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How to Save the Policyholders - Confidence Game

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How to Save the Policyholders
June 18, 2008
Pershing Square Capital Management, L.P.
Disclaimer
The analyses and conclusions of Pershing Square Capital Management, L.P. ("Pershing") contained in this
presentation are based on publicly available information. Pershing recognizes that there may be confidential or
otherwise non-public information in the possession of the companies discussed in the presentation that could lead
these companies to disagree with Pershing’s conclusions.
The analyses provided may include certain statements, assumptions, estimates and projections prepared with
respect to, among other things, the historical and anticipated operating performance of the companies. Such
statements, assumptions, estimates, and projections reflect various assumptions by Pershing concerning
anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and
contingencies and have been included solely for illustrative purposes. No representations, express or implied, are
made as to the accuracy or completeness of such statements, assumptions, estimates or projections or with
respect to any other materials herein. Actual results may vary materially from the estimates and projected results
contained herein. Pershing disclaims any obligation to update this presentation.
Funds managed by Pershing and its affiliates own investments that are bearish on participants in the financial
guaranty business including, but not limited to, MBIA, Ambac, and FSA. These investments may include, without
limitation, credit-default swaps, put options and short sales of common stock.
Pershing manages funds that are in the business of trading - buying and selling - securities and credit default
swaps. Pershing may change its position regarding the companies and has, and in the future may, increase,
decrease, dispose of, or change the form of its investment in the companies for any or no reason.
This presentation should not be considered a recommendation to buy, sell, or hold any investment.
1
Overview
f Review of Bond Insurance Corporate Structure
f Performance of Our Past Predictions
f MBIA and the Market’s Misperceptions
f Our New Short Idea
2
Bond Insurers:
Holding Companies vs.
Insurance Subsidiaries
A Holding Company Is Not A Bond Insurer
Holding Company
Dividends
Typically publicly traded
Stock Buybacks
Investment management activities
Debt Service
Dividends
Bond Insurance Subsidiary
Guarantees Bonds
Sells Credit Protection (CDS)
Wholly owned subsidiary of Holdco
Regulated by State Insurance Depts.
Insurance Premiums
Pays Claims
4
A Holding Company Is Not A Bond Insurer
Holding Companies
Holding Company
MBIA Inc. (MBI)
Typically publicly traded
Ambac Financial Group (ABK)
Investment management activities
Dividends
Bond Insurance Subsidiaries
Bond Insurance Subsidiary
Wholly owned subsidiary of Holdco
MBIA Insurance Corporation
Regulated by State Insurance Depts.
Ambac Assurance Corporation
5
On November 28, 2007, We Delivered a 145-page
Presentation on the Bond Insurers Entitled:
How to Save the Bond Insurers
November 28, 2007
Pershing Square Capital Management, L.P.
6
We Made the Following Predictions – Nearly All of Which
Have Come True(1)
3
f Rating Agencies require Bond Insurers to raise capital in order to
maintain Triple-A rating
3
f Bond Insurers unable to raise capital needed to withstand future
downgrades and losses
3
f Bond Insurer free cash flows deteriorate as premiums written
decline and eventually cease
3
3
f MTN and CP-backed assets / liabilities unable to roll
f Investment portfolio values decline and become less liquid as
guaranteed bonds trade as if uninsured
3
3
f Municipalities withdraw from muni GICs
3
f Liquidity facility covenant violations on deterioration in book value
due to MTM and other losses
?
f Insurance Subs’ dividends to Holdcos suspended by regulators
f Bond Insurers forced to sell underlying obligations at a loss to
meet redemptions
________________________________________________
(1) See page 134 of the “How to Save the Bond Insurers,” November 28, 2007.
7
We Drew the Following Conclusions – Half of Which Have
Come True(1)
3
3
9 Rating agencies downgrade Bond Insurers
9 Downgrade requires collateral posting by GIC
business and Holdco CDS counterparties
?
9 Holding Companies run out of cash and file for
?
9 Regulators put Insurance Subs in receivership
bankruptcy
________________________________________________
(1) See page 135 of the “How to Save the Bond Insurers,” November 28, 2007.
8
Things have continued to get worse
Housing Fundamentals Continue to Deteriorate
10
Nearly All Bond Insurers Have Been Downgraded
S&P Ratings as of:
November 28,
2007
Current
MBIA Insurance Corp.
AAA / Stable
AA / Watch Neg
Ambac Assurance Corp.
AAA / Stable
AA / Watch Neg
CIFG Assurance
AAA / Negative
A- / Watch Neg
XL Capital Assurance
AAA / Stable
BBB- / Watch Neg
FGIC
AAA / Stable
BB / Watch Neg
ACA Financial Guaranty
A / Watch Neg
Financial Security Assurance
AAA / Stable
AAA / Stable
Assured Guaranty
AAA / Stable
AAA / Stable
11
CCC / Watch Dev
Bond Insurer Reinsurers Have Also Been
Downgraded or Put on Negative Outlook
Moody’s Ratings as of:
November 28,
2007
Current
Channel Re
Aaa / Stable
Aa3 / Stable
BluePoint Re
Aa3 / Stable
Aa3 / Negative Outlook
Ram Reinsurance Co.
Aa3 / Stable
Aa3 / Negative Outlook
S&P’s Rating as of:
Radian Asset Assurance
AA / Watch Neg
12
A / Watch Neg
Reinsurer Downgrades will Further Increase the Capital
Required by Bond Insurers
“How does Moody’s assess the impact on guarantors of potential for stress among
their reinsurers?
When assessing capital adequacy, Moody’s applies a �reinsurance haircut’ to the capital a
guarantor would otherwise recognize from its use of reinsurance ceded to firms rated
lower than itself. For a Aaa-rated primary financial guarantor purchasing reinsurance
from a Aa-rated monoline financial guaranty reinsurer, the reinsurance credit
attributed is between 80-90% of the estimated ceded risk. If a monoline financial
guaranty reinsurer were downgraded to the single-A rating category, the credit
received would be 40-60%, and if downgraded to Baa1 or below, the credit would be
eliminated.”
Frequently Asked Questions
Moody’s, January 2008
13
Public Finance Insured Penetration has Declined
Dramatically
Only 26.3% of municipal new-issuance was insured in Q1’08
versus 51.3% in Q1’07
U.S. Municipal New-Issue Market Data (2007 – Current)
$150
Par Value Issued
Par Value Insured
$123.7
$125
$107.5
$104.7
$93.8
$100
$75
$84.9
$55.2
$55.9
$46.9
$43.3
$50
$22.3
$25
$0
Percent Insured:
MBIA Share:
Q1'07
Q2'07
Q3'07
Q4'07
Q1'08
51.3%
20.7%
45.2%
22.9%
50.0%
29.5%
41.4%
39.1%
26.3%
7.6%
Source: Based on FSA estimates. MBIA’s market share is calculated by dividing the U.S. public finance par value insured
(as recorded in the quarterly MBIA operating supplements) by the FSA market numbers.
14
Municipal Bond Insurance Becoming Obsolete
On June 12th, 2008, Moody’s announced that it would evaluate the
creditworthiness of municipalities and corporations on the same
ratings scale. This is expected to result in a wholesale upgrading
of municipal issuers, many to Triple-A.
“We do expect there will be a significantly higher number and percent of the
municipal ratings that become Triple-A.”
