Tuesday, January 22, 2008

Ambac, MBIA Lust for CDO Returns Undercut AAA Success

(Bloomberg) -- Municipal bond insurers such as MBIA Inc. and Ambac Financial Group Inc. had a good thing going.

For years, they earned some of the highest profit margins in any industry -- by writing coverage for securities sold by states and cities to build roads, schools and firehouses. During the past five years, MBIA's average profit margin was 39 percent, more than four times the average of the Standard & Poor's 500 Index, according to data compiled by Bloomberg. Ambac's average profit margin was 48 percent.

The good times are over, and the culprit isn't municipal bonds; it's subprime debt, a market the insurers waded into in pursuit of even greater profits. Some of the biggest bond insurers are facing potential claims that may deplete their capital. Their share prices have plunged, and credit rating companies are scrutinizing their AAA status. Ambac became the first insurer to lose its triple-A rating, when Fitch Ratings downgraded the company to AA on Jan. 18.

With the main players distracted by subprime woes, billionaire investor Warren Buffett's Berkshire Hathaway Inc. is expanding into their core business of insuring bonds in the $2.6 trillion municipal market.

Berkshire Hathaway

``The good, solid, old-fashioned but profitable business may gravitate over to Berkshire Hathaway,'' says Mark Adelson of Adelson & Jacob Consulting LLC, a New York firm that advises on the structured finance market. ``That was the bond insurers' anchor; that's what saw them through.''

The crisis has been brewing for about six years, ever since the insurers discovered collateralized debt obligations. These securities, part of an area known as structured finance, were created by Wall Street by repackaging assets such as mortgage bonds and buyout loans into new obligations for sale to institutional investors.

Attracted by top ratings from Standard & Poor's, Moody's Investors Service and Fitch and by lucrative premiums, the insurers agreed to pay CDO holders -- many of them banks that created the securities -- in the event of a default. Insurers backed $127 billion of CDOs that relied at least partly on repayments on subprime home loans, according to a Dec. 19 report by S&P, the No. 1 credit rating company.

``It looked so profitable and so easy that they let the portfolio shift too far toward structured finance,'' says Robert Fuller, who runs Capital Markets Management LLC, a Hopewell, New Jersey-based firm that advises municipalities and nonprofits. ``It morphed into this monster that is devouring them.''

CDO Rating Cuts

The tipping point came last year when the three major rating companies downgraded thousands of CDOs. Ratings on more than 2,000 CDOs were cut in November alone, with Fitch lowering CDOs backed by subprime mortgages 9.6 levels on average, according to a Dec. 13 UBS AG research report.

Rating cuts on CDOs and other securities backed by subprime mortgages and home equity loans led S&P to conclude bond insurers faced potential losses of $19 billion, the rating company said in its December report. That sent insurers scrambling for additional capital to protect their own credit ratings from being cut -- by the same companies whose judgments they had relied on in backing the CDOs.

Fitch Ratings said at the end of December that MBIA, Ambac and FGIC Corp., the fourth largest, had four to six weeks to raise $1 billion each to keep their AAA ratings.

MBIA Raises Capital

Seeking to avert a crippling reduction of its triple-A rating, MBIA, the largest of the companies, said in December that it would raise as much as $1 billion by selling a stake to private equity firm Warburg Pincus LLC. It said Jan. 9 that it will slash its dividend to 13 cents a share from 34 cents, and two days later it paid a yield of 14 percent to sell $1 billion of surplus notes, bonds issued by insurance companies that state regulators consider equity.

Shares of the Armonk, New York-based company fell 86 percent on the New York Stock Exchange to $8.55 on Jan. 18 from $60 on Aug. 3. They jumped 29 percent to $12.02 at 12:20 p.m. today in New York.

Ambac, the second largest, replaced Chief Executive Officer Robert Genader, 60, on Jan. 16, cut its dividend 67 percent and said it would raise more than $1 billion in capital. Two days later, it scrapped the plan to raise capital. The New York-based insurer announced today a $3.26 billion fourth-quarter net loss and said it is considering ``strategic alternatives.'' The company's shares dropped 90 percent to $6.20 on Jan. 18 from $62.82 on Aug. 31; they surged 25 percent to $8.31 at 12:20 p.m.

May Write Down Stake

Blackstone Group LP, the New York buyout firm run by Stephen Schwarzman, said Jan. 10 that it may write down its stake in FGIC, which it bought from Fairfield, Connecticut-based General Electric Co. in 2003 along with PMI Group Inc. and Cypress Group LLC.

The first to fall was ACA Capital Holdings Inc., whose ACA Financial Guaranty Corp. unit guaranteed $26.6 billion of CDOs backed by subprime mortgages, according to S&P. The New York- based firm was founded in 1997 by H. Russell Fraser, a one-time chairman of Fitch, to insure municipal bonds that triple-A rated insurers wouldn't cover.

