MBI's shareholder letter

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...

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...

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?...

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...
http://biz.yahoo.com/bw/080310/20080310005517.html?.v=1