10.03.2008 11:00:00
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MBIA Releases Letter to Owners
MBIA (NYSE:MBI) yesterday released the following Letter to Owners from
MBIA Chairman and Chief Executive Officer Jay Brown.
March 9, 2008
Dear Owners,
The big news of the past week was the announcement of our decision to
request withdrawal of our Insurer Financial Strength (IFS) ratings from
Fitch after the market closed on Friday. I will address that below, but
for most of us at MBIA, Friday was far more important for another
reason, as we sadly had to say goodbye to many of our colleagues. While
I knew the redeployment decision was one I would have to make early upon
my return, this didn’t make it any easier. We
wish our former associates the best of luck in the years ahead and won’t
be surprised if some of them wind up being stars at our competitors –
they are that good.
Rating Agency Overview Part 2*
I have received calls and emails from many of you following last week’s
letter on my observations of the rating agencies. By now you will have
seen that we requested Fitch to withdraw their IFS ratings on our
insurance subsidiaries (our letter to Fitch was posted on our website
after Fitch released it publicly). The questions on everyone’s
mind are, obviously, "Why Fitch, and why now?”
The answer comes from considering who the IFS ratings are intended for,
not from reacting to where the IFS ratings seem to be having the
greatest influence in today’s chaotic markets.
When a potential issuer evaluates how to access the market most
efficiently, they and their advisors contract with one or more rating
agencies to evaluate the credit instrument and to determine how it will
be rated based on its characteristics. If the issuer also wants to
evaluate the value of bond insurance on that credit instrument, then we
independently perform our own assessment and work with the selected
agencies to see how they have analyzed the issuer’s
credit. Having worked with Fitch on thousands of transactions, I can
assure you that MBIA believes their work, despite their modest market
share with our customers, is totally on par with the others and, in some
sectors, is best of breed.
After we agree to provide a financial guarantee on a transaction, the
security then trades in the market. Sophisticated investors will look at
both the underlying credit itself and at the value of our credit
enhancement. They will often purchase information about that credit from
the rating agencies or discuss it with them or with us, particularly
when that credit is in the news. (The Eurotunnel transaction comes to
mind where there were hundreds of such inquiries). The fact that every
credit is unique explains clearly why the tens of thousands of credits
we insure trade at such wide variances in spreads. If investors were
only looking at the MBIA guarantee, they would all trade virtually
identically!
Given that it is these issuers and investors that we are focused on, we
work extensively with the major rating agencies to analyze the strength
of our guarantee as it applies to the credits we insure. This is the IFS
rating. As noted last week, the three major rating agencies all use a
combination of their own fundamental credit analysis and other
information to decide on IFS ratings for MBIA. In the case of all three
agencies, this analysis often involves discussions between their credit
analysts in a particular sector as well as the bond guarantor credit
analysts talking with their counterparts at our shop, which enables us
to understand why there might be different views that impact their
overall assessment of our firm. Since S&P and/or Moody’s
are selected by virtually 100% of our issuers, whenever there is a major
credit sector event we almost always have a direct dialogue with teams
that have assessed that credit at the time of issuance and then continue
to monitor it, and its sector, in detail. The importance of this
communication and the understanding of the fundamental credits
underlying our guarantees cannot be underestimated as we manage both our
current portfolio and plan for our future.
In the case of Fitch, however, the situation is somewhat different.
While about 30% of our issuers (mainly on the U.S. public finance side
of the business) choose Fitch to do credit analysis at the transaction
level, virtually none of our issuers choose to work only
with Fitch. In fact, we could locate only three transactions in our
database. In contrast, over 85% of MBIA’s
total insured portfolio is analyzed at the transaction level by Moody’s
and S&P. This is the core of the difficulty we encounter in using Fitch’s
evaluation of our credit portfolio as we manage our business. Fitch has
been very aware of this issue of partial portfolio coverage, both at
issuance and over the life of the transactions.