S&P slashed ACA Financial's rating to CCC, a low junk level, from A in December and earlier this month suspended ratings on almost 2,150 bonds it insured. ACA Capital shares plunged 93 percent to 48 cents on Jan. 18 in OTC Bulletin Board trading from $6.70 on Aug. 31; the stock was suspended from trading on the New York Stock Exchange before the opening on Dec. 18. The shares were quoted at 65 cents, up 26 percent, at 12:20 p.m.

`Played With Fire'

``I knew that if they played with fire long enough, they were going to get burned,'' says Fraser, 66.

He left the company in 2001 over a dispute with the board about insuring CDOs, he says. Back then, it was debt of Enron Corp. and WorldCom Inc. -- companies that later filed the two largest bankruptcies in U.S. history -- that was being shoveled into CDOs.

``Companies that were having problems or were growing very fast began to turn up in all the deals ACA was offered,'' says Fraser, who moved to Wyoming to run a 12,000-acre (4,856- hectare) ranch and turn a ghost town into a museum of the Old West.

Fraser, who first rated MBIA and Ambac in the 1970s as an analyst at S&P and later helped turn Fitch into one of the three major rating companies, says that while ACA's original mission had been to help finance projects such as nursing homes and rural hospitals, the board didn't want to allocate the capital needed to insure riskier municipal bonds.

Credit Default Swaps

Backing CDOs with credit-default-swap contracts was more alluring, Fraser says. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a borrower's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should the borrower fail to adhere to its debt agreements.

By using swaps, ACA wasn't limited to guaranteeing only securities with a lower credit rating than its own. It could compete with AAA-rated insurers to back top-rated CDOs while having to maintain less capital than the triple-A companies. The top-rated insurers collected annual premiums for insuring CDOs with swaps that were 50 percent of the capital the rating companies required them to maintain, S&P said in a July 2007 overview of the bond insurance industry. ACA was scooping up premiums that were 130 percent of its required capital.

`Very Low Risk'

``ACA has had good success assuming exposure to very low risk supersenior CDO tranches, where the goal of the counterparty is risk transfer and the associated mark-to-market relief,'' S&P said.

By December, after S&P completed a ``stress test,'' it projected more than $3 billion of losses on those low-risk securities. Alan Roseman, ACA's CEO, didn't return a voice mail message seeking comment.

The deals could be complex, sometimes involving layers of potential risk related to the same troubled assets while appearing to offer diversification. As recently as June, Ambac insured $1.9 billion of a CDO called Ridgeway Court Funding II Ltd. whose holdings include other CDOs, some of which contain still more CDOs, according to documents prepared for investment managers that were reviewed by Bloomberg News.

Assets Being Liquidated

In one case, Ridgeway Court has a direct interest in Carina CDO Ltd., whose assets are being liquidated, according to a statement issued Jan. 7 by its trustee, Bank of New York Mellon Corp. Ridgeway also has an indirect interest through another CDO holding called 888 Tactical Fund Ltd. that has a stake in Carina. And it has still more indirect interest in Carina through two CDOs, Pinnacle Peak CDO Ltd. and Octonion CDO Ltd., that hold interests in 888 Tactical Fund, according to the documents.

Ridgeway Court Funding II experienced a so-called event of default after declines in the creditworthiness of its holdings indicated some senior investors may not be fully repaid, S&P said in a statement on Jan. 18.

While the bond insurers made big bets on CDOs using credit- default swaps, others in the market used similar contracts to bet against MBIA and Ambac. Credit-default swaps tied to MBIA's bonds rose to 26 percent upfront and 5 percent a year on Jan. 18, according to CMA Datavision in New York. That meant it would cost $2.6 million initially and $500,000 a year to protect $10 million in MBIA bonds from default for five years. The price implied traders were putting the chance MBIA would default in the next five years at 71 percent, according to a JPMorgan Chase & Co. valuation model. Credit-default swaps on Ambac rose to 26.5 percent upfront and 5 percent a year, implying a 72 percent risk of default within five years.

FSA, Assured Guaranty

Two of the seven top-rated municipal bond insurers have so far escaped the deepest pitfalls in the structured finance market: New York-based Financial Security Assurance Holdings Ltd., the third largest, and Bermuda-based Assured Guaranty Ltd. FSA is a unit of Brussels-based Dexia SA, the world's largest lender to local governments. FSA and Assured Guaranty are the only two bond insurers that deserve top credit ratings, says Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance, who has written two books on CDOs.

``All the AAA ratings are faux ratings at this point, with the exception of FSA and Assured Guaranty,'' she says.

