More MBIA Research: Spending some time listening to Jay Brown and friends

A couple of weeks ago I posted my original investigation into the business of MBIA Inc (MBI).  Over the two weeks since I have tried to better understand the business by reading or listening to every MBIA conference call from the last 4 years.  My bike rides, lunch hours, and early morning coffees have been spent  listening to or reading CEO Jay Brown and his management team provide their quarterly updates on MBIA.  In total I have went through 14 conference calls from start to finish (as an aside, if anyone knows of a good program that will turn streaming media files into mp3 files please let me know – having conference calls iPod-able makes them so much easier to listen to).  I have also read in whole or in part through the last 3 10-Qs and the last years 10-K.

By going through all of this information the conference calls I was hoping to answer 4 questions:

1. What exactly it is that MBIA has insured
2. The progress that MBIA has made on reducing what they have insured
3. The probability that the lawsuits against and for MBIA will settle in their favor
4. Whether or not, having bought MBIA, I have made a terrible mistake

I’m going to try to answer all of these questions in this post.

What MBIA has insured and how they making progress getting out of it

If I was going to label the conference calls from 2008 to present with a theme, it would be one of opportunistic deleveraging.  Slowly but surely MBIA has been able to reduce their exposure to the future default of the structured financial products that they had insured and that have since blown up.

These structure financial products can be broken up into 4 categories:

1. First Lien Residential Mortgage Backed Securities (RMBS)
2. Second Lien RMBS
3. Collateralized Debt Obligations (CDO’s) and CDO Squared
4. Commercial Mortgage Backed Securities (CMBS)

First Lien RMBS

First Lien RMBS has had very little in the way of problems and very little in the way of loss reserves or payouts.  MBIA generally insured the triple A tranches of each first lien RMBS.  So in effect if you took a bucket of 1000 mortgages, MBIA would begin to pay out insurance after the best 400-500 of those mortgages defaulted.  Being first lien, the underlying loans tended not to be of the exotic types that have suffered so greatly in the past few years.  Even with the problems that the housing market has had, that insurance has not been called upon and it remains unlikely it will be.

Second Lien RMBS

Second Lien RMBS are securities full of loans of the more exotic type, and they have been the source of much consternation for MBIA.  The second lien RMBS securities consist mostly of home equity line of credits (HELOC’s) and closed end second portfolios.  These securities were full of loans mostly originated by Countrywide, Rescap and IndyMac.  Of those three, Countrywide was “by far” the largest originator.

All three of these lenders are well known for their less than scrupulous tactics during the boom.  And thus it is that most (if not all?) of the defaulted second lien RMBS securities that MBIA is now paying out insurance on are subject to the put-back litigation.

So why can MBIA cry foul?  Basically, when MBIA and the originators created the terms of the insurance, it was with the expectation that the loans were of a certain quality, met certain criteria, and that, most importantly, that the documentation for each loan was correct and accurate.  On the Q2 2009 call MBIA defined a breach in these terms:

An example of a credit breach would be a loan that exceeds the debt to income or combined loan to value ratio guidelines for the relevant program. Compliance breaches would be things like missing good faith estimates or Reg Z forms in the files.

The terms of the insurance contract stated that MBIA did not have to review each individual loan.  Instead they could rely on the originators representations and warranties that the loans were on the up and up.  Of course, as it turns out many of the loans were not on the up and up and so now MBIA is in a position to litigate against the breach of the contract.

Once the securitizations began to default, MBIA began to review the loans that made them up.  And as soon as MBIA began to review the loans, they found breaches to be endemic, and they began to put-back the loans on the originators.  On the second quarter 2009 conference call (available on Seeking Alpha) the company said that:

Our loan level forensic review experts have re-underwritten nearly 24,000 loan files from 24 securitizations originated by four seller/servicers and they’ve found that over 18,000 had serious breaches of risks and warranties.

Until just recently (when a court ruling deemed further review no longer necessary, more on this later), MBIA has reviewed more loans each quarter and with that increased the size of the put-back litigation.  The last time that MBIA put a number to the loans that were in breach was the second quarter of 2010, when they said that “sometimes as low as 75% and some cases as high as 90% of the loans in the securitization are in violation of reps and warranties”.

