Richard, Confidence Game

Christine S. Richard’s Confidence Game: How a Hedge Fund Called Wall Street’s Bluff (Wiley, 2010) is a fascinating tale. It recounts Bill Ackman’s relentless efforts to expose flaws in MBIA’s business model even as he was amassing a huge short position against the company in the form of CDSs.

The story reaches all the way back to John Mitchell, Nixon’s subsequently disgraced attorney general, who early in his career created the “moral-obligation” bond. Mitchell’s idea was to bypass local referendums on debt issuance; the local government would set up a bond-issuing authority and then pledge that it “intended” to help pay off the authority’s debt if necessary. It did not, however, pledge “its full faith and credit to the repayment of the bonds,” so no taxpayer vote was necessary. (p. 63)

The municipal bond market relied on this implicit understanding between public officials and investors, and the muni bond insurance market, with help from the ratings agencies, exploited it. “If a smart investor could find bonds that were safer than they appeared, an even more astute businessperson could create a business guaranteeing these bonds. The bond insurance business was simple: In exchange for receiving an upfront insurance premium, the bond insurer agreed to cover all interest and principal payments over the life of the bond if the issuer defaulted. As long as the bond insurer maintained its triple-A rating, the bonds remained triple-A.” (p. 5) The insurer had to set aside some fraction of the amount of each bond it guaranteed in case of default. Given the extreme leverage involved, the insurance company had to underwrite to a no-loss standard.

MBIA’s triple-A rating was essential to its survival. Hence the paradox of “a company being triple-A rated even though the only thing that stood between the company and its collapse was a triple-A rating.” (p. 117) MBIA’s survival depended on Moody’s credit-rating system. And Moody’s helped MBIA and other municipal bond insurers because its rating system skewed the risk transfer involved in underwriting municipal bonds. It rated municipalities on the assumption, contrary to history, that they would never be bailed out. Municipal bonds with the same likelihood of default as corporate bonds were rated lower. When it rated the insurers, however, it factored in the “moral-obligation” quality of the underwritten bonds. As an investor wrote in an e-mail to the author, “Moody’s overrates MBIA and massively underrates municipals, thus generating this huge business of bond insurance. It is a racket that the taxpayers are subsidizing private bond-insurance companies. The ultimate irony is that the triple-A-rated bond insurers, who are rated on the corporate scale, are in fact riskier than the A-rated muni issuers, who are rated on the muni scale but are much less likely to default than the insurers. Who is insuring whom?” (p. 175)

Christine Richard’s book documents, thanks in large part to Bill Ackman’s meticulous research in building his case against MBIA, how a company that launched its business on Mitchell’s concept of bypassing pesky legalities extended this concept. For instance, MBIA backed CDOs at “super-senior levels” through CDS contracts. But insurance companies were prohibited by law from writing swaps. Time for a quick bypass. MBIA set up “an orphaned subsidiary,” a shell company owned by an apparently unaffiliated charity which sold credit-default swaps; MBIA guaranteed its obligations. Or when a securitization plan fell apart (an MBIA-owned company had bought tax liens which it then intended to use as collateral to back bonds, which MBIA would then insure) and MBIA ended up with about $500 million in exposure, a private placement, known in house as the “Caulis Negris” deal, made the problem vanish with the rating agencies none the wiser. “Caulis Negris” is bad Latin for “black hole.”

No one is a hero in Richard’s book. Although Bill Ackman is the focus of the story and some might consider him a hero, his motives were mixed; after all he made more than $1 billion betting against MBIA. It was a bet that took a long time to pay off; year after year as his investment was showing a growing paper loss Ackman pressed his case against MBIA in as many venues as possible. As a result he wasn’t simply ignored like Harry Markopolos in the Bernie Madoff affair; he was vilified in the press and investigated by both the SEC and Eliot Spitzer.

This is not a book with a single lesson. Its many interwoven threads point to the difficulties of financial regulation—short sellers can perform a valuable service even when they’re acting in their own best interest, rating agencies can create inequalities by making faulty assumptions in their models, no-loss underwriting standards can mask serious potential risk. And all this with no assumption of fraud.