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Martin Whitman Comments About MBIA

Martin Whitman's Third Avenue Value Fund released its 1Q 2008 shareholder letter yesterday. He significantly increased his position in MBIA and talks extensively about the case for owning MBIA. If you have any stake in any of the monolines, it is well worth reading his thoughts. His views counterbalance the views of shorts, led by Bill Ackman. I will only be quoting his thoughts regarding the bond insurers.

(The document is a two-column PDF so apologies about poor formatting in the quotes below. I hope I'm not breaking any legal rules by quoting a big chunk of the letter :) )

Significantly Increased Stakes in Financial Guarantors

Martin Whitman purchased additional shares of MBIA and subscribed to the surplus notes offering (only available to institutional investors). His stake in MBIA is around 10% of the common stock right now. The surplus notes are issued by the insurance subsidiary and hence have stronger likelihood of payment.

He also added to his positions in MGIC, Radian, and Ambac. His Ambac position is very small (relative to MBIA) so I am not sure how bullish his views are for Ambac. I am not sure if he doesn't like Ambac or if he is waiting to participate in any capital raising plans of Ambac. I'll talk below about the greater uncertainty of valuing CDOs compared to direct RMBS. Before I invested in Ambac, I carefully considered the fact that Ambac has a higher exposure to CDOs, which may be riskier than direct RMBS (many of my early posts on Ambac kept repeating this point).

Having said all that, I should note that the positions in the bond insurers and mortgage insurers is still only a moderately small portion of the Third Avenue Value Fund. In contrast, concentrated investors like me have a huge stake--which sadly whittled down to something small.

Third Avenue's Strategy

In Management’s opinion, there is much profit to be made in these issues at these prices whether the companies continue as going concerns, or enter into a period when the companies run-off their books of business in whole, or in part, as we wrote to you last quarter. Management classifies these investments as
“distress investments”, where the Fund tries to acquire meaningful positions in the most senior issue which will participate in a reorganization, i.e., the fulcrum security.
In prior distress investing for the Fund, the fulcrum security had always been a debt instrument. In these cases, however, the fulcrum security is the common stock.

I don't know much about Martin Whitman (my goal is to read his past shareholder letters at some point) but my understanding is that he is a very good distress investor. Him, and his firm, will be putting his distress investing skills to the test with his monoline investments. The above quote summarizes his overall strategy, which is to purchase the key fulcrum security (in this case the shares of the monolines) at (what he feels) is a huge discount to the ascertainable asset value, and then wait. He feels that this is a profitable opportunity whether the companies stay as going concerns or go into run-off (for those not familiar, insurance company run-off is similar to liquidation or bankruptcy for a typical company).

Retaining AAA Rating

Martin Whitman feels that MBIA has enough capital to maintain AAA rating but nevertheless points out three issues that may prevent an AAA rating from being retained:

1) The Credit Rating Agencies could be arbitrary and capricious, denying AAA ratings for highly subjective, qualitative reasons such as a supposed severe decline in “franchise value”.

The fact that the rating agencies depend on subjective factors to grant ratings means that one can never be sure of anything. Under great pressure from the bears, the rating agencies have been changing their capital requriement methodology over the last year. Instead of trying to improve their loss models and coming up with a hard capital requirement, they seem to have entered a world where things change by the minute.

2) MBIA is New York State domiciled with its principal insurance subsidiaries regulated by the State Insurance Department (“SID”) and is therefore subject to regulatory risk. The state leadership including the Governor of New York, Elliott Spitzer, appears not to fully appreciate the financial strength
of issuers such as MBIA, and furthermore, MBIA’s utter lack of need for a “Bailout” or a “Rescue”.

We have discussed the increased risk now that the government has started to meddle in the industry. As is generally the case, the government shows up late and starts forcing things the way it should have been, well after the 'should' part has become impossible. My impression is that Eric Dinnallo understands the situation and is working together with the insurers, but Elliott Spitzer clearly seems to be "trigger happy". Government officials like Spitzer are a huge threat to shareholders. Fortunately, Spitzer seems to have backed off after (likely) efforts by Dinnallo's office. It also seems the Wisconsin insurance office, led by Sean Dilweg, is competent and is working side-by-side with Ambac.

There is also further regulatory risk from other government officials who will be calling for someone's head--except for anyone in the government--when they seem muni bond costs skyrocket.

3) As has been well reported by the financial media, MBIA is being victimized by an apparently wellorganized bear raid headed by William Ackman
(“Ackman”) of Pershing Square Capital Management. While the bear raiders have been helpful to Third Avenue, in making it easier to acquire MBIA Common at depressed prices, the bear raiders might have the ability to adversely affect the going concern
attributes of MBIA, given the possible capriciousness of Rating Agencies and regulators.

