Shorting a stock requires much more skill than going long. Due to inflation, the natural tendency of prices is to go up than down. I have become a big fan of Ackman. Whether he is proven right or wrong ultimately is secondary. The way he has conducted his short campaign against the bond insurers is admirable.
January 18, 2008
Mr. Raymond McDaniel Mr. Stephen Joynt
Executive Chairman and CEO CEO and President
Moody’s Corp. Fitch Ratings
99 Church St. One State Street Plaza
New York, NY 10007 New York, NY 10004
Mr. Deven Sharma
Standard & Poor’s
55 Water Street
New York, NY 10041
Re: Bond Insurer Ratings
Ladies and Gentlemen:
As a Nationally Recognized Statistical Rating Organization, Moody’s, S&P, and Fitch
have been granted a level of authority that capital market participants and Federal and
State regulators have historically relied upon in evaluating the safety and soundness of
corporations, regulated financial institutions, and structured finance securities. To state
the obvious, because of your critical role in the capital markets, it is essential that the
ratings you publish are the result of comprehensive and accurate analysis.
As you well know, we have privately, in meetings and correspondence with you, and
publicly in various presentations that we have made, called into question your ratings of
the bond insurance industry, in particular, the ratings for MBIA Insurance Corp. and
Ambac Assurance Corp. and their holding companies.
Each of you, according to your recent public statements, is in various stages of updating
your ratings of the bond insurers. Unfortunately, however, your previous ratings
assessments have erred materially in their omission of certain critical analysis and the
inclusion of outright errors in your work. As you conduct your most recent revisions of
your analysis on the bond insurers, it is vital that you conduct a thorough assessment of
all aspects of the bond insurers’ business lines, their reinsurers, and investment portfolios
so that the rating decisions that you ultimately publish can be relied upon by capital
Below we highlight a number of factors that you have failed to consider in your prior
assessments of the bond insurers’ capital adequacy:
1) Impact of Losses Should be Measured on a Pre-tax Basis
We believe that each of you overstates the bond insurers capital cushion due to tax
benefits you include in calculating the impact of RMBS and CDO losses. For instance, in
S&P’s recent press release update published yesterday, MBIA’s losses on RMBS and
CDOs are expressed as “after-tax” losses. In order, therefore, to determine the actual
cash losses implied by S&P’s after-tax estimate, one must gross up the reported $3.18
billion of after-tax losses. Assuming a tax rate of 38%, it appears that S&P is estimating
MBIA’s actual cash losses at $5.13 billion, nearly $2 billion more than the losses
adjusted for tax benefits.
Insurance claims must be paid in cash. A bond insurer is only able to obtain tax benefits
if the insurer is a going concern and is able to generate sufficient taxable income in the
current or future years to offset the losses from paid insurance claims. Your analysis
makes the aggressive assumption that the bond insurers will remain going concerns and
will therefore be able to continue to write new premiums and generate income in the
Based on recent industry developments – including Berkshire Hathaway’s entrance into
the business – it appears unlikely that MBIA, Ambac and many of the other bond insurers
will be able to continue as going concerns. In a runoff scenario, we do not believe that
the bond insurers will generate sufficient taxable income to offset the net operating losses
generated by paid losses. While U.S. corporations can receive tax refunds by carrying
back tax losses up to two calendar years, the amounts that could be refunded from
carrying back losses are de minimis relative to claims payable. Even in the event the
bond insurers generate taxable income in future years, it may be many years before these
tax benefits can be realized, if ever, particularly in the event of corporate ownership
changes caused by capital raising or stockholder turnover.
Net operating loss carryforwards are not cash and are not available to pay claims and
should therefore not be deducted from losses in calculating bond insurer capital
adequacy. By using after-tax loss estimates rather than pre-tax losses – the amount that
will need to be paid in cash – you are understating the actual losses payable by more than
Your updated rating assessments should be adjusted to exclude tax benefits in your
calculation of capital adequacy
2) Covenant Violations and Loss of Access to Liquidity Facilities
As a result of recent losses, both MBIA and Ambac have triggered covenant violations on
their liquidity facilities. As a result, Ambac has lost access to $400 million of funding
and MBIA to $500 million of capital. The impact of the loss of these facilities is material
to the liquidity profile of the holding companies and their insurance subsidiaries and must
be considered in your credit assessment.
3) Loss Estimates Must Incorporate Reinsured Exposures
Your ratings of the bond insurers are based on the bond insurers’ net credit exposures.
