing and circular nature of the company’s exposures makes it, we believe, a poor candidate for a AAA rating.
In light of MBIA’s enormous leverage, the company’s credit quality, underwriting, transparency, accounting, and track record must be beyond reproach. The company can simply not afford any significant risk of loss in its nearly $500 billion of net par exposure, for a mere 20 to 35 basis points loss would equate to levels sufficient to cause a rating agency downgrade of the company.89 In addition, and as importantly, the company must have minimal liquidity risk. Based on our research, we conclude that MBIA fails to meet these standards.
The irony is that if MBIA had listened to him -- even as recently as two years ago! -- the company would probably be doing fine right now. Instead, it chose to ignore and attack him (and, full disclosure, me as well, to a much lesser extent), so forgive me for feeling a bit of Schadenfreude.
Disclosure: Author manages funds that are short MBIA