– Gail Sussman, Moody’s Managing Director,
as quoted by WSJ, June 12, 2008
“If rating agencies level the playing field in terms of how they rate municipal
versus corporate obligations, there will be little need for a financial guaranty
insurance marketplace as we know it.”
– Ajit Jain, head of Berkshire Hathaway Assurance Corp.,
Congressional Testimony, March 2008
15
Insured Global Structured Finance Originations Vanishing
The market for insuring asset-backed issuances, a key source of
reported “profitability,” has nearly disappeared
$26.7bn
$14.2bn
$1.6bn
$1.2bn
Q1’07
Q1’07
Q1’08
________________________________________________
Source: MBIA and FSA operating supplements.
16
Q1’08
New Entrants
The entrance of new participants in an already shrinking market
for municipal bond insurance significantly impairs the future
business prospects of legacy Bond Insurers
f As of Q1’08, Berkshire Hathaway Assurance Corp. received a Triple-A rating
and was licensed to operate in all 50 states. Berkshire wrote $400mm of
premiums in its first full quarter of operations, more than any other market
participant
f On May 28th, The New York Post reported that Ripplewood Holdings was
looking to raise $1.5 billion to fund the creation of a municipal bond insurer
f On May 29th, The Bond Buyer published an article stating that two pension
funds, the California Public Employees’ Retirement System and California
State Teachers’ Retirement System, are considering the formation of a new
bond insurer
f On June 4th, Macquarie Group’s Municipal and Infrastructure Assurance
Corp. published a Notice of Intention to launch a municipal bond insurer in
the United States
17
The Environment Has Changed…
9
Nearly all Bond Insurer share prices have declined 90% +
9
Management credibility and franchise values have been impaired
9
Capital raising options are materially diminished if not eliminated
9
The housing market continues to deteriorate, increasing CDO and ABS
losses
9
“Temporary” MTM losses are increasingly becoming permanent
9
Rating agencies have begun to downgrade Bond Insurers
9
Demand for bond insurance appears likely to be permanently diminished
9
There is increasing competition from better-capitalized new entrants
9
Investment portfolio assets are declining in value
9
Asset / Liability businesses are liquidating as municipalities and
structured finance issuers make withdrawals and Insurers issue fewer
new GICs or MTNs
18
…But More Change Can Be Expected
Could Ultimately Result In:
Potential Future Events
SFAS 163 requires Bond
Insurers to increase loss
reserves
Bond Insurers will become
insolvent due to insufficient
capital
Holding Companies
file for bankruptcy
Regulators will place certain
Bond Insurers into
rehabilitation
Mark-to-Market Termination
provisions triggered on CDS
contracts
19
The Market’s View of MBIA
MBIA’s Stock Price Has Fallen…
The decline in MBIA’s stock price since our November
presentation significantly impairs the Company’s ability to raise
additional capital in the future
$45
$40
December 11, 2007:
Warburg commits $1bn
to MBIA
$30
March 7, 2008:
MBIA requests
withdrawal of Fitch rating
$25
$20
$15
$10
$5
$0
Nov-07
June 11, 2008:
MBIA reneges on
prior commitment to
downstream
$900mm to
Insurance Sub
January 9, 2008:
MBIA announces
$1bn surplus note
offering
$35
November 28, 2007:
Value Investor
Conference
December 20:
MBIA discloses $8.1bn of
previously undisclosed
mortgage exposures
Dec-07
January 17, 2008:
Moody’s puts MBIA’s
Triple-A rating on review
Jan-08
June 5, 2008:
S&P downgrades MBIA
Mar-08
21
May 12, 2008:
MBIA 8-K announcing
recommitment to
downstream $900mm
Apr-08
$6
Jun-08
…MBIA Insurance Corp’s Surplus Notes Trade like “Junk”…
July 15th marks the date of the first interest payment on MBIA
Insurance Corp.’s 14% Surplus Notes. The payment is subject to
regulatory approval
110
100
90
80
70
64.5
60
50
Jan-08
Feb-08
Mar-08
Apr-08
22
May-08
Jun-08
…CDS spreads have widened dramatically, but now imply
more credit risk at MBIA Insurance Corp. (Subsidiary) than
MBIA Inc. (HoldCo)
2,000 bps
1,800 bps
1,780bps
1,600 bps
1,400 bps
1,380bps
1,200 bps
1,000 bps
800 bps
600 bps
400 bps
200 bps
0 bps
Jan-08
Feb-08
Mar-08
Apr-08
HoldCo CDS
Insurance Sub CDS
Source: Bloomberg. Data as of 6/18/2008.
23
May-08
Jun-08
Why does the Market perceive MBIA Insurance to have
more credit risk than MBIA Inc.?
f Higher than expected loss reserves at MBIA Insurance Corp.
f Large mark-to-market losses that are increasingly also true
economic losses
f MBIA Insurance Corp. downgraded by rating agencies
f Decision by MBIA Inc. to retain $900M originally promised to
bolster capital position of MBIA Insurance Corp.
f Belief that MBIA Inc. is insulated from default of MBIA
Insurance Corp.
f Management claims that MBIA Inc. has more cash than debt
24
We Believe MBIA Inc.’s (HoldCo) Credit Position is Worse
than MBIA Insurance Corp.
f Cross-default provisions in MBIA Inc. debt that trigger upon
insolvency of, or regulatory action at, MBIA Insurance Corp.
f MBIA Inc. has large liabilities with near-term maturities and
mark-to-market collateral posting obligations
f Fair value of MBIA Inc. investment assets have declined and
appear to be less than MBIA Inc.’s liabilities after excluding
the carrying value of equity in MBIA Insurance Corp.
f Questionable ability, if any, to access Insurance Subsidiary
dividends or to raise additional capital
f Likely to be negligible recovery value for unsecured debt and
equity holders at MBIA Inc.
25
Insolvency of MBIA Insurance
Corp. (“MBIA Insurance” or “MBIA
Ins.”) triggers a Cross-Default at
MBIA Inc. (the “Holding Company”
or “HoldCo”)
MBIA Inc. Defaults if MBIA Insurance Becomes
Insolvent or is Subject to Regulatory Intervention
Because of a cross-default provision in the indenture of MBIA
Inc.’s debt, MBIA Inc. could be forced into bankruptcy if the
Insurance Sub were insolvent and/or put into rehabilitation
Source: Senior Indenture of MBIA Inc.’s $350mm 5.70% Senior Notes due 2034, 11/24/04
27
MBIA GICs: More Events of Default
Similar provisions are also standard in MBIA’s Guaranteed
Investment Contracts (“GICs”)
“5.1 Events of Default…
(c) INC [MBIA Inc.] or the Insurer [MBIA Insurance Corp.] shall (i) voluntarily commence any
proceeding or file any petition seeking relief under the United States Bankruptcy Code, or
any other Federal, state or foreign bankruptcy, insolvency or similar law, (ii) consent to the
institution of, or fail to controvert in a timely and appropriate manner, any such proceeding or
the filing of any such petition, (iii) apply for, or consent to, the appointment of a receiver,
trustee, custodian, sequestrator or similar official for such party or for a substantial part of its
property, (iv) file an answer admitting the material allegations of a petition filed against it in
any such proceeding, (v) make a general assignment for the benefit of creditors, (vi) become
unable, admit in writing its inability or fail generally to pay its debts as they become due or
(vii) take action for the purpose of effecting any of the foregoing.”