Once MBIA began to initiate court proceedings they became more tight-lipped about quoting individual loan volumes that were being put-back.   However they did continue to provide an estimate of total the loan balance being put back as well as the booked recovery.  The latest estimate, from the Q1 2012 call, was that $4.8B worth of loans had been put-back on originators and were now the subject of the legal battle.  Of that $4.8B, MBIA has booked an expected $3.2B in recoveries from the litigation (I’ll provide some more detail on this a little later on).

It should be pointed out that all along MBIA has been paying out  insurance on these defaulted second lien RMBS securities.  Most of the $3.2B in expected recoveries relate to cash that MBIA has paid out to investors on the securities.  Another aspect of the insurance contracts is that MBIA has to pay out the cash regardless of whether there was a misrepresentation or not.  The terms specify that it is up to MBIA to recover money paid out on breached loans directly from the originator.  Of course this is exactly what they are trying to do.

When I thought about the MBIA put-back case with this in mind, it began to see the very strong position that MBIA is in.  This isn’t some claim of damages due to missed opportunity.   This is about real dollars that MBIA has paid out as they have held up their end of the bargain on the insurance contracts they agreed to.   And now they want the originators to come clean in cases where they didn’t hold up their end.  MBIA wants their money back.

That there was massive fraud in the years leading up to the mortgage crisis in 2008 does not seem to be very much in doubt.  The terms of the insurance state clearly that MBIA was relying on the originators to insure that the loans being put into the securitizations were legitimate.  MBIA has been paying out money on these securities since most of them have defaulted.  That MBIA is entitled to get its money back seems like a no-brainer.

CDO and CDO Squared

MBIA insured 3 different types of CDO’s.  There was CMBS CDO exposure, which were CDO’s made up of commercial mortgage backed securities the multi-sector CDO exposure, which were CDO’s made up of a whole range of whole loans, RMBS and CMBS, and there was CDO squared exposure, which were CDO’s that were made up of other CDO’s .

As you can imagine, when the bankers had drained the swamp to the point where they were making CDO’s of CDO’s, the sludge in the bottom was quite toxic. As such, the CDO squared positions were the first to blow up and the first to be mitigated.  But that was soon  to be followed by the multi-sector and plain vanilla CMBS flavors.

In each of these cases MBIA has reduced the exposure in two ways: by commutations (basically paying a fee up front to have the insurance annulled), and where applicable by put-back litigation.

Commutations are a fancy word for saying that MBIA gave the insuree some money up front in exchange for not having to pay if the security blew up later.  The costs of doing so aren’t cheap, but they generally are done at a significant discount to the actual cost of insuring the security if it does fail.  MBIA also may have benefited in its commutation negotiations earlier on in 2009-10 because some of the counter-parties looked at MBIA’s insurance at risk and then looked at the economy and said we should probably take something while we can still get it.

MBIA has talked regularly about the volume of commutations that they have done.  The amounts are significant.  With respect to the CDO squared positions, they have been reduced from over $10B at the beginning of 2008 to nothing as of the end of the year 2011.  Multi-sector CDO’s, which are basically securities that could have everything and anything in them (think the Gramercy Capital CDO’s that I analyzed in some detail as an example of a multi-sector CDO) have seen exposure reduced from $25B to $6B.  Commercial Real Estate CDO’s have gone down from $13B to a little over $5B.

MBIA hasn’t talked specifically about the CDO put-backs for quite some time.  The last time they did, which was the Q4 2009 call, they said the amount under litigation was significant:

For the CDO related litigation the amount at stake represents a significant portion of the $2.5 billion of present value of ultimate incurred loss that we are estimating for our CDO portfolio.

What’s not very clear is how much of the $3.1B in booked recoveries is related to CDO breaches.  It may not be that much, because interestingly, while a significant amount of reserves have been booked against the remaining CDO portfolio, there has yet to be a payout from the default of any of the (remaining and as of yet not commuted) CDO’s.

