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I received an e-mail recently that I figured I'd just post up here for the record. Either some brilliant insights that history will later recognize, or only one of a million other such notes claiming everything's falling apart when everything rarely does. Here it is in its entirety. --DG


MBIA could be the catalyst for much of what we're seeing. I'm wondering how much WCOME debt they're going to be asked to cover after the bankruptcy filing becomes official.

Abstract: MBIA is the LTCM that is about to set off the powderkeg of a global financial market we have. They are effectively sporting a "debt" to equity ratio in the triple digits, and apparently occupy a blind spot in the financial reulatory picture. They insure over $400B par value of bonds, and $720B total value, on - get this - a mere $4B equity! All it would take is one major bankruptcy of an insured party, and they're under. The ramifications of an MBI bankruptcy are non-obvious, but enormous. Instantly, the triple-A financial rating of $440B par value of bonds vanishes. Hundreds of billions of dollars in debt is exposed as the junk that it is, which results in the forced liquidation of a huge portion of that by parties that are not permitted or are not comfortable holding junk. You think the billions lost on Worldcom bonds was bad? You ain't seen nuttin' yet. Instant junk bond chaos. Liquidity vaporized. No more asset-backed securities market. All it would take is one $4B knock - and it may have already happened in WCOM.

Risky Hide and Seek

I was having a discussion yesterday with a colleague regarding the foolishness of my present broker. (They have permitted customers to run to 25% equity in margin accounts for the past two weeks. Yesterday, they extended it *another* two weeks. A sign of a big customer in trouble? Maybe just foolishness on the part of my broker? Either way it smells really bad...) We ended up talking about the asset-backed securities market, when all of a sudden, I put together several pieces of the puzzle I'd been holding for a long time - I just didn't know what the puzzle was supposed to look like in the first place. I've long suspected that we're in a depression, and that things would get far worse than even we early bears can possible imagine. What I was lacking was the precipitating event, the roadmap into the financial morass I've been expecting. Yesterday, that map crystallized for me.

We know that the stock, credit, home mortgage, and derivatives market excesses will all play a role in the downturn. But, is there a critical catalyst that sets off the volatile mixture? Could it be the enormous leverage at Fannie Mae, responsible for hundreds of billions of dollars in credit creation? Perhaps, but it has implicit government backing which could become explicit if it meant saving the markets from themselves. Could it be a huge, bad bet by a single large derivatives counterparty? Could happen. But what I realized yesterday is that there is one scenario that may already be in its endgame, with the ability to destroy the whole asset-backed securities market.

There is a corporation called MBIA, ticker MBI, that is one of the "enablers" of the entire financial sham we live in. The geniuses on Wall Street realized that by "repackaging" risk (translation: hiding), they could take risky debt (telecom debt, home equity, credit card, and automobile receivables) and sell it to the unwitting public. The motive? Capture the risk premium and siphon it off, while transferring the risk somewhere else. Brilliant - utterly brilliant. All that was necessary was an intermediary to sanitize the debt.

They found a willing accomplice in MBIA. What MBIA does is take a bond backed by poor credit risks, like the aforementioned credit card receivables, and bless it. As one of the very few companies with a triple-A financial strength rating, they can magically turn junk bonds into pristine investment grade debt, transforming lead into gold - for those foolish enough to believe. With an MBI AAA stamp of approval, the debt is clean enough to work its way into pretty much any financial nook or cranny in the world. It has permitted foolish lending like 125% home equity loans, 6% credit cards, and subsidized zero-interest auto loans, as well as the vast mountains of cash loaned to stupid telecom schemes. And it all works great - until it doesn't.

Caveat Emptor

So examine for a moment the health of this liquidity press. Operating income has been running around $150M per quarter. Not bad - they've got the interest payments on their $7.2B in debt covered pretty well. They've even racked up $3.5B in retained earnings to date. But at what price? They are now on the hook to guarantee interest payments to the tune of $720B! Some deal for shareholders. Granted, the majority of the debt is low risk. But they jumped headlong into the asset-backed market in recent years, vastly underestimating the risks they were accepting in agreeing to back $152B in risky debt. They clearly did not get a large enough premium to accomodate the risk in this new financial instrument.