A couple of years ago they contracted to have an extensive default study
performed, and they built a complex model (MATRIX) to use both their own
data and ours. They requested that we supply the ratings from the other
two agencies and our own internal ratings to use as inputs. The default
study (which we have asked for so we can understand the model, but which
they have not yet provided or made public) establishes the parameters of
the model, and then Fitch selects which rating to use in the model. For
those transactions that they haven’t rated
(in MBIA’s case, over 70% of our insured
portfolio), Fitch’s capital modeling relies
heavily on ratings information from its competitors that we supply, and
does so in a way that results in inappropriate capital requirements for
our company – specifically, they use the "lower
of” the other two agencies’
ratings.
The end result is that we have very little idea why Fitch’s
capital model produces the charges it does, and why it can change so
rapidly at any point in time when there is no obvious change in our
circumstance or in the credit market at large. A good example of this is
when we received an affirmation of our rating from Fitch on January 16th
at the Triple-A Stable level following our successful $1 billion surplus
notes offering. Then on February 5th, Fitch
announced that they were putting us on review for possible downgrade!
Did the world (or their model) really change that much in two weeks? The
only event of note that I can think of is the fact that the other two
agencies put us on review for possible downgrade in the intervening time
period.
Given the fact that every investor in an MBIA-enhanced security has the
benefit of transaction-level credit analysis from either or both Moody’s
and S&P and has received in the past two weeks an affirmation of our
Triple-A (an upgrade to negative outlook –
but we are working on doing even more), the value of the IFS rating from
Fitch to potential issuers or to investors in our securities seems
limited at this time. Of equal importance in today’s
environment, the impact of even a hint of change in Fitch’s
IFS ratings for MBIA causes serious volatility in terms of how our
company is viewed in the equity markets, the CDS market (more on that
later) and the reputation of our firm.
This is the core rationale why we asked Fitch to withdraw their IFS
rating on MBIA.
In response to the question I see bouncing through the financial press
and on the internet as to whether the "real”
reason we withdrew the ratings now is because we were about to be
downgraded, I can only say this: I have had just one meeting with Fitch
since I returned, and because of the issues I described above, there is
no way my team can estimate what the Matrix model will produce in any
given week, nor why changes may occur, nor when. The fact is, we have
been assessing the value of Fitch’s IFS
ratings for some months now. Given our belief that there was no
announcement pending from them in the near-term as they were still
requesting information, and in light of our conclusion that Fitch’s
IFS ratings are limited in value because of their relative lack of
direct transaction-level analysis, we believe it was an appropriate time
to request that Fitch no longer provide us with its IFS ratings.
We do intend to work with Fitch to perform the analysis needed to rate
our own debt securities. Equally important, we are planning on working
with them in the future in those areas where they have a major share of
the market and when we have different insurance entities targeted at
those markets that fit our credit risk appetite.
CDS from my chair: "The
Place Where the Big Guys Play for Big Stakes!”
Although Fitch dominated our conversations last week, since returning to
MBIA I have also heard from many of you regarding credit default swap ("CDS”)
contracts written on MBIA’s holding company's
debt and insurance subsidiary’s insurance
claims-paying ability. You have asked, "Why
are MBIA’s spreads so wide, given the
stabilization in the business and recent Triple-A ratings affirmations
by both Moody’s and S&P?”
(You are not the only ones asking this question, as this was also one of
the first questions posed to me in the Bloomberg interview on Monday of
last week.) According to our team downstairs in Asset Management, the
one-year basis point equivalent CDS spread on the holding company is
around 1,700 basis points, and the annualized basis point equivalent
cost of credit protection for a five-year contract is approximately 800
basis points. Before I delve into my answer, let me first provide a
brief primer on the mechanics of CDS contracts. (By the way, I too had
to dig a little internally to refresh my memory around this esoteric
market.)
Credit default swaps allow investors to insure against the credit risk
of an underlying debt security (i.e., our holding company public debt)
or a reference entity (in our case, our financial guarantee policies
written). The contract is entered into by two counterparties, one being
the seller of credit protection and the other being the buyer of credit
protection. MBIA is not a party to any of the referenced transactions.