AAA Rating Affirmed

The three major credit rating companies have affirmed FSA's AAA rating with a stable outlook. Assured Guaranty, which earned a Moody's top Aaa rating in July, opened a new office in Sydney and plans to expand into Asia. Dexia shares declined 25 percent in Brussels trading to 15.14 euros ($22.14) on Jan. 18 from 20.21 euros on Aug. 31; they rose 7 percent today to close at 14.94 euros. Assured Guaranty shares fell 33 percent to $17.46 on Jan. 18 from $26.07; they rose almost 5 percent to $18.33 at 12:20 p.m. in New York.

The siren call of CDOs was too strong for most insurers to resist. Virtually all of the securities were rated triple A and backing them required very little capital.

``This type of risk is thought to be one of the most profitable for the bond insurers,'' S&P said in a 2007 industry report.

Annual premiums on CDOs averaged 50 percent of the capital that the rating companies required the insurers to set aside, according to S&P. That compared with an average risk-adjusted profit ratio of 8 percent for insuring other types of structured-finance securities.

What the insurers hadn't bargained on was that the rating companies themselves, including S&P, had grossly underestimated the risk of CDOs.

`Charged Too Little'

``Insurers got into trouble because they charged too little for the risk they took on,'' says Joshua Rosner, managing director of New York-based research firm Graham Fisher & Co. While they shielded banks from taking writedowns on their CDOs, they undermined their own credibility, Rosner says. ``They lost their way out of greed.''

The lack of data on the securities that backed CDOs should have been a red flag. CDO prospectuses warned that reliable default rates for some types of securities backing the CDOs didn't exist, Tavakoli says.

Structured-finance adviser Adelson says analysts failed to see that the mortgage market was becoming riskier. They relied instead on models to predict the performance of CDOs based on historical defaults, recovery rates and correlation risks for various credit ratings. They didn't consider how piggyback loans, which are loans used to borrow a down payment, would perform when extended to people with a history of not paying their bills, Adelson says.

'They Got It Wrong'

``They treated it like a math problem, and they got it wrong.''

That became obvious in October, when New York-based Merrill Lynch & Co., the biggest U.S. brokerage firm, announced $8.4 billion of writedowns on subprime mortgages, asset-backed bonds and bad loans. Analysts used the numbers to shine a light on CDO prices. They began to estimate losses in the billions when the guarantees on securities were marked to reflect the market's view of the CDOs.

William Ackman, the managing partner of Pershing Square Capital Management LP, wasn't surprised. Ackman, who co-founded a hedge fund firm called Gotham Partners LP in 1993 after graduating from Harvard Business School, began betting against MBIA in the summer of 2002. The insurer had larger mark-to- market losses on CDOs than it was disclosing, was underreserving against possible losses and didn't deserve its AAA rating, Gotham said in a report later that year.

`Soundness of Our Book'

MBIA's CEO at the time, Joseph Brown, said Gotham was wrong. ``We stand firmly by the soundness of our book of business and the quality of our underwriting,'' he said in a statement reported on Dec. 9, 2002, by Bloomberg News. Brown is now nonexecutive chairman of Seattle-based property and casualty insurer Safeco Corp.

New York-based Pershing Square stands to make billions if MBIA's and Ambac's holding companies go bankrupt. Ackman said in a Jan. 10 interview on Bloomberg Television that MBIA needed to raise far more capital than the rating companies had required to protect policyholders from losses on subprime securities he estimated could hit $10 billion.

``Every action taken to protect policyholders will not be good for the holding company,'' Ackman said. That's because the insurance unit will need to retain capital rather than pass it along to its parent, he said.

Tom Becker, a spokesman for MBIA, declined to comment.

Other Side of Argument

Martin Whitman, the 83-year-old chairman of New York-based Third Avenue Management LLC, is on the other side of the argument. Whitman increased his stake in MBIA to more than 10 percent at the end of 2007. In an Oct. 31 letter to investors, he said MBIA's critics were too focused on its mark-to-market losses.

``The company, however, will remain with a quite strong capital position,'' said Whitman, whose firm is the second- biggest holder of both MBIA and ACA shares.

ACA founder Fraser says the bond insurance industry needs to do more than raise capital: It needs to restore faith in its unquestioned ability to assess credit risk.

`It's Going to Hurt'

``There's no reason for an AAA-rated bond insurer to be doing anything with subprime mortgages,'' Fraser says. ``It's going to hurt their business because municipalities are going to ask, 'Is this insurance really worth it?'''

By chasing the higher profits of CDOs while underestimating the risks, the bond insurers jeopardized their basic business: insuring municipalities against default. In practice, cities and states rarely default. That's because they can raise taxes to meet obligations or refinance their debts. The designers of CDOs don't have those options.

While the big insurers work to restore confidence by getting back to basics, Buffett's Berkshire Hathaway Assurance Corp. is already making inroads. It insured its first bond, a $10 million issue from New York City, after winning approval in December from the New York State Insurance Department to guarantee debt.

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