That is, you reduce their credit exposure by those exposures that have been reinsured.
This is best understood by example.
As of September 30, 2007, MBIA has re-insured approximately $80 billion of par value
of its exposures. More than $42 billion of this reinsurance was purchased from Channel
Re, a Bermuda- based reinsurer whose only customer is MBIA. The two most senior
officers of Channel Re are former executives of MBIA. MBIA owns 17% of the
company and has two representatives on Channel Re’s board of directors.
On recent conference calls, Moody’s and S&P have stated that they have not yet updated
their ratings of the monoline reinsurers including Channel Re. Earlier this week, on
January 16th, Partner Re and Renaissance Re, the majority equity owners of Channel Re,
wrote off the entire value of their investments in Channel Re due to losses it has recently
incurred that substantially exceed Channel Re’s capital, an impairment that Channel Re’s
two majority owners have concluded is “other than temporary.”
Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s
credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and
S&P continue to rate the company Triple A with a stable outlook. Fitch does not rate
Channel Re and apparently relies on S&P’s and Moody’s stale Triple A ratings in its
analysis of MBIA’s capital adequacy.
Captive reinsurers whose ratings are not regularly updated offer the potential for abuse.
We believe that MBIA reinsured on a quota share basis 25% of its 2007 CDO
transactions with Channel Re. As a result of Moody’s and S&P not updating its ratings
of Channel Re, these exposures do not appear on MBIA’s list of exposures and have not
been included in your calculation of MBIA’s capital adequacy.
MBIA’s second largest reinsurer is Ram Re which has reinsured $11 billion of par as of
September 30, 2007. While the rating agencies have not updated their credit ratings of
Ram Re, the market appears to have already done so. The publicly traded stock of Ram
Holdings Ltd., the parent company of Ram Re, has declined 92% in the last year. The
company currently trades as a penny stock with a market value of $32 million.
We believe that Ram Re is substantially undercapitalized and therefore, like Channel Re,
is unlikely to be able to meet its obligations to MBIA.
We also note that MBIA reinsures Ambac, and Ambac reinsures MBIA. You must also
consider the iterative impact of downgrades of one on the other with respect to both
reinsurance and their respective guarantees of each other’s investment portfolio assets
which we discuss further below.
In your updated assessment, it is critical that you update your ratings of the bond
insurers’ reinsurers and reconsolidate and calculate the losses on these exposures that
have been reinsured with reinsurers that are inadequately capitalized.
4) Investment Portfolios are Riskier Than They Appear
As you are well aware, the investment portfolios of the bond insurers include a
substantial amount, often a majority, of bonds that are guaranteed by either the bond
insurer itself or by other bond insurers. The bond insurers include these guarantees in
calculating the weighted average ratings of their investment portfolios. We note that a
minimum average Double A rating is a key rating agency criterion for the insurers’ Triple
A guaranty to oneself is of course worthless and therefore you should exclude the bond
insurers’ guaranty of its own investment obligations and use the underlying ratings of
these instruments in determining the portfolios’ credit quality.
You should also carefully calculate the impact of a downgrade of the bonds held by one
bond insurer that are guaranteed by other insurers in your calculation of capital adequacy.
In light of the general distress in the industry, we believe that the rating agencies should
evaluate the bond insurers’ investment portfolios as considered on an underlying rating
5) Commercial Mortgage Backed Securities (CMBS)
To date, you have limited your analysis to RMBS securities and other structured finance
securities with exposure to RMBS (CDOs). This limited review of exposures ignores the
fact that the same lending practices and flawed incentive schemes that fueled the
subprime lending bubble have been very much at work in CMBS and corporate finance.
On January 17, 2008, Fitch commented that it believed that CMBS delinquencies are
“likely to double, and perhaps even triple, by the end of 2008.” As of September 30,
2007, MBIA had insured $43 billion net par of CMBS securities, the vast majority of
which was underwritten in the past two years. Failing to consider the potential for losses
in this portfolio in your calculation of capital adequacy is simply negligent.
6) Claims-Paying Resources Definition Overstates Capital Available to Pay Claims
The rating agencies have adopted the bond insurance industry’s definition of capital in
the form of “Claims Paying Resources” or “CPR.” We believe there are significant flaws
with the calculation of CPR used by the industry and the rating agencies.