These counterparties also have very different incentives than our
traditional stakeholders, namely you as owners and our fixed-income
investors of wrapped securities, which will become very clear as we look
more closely at this market below. Buyers of credit protection pay the
seller a fee in return for the promise to receive a cash settlement
payment (or, deliver the underlying referenced security in exchange for
a full par payment on that security) if a default on the underlying
security occurs. In a typical CDS contract there are three possible
events that would trigger a payout: 1) a failure to pay a principal or
interest payment, 2) a bankruptcy filing, and/or 3) a debt
restructuring. CDS contracts have a limited term, which is defined in
the contract.
So here is how this relates to us: investors who enter into CDS
contracts buying protection on MBIA Inc., our publicly traded holding
company, will realize a benefit if MBIA Inc. defaults on its debt before
that contract matures. For instance, to insure against default of $10
million of MBIA Inc. debt within the next year costs $1.7 million (using
the spreads quoted above), while the same coverage for the next five
years costs approximately $800 thousand per year (or, said another way,
it costs approximately $4 million to purchase a five-year, $10 million
insurance policy on MBIA Inc.’s debt).
By my simple bond math, this pricing on five-year CDS indicates an over
60% chance that MBIA will default within five years (depending on the
timing and recovery value assumptions of the bonds at default). As an
interesting side bar, Moody’s historical
corporate bond default tables show the cumulative defaults for Aa-rated
entities (our holding company’s rating) over
5 years to be 0.18%, and the cumulative default history for Ba-rated
entities (9 rating notches below where we are currently rated) to be
11.3%. So to be clear, the implied default rate on our CDS pricing is
approximately 300 times greater than our rating would imply versus
historical data, and approximately 6 times greater than a rating 9
notches lower than ours.
Now let’s consider what a person buying CDS
on MBIA Inc. is really protected against. For simplicity’s
sake, let’s use our 1-year CDS in this
example. Over the next year, MBIA Inc. would have to make approximately
$80 million in interest payments on its outstanding debt and no
scheduled payments of any principal. Thus, someone buying one-year
credit protection on MBIA Inc. is betting that the $1.6 billion in cash
and short-term investments currently held by MBIA Inc. will not be
sufficient to cover its $80 million of interest expense. As a former
old-time CFO, this frankly doesn’t make sense
to me. Even when we contribute a substantial portion of the $1.1 billion
into our insurance and asset management subsidiaries, we would still be
left with approximately $500 million in cash to cover the next year’s
financial obligation of $80 million.
I should note that the analysis I have laid out above assumes MBIA Inc.
1) receives no dividends from its insurance subsidiary (although we are
eligible to start paying regular dividends in May) or its asset
management subsidiary (as much as $80 million in 2008), 2) generates no
income from its cash and short-term investments at the holding company,
and 3) does not draw upon its existing $500 million available revolving
line-of-credit. In addition, this recognizes that 4) the $28 billion of
liabilities of our asset/liability management business that are
guaranteed by our insurance company and held at MBIA Inc. are backed
fully by the $28 billion of existing assets dedicated to this
asset/liability management business that also reside at MBIA Inc. Taking
all this into account, by my calculations (ignoring the $1.1 billion),
we have approximately $500 million of cash at the holding company
covering over three years of interest and scheduled principal payments,
before the benefit of the 4 items noted above.
Also, it is important to keep in mind that we do not have any principal
payments pending on our debt until 2010, and even that payment is just
$100 million, net of a cross-currency swap on the debt. Further, the
funded debt at MBIA Inc. does not have maintenance covenants or
acceleration provisions tied to our operating performance (e.g., default
can only be caused by us missing an interest or principal payment).
Now that we’ve discussed how improbable
default is at MBIA Inc. over the next year, take a look at the below
chart, which shows the approximate annual cost of buying CDS on MBIA
Inc. based on the contract’s maturity. This
chart shows that on an annual basis it is more expensive to buy shorter
dated credit protection than longer dated protection on MBIA Inc. Now I’ve
heard of, and lived through, inverted yield curves, but I find the
inversion of this CDS curve to be quite perplexing.