Sample MBIA Inc. GIC
28
Insolvency of an Insurer
From a regulatory point of view, MBIA appears to be solvent based
on its statutory financial filings.
В§ 1309. Insolvency of an insurer.
(a) Whenever the superintendent finds from a financial statement or report on
examination that an authorized insurer is unable to pay its outstanding
lawful obligations as they mature in the regular course of business, as
shown by an excess of required reserves and other liabilities over admitted
assets,…
However, reported solvency is based on management’s estimate
of future losses. MBIA currently has taken loss reserves of
approximately $2 Billion versus third-party estimates of ~$10-$15
Billion+.
29
Insolvency of an Insurer (cont.)
Under New York Insurance Law В§ 1309, a Bond Insurer can also be
deemed insolvent if it does not have sufficient assets to pay all
accrued claims and still retain sufficient assets to reinsure its risks
В§ 1309. Insolvency of an insurer.
(a) … or by its not having sufficient assets to reinsure all outstanding risks with
other solvent authorized assuming insurers after paying all accrued claims
owed, such insurer shall be deemed insolvent and the superintendent may
proceed against it pursuant to the provisions of article seventy-four of this
chapter.
30
Determining Solvency at MBIA Insurance Corp.
f The cost to reinsure MBIA’s public finance exposures can be
conservatively estimated to equal the current Deferred
Premium Revenue on the Company’s Balance Sheet
f MBIA’s mark-to-market on its CDS provides a conservative
estimate of the cost to reinsure the Company’s Structured
Finance exposures that are executed in CDS form
 “In
the absence of an actual financial market, we value these insured
credit derivatives at the estimated amount that financial guaranty
insurers with comparable credit ratings as us would require to assume
these contracts.”
– MBIA 2007 10-K, page 95
f We estimate the cost to reinsure other Structured Finance
exposures (not executed through CDS) to be 5% of par
outstanding
31
Under the NYSID Reinsurance Test, We Believe MBIA
Insurance Corp. is Insolvent
We believe that MBIA would require $8.4bn more in capital to pay
accrued claims and reinsure its exposures
MBIA Insurance Corp. Balance Sheet Data ($ in millions)
3/31/2008
$18,690
(442)
(77)
(2,129)
(2,360)
(337)
(341)
$13,004
Total Assets
Less: Deferred acquisition costs
Less: Goodwill
Less: Deferred income tax assets (non-transferrable)
Less: Total debt & VIE notes
Less: Securities sold under agreements to repurchase
Less: Payable for investments purchased
Adj. Assets
Loss and LAE reserves
Accrued Claims Owed
(1,542)
($1,542)
Net derivative liabilities (as recorded on MBIA Insurance Corp. balance sheet)
Less: SFAS 157 (benefit of discounting liabilities at L + MBIA CDS)
Cost of Reinsuring CDS Contracts
(8,197)
(3,564)
($11,761)
Net par value of structured finance insured portfolio
Less: MBIA's CDO exposure via CDS
Non-CDS structured finance portfolio
Cost to reinsure (%)
Cost to Reinsure Non-CDS Structured Finance Portfolio
230,123
(129,600)
100,523
(5.0%)
($5,026)
Deferred premium revenue
Fair market premium (Berkshire offered 1.50x)
Cost of Reinsuring Existing Public Finance Book
(3,046)
1.00x
($3,046)
Total Reinsurance Cost & Accrued Claims Owed
($21,375)
Assets in Excess of Reinsurance Cost
($8,372)
32
These loss reserves
do not reflect the
$1.4bn FMV shortfall
in MBIA’s IMS
business
Note: MTM losses on CDS and SFAS
157 benefits references on page 49 of
MBIA Inc. Q1’08 10-Q. SF par value and
CDS information from the MBIA Q1’08
operating supplement. Cost to reinsure
Non-CDS SF Portfolio based on Wall
Street broker/dealer estimated annual
cost of insuring remaining pools of ABS
(50bps), CMBS (200bps), and RMBS
(200+bps).
We believe that MBIA has materially misrepresented the
potential for acceleration of their CDS contracts
“MBIA Corp.’s insured credit derivative policies are structured to prevent large
one-time claims upon an event of default and to allow for payments over time
(i.e. “pay as you go” basis) or at final maturity. Also, each insured credit default
swap MBIA Corp. enters into is governed by a single transaction International
Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement relating
only to that particular transaction insurance policy. There is no requirement
for mark-to-market termination payments, under most monoline standard
termination provisions, upon the early termination of the insured credit
default swap. However, some contracts have mark-to-market termination
payments for termination events within MBIA Corp.’s control.”
– MBIA 2007 10-K, page 17
We believe that the above disclosure is
materially false and misleading
33
Bond Insurer Insolvency Triggers Mark-to-Market
Termination of CDS Contracts
Bond Insurance CDS contracts are subject to termination at the option
of the Insurer’s counterparty at current market prices should the
underlying insurer become insolvent or subject to regulatory
intervention
“[Fitch’s downgrade of CIFG] is based, in part, on recent conversations with
CIFG's management, in which the company has indicated it could be at greater
risk of falling below regulatory minimum capital requirements, if the company's
loss provisions increase in future periods which could trigger an insolvency
proceeding by regulators. If this were to occur, CIFG's entire $57 billion credit
default swap (CDS) portfolio, which is the primary form of execution for the
company's entire collateralized debt obligation (CDO) exposure (including
investment grade corporate, high-yield corporate, and structured finance CDOs)
would be subject to termination at current valuations. Based on current market
valuations, Fitch does not believe CIFG would have sufficient claims-paying
resources to meet these obligations, triggering a likely default of its insurance
subsidiaries.”
– Fitch Ratings, Downgrade of CIFG to �CCC’, May 30, 2008
34
What is the appropriate rating for a business with
terminal liquidity risk?
The Rating Agencies have consistently stated that the Bond
Insurers have no CDS liquidity risk
“Overall, we view CDS activity as not materially changing the liquidity risk within
the industry, and see the efforts of financial guarantors to establish contractual
standards for CDS execution that mimic the conventional guaranty policy as
reflective of their strong commitment to risk mitigation. Failure to maintain this
discipline would surely threaten our existing rating paradigm.”
“The inability of a claimholder to demand acceleration of payments is the most
significant liquidity safeguard afforded the guarantors. It is an essential element
that supports the business model and is supportive of the extremely high ratings
of firms in this sector.”
— Moody’s, “Liquidity and Downgrade Risk In the
Financial Guaranty Industry”, July 2006
The rating agencies have continued to mislead the investing public
by ignoring and not disclosing CDS mark-to-market termination
risk in determining ratings for bond insurers
35
We Believe MBIA Inc. Has Insufficient
Assets To Cover Its Liabilities
We believe that MBIA’s CEO has misrepresented
the financial standing of the Holding Company
“As I have noted to you previously, we monitor liquidity at the insurance
company, in the asset management operation and at the holding company to
minimize any short and medium term issues. The decision not to move any of
the holding company cash down to the insurance company leaves the holding
company with more cash than its total outstanding debt, a fact that seems
to be totally ignored by the market as the spreads on our holding company CDS
continue to widen.”