First, bond insurers include the present value of future premiums discounted at extremely
low discount rates ~5% in their calculation of claims paying resources. Substantially all
of these premiums are from structured finance guarantees. We believe that the bond
insurers and the rating agencies do not adequately consider the facts that: (1) when
structured finance obligations default, accelerate, or otherwise prepay ahead of schedule
these premiums disappear, (2) purchasers of secondary market guarantees are likely to
terminate their periodic premium payments because of the deteriorating credit quality of
the bond insurers, (3) the reserves for losses on these exposures (for example 12% of
premium for MBIA) have proven to be inadequate and therefore overstate the net
premium income, and (4) there is no provision for overhead, remediation, legal or other
costs required for the bond insurers to run their business going forward. There is also no
mechanism whereby the bond insurers can borrow against these potential future
premiums to be used to pay claims in the present day.
There is no other financial institution in the world which takes the present value of
interest spread income on loans in its portfolio and adds it to its capital. For all of the
above reasons, we believe that the present value of future premiums should not be
included in CPR.
CPR includes the bond insurers’ so-called depression lines of credit. As you well know,
depression lines of credit can only be drawn to pay claims on municipal obligations and
only after a substantial deductible. In that the losses are occurring primarily on structured
finance obligations, these lines of credit should not be included in CPR
The Capital Base included in CPR is also likely to be overstated because the investment
assets of the bond insurers consist primarily of bond insurer guaranteed obligations that
are valued inclusive of the guarantee, when they should be valued on an unwrapped basis.
The high degree of balance sheet leverage for certain bond insurers means that small
changes in the values of these portfolios have a large impact on the bond insurers’ capital
You should adjust your estimate of CPR for each insurer to reflect the above factors in
order to accurately establish the capital available to pay claims.
7) MBIA’s $1 Billion Surplus Note Issuance
Last Friday, MBIA priced an offering of surplus notes at par with a 14% yield. Within
one week the notes traded down to the mid-70s and have a yield to call of more than
20%. Previous to their pricing, the notes were rated by Moody’s and S&P at Double A.
The MBIA surplus note issuance is perhaps the clearest example of the failure of the
rating agencies to accurately assess the creditworthiness of a bond insurer. MBIA is still
rated Triple A by all three raters. The notes received a Double A rating because of their
subordination to the other obligations of MBIA Insurance Corporation. That said, how
can a billion dollars of Double A rated obligations sell in a cash transaction between
sophisticated parties at a 14% yield, and then trade to yield of 20% or more — a rate
consistent with a Triple C or near-to-default obligation?
Bank of America 5 ¾% bonds due 2017, obligations of a financial institution that is also
rated Double A, closed today at 5.55% yield, a more than 15 percentage point lower rate
than the MBIA surplus notes. This is prima facie evidence that your ratings of MBIA are
Billions of MBIA’s CDO Exposure Require Payment on Default
You have stated that bond insurers have no accelerating CDO guarantees and that all of
their contracts are structured as “pay-as-you-go.” I quote S&P from a paragraph entitled,
“Time is On Their Side,” in their December 19, 2007 report: “Detailed Results of
Subprime Stress Test of Financial Guarantors.”
“As for swap exposure, except for ACA there are no collateral posting
requirements and swaps are written in pay-as-you-go format.”
On January 9, 2008, MBIA filed a copy of a powerpoint presentation which was used in
the Surplus Notes offering road show. On page 8, MBIA states that $8.1 billion of its
Multi-sector CDOs require payment with “Credit events as they occur.”
The liquidity demands of accelerating CDO exposure create extreme liquidity risk and
must be considered in the context of the bond insurer ratings. We encourage you to
examine all of the bond insurers CDS/CDO exposure to determine the amount of
exposure that is not pay-as-you-go, but rather accelerates, and consider the liquidity
demands of such exposures in your rating assessments.
9) Holding Company Liquidity Risk
In light of recent events, we believe it is likely that most bond insurers will be prevented
from upstreaming dividends to their holding companies as a result of regulatory
intervention, as regulators work to preserve capital for policyholders.
Most bond insurer holding companies have limited cash, have lost or will lose access to
liquidity facilities, and have substantial cash needs for interest payments, operating
expenses, and dividends (for so long as they continue to be paid). In addition, bond
insurers with substantial investment management or swap operations have additional
liquidity needs in the event of a downgrade.
We believe that both MBIA and Ambac have substantial collateral posting obligations in
the event of a holding company downgrade. For example, MBIA has $45 billion of
derivative obligations at the holding company that relate to currency, interest-rate, and
credit default swaps that the holding company has entered into. The combination of
volatility in each of these markets and the increased collateral demands required in
holding company downgrade scenarios will put a severe strain on holding company
The bond insurers’ muni-GIC business is also a large potential liquidity strain as
municipalities withdraw funds from these GIC programs, assets must be liquidated,
and/or collateral must be posted. Various MTM programs also create liquidity risk as
assets may have to be sold to meet redeeming bondholders. The liquidity risks of these
programs and the underlying assets should be carefully examined.