Commercial Mortgage Backed Securities (CMBS)

The CMBS portfolio was a bit of a laggard in terms of generating losses for MBIA Corp, but it has made the best of its potential to play catch up.  Commercial mortgages didn’t fall apart until late 2009 because, unlike residential mortgages, they weren’t so much in a bubble or being held up by out-and-out fraud but instead they went south for the good, old fashioned reason that the economy tanked.  MBIA Corp has been reserving against losses on its CMBS insurance since about that time.  As late as the second quarter of 2011 the company said:

At this point in time, we would say 2/3 to 3/4 of the remaining volatility in our balance sheet centers around CMBS reserves.

Since that time the losses in CMBS have continued to mount.  In particular, Q1 2012 saw a big increase to CMBS reserves, but it wasn’t because of further deterioration to the loan book.   Just like with the CDO exposure, MBIA has been reducing its CMBS exposure through commutations.  In the first quarter 2012 conference call the company said the following:

Losses for commercial real estate transactions this quarter were $296 million. About $60 million of that incurred loss on CMBS was driven by deterioration in the small number of remaining transactions. The balance reflects cost of commutations executed or agreed to that were in excess of the year-end 2011 reserve levels. In aggregate, we’ve commuted or agreed to commute $11.5 billion of exposure since January 1.

As I already said, commutations aren’t cheap, particularly now that MBIA solvency is not of such immediate concern.   The commutations on CMBS are costing more than was initially anticipated, thus the bigger hit to the reserves.

But while the commutations have cost a few pennies, they have also taken the most dangerous loans off the books.  If you look at MBIA’s disclosures as of December 31st, total CMBS exposure was about $18B.  Of that amount, only $6B was BBB rate or lower.  The rest was higher rated collateral that should be less susceptible to default.  That they have since commuted $11.5B of exposure suggests that most of the commutations are behind them and that most of the most volatile loans are now off the books.

On to the Lawsuits…

Meanwhile, the court cases drag on.  Likely the next case to get a significant ruling will be the transformation case.  To refresh on what I already touched on in my previous post, in early 2008 MBIA Inc. made efforts to transform itself into two legally independent entities.  One entity (MBIA Corp and please be careful to remember that this is MBIA Corp while the parent is MBIA Inc.) would handle all of the structured finance insurance (as well as the asset management business) while the other (National) would handle the municipal insurance.

A number of banks took issue with the transformation, purportedly because they were concerned about the solvency of MBIA Corp and its ability to pay its claims, but more realistically because they saw the massive put-backs that MBIA was about to shuffle on back to them and they wanted leverage to counter that litigation.

Sure enough, slowly the number of banks has dwindled down as MBIA has settled its put-back settlements with the banks, to the point today where the case is being made by two banks: Bank of America and Societe Generale.  Bank of America is the ringleader here, which is not surprising since Bank of America has the most to lose from a successful put-back of Countrywide loans.

The transformation case has gone through its hearings and is expected to be ruled upon by the judge by August (for an excellent synopsis of the hearings, go here).  It turns out that the case will not go to a full trial, because as per the New York state law the hearing is intended to be “expeditious”, with a judge only hearing and ruling.  Given that the process started back in 2009 I might question the validity of the term.   Nevertheless, the trial/hearing has come to an end.  Not that we should expect this to be the last round.  As Alison Frankel, who has been covering the case in her column “News and Insights” has pointed out, regardless of the ruling it is almost assured that the case will go to appeal.

So far, however, what has occurred has been mostly in the favor of MBIA.  That there were no witnesses called during the hearings, with the judge instead relying on documents and transcripts, has to be seen as a positive for MBIA.   If the judge really felt that there were questions of fact, she would have wanted to hear from the various regulators in charge of the case.

Also in MBIA’s favor was Bank of America’s failed attempt to change the question at hand.   The subject of the trial is to be whether the New York Insurance Department (NYID – the regulator that approved the transaction) acted in an “arbitrary and capricious” manner.  Bank of America appears to have made numerous attempts to change that focus  to one of whether MBIA “deceived” the NYID by not providing them with all and/or accurate information about the financial state of MBIA Corp and National post split.  Well the judge nixed that attempt, leaving only at question whether the regulators were openly negligent in their decision.

