donsutherland1

Today, before the House Committee on Financial Services, MBIA's Chief Financial Officer Charles Chaplin embarked on a strategy that essentially amounted to blaming others for MBIA's current financial challenges. At the hearing, he decried the presence of William Ackman, a leading hedge fund manager and challenged Ackman's credentials declaring, "MBIA questions the characterization of Mr. Ackman's expertise." He then proceeded to rip Mr. Ackman's "open source model" for evaluating MBIA's risk exposure. In addition, he heaped blame on a "small, upstart rating agency with no information about the deals MBIA insures..."

However, the latter part of Mr. Chaplin's testimony undermined his own case and highlighted questions concerning the effectiveness of MBIA's performance in evaluating its own risk exposure. The testimony stated:

MBIA's strategies in writing RMBS and CDO business appeared sound at the time, because the Company attached at the highest levels of the capital structure. In retrospect, the Company missed some of the warning signs and is now paying the price, both through expected claims on its policies and through a loss of confidence in the value of its product, the financial guarantee... MBIA's practice was to work with large, investment-grade servicers with historically strong origination and loan performance attributes. Unfortunately in the heat of the recent market, even some of these servicers relaxed their standards... [b]ond insurers made mistakes over the past decade in expanding and diversifying their portfolios into some areas of structured finance...that have encountered unprecedented credit and liquidity stress.

Key points:
• MBIA's strategies "appeared sound at the time..." Perhaps this was on account of MBIA's discounting the actual risk associated with the business it was underwriting? Perhaps this was on account of MBIA's modeling failing to capture some of the risks Mr. Ackman's model had highlighted in advance?
• "...the Company missed some of the warning signs..." That, more than anything, is an admission that MBIA was caught asleep at the proverbial switch.
• "...some of these servicers relaxed their standards..." Insurance is about risk assessment. Assuming that servicer risk remains unchanged is fundamentally at odds with prudent insurance practices. Assuming a static risk environment in a setting of dynamic global financial markets is outright reckless.
• "[b]ond insurers made mistakes over the past decade in expanding and diversifying their portfolios into some areas of structured finance...that have encountered unprecedented credit and liquidity stress." Game, set, match. MBIA had a flawed strategy of expanding into an area of finance the company did not adequately understand.

Rather than criticizing Mr. Ackman, Mr. Chaplin would much better to study anew the historic experience with insuring risk. Several lessons would stand out:

• Risks are never unchanging and familiarity with risk exposure has often been incomplete prior to crises. Former Treasury Secretary Robert Rubin wrote of the Asian financial crisis, "My view of the extent to which creditors and investors had lost their sense of the risks involved in emerging markets was borne out when we began to explore the idea. We asked the commercial and investment banks how much exposure they had to South Korea by way of financial derivatives, apart from their direct loans. Most had a very imprecise idea, and some took a full week to find out." In short, decisions based on an assumption of unchanging risk are inherently flawed.
• Long periods of market expansion have typically led to a degradation of lending and investment practices, as seemingly superior returns lure more and more lenders and investors to the instruments providing those returns. Indeed, by November 1987, Standard & Poor's warned that issues of high-yield bonds were growing riskier and that such a development "could translate into higher default rates than in the past."
• Securitization, which is beneficial in packaging and disseminating illiquid assets, is not synonymous with eliminating risk associated with underlying assets. Indeed, when securitzation was at its infancy in 1985, New York Times economics columnist Leonard Sloane wrote of instruments that securitized assets, "Most of these issues...contain loans guaranteed by an insurance company and are therefore granted a higher rating by the rating agencies than they would otherwise receive." In other words, this practice created perceptions of lower risk when, in fact, the underlying assets had greater marketplace risk than what had been implied. Sound insurance practices would have dictated that the insurers pay continual attention to the risk of underlying assets associated with such instruments.
• No single company is indispensable. Although Drexel Burnham Lambert dominated the high-yield bond market prior to its being convicted on securities fraud cases that brought about its demise, the high-yield bond market survived and later grew dramatically. The same will hold true for the bond market whether or not MBIA survives. Right now, MBIA does not face an existential threat and a large part of its business remains sound. However, it should not operate from the premise that it is indispensable. Otherwise complacency that could arise from such an assumption might well hinder its ability to take the steps necessary to surmount its present challenges.

When it came to the maligned Mr. Ackman's testimony, Mr. Ackman told the Congress, "The poor decisions of holding company executives are the primary cause for the bond insurers' problems..." It is no wonder that bond insurance executives such as Mr. Chaplin would seek to discredit Mr. Ackman. Deflection of blame is always easier than facing the difficult challenges of analyzing and learning from one's own shortcomings.

As the economic expansion grew and the securitizaton of assets proliferated, bond insurers such as MBIA should have been asking questions such as:
• Do we adequately understand our risk exposure?
• What will happen to the CDOs, structured investment vehicles if interest rates change?
• If a shock affects one sector of the financial markets, could it have implications for sectors covered by MBIA's insurance?
• What impact would such developments have on MBIA's capital structure?
• What implications did a rising housing bubble in which home prices rose disproportionately relative to fair market rents suggest for MBIA's insurance risks?
• What was MBIA's experience during previous crises e.g., housing slumps, S&L insolvency, Asian financial crisis, etc.?
• What strategies does MBIA have for shoring up its capital base for the major contingent situations that could materially impact its business?

In sum, MBIA is largely to blame for the challenges facing it. Ratings agencies will do investors no favors by shielding MBIA from ratings downgrades. Ratings decisions should be based strictly on the riskiness of MBIA's business. Otherwise, the financial marketplace will continue to be distorted by valuation risk arising from an improper assessment and pricing of risk. That valuation risk could compound the magnitude of macroeconomic risk associated with the unwinding of the housing bubble and repricing of complex securities.

donsutherland1