ACA’s immolation is but one example of what happens to a once-investment grade bond
insurer which, if downgraded, is required to post collateral.
In addition, as a result of shareholder, bondholder, and/or surplus noteholder litigation,
we expect holding company legal expenses and eventual litigation claims to rise
substantially. Because the holding companies typically provide indemnities for
employees and directors, we would expect that directors would be loathe to allow
liquidity to leave the holding company estate, depriving directors and employees of the
resources to protect themselves from claims. In these circumstances, we would expect
companies to seek bankruptcy as a means to protect the allocation of value among
10) MBIA - Warburg Pincus Transaction
You have assumed in your analysis that the Warburg Pincus deal and follow-on rights
offering are certainties even though neither transaction has closed. While Warburg has
made affirmative statements about the transaction, both publicly as well as privately, to
surplus note buyers and the media, we believe there continues to be transaction closure
risk for both the initial stock purchase and future rights offering, with the rights offering
having greater uncertainty.
You have also assumed that 100% of the $1 billion Warburg deal will be downstreamed
to the insurance subsidiaries and this, too, is not a certainty. You should receive
assurances from MBIA and require it to contribute the full billion dollars to its insurance
subsidiaries before you include the funds in calculating insurance company capital.
With the collapse in MBIA’s stock price and today’s downgrade of Ambac, we believe it
will be difficult for MBIA to execute the rights offering, particularly before the March
31st, 2008 drop dead date. With the stock at $8.55 per share and the market aware that
the $500 million in rights offering proceeds is insufficient to adequately capitalize the
company, it will be difficult to set a market-clearing price. Assuming for a moment the
price is set at $5.00 per share, the company would have to issue 100 million shares and
may sell control to Warburg at a discount in the event shareholders elect not to
participate. We believe a shareholder vote and approved registration statement will likely
be required in such a circumstance, delaying the ability to consummate the transaction
beyond the March 31st Warburg backstop drop dead date.
11) Future Business Prospects and Franchise Value Have Been Irreparably
Following the dramatic decline in share prices, widening of credit protection spreads,
dismal performance of the high yield surplus note issuance, and recognition of multibillion
dollar losses in a supposed “no-loss” business, the ability of bond insurers to
market their “AAA” seal of approval has been permanently undermined. As uncertainty
has grown, municipalities have raised capital without insurance and found that they can
borrow at attractive rates as compared to historical insured bond issuances.
The entrance of Berkshire Hathaway is a devastating competitive reality that will capture
the lion’s share of an already shrinking market for municipal bond insurance. While
some commentators have suggested that this might create a pricing umbrella that will
benefit the existing bond insurers, this is demonstrably false. Because Berkshire
Hathaway already possesses a real Triple A rating, the bonds that are wrapped with its
guarantee will trade with a tighter spread when compared to a bond insured by a
traditional bond insurer, even one without legacy structured finance exposure.
Consequently, Berkshire will be able to charge higher premiums than the other monolines
by taking a higher percentage of the spread (perhaps as much as 80% or more) that is
saved through the use of insurance, and still provide the issuer with an overall lower cost
of borrowing that if they bought insurance from a traditional monoline. As such, we
believe that Berkshire Hathaway will likely quickly reach an 80%-90% market share of
municipal bond insurance.
12) Going Concern Opinion
In light of all of the above and other current developments, we believe it will be difficult
for MBIA, Ambac, and certain other bond insurers to obtain going concern opinions from
their auditors. You should consider the likelihood of the insurers’ obtaining clean
opinions and the implications if they do not in your rating assessments.
Lastly I encourage you to ask yourself the following question while looking at your
image in the mirror:
Does a company deserve your highest Triple A rating whose stock price has
declined 90%, has cut its dividend, is scrambling to raise capital, completed a
partial financing at 14% interest (now trading at a 20% yield one week later), has
incurred losses massively in excess of its promised zero-loss expectations wiping
out more than half of book value, with Berkshire Hathaway as a new competitor,
having lost access to its only liquidity facility, and having concealed material
information from the marketplace?
Can this possibly make sense?
Please call me if you have any questions about the above. As usual, I will make myself
available at your convenience.
William A. Ackman