What the CDS market is telling us through this curve is that it believes
that the greatest risk of default for MBIA Inc. is over the next year.
Given the example I just walked through above, I hope you will agree
that default at MBIA Inc. is highly improbable over the next year (I
think even our most vocal critics will agree that $500 million+ of cash
should be enough to pay $80 million in holding company financial
payments). If, as the CDS market is telling us, the risk of default at
MBIA Inc. diminishes the further we go out in the future, and as we just
discussed, there is minimal risk of default over the next year, one
might wonder what are those investors buying CDS protection spending
their money on? Given our robust financial position at MBIA Inc., I
would certainly argue that the existing spread in the short-term is
illogical.
I suppose one potential explanation could be fear that the New York
State Insurance Department (NYSID), the regulator of our insurance
subsidiary, might not allow our insurance subsidiary to pass dividends
up to MBIA Inc. this year. While I discussed above why our holding
company remains solvent for many years even without dividends from our
regulated insurance subsidiary, let’s explore
the NYSID point anyway.
I think a lot of the confusion regarding what the NYSID will and will
not allow our insurance subsidiary to do stems from a misunderstanding
of the NYSID’s mandate. As stated by both
NYSID Commissioner Eric Dinallo and New York State Governor Eliot
Spitzer during their congressional testimony on February 14th,
the NYSID’s mandate is to ensure that
financial guarantors have sufficient capital to pay policyholders in the
event of claims. To be clear, the NYSID’s
mission is not to ensure that
financial guarantors maintain Triple-A ratings. Given that much of the
debate in the markets (with the exception of a few, albeit vocal,
self-interested parties) has been around whether MBIA’s
insurance subsidiary deserves a Triple-A rating or a Double-A rating, I
find it improbable that anyone could conclude that MBIA’s
policyholders bear sub-investment-grade default risk. (Last time I
checked, Double-A-rated insurance companies such as Allstate,
Prudential, and State Farm were considered very well capitalized, and we
of course were recently affirmed Triple-A).
Mr. Dinallo has affirmed this in a letter to the House Subcommittee on
Capital Markets dated February 4, 2008, saying, "A
move from AAA to AA still leaves a highly solvent, financially strong
FGI (financial guarantor insurer), particularly when compared to the
vast majority of other regulated insurers.”
Therefore, I remain very comfortable that the NYSID will continue to
allow MBIA’s insurance subsidiary to
distribute regular dividends to the holding company, even if we don’t
need them to cover our fixed charges. In the history of MBIA, even
through every credit crisis we have seen, our regular dividend was never
impeded. I should also note that we always evaluate the capital of all
of our subsidiaries and make certain that we have the capital in place
that we want before requesting a dividend. (For clarification, the
dividend from MBIA’s insurance subsidiary to
MBIA Inc. is separate and distinct from the dividend that MBIA Inc. pays
its shareholders, which the Board of Directors recently eliminated.)
Turning back to the CDS market and why I labeled this section "The
Place Where the Big Guys Play for Big Stakes,”
I had our team downstairs run another little exercise that might explain
a bit why some of our critics are more vocal than others. If someone had
purchased protection, say, in January of last year when spreads on our
five-year CDS were relatively benign, they would have paid about 40
basis points per year. If they wanted to bet a $30 million annual fee
that MBIA Inc. would fail, they could have purchased $7.5 billion in
protection. How has this trade faired in the intervening period?
Throughout 2007 and into this year, credit spreads on the MBIA Inc.
5-year CDS have soared steadily upward through January 22nd
reaching a peak of nearly 1,500 basis points before falling back to
600-900 over the past couple of weeks. On paper, the value of the trade
peaked north of $2.6 billion on January 22nd
and has since fallen back by nearly half that amount. The reality is
that for the guys who play in this $45 trillion zero sum game (always a
winner and a loser), the $30 million is chump change. It is also why,
given the amount of money that can be made here, people will go to no
ends insisting the company will be broke in mere weeks. I think it also
gives you an idea as to one of the reasons I made the decision to
disentangle our insurance subsidiaries from the credit derivative
markets, given the different incentives of players in this market from
our own stakeholders.
