26 March 2007

Bond insurers and rating agencies in bed

Short-Seller Fires Torpedo at Biggest Bond Insurer: Joe Mysak

By Joe Mysak

March 23 (Bloomberg) -- If you want to piece together the sad recent history of MBIA Inc., the biggest municipal bond insurer, you could go through articles, sift through disclosure documents, attempt to gain access to transcripts of board meetings.

Or you could read through a 32-page letter written by William Ackman of Pershing Square Capital Management in New York.

The letter, a copy of which was obtained this week by Bloomberg News, is dated March 2 and was sent to John Siffert of Lankler Siffert & Wohl.

Siffert is a lawyer who was hired by MBIA Inc. at the behest of regulators after the firm settled a federal fraud investigation in January. He is looking into how the company does business.

The letter doesn't make for cheery reading, if you are an MBIA shareholder or if you own bonds insured by the firm. In fact, it reads a lot like an indictment, with prescriptive remedies including axing management, making them give back their bonuses and installing an independent board of directors.

Ackman has been a bear on MBIA stock for years, and in the letter says he expects ``having a net short position'' in MBIA Holdings, which is the insurer's parent, ``for the foreseeable future.'' That is, he's betting that MBIA stock goes down.

Happy Days

If you have been following the story at all, and you probably have if you either own the company's shares or some of the almost $1 trillion in bonds it has insured, you probably thought that all of its troubles were behind it.

That was certainly the opinion of investors and analysts contacted after the firm paid $75 million in January to conclude the federal inquiry into the securities and accounting fraud regulators said MBIA engaged in to conceal some stiff losses, the result of a hospital bond default. MBIA neither admitted nor denied wrongdoing.

Not so, says Ackman. ``We believe that there are a substantial number of additional troubled exposures at MBIA Insurance that are not properly accounted for, thereby giving the NYSID and members of the investment and analyst community a false sense of MBIA Insurance's capital adequacy,'' he writes.

NYSID is the New York State Insurance Department.

Ackman wants the Armonk, New York-based MBIA Insurance to hire an independent consultant to look at what the company has insured as well as its reserves and capital.

Conflicts of Interest

And then there's this little bombshell.

``While MBIA might claim that the ratings agencies effectively serve this function, we believe that the rating agencies have actual and perceived conflicts of interest in that MBIA Insurance is effectively one of the largest customers (if not the single largest customer) of Moody's, Standard & Poor's and Fitch as one of the largest public finance guarantors and structured finance issuers in the world.''

The rating companies regularly are paid by MBIA to evaluate the bonds it insures. They are the ones that determine the firm's so-called claims-paying ability. If you want to be a big-time municipal bond insurer, you want this to be AAA.

But wait a minute, as they say on late-night television: That's not all!

``Over the coming weeks and months we anticipate providing you with additional analysis of Holdings' other business practices that fall within the broader scope of your investigation,'' Ackman writes.

So, yes, it seems there's more.

Sleep Insurance

The Ackman letter was featured in a story on Bloomberg News on Wednesday. Predictably enough, nobody wanted to talk about it. But it doesn't look like Ackman is going away.

What a mess. Bond insurance didn't start this way. The insurers were supposed to underwrite business to a famous ``zero- loss standard,'' as they called it. That is, they never really expected to pay a claim. Can you imagine? The stuff they insured -- state and local bonds -- hardly ever defaulted.

There was a lot of resistance to using this new product when it was introduced back in the 1970s. Bond insurance? Who needed such a thing? Who would want it?

Well, a lot of people, it eventually turned out. Issuers liked it because it put a triple-A rating on their bonds, which meant they wouldn't have to pay as much to borrow. Investors liked it because even if the unimaginable happened and an issuer failed to make its debt service payment, they would still receive timely repayment of principal and interest. More than half of the municipal bonds that are sold every year are now insured.

The model works, until the insurers start looking for profits in other businesses and riskier credits. And now comes a great unraveling.

Bond insurance used to be known as investor's sleep insurance. How quaint.

(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)

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