HEARD ON THE STREET
Backing Corporate Bonds
Can a Be Risky Business
By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
With defaults on corporate bonds rising sharply this year, credit risk is a huge topic of late.
So, it perhaps should come as no surprise that a company whose main business is providing guarantees against bond defaults is drawing scrutiny over how much risk it poses to investors.
During the late 1990s, the company, MBIA Corp., branched out from its long-profitable, low-risk business of guaranteeing municipal bonds to the faster-growing, but riskier, business of guaranteeing corporate bonds. Now, a hedge fund has placed a big and complex bet that MBIA's move could cause the company problems -- even as MBIA's stock has recovered from its lows of the summer, indicating that other investors believe its prospects are improving.
In an unusual move, hedge fund Gotham Partners LLC is going beyond the stock market to bet against MBIA's stock, which has risen to $44.50 from a low point of $34.93, though it is still below its 52-week high of $60.11. Gotham is using a low-profile market where participants buy and sell "insurance" against potential corporate defaults -- so-called credit-default swaps -- to place one of its bets.
The hedge fund's move comes as the credit-default swap market has gained a reputation among professional investors as an early-warning system. Since last year, the market has signaled problems for numerous telecommunications and energy-trading companies. Starting in May, market watchers noticed a steady increase in demand for protection on triple-A-rated MBIA. From levels consistent with its high rating, involving a charge of $20,000 or $30,000 for $10 million of annual protection, the insurance price rose to $180,000 as of early November, where it still stands. That is more than what the market demands for triple-B Marriott International Inc.
The question for Gotham, which has a massive position of more than $1 billion, is this: Has MBIA, in expanding beyond its role as a backer of government debt, gotten riskier than most people realize? Its expansion came just as the corporate-debt market was poised for a massive downturn, driven by the bursting of the telecommunications-investment bubble. This year alone has seen the greatest volume of defaults, in inflation-adjusted dollars, since the Great Depression, according to Moody's Investors Service.
Gary Dunton, MBIA's president, says the answer is no. "We are confident in our ability to analyze risk. We remain long-term buyers and holders of risk," he says.
But Gotham maintains that MBIA will potentially be forced to make good on billions of dollars of the corporate guarantees, depleting reserves and eating into its capital. The hedge fund also raises concerns about $8 billion in liabilities that MBIA has guaranteed in transactions that aren't on its balance sheet, on top of $1 billion of debt on its books. All together, after reinsurance, MBIA has net exposure to $467 billion in bonds, the majority of them municipal. To meet claims, it has more than $10 billion in capital and reserves, plus external capital sources.
"This is a company built on faith," says William Ackman, a founding director of 10-year-old Gotham, with $385 million under management. "It depends on the markets believing that they have the resources to back all their claims." Bargain-hunting Gotham is best known for the large position it built in Rockefeller Center Properties Inc. in the mid-1990s when the property was in bankruptcy. The New York landmark ultimately was taken over by a group including Goldman Sachs & Co. and Tishman Speyer Properties.
While Mr. Ackman declined to reveal how much Gotham spent building its MBIA position, which has reached a magnitude almost unheard of in the young credit-default swap market, it could have done so for less than $15 million, market participants calculate. Gotham also has sold MBIA shares short, aiming to replace them later with cheaper ones. Greenlight Capital Inc., another New York hedge fund, is short the shares as well.
Short-Seller's Dream
In turning to the credit-default swap market, the hedge funds are proving it a short-seller's dream. While the protection bought by Gotham will pay out if MBIA defaults on its debt, the fund's aim is to profit by reselling the insurance, at a higher price, as a default isn't likely. The hedge fund doesn't need MBIA to default to make money; it just needs the price of the protection to rise.
MBIA's chief executive, Joseph Brown, said at a recent investor conference that the credit-default swap market "is thin and bounces around. It shrinks in real quickly if you try to create any volume." But the apparent unwillingness of more insurance sellers to step forward to reduce the price of MBIA coverage and bring it back into line with that of a triple-A credit rating suggests to some market observers that the hedge funds' bearish views are widespread. Those selling in this market are a variety of insurance and reinsurance companies as well as banks and even other hedge funds.
"The credit-default market is saying that ... people no longer think of them as triple-A," says Dan Castro, a managing director in structured finance at Merrill Lynch & Co.
In the Hot Seat
The upshot: The ratings agencies themselves are in the hot seat on this one. Isn't the market sending them a message about MBIA, whose triple-A standing is important to its ability to insure all sorts of securities?
"The credit-default swap market is not really an efficient means to measure credit risk," says David Litvack, who covers MBIA for Fitch Ratings. "It is affected by other factors such as supply and demand. Our analysis is more scientific."
The agencies say they are a long way away from considering a downgrade. For example, Standard & Poor's Ratings Group adopts a complex procedure involving stress scenarios to test a company's credit-worthiness at the triple-A level. "We are still comfortable," says S&P analyst Richard Smith. Fitch's Mr. Litvack says losses of $1 billion to $2 billion would lead Fitch to reconsider its rating.
Ways to Grow
MBIA's expansion into the corporate-debt arena came as its sought ways to grow more. Now, premiums related to so-called structured finance represent more than half of total premiums for the 30-year-old company. When entering the new market, it sold insurance on individual corporations. But it departed from the line in 1999, citing riskiness, and since has insured only pools of corporate debt known as collateralized debt obligations. MBIA retains about $300 million of exposure to individual corporations, while the face value of the CDO slices it has insured stood at net $66 billion as of Aug. 31, more than 90% of which are rated single-A or above.
Gauging potential losses is difficult. CDO performance varies widely. A big factor is the type of debt pooled: bank loans or bonds, for example. Unquestionably, though, credit markets have experienced record turbulence. Even as defaults in the high-yield market peaked in January at 10.7%, recoveries to creditors had been dropping, last year averaging 16 cents to 21 cents on the dollar for high-yield bonds, half the historic average.
Up the Yield Curve
All the guarantors have scrambled up the credit curve as the environment has deteriorated. MBIA says it will only be at the end of the life of the CDOs -- those on its books mature over the next nine years -- to know what losses, if any, will result. The company says it has set aside small reserves on one transaction.
As for the off-balance-sheet entities, the company says that if these obligations were brought on to its balance sheet, the added debt would be offset by the addition of assets. MBIA's Mr. Dunton concedes that the obligations contain some car loans and home loans to consumers with risky credit histories, but declined to comment further on their nature. "If there were losses, we would be required to put up case reserves, and we have not done so," an MBIA spokesman says.
Write to Henny Sender at henny.sender@wsj.com1 |