To close, while I’ve spent much of this
letter referencing CDS at MBIA Inc., I could analyze in a similar
fashion the misvaluation of CDS at our insurance subsidiary where, given
the pay-only-when-due nature of our liabilities, the CDS spreads make
even less sense; but I won’t, in the interest
of your time and saving reams of paper (feel free to shoot me an email
though if you’d care to dig in further).
So, after thinking carefully through the facts, I yet again ponder the
question asked by many of you: Why are MBIA’s
CDS spreads so wide, given the stabilization in the business and recent
affirmation of our Triple-A rating by both Moody’s
and S&P? It is certainly appropriate that spreads should have widened
from a few years ago. Make no mistake about it, we wrote some business
that in hindsight we wish we hadn’t, and
those decisions have certainly had an impact on the market’s
confidence in MBIA. I would also agree that the financial system
currently has more risk in it today. There is also the possibility that
CDS on MBIA is being used by banks and hedge funds to hedge direct or
indirect exposures to other asset classes like RMBS and CDOs, and thus
our spreads are being influenced by technical trading which does not
really have any bearing on our real financial health. Or is it just that
we are being used as a ping-pong ball in a high stakes games by the big
guys?
While all this may be driving the cost of hedging MBIA’s
credit exposure, do we really believe our holding company will default
on a financial obligation in the next year? Should the spreads on our
CDS be as wide as they are now? Should our CDS curve be inverted? Based
on fundamentals as they relate to our company and matter to our owners
and fixed-income investors, I really don’t
think so.
How did MBIA Become the Linchpin
Supporting the Market Value of the Entire Global Financial System??
Having been on the outside of the company up until three weeks ago, I
had a ringside seat as the financial press and TV networks came to
conclude that MBIA and the other financial guarantors were at the center
of the current credit crisis. Chuck Chaplin has written a nice primer
on Mark-to-Market (MTM) from his perspective, which is available on
our website. You might want to read it first before tackling this
section, which addresses the implications of the media’s
conclusions.
As noted in Chuck’s primer, as credit spreads
in the credit derivative market have soared, the impact of MTM on that
portion of our contingent credit portfolio has risen dramatically,
reaching $3.7 billion at year-end. While we currently expect that we
will see only $200 million in losses from that business, the $3.7
billion is still a very big number in anybody’s
book. As his piece points out, MTM losses and gains do not show the
fundamental economic credit performance of our financial guarantee
business over time. However, for other financial institutions, the role
of the MTM is very different. The real story that has dragged us into
the spotlight is what was happening at the same time in the major banks
and financial institutions that held similar underlying assets, some
insured by us and others, some not insured.
I have no idea how much of these assets are distributed around the
world, but it doesn’t take much sleuthing to
find $500 billion. Assuming that half is not insured, let’s
first look at what happened to that $250 billion as the global capital
markets for these instruments completely froze up at the end of last
summer. Since virtually all of the holders of these types of assets are
either regulated financial institutions or large-scale fixed-income
asset managers, they are all subject to valuing these assets at a price
at which they can immediately
be sold. Given the virtual total lack of liquidity in recent months, the
holders of these securities turned to a variety of instruments that
trade in the credit derivative market discussed above and used them as
credit derivative inputs to a wide range of valuation models. While the
actual valuations for any instrument are difficult to establish, it is
reasonable to assume that the combined effect on the $250 billion was a
loss in value of at least 50% or $125 billion. For regulated financial
institutions, this valuation loss comes from the regulated capital they
must hold to support existing and future business. A significant portion
of the capital raising we saw late last fall was to replace this lost
regulated financial institution capital, an effort that has continued
into this year.