– CEO Jay Brown, June 11, 2008 Letter to Shareholders
In our opinion, this is a materially false and misleading statement
37
MBIA Inc. has large collateralized borrowings
tied to its Investment Management business
“MBIA Asset Management also raises funds through its affiliate GFL [MBIA
Global Funding LLC]. GFL raises funds for management through the issuance of
MTNs with varying maturities (“GFL MTNs”), which are in turn guaranteed by
MBIA Corp. GFL lends the proceeds of these GFL MTNs issuances to the
Company (“GFL Loans”). Under agreements between the Company and MBIA
Corp., the Company invests the proceeds of the investment agreements and
GFL Loans in eligible investments, which consist of investment grade securities
with a minimum average Double-A credit quality rating. MBIA Inc. primarily
purchases domestic securities, which are pledged to MBIA Corp. as
security for its guarantees on investment agreements and MTNs.”
– MBIA 2007 10-K, page 18
MBIA Inc. has $25.1 billion of secured borrowings in
addition to its $1.2 billion of unsecured long-term debt
38
MBIA HoldCo-Only (Unconsolidated) Balance Sheet: 12/31/07
($ Millions)
Investments
Cash & cash equivalents
Investments in wholly-owned subs
Intercompany loan receivable
Accrued investment income
Receivables for investments sold
Derivative assets
Deferred income taxes, net
Other assets
Total Assets
24,594
79
4,760
1,449
391
111
854
285
30
$32,553
Investment agreements
Intercompany loan payable
Dividends payable
Securities sold for repurchase
Long-term debt
Payable for investments purchased
Derivative liabilities
Other liabilities
Total Liabilities
Shareholders' Equity
15,813
9,426
42
1,168
1,225
6
482
734
$28,897
$3,656
Less: Equity in MBIA Insurance Corp.
Adj. Shareholders' Equity
(4,543)
($887)
Source: MBIA Inc. 2007 10-K, MBIA Inc. (Parent Company), pg. 161
39
Includes $4.5bn of
Insurance Sub equity
GICs secured by MBIA
Inc.’s pledge of assets
and recourse
Medium term note
(“MTN”) funding
Includes MBIA
Insurance Sub equity
MBIA Inc.’s Investment Portfolio Suffering Losses
($ Billions)
3/31/08 12/31/07
Investment Agreements
Global Funding MTNs
Repurchase Agreements
IMS Liabilities (Book Value)
$15.8
8.3
1.0
$25.1
$16.1
9.4
1.2
$26.7
IMS Assets (Fair Value)
$23.7
$26.3
IMS Shortfall
($1.4)
($0.4)
Based on management’s fair market valuation of IMS assets as of 3/31/08,
MBIA HoldCo faces a $1.4 billion funding shortfall in its IMS segment.
This excludes potential losses arising from its Conduits ($4.3bn of assets at
amortized cost and $4.3bn of liabilities as of 12/31/07)
Source: MBIA Inc. 2007 10-K, Q1’08 10-Q, Q4’07 Earnings Presentation and Q1’08 Earnings Presentation.
40
MBIA HoldCo Faces Margin Calls from MBIA Ins.
as the Value of Its Investment Assets Declines
“These transactions are entered into with MBIA Investment Management Corp.
(“IMC”), a wholly owned subsidiary of MBIA Inc., in connection with IMC’s
collateralized municipal investment agreement activity. It is MBIA Corp.’s
[Insurance Sub] policy to take possession of securities used to collateralize
such transactions. MBIA Corp. minimizes the credit risk that IMC might be
unable to fulfill its contractual obligations by monitoring IMC’s credit exposure
and collateral value and requiring additional collateral to be deposited with
MBIA Corp. when deemed necessary.”
–MBIA Insurance Corp. 2007 10-K, page 9
The Problem: MBIA Insurance Corp. is controlled by
executives whose compensation is tied to Holding Company
performance. There are no independent directors to
oversee MBIA Ins. collateral calls and to protect
policyholder interests
41
MBIA HoldCo is Liable For Undercollateralized Claims
Paid by MBIA Ins. on MTNs or GICs
“MBIA Corp. has also issued guarantees of certain obligations issued by its investment
management affiliates that are included in the previous tables. These guarantees take the form of
insurance policies issued by MBIA Corp. on behalf of the investment management services
affiliates. Should one of these affiliates default on its insured obligations, MBIA Corp. will be
required to pay all scheduled principal and interest amounts outstanding. As of December 31,
2007, the maximum amount of future payments that MBIA Corp. could be required to make
under these guarantees, should a full default occur, is $25.7 billion. These guarantees
have a maximum maturity range of 1-56 years, were entered into on an arm’s length basis
and are fully collateralized by marketable securities. MBIA Corp. has both direct recourse
provisions and subrogation rights in these transactions. If MBIA Corp. is required to make
a payment under any of these affiliate guarantees, it would have the right to seek
reimbursement from such affiliate and to liquidate any collateral to recover amounts paid
under the guarantee.”
–MBIA Insurance Corp. 2007 10-K
There is a $1.4 Billion shortfall between the value of Holding Company
investment management assets and liabilities which should require
MBIA Inc. to pledge its remaining cash assets to MBIA Ins. to secure
MBIA Ins.’s GIC and MTN guarantees
42
MTN and CP Vehicles Effectively in Liquidation
Following its downgrade, we believe it is unlikely that MBIA will be
able to raise additional funding for its MTN and GIC programs
Triple-A One Funding
(Commercial Paper)
MBIA Global Funding LLC
(MTNs)
$9.5bn
$8.1bn
$0.9bn
$0.4bn
Nov-07
Nov-07
Current
________________________________________________
Source: Bloomberg and Capital IQ.
43
Current
In our view, MBIA Inc. is Insolvent – Unsecured Creditors
and Shareholders will have minimal, if any, recoveries
Total Assets: $25.1bn
Total Claims: $27.9bn
GICs
MTNs
Repurchase Agreements
Total Secured Claims
$15.8bn
8.3
1.0
$25.1bn
FV of IMS Assets
$23.7bn
— Pledged to MBIA Insurance Corp.
Source: MBIA Q1’08 10-Q.
Source: MBIA Q1’08 Earnings Presentation.
HoldCo Cash (needed for collateral?) $1.4bn
HoldCo Long-Term Debt
$1.2bn
Market Cap (6/16)
$1.6bn
Unsecured debt and shareholders of
MBIA Inc. would likely receive de minimis,
if any, recoveries in bankruptcy
44
What Should the Regulators do?
f The insurance regulators should act now to ensure maximum
recoveries at MBIA Insurance Corp.
В MBIA Inc. effectively has a 100% margin loan from MBIA
Insurance Corp. and has invested the proceeds in assets that
are declining in value
 MBIA’s CEO is proposing to use HoldCo cash for MBIA Inc.
special dividends or share repurchases that would otherwise be
available to meet collateral obligations or reimburse MBIA Ins.
claims
f MBIA Insurance Corp. is controlled by executives of MBIA Inc. with
economic interests that conflict with the interests of MBIA Insurance
and its policyholders
f In Rehabilitation, the Superintendent can control the management of
all assets and liabilities to maximize value for policyholders
f The forgotten constituency: public and corporate pension funds,
money market investors, etc., which own structured finance assets. It
is not as simple as Municipalities vs. Wall Street CDS counterparties
45
Our New Short Idea
Is FSA Triple-A?
FSA Organizational Chart
Source: FSA 2007 Investor’s Overview.
48
FSA Insurance Portfolio / GIC Business Overview
GIC Business
(Financial Products)
$18.8bn Investment Portfolio
Financial Security Assurance
(Financial Guaranty)
$434.2bn Net Par Outstanding
Source: FSA Q1’08 earnings presentation.