Net Par % of Net
Amount Par Amount
Global Structured Finance Outstanding Outstanding
United States
Auto 16.7 3.7
Credit Cards 15.8 3.5
Leasing 6.3 1.4
Other 5.4 1.2
Home Equity 24.9 5.5
Other 9.2 2.0
First Mortgage 6.7 1.5
Corporate Debt Obligations 16.6 3.7
Pooled Corp. Obligations & Other 9.3 2.0
Financial Risk 3.9 0.9
Total United States 114.8 25.4
Non-United States
Corporate Debt Obligations 21.1 4.7
Pooled Corp. Obligations & Other 8.1 1.8
First Mortgage 4.0 0.9
Other 0.7 0.1
Home Equity 0.4 0.1
Asset-Backed 1.3 0.3
Financial Risk 1.4 0.3
Total Non-United States 37.0 8.2
Total Global Structured Finance 151.8 33.6

Regulators have been asleep at the switch. They have permitted MBI to extend insurance on the same terms as their old-line municipal bond insurance - with policyholder leverage ratios running right at the legal limit of 150:1. Running municipal bond insurance to the limit is one thing - you have some recourse on the income stream. Running asset-backeds to a 150:1 leverage ratio is sheer insanity. Worse than Fannie Mae. What happens if the assets backing the paper aren't valued correctly? Or what if they are valued correctly at time of issuance, only to see their valuations plummet, like telecom equipment pricing of late? Is there collusion between regulators and the industry, or are they just not sharp enough to see the huge problem looming? Maybe someone else can answer that question.

Dominoes anyone?

Which brings us to the $700 billion question: what happens when MBIA can't pay up? As you can see from the table below, MBIA represents nearly *half* of the financial guarantee industry.

As of December 31,
1997 1998 1999 2000 2001
(Dollars in millions)
MBIA Corp.
Net insurance in force $ 513,736 $ 595,895 $ 635,883 $ 680,878 $722,408
Qualified statutory capital 3,140 3,741 4,152 4,505 4,940
Policyholders' leverage ratio 164:1 159:1 153:1 151:1 146:1
Financial guarantee industry (1)
Net insurance in force $1,262,697 $1,416,433 $1,616,226 1,639,829 *
Qualified statutory capital 8,851 9,833 11,139 11,845 *
Policyholders' leverage ratio 143:1 144:1 145:1 138:1 *

Here's the part that escaped me until just recently: if MBIA goes under, they are one really big domino. While it is bad enough to have a major insurance company go under, it's even worse to have one that is so key to the credit formation that's been taking place outside the banking industry. However, the most serious impact comes from neither of these. Consider what would happen if the MBIA AAA blessing suddenly vanishes from a security. It is no longer AAA. What happens to the yield? It must go up. What happens to the price? It must fall. And what happens to the golden rating? It reverts to its true leaden state. That's where the real problems start. We're talking about an instantaneous credit downgrade to $450 billion in debt. The most unfortunate part is that much of the debt has found its way into nooks and crannies of the financial system that require a certain level of pristine investment grade debt. Without the golden sheen of MBIA's insurance, much of the remaining debt will be put up for forced sale to comply with the regulations of the entities holding the downgraded debt.
First, the Good News

The good news is that MBIA is still in business. The bad news is that the disease that will take them under may already be entering its terminal stage. At question is whether or not they are guaranteeing any financial instruments that relied upon timely debt payment from Worldcom. It is entirely conceivable that they are, and it's even possible that they themselves don't even know it yet. The increases in credit card portfolio losses could also be pushing them over the edge. The thing is, they won't have to admit it until they are forced to, and that won't show up until an actual bankruptcy filing leads to a big insurance claim. That's why bankruptcies are so important: they force a "mark to market" of assets, and the legal actions force all those exposed to show their hands.

Risk management was at the root of this enormous bubble. We have an incredibly complicated, novel system of passing around the exposure that has never been seriously tested, until now. You want to know where all the risk in the system went during the 90s? It went right here. And now with liquidity foundering, a looming MBIA insolvency may already be in progress.


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This is a doomsday forecast. I would like to think that securitizations with the debt diversified among many borrowers are not about to all default at one time.
What would be the catalyst ? Some cataclysmic event. In which case this would be the least of our problems.
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I agree. If doomsday financial forecasts come true, that means doomsday came true. In which case perhaps our currency won't even matter much, let alone our silly shares. :)

Foolish best wishes, and hope you're enjoying Fooldom,

David G.
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This report from Gotham Partners seems germane to the discussion...

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Maybe it's because I'm back from vacation about 10 days after you posted, but that link doesn't work for me. Any alternate one? --DG
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Maybe it's because I'm back from vacation about 10 days after you posted, but that link doesn't work for me. Any alternate one? --DG

Strange; the link does seem to be dead indeed. Whitney Tilson has a copy on his site:

Also, MBIA has some rebuttals to the report's assertions at They include a link to the Gotham Partners report, the (broken) link that I gave.

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Was this what you were talking about in your past from 2002?

- Andrea
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Is that what your post was talking about?

- Andrea
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