Everything I read about this case suggests to me that MBIA should win it.  Consider that MBIA initiated the process of transformation in early 2008 and it was decided upon well before the collapse of Lehman.  I don’t think that anyone (aside from perhaps a few rogue traders like Michael Burry, Kyle Bass and Steve Eisman) was anticipating the eventual collapse that was occurring in the housing market.  The general consensus (which was albeit based on the flawed assumptions and misinformed opinion) was that housing might decline gently or stabilize soon.  Bank of America itself was buying Countrywide in early 2008 in hopes of having a coup when the housing market recovered.   Hell, even Bernanke was asaying he saw the sky clearing up ahead, what with sub-prime contained and all.  I think that to make the case that the NYID acted in a manner that was “arbitrary and capricious” you would have to go down a rather imaginary road that assumed that they, and they alone,  knew what was coming before anyone else did.   And I simply don’t see how that flies.

Also, the whole case wreaks of such cynicism that I can’t imagine the judge is not plugging her nose just a little at it.  The question of the solvency or insolvency of MBIA Corp is directly related to the fraudulent mortgages that they insured that were (I’ll be darned) originated by Bank of America themselves (through its Countrywide subsidiary).  Does this not seem a bit disingenuous?   Had it not been for the breaches of reps and warranties, MBIA Corp would quite possibly be in quite a solid financial position.  You might not even need to have a transformation at all.

The Put-back Cases

MBIA has put-back cases in various states of proceedings against a number of the largest originators.  The company has litigation against Bank of America, Residential Funding Company (Rescap).  The first of the put-backs likely to be settled, and also by far the biggest of the bunch, is the case against Countrywide and Bank of America.

In the last 10-Q MBIA presented a 10 point summary of why they feel confident about the outcome of the put-back case:

1. the strength of the Company’s existing contract claims related to ineligible loan substitution/repurchase obligations;
2. the settlement for $1.1 billion of Assured Guaranty’s put-back related claims with Bank of America in April 2011;
3. the improvement in the financial strength of the sellers/servicers due to mergers and acquisitions and/or government assistance, which should facilitate their ability to comply with required loan repurchase/substitution obligations. The Company is not aware of any provisions that explicitly preclude or limit the successors’ obligations to honor the obligations of the original sponsor. The Company’s assessment of any credit risk associated with these sponsors (or their successors) is reflected in the Company’s probability-weighted potential recovery scenarios;
4. evidence of loan repurchase/substitution compliance by sellers/servicers for put-back requests made by other harmed parties with respect to ineligible loans; this factor is further enhanced by (i) Bank of America’s disclosure that it has resolved $8.0 billion of repurchase requests in the fourth quarter of 2010; (ii) the Fannie Mae settlements with Ally Bank announced on December 23, 2010 and with Bank of America (which also involved Freddie Mac) announced on December 31, 2010, and (iii) the Company’s settlement agreements entered into on July 16, 2010 and December 13, 2011 respectively, between MBIA Corp. and sponsors of certain MBIA Corp.-insured mortgage loan securitizations in which the Company received consideration in exchange for a release relating to its representation and warranty claims against the sponsor. These settlements resolved all of MBIA’s representation and warranty claims against the sponsors on mutually beneficial terms and in aggregate were slightly more than the recoveries previously recorded by the Company related to these exposures;
5. the favorable outcome for MBIA on defendants’ motions to dismiss in the litigations discussed above, where the respective courts allowed MBIA’s contract and fraud claims against the defendants to proceed;
6. the favorable outcome in the Countrywide litigation on MBIA’s motion to present evidence of liability and damages through the introduction of statistically valid random samples of loans rather than on a loan-by-loan basis;
7. the favorable outcome in the Countrywide litigation denying Bank of America’s motion to dismiss MBIA’s claims for successor liability as well as a decision from the New York Supreme Court Appellate Division, First Department, which lifted the stay on discovery related to successor liability claims at Bank of America;
8. the favorable outcome in the Countrywide litigation on MBIA’s motion regarding causation and MBIA’s right to rescissory damages;
9. the unanimous ruling from the New York Supreme Court Appellate Division, First Department, in the Countrywide litigation allowing MBIA to pursue its fraud claims; and
10. loan repurchase reserves and/or settlements which have been publicly disclosed by certain sellers/servicers to cover such obligations.