But what happened to the other $250 billion in insured assets? While it
is very difficult to determine even for one institution, it would appear
that some institutions took modest losses on the insured assets, some
hedged the exposure in the credit derivative market (contributing to the
significant spread widening of the financial guarantors’
CDS) or by shorting equity positions, and some did nothing. This is
where the regulators of the major financial institutions started to
coordinate their efforts with the New York State Insurance Department,
which is the primary regulator of most of the financial guarantors. The
basic question being, "Is it reasonable for a
small handful of financial guarantor companies like MBIA to be the
accounting support to stave off another $125 billion in MTM losses?”
If the institutions were submitting claim requests for actual realized
losses to the financial guarantee companies, the answer is clearly no.
This is the dilemma we find at the accounting juncture between the
guarantors and their financial institution counterparties. If the
guarantors maintain a very high rating, the valuation models for
financial institution counterparties will allow them to maintain high
valuations and only recognize modest MTM losses, therefore significantly
reducing the need for additional capital to supplement their regulated
capital bases.
The sheer folly of suggesting that MBIA, the largest financial
guarantor, could be the linchpin holding up the market value of the
global financial system has lit a bonfire under the financial press that
has lead to the daily speculation (or real-time if you follow the TV
networks) about our fate. Not surprisingly, we have seen many thoughtful
pieces starting to appear on the real versus theoretical implications of
current accounting valuation dictates, on the moral hazard implicit in
the credit derivative market, and on the issues brought about by
significant recapitalizations arising from recent valuations.
Recognizing this, we are working harder to explain our side of the story
but the real answer ultimately will involve a more coordinated effort to
regulate all of the different financial institutions in a more
coordinated fashion. From my perspective, given the sheer size of the
$45 trillion credit derivative market, it clearly has to be included in
any effort. New York has an effort underway with the New York State
Commission to Modernize the Regulation of Financial Services headed by
NYSID Superintendent Eric Dinallo. While clearly New York can’t
do it all, we are pleased to see this initiative in our home state. I
expect that this crisis has given the Commission and the folks in
Washington real food for thought on what type of reform is needed.
While we are working diligently to improve our capital margins and
strengthen our Triple-A ratings, we made the decision to exit the credit
derivative business from our insurance companies. I think the outline
above makes it clear why this is a good decision for your company.
Closing Thoughts
For those of you have gotten all the way through this letter, I
apologize for taking so much of your valuable time. But these are issues
that you as owners must understand clearly in order to feel comfortable
deciphering some of what you read and hear in the financial press and
what you observe in the capital markets around the world.
I don’t expect that I will be writing to you
as frequently going forward unless there are significant events that
occur. I will be writing you at each quarter’s
end when we release results and file our 10Qs. The good news is that we
are starting to write some business in the new issue market, and I have
my first couple of credit underwriting meetings this week, a lot more
fun than writing letters.
Sincerely,
Jay Brown
Chairman and CEO
MBIA
* for Part 1, see my Letter
to Owners dated March 3 on mbia.com
This release contains statements about future results that may
constitute "forward-looking statements" within the meaning of the safe
harbor provisions of the Private Securities Litigation Reform Act of
1995. Readers are cautioned that these statements are not guarantees of
future performance. There are a variety of factors, many of which are
beyond MBIA's control, which affect the operations, performance,
business strategy and results and could cause its actual results to
differ materially from the expectations and objectives expressed in any
forward-looking statements. Accordingly, readers are cautioned not to
place undue reliance on forward-looking statements which speak only as
of the date they are made. MBIA does not undertake to update
forward-looking statements to reflect the impact of circumstances or
events that arise after the date the forward-looking statements are
made. The reader should, however, consult any further disclosures MBIA
may make in its future filings of its reports on Form 10-K, Form 10-Q
and Form 8-K.
MBIA Inc., through its subsidiaries, is a leading financial guarantor
and provider of specialized financial services. MBIA's innovative and
cost-effective products and services meet the credit enhancement,
financial and investment needs of its public and private sector clients,
domestically and internationally. MBIA Inc.'s principal operating
subsidiary, MBIA Insurance Corporation, has the following financial
strength ratings: Triple-A with negative outlook from Standard & Poor's
Ratings Services and Triple-A with negative outlook from Moody's
Investors Service. Please visit MBIA's Web site at www.mbia.com.
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