Note: Investments at amortized cost.
49
FSA is a Highly Leveraged Bond Insurer and GIC
Provider
FSA is highly leveraged compared with other Bond Insurers
Net Debt Service Outstanding /
Statutory Capital
GIC & MTN Liabilities /
Statutory Capital
212.4 x
8x
200 x
6.8 x
149.1 x
150 x
6x
100 x
4x
50 x
2x
0x
0x
3.7 x
Source: FSA and MBIA Q1’08 operating supplements. FSA GIC & MTN liabilities of $20.4bn at par value as
reported on page 72 of the FSA Holdings Q1’08 10-Q.
50
FSA Holdings’ GAAP Equity Significantly Declined
in Q1’08
FSA Holdings Balance Sheet Data
12/31/2007
3/31/2008
Total investment portfolio
Cash
Deferred Acquisition costs
Prepaid reinsurance premiums
Reinsurance recoverable on unpaid losses
Deferred tax asset
Other assets
$24,634
27
348
1,120
74
412
1,714
$22,055
45
346
1,129
125
1,454
2,048
Total Assets
$28,329
$27,203
2,871
275
21,400
730
1,478
3,003
526
20,889
730
2,011
$26,754
$27,159
$1,576
$44
Deferred premium revenue
Losses and LAE
Financial products segment debt
Notes payable
Other liabilities
Total Liabilities
Shareholders' Equity
Source: FSA Holdings Q1’08 10-Q.
51
FSA CDS Spreads Have Widened Less than those
of Other Bond Insurance Subsidiaries
Bond Insurer 5-yr CDS Spreads (2007 – Current)
4,000 bps
3,800bps
3,500 bps
3,000 bps
2,800bps
2,500 bps
2,075bps
1,970bps
2,000 bps
1,500 bps
1,000 bps
655bps
500 bps
0 bps
Jan-07
455bps
Apr-07
Aug-07
FSA
MBIA
Nov-07
ABK
AGO
Source: Bulge-bracket broker-dealer. As of June 18th, 2008.
52
FGIC
Mar-08
XL
Jun-08
The Market’s Perception of FSA
To date, Moody’s and S&P have taken a favorable view of FSA,
noting its avoidance of ABS CDOs and its limited exposure to
other mortgage-related issuances
“The financial strength ratings of Assured Guaranty Corp. (AAA/Stable), Financial Security
Assurance Inc. (AAA/Stable), and Radian Asset Assurance (AA/Stable) were not reviewed in
conjunction with this latest stress test. These companies do not have material amounts of
direct nonprime mortgage or ABS CDO exposure and therefore, in our view, are not at risk to
have significant losses from these sectors.”
Detailed Results of Subprime Stress Test of Financial Guarantors
S&P, February 25, 2008
“Based on our updated analysis, we believe that FSA remains adequately capitalized for its
rating under both the base case and stress case approaches. FSA has largely side-stepped
the problems arising from mortgage-related exposures, as the company did not underwrite
ABS CDOs in recent years.”
Moody’s Announces Rating Actions on Financial Guarantors
December 14, 2007
53
Pershing’s Perception of FSA
As of 3/31/08, FSA has:
f $19bn of net direct RMBS exposure through its insurance
subsidiary
В $7.5bn HELOCs
В $1.5bn Alt-A CES
В $5.1bn Subprime
В $1.7bn Alt-A 1st Lien
В $2.8bn Option ARMs
f Significant liquidity risk in Guaranteed Investment Contract
(“GIC”) program
f Highest-risk investment portfolio of any Bond Insurer in our view
54
RMBS Exposures
Quick Review: What is a HELOC / CES?
Home Equity Lines of Credit (HELOC) and Closed-End Second
Mortgages (CES) securitizations are junior to even the most
subordinated tranches of a typical Mezzanine CDO
AAA
First Lien
RMBS
House
High grade
CDO
First
Mortgage
Second
Mortgage
Equity
AA
A
A
BBB
BB
BB
Equity
Second
Lien RMBS
AAA
AA
A
A
BBB
BB
Equity
56
Mezzanine
CDO
HELOCs /
CES
What Happens When Housing Values Decline?
Bond Insurers typically insure HELOCs and CES to the underlying BBB
level. HELOCs and CES are in a first-loss position and are leveraged to a
decline in housing values
AAA
Decline in Home Value
First Lien
RMBS
House
High grade
CDO
First
Mortgage
Second
Mortgage
Equity
AA
A
A
BBB
BB
BB
Equity
Second
Lien RMBS
AAA
AA
A
A
BBB
BB
Equity
57
Mezzanine
CDO
HELOCs /
CES
We Believe FSA’s Loss Reserves are Too Low
f Management does not appear to grasp the full risks of its
exposures
f Credit impairments taken on direct RMBS exposures are
still too low in our opinion
f Quality of underlying collateral is poor
В Primarily 2006-2007 vintage
В Countrywide HELOCs are largest exposures
 Material ratings downgrades in Q1’08
58
HELOCs Stress Loss Estimates as of 12/31/07
As of December 31, 2007, FSA’s stress scenario for its HELOCs projected
that total lifetime losses would not exceed $125 million
Source: FSA 2007 Results and Business Profile, February 12th, 2008 .
59
Management Reaffirmed HELOC Loss Estimates on 2/29/08
“The stress tests you've made on the HELOC exposure at Dexia is the same in Q4 in terms
of amount. And during the period, the situation seems to have worsened a lot on this type
of asset. A lot of your competitors are saying so, and I'm not talking only of MBIA or
AMBAC, but I'm talking of U.S. banks. Could you explain why the stress test is the same,
and could you maybe give us some details on the way it is calculated? Thank you.”
– Christine Ricetti, Analyst, Natixis
Q4’07 Earnings Call Transcript, February 29th, 2008
“Yes. In fact, the stress test was made on some assumption about the level of default that
would be kept over the life of the transactions. And when you make the same tests at end of
Q4, you find the same type of figure. In fact, it was a little less than $125 million, so this is
the result of the math, I would say. In the meantime, the expected loss, what we think we
could lose, has increased, and this is the reason why we reserved $65 million on the HELOC
portfolio over the Q4, and that was taken out of the general reserves. So this has no impact
on the P&L, but the result of the stress test was exactly the same.”
– Bruno Deletre, Director of Public Finance, Dexia
Q4’07 Earnings Call Transcript, February 29th, 2008
60
New HELOC Loss Estimates are Dramatically Higher
On March 31, 2008, one month after confirming that losses associated
with HELOCs would not exceed $125 million under management’s
“stress” assumptions, FSA booked a $229mm case reserve against its
HELOCs and projected total eventual losses of $333mm
Source: FSA Q1’08 Earnings Presentation.
61
How Could Management’s View of Losses Change So
Quickly?
Management relies on third parties for information regarding the
performance of the collateral underlying its insurance obligations
“The 125 million that we said to the market at the end of the third quarter, and then
again at the end of the fourth Quarter, was a -- what we thought was a very
conservative upside projection of the progression of potential delinquencies in
losses in these transactions, and it turns out that that was just not sufficiently
conservative…
Countrywide, I think, was simply overwhelmed by the amount of servicing challenge
that they faced in the -- toward the end of 2007 and early 2008, and it was really
not until the end of March that they were able to provide us with that information.