Its worth noting all the “favorable outcomes” on the list.  Almost all of the decisions thus far have sided with MBIA.  The most recent decision that affirmed the position of MBIA was a ruling in favor of Syncora, in a case against the former MBS origination wing of Bear Stearns.

“…on every other point, the federal judge sided with Syncora and its lawyers at Patterson Belknap Webb & Tyler, and in ways that may protect Syncora when the state appeals court reviews Bransten’s ruling in the Countrywide case. Bransten began her analysis with the insurance contracts between the monolines and Countrywide, concluding that under state insurance law the bond insurers simply had to show that Countrywide misstated the risk profile of the underlying mortgage pool when it induced MBIA and Syncora to insure the mortgage-backed notes. She declined, however, to grant summary judgment to Syncora and MBIA on the broader question of whether Countrywide breached MBS servicing agreements — as opposed to insurance contracts — merely by misrepresenting the quality of the underlying loans, or whether insurers (and, by extension, investors) could only assert put-back demands for defaulted loans.”

As I briefly mentioned earlier, up until recently MBIA had been stepping through securities on a loan by loan basis, looking for breaches that would allow them to put back the securities on the originator.  Not any more.  Another recent decision concluded that MBIA will not be forced to investigate each loan individually to determine whether it was in breach or not, instead being able to rely on statistical sampling.  According to the last 10-Q

Legal decisions have led the Company to conclude that the practice of reviewing individual loans for the purpose of assessing put-back recoveries is no longer necessary. The Company determined in the context of the favorable decision on its motion in limine addressing the use of sampling to establish breach-of-contract claims in the Countrywide litigation (MBIA Insurance Corp. v. Countrywide Home Loans, Inc., et al, Index No. 602825/08 (N.Y. Sup. Ct.)) that a sufficient number of loans in each securitization have already been reviewed to demonstrate widespread breaches of the contractual provisions of the agreements with the sponsors. Furthermore, MBIA has received subsequent opinions which have confirmed that the Company is not limited to a loan-by-loan put-back remedy and can seek a pool-wide remedy based on sampling and extrapolation, as well as decisions in MBIA’s favor related to causation and rescissory damages.

As I already mentioned, the outcome of the put-back litigation will essentially determine whether there is value in MBIA Corp (the financial structuring wing) or not.  If the outcome is favorable, the value is not inconsequential.  Below is the adjusted book value of MBIA Corp.   Adjusted Book Value accounts for all expected loss payments by MBIA, all expected premium receivables, and most importantly, the $3.1B that MBIA thinks it has coming back to them from litigation.

Like the transformation case, the put-back case looks strong for MBIA.  The rulings thus far have narrowed the banks ability to deflect the blame or limit the scope.  In addition to the above rulings, perhaps the biggest win for MBIA was the court decision that in order to put-back loans MBIA only had to show that the loan was breach, and not that the breach was responsible for the default.   MBIA had found billions of dollars of breached loans within months of beginning their investigative process, and the tone of management on the conference calls was always one of confidence and to a large extent dismay when they spoke of the scale of the fraud that they were uncovering.

A terrible mistake?

I don’t think so.  In fact just the opposite.

I wish that MBIA had not risen so soon after I first discovered the idea.  I would have liked to have a larger position.  As it is, the stock accounts for about 4% of my portfolio.  While I had originally hoped for a move back down to the single digits, I now think I would be inclined to buy more if it dipped to even the low 10’s.

Both the put-back case and the transformation case are winding down and we should not have more than 6 months before we see some significant rulings on both cases.  I have to think we will see a settlement with Bank of America before it goes that far. I just can’t see Bank of America stringing this out, the risk of a ruling that puts into question the much larger

A settlement in the $3B range would leave MBIA Corp with an adjusted book value of around $14 per share.  National has an adjusted book of $20 per share.  Netting out holding company debt and you are left with a valuation of the holding company of above $30.

What’s more, that valuation is looking strictly in the rear view mirror.  Considering only the premiums earned and the expected claims paid.  There is nothing in the valuation about new insurance written.  If MBIA begins to write municipal insurance again what is the stock worth then?  How about if they can get themselves back into some of the simpler first lien RMBS under-writings?  I hesitate to put a number to the eventual value of the company, but suffice to say that I think the upside potential is tremendous.