Bear raiders, as Whitman calls it, will become less and less of an issue in my view. They are only a threat insofar as they are given power to represent short interests. I think even the media is getting tired of them. As stock prices fall, shorts will face increasing risk. For example, if you bought MBIA when it was $20 and it drops to $10, you will lose 50%. But if you shorted when MBIA was $10 and it goes to $20, your loss is 100%. So new short positions will be very risky for many.

Martin Whitman vs Bill Ackman

Ackman recently laid out his views in two publications, “How to Save the Bond Insurers”, dated November 28, 2007, and “Bond Insurers Transparency: Open Source
Research”, dated January 30, 2008. He also published “Is MBIA Triple A?”, in 2002.

While he is an articulate advocate, Ackman’s arguments are off base. This all can be laid out in three points.

Martin Whitman takes on Bill Ackman directly and rebuts him with three arguments:

1) Ackman does not seem to understand the Property and Casualty (“P&C”) Insurance business and its sources of profitability. Ackman believes that the Bond
Insurer Model does not work because the insureds are able to buy an AAA credit rating so cheaply.

Profitability for P&C’s are primarily a function of two factors: Underwriting
Profit (or loss), as measured by the Combined Ratio; Underwriting expenses and loss expenses, as a percentage of Premiums Written and Premiums Earned.

Historically, the MBIA combined ratio has ranged between 30%-40% (underwriting profit 60% to 70%). Looking past the current structured finance debacle, MBIA seems to have a pretty good shot at returning to old combined ratios, especially if some of the weaker bond insurers have to exit the industry and MBIA does not.

The second element of P&C profitability is net investment income; i.e., essentially investing in performing loans. In part, net investment income is a function of how much time elapses between when an insurance premium is received and when a claim is paid to an insured. Insofar as the period is far distant, the liability is said to be “long-tail”. P&C companies with “long-tail” liabilities have the ability to generate large net investment income as cash balances are invested in performing loans. MBIA iabilities are quite long-tail.

In addition, I would add that it is reasonable to expect the bond insurers to pick mostly "good risk" over "bad risk". That's their expertise and that's what they spend all day long doing--that's what insurance companies do for a living! Who knows how good their risk picking is (they have been very poor for the subprime structured products) but, even in a pessimistic case, I would expect their performance to be slightly better than randomly picking (as the market price implies). In other words, I would expect an aggregate index such as an ABX index to be worse than insured ABS of RMBS (without even accounting for the fact that the monolines generally insured the senior tranches and have more rights to receive cash flow than the lower tranches).

(on another note, here is a good article from bankstocks.com talking about the fact that the ABX index may not be representative of ABS of RMBS exposure for other companies. Note that this probably doesn't apply to monolines (I think monolines insure long-duration bonds) but other companies like Fannie Mae and Freddie Mac may perform better than the ABX index would imply.)

2) The use and limitation of Generally Accepted Accounting Principles (“GAAP”) in the analysis of investment portfolios or insurance books of
business. The publications argue that prices, as determined by marks to market, or mark to model, always deserve 100% weight. This is arrant nonsense.

Market prices do deserve dominant weight in an analysis where the portfolio consists wholly of common stocks and non-performing loans held in trading accounts. Market prices deserve little or no weight, when the portfolio consists of performing loans, and in force policies, to be held to maturity. FASB 133 requires marks to market and marks to model, in accounting for derivatives under GAAP, and changes in market are reflected in the reported income account. FASB 133 is pretty much irrelevant for MBIA
– a buy-and-hold investor in performing instruments.

Paul Samuelson, the Nobel Laureate economist, had it about right for most markets when he said, “the market has correctly predicted nine of the last five recessions.” MBIA’s losses will be determined not by market prices but, rather, by what percent of obligations default and how these defaults are worked out.

As I remarked in yesterday's post, mark-to-markets for illiquid assets held to maturity make no sense whatsoever. All these "bogus" losses send misleading signals to market participants.

The biggest argument made by shorts, especially people like Reggie Middleton, is their notion that all the mark-to-market losses are "real". The monolines will take losses but no one can prove it will be anything that the mark-to-market prices indicate.

3) The publications pay little attention to the rules of seniority and priority of payment in evaluating, or understanding, senior tranches of debt. The argument that if an entity is in trouble, every liability on the balance sheet of that entity is also in trouble is strictly “amateur hour”. Frequently, senior issues sail through troubles unscathed. (Remember Third Avenue’s investments in Pacific Gas & Electric First Mortgages a few years back)...