So at the end of March, having seen data that was essentially consistent with our
prior reserve estimates, until that time, we received the March charge-off
information, which was higher, and that was disappointing, but more importantly,
we got the next six months of delinquency progression information, which showed a
continued rise in delinquencies, and we felt we just could not ignore that.”
– Mr. Robert Cochran, CEO of FSA, Q1’08 Earnings Transcript
62
FSA Loss Assumptions as of 12/31/07
Cumulative Default Rate
near-term reversion to
“steady state”
Cumulative pool losses:
8% to 26%
Source: FSA Q4’07 Earnings Presentation .
63
FSA Loss Assumptions as of 3/31/08
Despite the fact that FSA’s 12/31/07 “stress case” underestimated losses
by more than 100%, FSA continues to believe lifetime cumulative pool
losses will not exceed 30% of original par
Cumulative Default Rate
near-term reversion to
“steady state”
Cumulative pool losses:
10% to 30%
Source: FSA Q1’08 Earnings Presentation .
64
Why are FSA’s Loss Estimates So Low?
FSA projects future pool losses on its HELOCs will total $1.5bn. FSA is
assuming it will only be responsible for 15% of this amount ($229mm)
FSA’s Assumptions (as of 3/31/08):
Future excess spread
dependent on material
improvement in
collateral
performance
No other Bond Insurer
of which we are aware
includes recoveries
from reps &
warranties in loss
assumptions
Relies on the
solvency of
downgraded
reinsurers
Countrywide has
terminated draws on
HELOCs for many
customers
Source: FSA Q1’08 Earnings Presentation.
65
HELOCs Are Only Getting Worse
The underlying ratings on FSA’s insured par of HELOCs have significantly
deteriorated in Q1’08
As of Q1’08
As of Q4’07
Despite having ~$3bn of Below-Investment-Grade HELOCs exposure,
FSA expects to incur only $333mm of losses
Source: FSA Earnings Presentations.
66
HELOCs Aren’t the Only Problem: Alta-A CES
As of Q1’08
As of Q4’07
Source: FSA Earnings Presentations.
67
HELOCs Aren’t the Only Problem: Subprime
As of Q1’08
As of Q4’07
Source: FSA Earnings Presentations.
68
HELOCs Aren’t the Only Problem: Alt-A 1st Lien
As of Q1’08
As of Q4’07
Source: FSA Earnings Presentations.
69
HELOCs Aren’t the Only Problem: Option ARMs
As of Q1’08
As of Q4’07
Source: FSA Earnings Presentations.
70
FSA’s GIC Business
What is a Guaranteed Investment Contract (“GIC”)?
f With municipal GICs, municipalities deposit proceeds of a
bond issue with Bond Insurer HoldCo and receive GICs,
which are guaranteed by the Insurance Subsidiary
f With structured finance (“SF”) GICs, SF issuers purchase
GICs for use as a funding source for credit-linked notes in
CDOs
f HoldCo commits to repay principal plus interest (~LIBOR)
to GIC-holder according to an agreed-upon schedule,
subject to early redemption and collateral posting
obligations which increase upon a downgrade of the
Insurance Subsidiary
f Insurance Subsidiary guarantees HoldCo’s interest and
principal payments, and HoldCo invests the proceeds in
higher yielding assets
72
What is a Guaranteed Investment Contract (“GIC”)?
f The terms of the GIC may place limitations on the timing and
amount of withdrawals
В Municipalities typically can withdraw according to scheduled
construction expenditures
В Structured Finance entities typically withdraw to pay principal
and interest as due on liabilities
f However, many GICs contain provisions which allow
accelerated withdrawals
В Municipalities can withdraw if pace of construction is faster than
planned
В Structured Finance entities can withdraw upon CDO events of
default or to pay shortfalls of principal or interest
В Nearly all GICs can be withdrawn if the guarantor is
downgraded to a pre-determined rating
73
Overview of FSA’s GICs
FSA has sold GICs principally to structured finance issuers to fund
credit linked notes (CLNs)
f Structured GICs (~$12bn)
В Includes GICs issued to provide returns to CLNs used in CDOs with credit
exposures to pooled corporates, senior secured loans and asset back
securities (ABS CDO GICs)
В Funds may be withdrawn in the event of deterioration in the credit
performance of the underlying CDO, typically upon the occurrence of
CDO events of default
В ~$6bn of ABS CDO GICs, $2.5bn of which contain overcollateralization
tests which, if failed, could result in an early withdrawal of funds
f Municipal GICs (~$7bn)
В Construction GICs may be drawn more quickly than anticipated to pay for
project expenses
В Debt services reserve fund GICs may be drawn unexpectedly upon
payment default by the municipal issuer or rising municipal debt costs
74
What is an ABS CDO GIC?
ABS CDO GICs are deposits whose liquidity risk is tied to the
performance of the underlying ABS CDO
“The majority of non-municipal GICS insured by FSA are purchased by issuers of
credit-linked notes that provide credit protection with respect to structured finance
CDOs. These issuers of credit linked-notes typically sell credit protection by issuing a
CDS referencing specified asset-backed or corporate securities. Such GICs may be
drawn unexpectedly to fund credit protection payments due by the credit-linked note
issuer under the related credit default swap or upon an acceleration of the related
credit-linked notes following a credit-linked note event of default. Recent
developments with respect to CDOs of ABS could result in material early draws on
GICs associated with these transactions. The Company's GIC business has been
increasing its liquid assets in anticipation of further draws on CDO of ABS GICs. The
ability to access additional funding through the issuance of GICs has been hampered
by a material reduction in new GIC issuances during the first quarter of 2008.”
–FSA Q1’08 10-Q
75
Overview of FSA’s GIC & MTN Program
FSA’s GIC program essentially operates like a bank. It funds itself with
GIC deposits and FSA-guaranteed MTNs issued by Variable Interest
Entities (“VIEs”). FSA then invests the proceeds to earn a spread
Balance Sheet of a Traditional Bank:
Assets:
Cash
Personal Loans
Student loans
Auto loans
Mortgages
Credit card loans
Etc…
Liabilities:
Bank earns spread on
interest earned on assets
less funding cost of
liabilities
Demand deposits
Savings accounts
CDs
Etc…
Equity provides cushion for
asset losses
Equity ~10%
76
FSA’s GIC Business is Like a Bank with No Equity
Unlike a traditional bank, however, FSA’s GIC business has no
equity cushion to protect it against losses on invested assets
($ Billions, as of 3/31/08)
Illustrative FSA GIC & MTN Balance Sheet
(at amortized cost)
Assets:
The assets
backing FSA’s
GICs are highrisk
Subprime
Alt-A
HELOC / CES
Other RMBS
Corporate
Other
VIE assets
Cash
TOTAL
Liabilities:
$8.0
2.8
0.5
1.3
0.9
3.3
??
1.5
VIE assets + $18.8
ABS CDO GICs
Other SF GICs
Muni GICs
Other GICs
VIE debt (MTNs)
TOTAL
$5.8
4.5
6.7
1.7
??
VIE debt + $18.7
GICs and VIE debt are
wrapped by FSA’s
insurance subsidiary
and typically fund at
~LIBOR
The lack of equity
in FSA’s GIC
business leaves no
margin for error
Source: FSA Holdings Q1’08 10-Q and earnings presentations. Amortized cost of VIE assets and liabilities undisclosed.
