Bill Ackman Was Right: MBIA, Ambac on `Ratings Cliff'

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By Christine Richard
June 18, 2008 (Update1)

June 18 (Bloomberg) -- Bill Ackman was right: the world's largest bond insurers aren't worthy of a AAA credit rating and may be headed for the bottom of the scale.

Ackman, the 42-year-old hedge fund manager who says he stands to make hundreds of millions of dollars betting against MBIA Inc. and Ambac Financial Group Inc. if they go bankrupt, will tell investors at a conference in New York today that losses posted by bond insurers may threaten to breach the capital limits allowed by regulators, making them insolvent.

That once-unthinkable scenario would trigger clauses in $400 billion of derivative contracts written to insure collateralized debt obligations and other securities, allowing policyholders to demand immediate payment for market losses, which have reached $20 billion, according to company filings. Downgrades of the insurers would cause a drop in rankings for the $2 trillion of debt that the companies guarantee, wiping out the value of the CDO insurance held by Wall Street firms, analysts at Oppenheimer & Co. said.

``Given the volume of credit-default swap contracts the industry has written, there is a real element of a ratings cliff across the bond insurance sector,'' said Fitch managing director Thomas Abruzzo, the first analyst to strip MBIA and Ambac of their top ratings.

Ambac said today it asked Fitch to remove ratings on all of the company's subsidiaries. MBIA asked Fitch to stop assigning a financial strength rating in March.

17 Levels

CIFG North America may fall first. The company's credit rating has been cut by 17 levels to CCC from AAA by Fitch since March because of concern it won't be able to make payments on $57 billion of the contracts.

Ackman said CIFG ``provides a road map for what happens to a bond insurer when its capital is depleted.'' Ackman, whose $6 billion Pershing Square Capital Management hedge fund in New York returned 22 percent last year, began betting against bond insurers in 2002. In his report ``Is MBIA Triple-A?,'' Ackman was the first to say the insurer's use of derivatives to guarantee debt threatened to drain capital.

MBIA, of Armonk, New York, Ambac, Security Capital's XL Capital Assurance and FGIC Corp. also have guarantees with similar clauses to CIFG that may allow policyholders to demand billions of dollars if the companies became insolvent, according to company filings.

CIFG, XL Capital Assurance, and FGIC's insurance unit may all fall short of regulatory capital requirements by June 30, according to Robert Haines, an analyst with CreditSights Inc. in New York.

`Highly Theoretical'

Downgrades may cause Citigroup Inc., Merrill Lynch & Co. and UBS AG to write down the value of insured-debt holdings by at least $10 billion, according to Meredith Whitney, an analyst at Oppenheimer in New York. Banks and insurance companies would also be required by regulators to hold more capital to protect against losses on lower-rated debt, according to analysts at Charlotte, North Carolina-based Wachovia Corp.

CIFG is working on a plan to bolster capital, spokesman Michael Ballinger said. Because MBIA has a surplus of $3.9 billion, insolvency is ``both highly theoretical and extremely unlikely,'' Kevin Brown, a spokesman for MBIA said in an e-mailed statement. Vandana Sharma, a spokeswoman for Ambac, with a $3.6 billion surplus, declined to comment, as did Security Capital spokesman Michael Gormley and New York-based FGIC's chief risk officer, John Dubel.

Insurers, including MBIA and Ambac, expanded beyond municipal debt into insuring CDOs, which package pools of securities and slice them into pieces of varying risk. The move was criticized by Ackman, who said it may ultimately bankrupt the companies.

Pershing Square

In January, Ackman, who started a hedge fund after working at his family's commercial mortgage brokerage, estimated MBIA and New York-based Ambac faced losses on home-loan securities of almost $12 billion each, a claim the companies disputed as recently as February.

Ackman said he took an interest in MBIA after asking a credit-market trader which companies didn't deserve AAA ratings. That led to his report and his decision to take a short position in MBIA and Ambac stock, selling borrowed stock, expecting to repurchase it later at a lower price. Ackman also bought credit- default swaps on MBIA and Ambac debt. The swaps would rise in value if doubts about the companies grew.

Pershing Square profited as MBIA tumbled 91 percent in the past 12 months and Ambac plunged 98 percent in New York Stock Exchange composite trading. Security Capital is down 99 percent.