With the exception of Home Equity Lines of Credit (“HELOCs”) and Closed-end Second Liens (“Closed- End Seconds”), virtually all of MBIA’s structured debt portfolio appears to be in senior tranches and super senior tranches. Losses are likely to be small, especially against the background that MBIA has $17 billion of claims paying ability and that the gross cash flows from MBIA’s operations, even if the company writes little new business, should exceed $1.3 billion per year through 2016 made up of net investment income, installment premiums, upfront premiums and investment management revenue.

Amateur hour! :) It doesn't help with the massive losses on my investment but at least I'm not living in the "amateur hour" camp...

Whitman goes to give a simple example illustrating how losses for senior tranches will be lower than for the debt as a whole. It's amazing that very few seem to understand this. I suspect the problem is that investors are confused between the RMBS/CDO/etc exposure of the monolines versus the exposure by investment banks, hedge funds, and so on. The banks/hedge funds/etc generally have exposure to all the tranches of the debt, whereas monolines generally only insure the senior tranches.

Having said that, as Whitman points out, MBIA does not have this benefit when it comes to HELOCs and CESes. One of the reasons I like Ambac over MBIA is because MBIA will likely post higher losses on their HELOCs and CESes.

Furthermore, CDOs and CDO-squareds may insure lower-rated tranches. These CDOs are known as mezzanine CDOs (as opposed to high-grade CDOs). The monolines will likely take losses on these lower-quality CDOs. In fact, the biggest cloud over Ambac and MBIA are their CDO-squareds. To confuse the matter, the subordination for these lower quality CDOs tends to be higher so it's hard to say how bad the losses will be.

One thing about direct RMBS is that it is easier to analyze than CDOs. The example Whitman uses can be used (with more specific default rates and loss recoveries) to analyze direct RMBS to a high degree of confidence. In contrast, CDOs have secondary effects that are hard to figure out (CDO-squareds are even worse). I am guessing here but I suspect some investors (like Whitman/Warburg Pincus/etc) took positions in MBIA rather than Ambac due to difficulty in analyzing Ambac's CDOs.

I decided to go with Ambac, instead of MBIA, even knowing its CDO exposure due to a bunch reasons I mentioned when I took the position. One thing that I am curious about is whether CDOs will outperform direct RMBS due to them being pooled assets. The whole purpose behing pooling assets (and creating structures like CDOs) was to lower risk by spreading them across multiple assets. It's sort of like investing in a mutual fund rather than directly taking positions in stocks. (The dissapointment with Ambac is their inability to retain their AAA rating. I was sure they were going to keep it.)

Who Needs Bailouts?

Martin Whitman points out that the whole notion of bailouts conflicts with shareholder interests.:

In recent months, there have been draconian-type statements from the media about the need to arrange bailouts and rescues for the Bond Insurers, in general, and MBIA, in particular. This concern seems grossly misplaced. Neither MBIA nor Ambac seem to need bailouts, since in each instance the companies seem to have more than ample resources to meet any contractual requirements to policy holders. Rather, it is other financial institutions that hold insured obligations who need the bailout or rescue, if they are to avoid massive accounting charges against their
income accounts and balance sheets, insofar as Bond Insurers are downgraded from AAA.

Unfortunately, these other vested interests are stronger than the monolines. Throw in the government acting in its interest and I am not sure anyone is going to accept the fact that the banks are the ones that need the bailout more so than the monolines.

Governor Spitzer’s apparent concern that municipalities will have to pay more to borrow if MBIA is downgraded is certainly misplaced. Municipalities, now seeking to borrow or seeking to borrow in the future, will be able to acquire AAA wraps from many insurers, including new entrants.

The problem is that the government doesn't want to pay the higher premiums being charged by other insurers like Berkshire Hathaway Assurance or Assured Guaranty. The government doesn't realize that forcing the troubled monolines into a corner won't lower the fees. The "municipalities", which can include quasi-private entities, will have to pay higher fees regardless of whether Ambac and MBIA lose their rating or not.

Credit enhancement has been, and will remain, an important United States industry. Bond Insurers are likely to remain important credit enhancers. Others in
the industry include private sector commercial banks which issue Letters of Credit; quasi-public enterprises, such as Fannie Mae and Freddie Mac, which insure qualified mortgages; and Federal, State and Local governments themselves.

I also share Whitman's view that credit enhancement is not going to dissapear. People have been questioning the need for bond insurance but we'll see what happens without insurance. The New York Times had an article recently talking about how municipal GO bonds (general obligation bonds--these have taxing power) would be rated close to AAA if they used a corporate rating scale. Apart from the fact that no one expects the rating system to change soon, adverse developments on this front likely won't impact bond insurers very much. If my understanding is correct, almost 70% of the insured muni bonds are not general obligation bonds. Instead, they are public-private partnerships, revenue-linked bonds, and so forth. These don't have taxing power and it is highly unlikely many of them would be rated AAA.

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