77
FSA Invested its GIC and MTN Proceeds in HighRisk Assets
($ Millions, as of 3/31/08)
Amortized
Cost
Percent
of Total
Non-Agency RMBS
Subprime
Alt-A
Option ARMs
CES
HELOCs
NIMs
Prime
Non-Agency RMBS
$8,009
2,834
890
204
299
300
157
$12,693
42.6%
15.1%
4.7%
1.1%
1.6%
1.6%
0.8%
67.4%
$6,198
1,823
655
143
224
216
104
$9,363
(22.6%)
(35.7%)
(26.3%)
(30.1%)
(24.9%)
(28.0%)
(34.1%)
(26.2%)
Other
Agency RMBS
US Municipal bonds
Corporate
CBO/CDO/CLOs
Other (primarily ABS)
Total
1,109
578
865
469
1,604
$4,624
5.9%
3.1%
4.6%
2.5%
8.5%
24.6%
1,074
533
749
377
1,395
$4,127
(3.2%)
(7.7%)
(13.4%)
(19.6%)
(13.0%)
(10.7%)
1,504
$18,821
8.0%
100.0%
1,504
$14,995
0.0%
(20.3%)
NA
NA
NA
NA
1,163
$16,158
Cash & cash equivalents
Total FP Portfolio (excl VIEs)
VIE assets
Total GIC Business Assets (incl VIE
Fair
Value
FMV
Discount
Includes $400mm
of subprime RMBS
underlying
transactions and
$300mm of agency
guaranteed CMBS
(Source: FSA Q1’08
Earnings Presentation)
NA
NA
Source: FSA Holdings Q1’08 10-Q, pages 70, 79 and 80. Fair value represents the company’s fair value estimates for the underlying securities.
Fair value of VIE assets assumed to be carrying value (as shown on page 70 of the 10-Q).
78
FSA’s GIC Program is Currently Like a Bank with
Negative Equity
FSA invested its GIC proceeds in high-risk assets, many of which
trade at steep discounts to amortized cost
($ Billions, as of 3/31/08)
Illustrative FSA GIC & MTN Balance Sheet
(at fair value)
Assets:
Subprime
Alt-A
HELOC / CES
Other RMBS
Corporate
Other
VIE assets
Cash
TOTAL
Liabilities:
$6.2
1.8
0.4
1.0
0.7
3.0
1.2
1.5
ABS CDO GICs
Other SF GICs
Muni GICs
Other GICs
VIE debt
$5.7
4.4
6.9
0.7
2.6
$16.2
NEGATIVE EQUITY ($4.3) TOTAL
$20.4
March 31, 2008:
On a fair value
basis, FSA’s GIC
program currently
faces a $4.3 billion
shortfall
________________________________________________
Source: FSA Holdings Q1’08 10-Q. Effective 1/1/08, FSA elected to account for certain fixed rate FP segment (GIC program) debt at fair value under the fair value
option in SFAS 159. The fair value option allows the fair value adjustment on debt to be offset with the fair value on derivatives economically hedging interest
and foreign exchange risk. All of the FP segment debt carried at fair value was categorized as Level 3 in the SFAS 157 fair value hierarchy.
79
What Could Cause FSA to Realize this $4.3bn Loss?
As of now, the $4.3bn shortfall represents an unrealized loss;
however, there are two ways the company could be forced to
realize this loss
f The unrealized losses in the GIC program investment portfolio
could be deemed other than temporary impairments (“OTTI”)
В As of 3/31/08, management concluded there were no OTTI
impairments in the FP investment portfolio, despite the significant
discount to fair market value at which the assets are trading
В Management expects unrealized losses will reverse over time
В Under GAAP, the longer an asset is in a position of unrealized loss,
the more likely it is to be realized as OTTI
f Liquidity Risk
 Faster than anticipated withdrawals of FSA’s GIC liabilities could
force the company to liquidate assets at a loss
80
FSA’s Updated Risk Factors
Since Q3’07, FSA’s disclosures have been updated to include
the following risks:
New Risk Factor in the 2007 10-K:
f “Adverse loss developments on structured finance CDOs
may require increased liquidity in the Company’s FP
Investment Portfolio”
New Risk Factor in the Q1’08 10-Q:
f “Impairments to assets in the FP Investment Portfolio
proving to be �other than temporary’ rather than temporary,
resulting in reductions in net income”
Source: FSA Holdings 2007 10-K and Q1’08 10-Q.
81
We Believe that FSA Will Likely Be Forced to Sell
Investment Assets at a Loss to Meet GIC Redemptions
f Events of Default in ABS CDOs underlying
FSA GICs will lead to earlier than
anticipated redemptions
f Slower prepayment speeds on the
collateral backing FSA’s GIC business
reduce cash flows to fund FSA’s GIC
interest payments and early withdrawals
f FSA is dependent upon its ability to issue
new GICs
f FSA has collateral posting and
termination provisions in the event of an
FSA rating downgrade
82
FSA will likely
be forced to sell
assets at a loss
to provide
liquidity for its
GIC business
Realization of
the $4.3bn
unrealized loss
FSA Seeks to Manage Liquidity Risk by “MatchFunding”
“The Company manages this risk through the maintenance of liquid collateral
and liquidity agreements. To minimize the refinancing risk in the FP
Investment Portfolio, bonds in the portfolio are targeted to have shorter
weighted average lives than those of the related funding obligations. While
this investment strategy poses a degree of reinvestment risk, the Company
believes it minimizes liquidity risk. Currently, primarily as a result of slower
prepayment rates of residential mortgage loans underlying bonds in the
portfolio, the weighted average lives of the investments in the portfolio closely
match but are not shorter than those of the related funding obligations.”
–FSA Holdings 2007 10-K
83
How A Match-Funded Business is Supposed to Work
Assets in a match-funded portfolio are targeted to have equal
or shorter weighted-average lives than those of the related
funding obligations
Liability
Maturities
Year 1
Year 2
84
Asset
Maturities
Year 3
Weighted-Average Lives of Liabilities Decreasing
CDO events of default in FSA’s structured finance GIC portfolio
are accelerating GIC withdrawals
FSA Q1’08 Earnings Presentation
85
Weighted-Average Lives of Assets Increasing
In Q1’08, the weighted-average life (WAL) of FSA’s GIC program
investment assets materially increased. This is likely the result of (i) a
decrease in prepayment rates on the underlying collateral and/or (ii)
FSA liquidating its short-dated assets to fund GIC withdrawals
f “In 2007, the weighted average life of the FP Investment Portfolio was
5.3 years”
–FSA Holdings 2007 10-K
f “In the first quarter of 2008, the weighted average expected life of the
FP Investment Portfolio was 6.3 years”
– FSA Holdings Q1’08 10-Q
86
What Happens When Match-Funding No Longer Matches?
Early GIC withdrawals and under-performance of the assets in FSA’s investment
portfolio have created an asset/liability mismatch and liquidity risk. FSA may be
forced to sell illiquid and/or long-dated assets at a loss to meet withdrawals
Liability
Maturities
Asset
Maturities
Liquidity
Risk
Year 1
Year 2
87
Year 3
FSA Mgmt Appears Unconcerned About GIC Liquidity
“As you know, this negative AFS reserve results mainly from three
categories of exposures. The first one is FSA's financial products
portfolio, which amounts to a little more than $19 billion. You see
here a breakdown of this portfolio by credit rating. The credit ratings
are very strong. Here again we are positioned to keep these
commitments until their final maturity. The position of our GICs is
very strong in terms of liquidity, so we will certainly not be in position
to be a forced seller in the market. And the average ratings are very
high, 99.2% of the ratings are above A. However, as we state on the
following slide, some transactions have less robust credit protection
than others, and therefore we cannot exclude that if there is a further
deterioration of the market in the coming quarters there might be
some potential economic losses.”