Investor Bets

Instead of writing standard insurance policies for the CDOs, the companies provided guarantees in the form of credit-default swap contracts, financial instruments that allow one party to assume the risk of a security defaulting in exchange for a fee from another.

The contracts were designed to mirror insurance policies, said Bob Mackin, the Albany, New York-based executive director of the Association of Financial Guaranty Insurers.

Unlike insurance, the swaps include so-called termination clauses that can be triggered if a company becomes insolvent, Mackin said. The feature requires insurers to compensate CDO holders for any drop in value, or mark-to-market loss, on the securities.

Moody's wrote in 2006 that the companies were ``well insulated from liquidity risk,'' because credit-default swaps ``protect the guarantor from ever having to pay claims on an accelerated basis.'' Moody's spokesman Abbas Qasim declined to make analysts available for this story.

`Serious Consequences'

The credit ratings of some CDOs have tumbled so far that the insurers have recorded combined unrealized losses of at least $20 billion.

Some companies' termination payments would eat up all their claims-paying resources, according to filings and rating company reports.

``It doesn't make sense for companies and regulators to have gone knowingly into this, given the very serious consequences,'' said Lawrence Hamilton, an insurance attorney with Mayer Brown LLP in Chicago. ``At the time, the possibility of a bond insurer becoming insolvent seemed so remote.''

If a company's surplus to policyholders -- or assets over liabilities -- falls below zero, it's considered insolvent under New York State Insurance Department rules and would be taken over by Superintendent Eric Dinallo, unless it comes up with a plan to correct the impairment, Deputy Superintendent Michael Moriarty said in an e-mailed statement.

Moriarty wouldn't comment on the likelihood of the department taking over the companies under that scenario.

`Extremely Alarming'

In a June 8 report, CreditSights' Haines wrote that ``statutory surplus levels at some of the monoline financial guarantors are extremely alarming.''

Companies may avoid making the termination payments by raising capital or reducing loss reserves. CIFG and FGIC are seeking ways to raise capital, they said. MBIA and Ambac have said they don't anticipate losses will be large enough to erode their surpluses.

Even in an insolvency, regulators may step in to halt the payments or banks may decide not to demand compensation, Abruzzo said. ACA Financial Guaranty Corp. has reached five agreements with banks since December, allowing it to avoid posting collateral on CDOs it guaranteed using swaps. ACA has been cut to CCC by S&P.

Fitch is assuming in its ratings that regulators will allow the payments, Abruzzo said.


CIFG, based in Hamilton, Bermuda, had a surplus of $80 million at the end of the first quarter, down from $103 million, according to filings. It set aside more than $100 million for losses in the first three months of the year.

Security Capital's XL Capital Assurance booked about $200 million of losses in the first quarter, shrinking its surplus to $167 million, according to company filings. SCA, based in Hamilton, Bermuda, wouldn't be able to cover termination payments on swaps if they were triggered, according to regulatory filings. XL is rated BB by Fitch, A3 by Moody's and BBB- at S&P.

FGIC had a cushion of $366 million at the end of March, compared with loss reserves of about $1.8 billion taken in the past year, according to company filings. FGIC is rated BBB by Fitch, Baa3 at Moody's and BB by S&P.

MBIA and Ambac may need to raise capital to avoid becoming insolvent if loss reserves continue at the recent pace, Haines said. The companies were both cut to AA from AAA by Fitch and S&P. Moody's said on June 4 that it probably will also reduce its ratings.

S&P spokeswoman Mimi Barker declined to make analysts available for this story.

`Nightmare Scenario'

In the past two quarters, MBIA's insurance unit set aside reserves of $2 billion to cover losses on $51 billion of guarantees on home-equity securities and CDOs backed by subprime mortgages.

Ambac booked about $2 billion of loss reserves, leaving it with a statutory surplus of $3.6 billion. It guaranteed around $47 billion of CDOs and home-equity debt.

While both companies are above the regulatory capital requirements, S&P said in a February report that in a ``stress case scenario,'' MBIA may be forced to pay a total $7.9 billion in claims on a present-value basis and Ambac may be forced to pay $6.2 billion.

``That's what puts these companies into the nightmare scenario,'' CreditSights' Haines said.

To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net
Last Updated: June 18, 2008 14:32 EDT