Dexia Earnings Call – May 14th, 2008
88
Fitch Ratings Is Concerned About FSA’s GIC Liquidity
“While FSA has minimal direct insured exposure to SF CDOs, the company has significant
indirect exposure to this asset class through its GIC program, which could place future
stress on FSA's liquidity resources to the extent the underlying transactions experience
credit deterioration. FSA currently has $10 billion of GIC liabilities tied to credit-linked notes
(CLNs) that provide credit enhancement to ABS structures, of which about $6 billion
pertain directly to higher-risk SF CDOs. Actual credit losses in the underlying transactions
would be expected to result in draws on the CLNs, which would in turn cause FSA to pay
off the related GIC obligations earlier than anticipated.
Fitch notes that the CLN draw, in and of itself does not result in a direct credit loss to FSA.
The actual credit loss is realized by the CLN provider who has deposited funds in an FSA
GIC. However, there is the potential for a substantially higher than expected level of draws
on the CLNs, which could require FSA to liquidate GIC program invested assets, of which
a very high percentage contain subprime RMBS assets that are highly correlated to SF
CDOs. In the current stressed environment, these assets would likely be sold at levels well
below par, and result in realized capital loss upon sale. Such a loss would affect earnings
and reduce FSA's capital and claims-paying resources.”
Fitch Ratings – January 24th, 2008
89
FSA’s “Stress” Liquidity Scenario as of Q3’07
Management’s
Liquidity “Stress”
scenario for its
GIC business as of
Q3’07 suggested
cash on hand
would not dip far
below $1bn
Source: Q3’07 Dexia Earnings Presentation.
90
FSA’s Q1’08 Updated Assumptions Produced the Following
“Stress” Liquidity Scenario
Management’s
Liquidity “Stress”
scenario for its
GIC business as of
Q1’08 suggested
cash on hand
might drop as low
as ~$500mm
Source: Q1’08 FSA Earnings Presentation.
91
FSA’s Assumptions Regarding GIC New Issuance and
Withdrawals are Aggressive in Our Opinion
FSA’s liquidity model assumes that the company will continue to
issue $3.2bn of new GICs per year
Pershing estimates that
more than half of GICs
issued were for ABS CDO
and other SF related GICs.
This market has materially
declined in recent months
FSA Q1’08 Earnings Presentation
92
FSA’s GIC New Issuance Materially Decreased in Q1’08
FSA’s GIC new issuance volume declined more than 90% in Q1’08.
On an annualized basis, this suggests FSA would only be able to
issue $420 million of new GICs over the course of 2008
FSA GIC New Issuance (2007 – Current)
$2,000
$1,600
$1,900
$1,485
$1,401
$1,389
$1,200
$800
$400
$105
$0
Q1'07
________________________________________________
Q2'07
Q3'07
Q4'07
Source: FSA operating supplements. Uses par value of financial products originations as a proxy for historical
GIC new issuance.
93
Q1'08
We Think $3.2bn of GIC New Issuance is an Aggressive
Assumption
f FSA was only able to issue $105 million of total GICs in Q1’08
f According to the Q4’07 operating supplement, FSA originated $6.2bn of GICs in
2007.(1) Of this amount, we estimate more than 60% related to structured finance
and other non-muni GICs, suggesting total muni GIC issuance was no higher
than $2.5bn
f Turmoil in the municipal debt market has reduced current market demand for
GICs
f As the CDO market has dried up, the structured finance GIC CDO market has
also diminished, impairing the company’s ability to issue new structured finance
GICs
f On February 4th, 2008, FSA received a Wells Notice from the SEC regarding
FSA’s involvement in the bidding process for municipal GICs
f On a fair market value basis, FSA’s GIC liabilities are substantially undercollateralized
________________________________________________
(1) Par value of financial products originations as reported in the Q4’07 FSA operating supplement.
94
FSA’s Liquidity Depends Upon the New Issuance of GICs
Reducing FSA’s GIC new issuance volume to $1bn per year
suggests FSA could require billions more of additional liquidity to
fund GIC withdrawals
($ Millions)
$4,000
$2,000
$0
($2,000)
($4,000)
($6,000)
($8,000)
Mar-08
Feb-09
Dec-09
Oct-10
$3.2bn GIC New Issuance
Aug-11
Jun-12
May-13
$1.0bn GIC New Issuance
Note: The $1.0bn GIC New Issuance scenario represents an illustrative adjustment to management’s Q1’08 “Stress” liquidity
scenario. It is calculated by reducing liquidity by $550 million per quarter ($3.2bn less $1.0bn divided by four quarters).
95
What do you call a business that
relies on capital from new investors
to pay off old investors?
Is FSA Triple-A?
~$13.0bn
~$3.3bn
BBB RMBS
~$5.4bn
BIG
HELOCs /
CES
$4.3bn
GIC
Shortfall
10 bps
Selected
Risks
$3.0bn
$0.5bn
Statutory
Capital
Note: Excess capital as implied by Moody’s May 24, 2008 report on FSA.
BIG and BBB ratings estimated from charts shown in FSA’s Q1’08 Earnings Presentation and
97
refer to net par exposures at the insurance subsidiary.
Excess
Capital
(over Moody’s AAA minimum)
Who’s Holding the Bag?
Losses in FSA’s GIC business would most likely be incurred by
municipal GIC holders and FSA policyholders
f Municipal GICs have longer weighted-average lives than
structured finance GICs
f All GIC obligations are guaranteed by FSA’s Insurance
Subsidiary
98
Other Concerns
f FSA’s Wells Notice could pose significant legal liability and diminish
FSA’s new business prospects and ability to participate in the
municipal GIC business
f FSA has significant exposure to other Bond Insurers and reinsurers
В $26bn of par ceded to Radian Asset Assurance
В $13bn of par ceded to Ram Reinsurance
В $1.3bn of FSA Insurance Sub investment portfolio wrapped by
MBIA / Ambac (~23%)
В $8bn of par ceded to XLFA
В $2bn of par ceded to CIFG
f FSA has insured more than $80bn of CDS exposure with MTM
termination rights upon insolvency or regulatory intervention
99
Will Dexia Inject More Capital into FSA?
f What’s the upside?
В Demand for municipal bond insurance is decreasing
В FSA has announced it will be significantly reducing its structured finance
insurance business
 We estimate FSA’s normalized net income from underwriting public
finance to be no more than $200mm, not including losses it might incur on
its current insurance portfolio or GIC business
В In recent years, Bond Insurers have traded at peak multiples of ~12x
forward earnings, suggesting a maximum (base case) value of ~$2.4bn
for FSA as a going-concern
f FSA likely requires more than $2.4bn of capital to fund losses
f We estimate Dexia’s market value has declined more than $2.4bn due to
concerns arising from its ownership of FSA
f Dexia has historically taken a very conservative approach to underwriting risk.
Funding further losses at FSA is inconsistent with this strategy
f Therefore, we do not believe that Dexia will contribute capital to support FSA
100
Q&A
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