MBIA’s $8.1 Billion CDO Squared Bombshell

MarketWatch, Bloomberg, and Reuters, among others, reported on the disclosure by the largest bond guarantor, MBIA, of its exposure to $30.6 billion in “complex mortgage securities.” What was particularly worrisome was that in the total is $8.1 billion of collateralized debt obligations of the particularly risky “CDO squareds” variety, or CDOs of CDOs. Bear in mind that the bond insurer has only $6.5 billion of equity.

The reaction was fast and harsh. The stock price, already battered, fell a further 26%. As Bloomberg reports, the prices on credit default swaps rose sharply:

Credit-default swaps for MBIA soared as much as 145 basis points to 625 basis points, the widest ever, before narrowing to 560 basis points, according to prices from CMA Datavision in London. That means it costs $560,000 a year for an investor to protect $10 million in MBIA bonds from default for five years.

One-year contracts surged to 1,050 basis points, prices from broker Phoenix Partners Group show. That implies investors are pricing in a 20 percent chance of default by March 2009, according to a JPMorgan Chase & Co. valuation tool used by Bloomberg.

Contracts on MBIA’s bond insurer, MBIA Insurance, climbed 58 basis points to 303 basis points after reaching 340 basis points earlier today, CMA prices show. Contracts tied to Ambac rose 13 basis points to 578 basis points, according to CMA.

Standard & Poors had lowered MBIA’s outlook to negative prior to this disclosure. Fitch today said it would reexamine the insurer for a potential downgrade, and gave it four to six weeks to raise $1 billion in capital. Note that while the Warburg Pincus deal would seem to fill the bill, some now feel its completion is in doubt. From Reuters:

The announcement may scuttle MBIA’s $1 billion investment from buyout firm Warburg Pincus LLC WP.UL, according to rating firm Egan-Jones Rating Co. Warburg said on December 10 it would initially invest $500 million by purchasing MBIA shares at $31 each, a move that helped restore some investor confidence and had pushed MBIA shares as high as $37.50 the day the deal was announced.

The agreement between Warburg and MBIA does not have a “material adverse change” clause, or MAC, sources close to the deal said, meaning Warburg cannot cite that as a reason for backing out of the offer.

But with any acquisition, it’s always possible to back out of a deal until it actually closes — even a deal without a MAC clause. Cerberus Capital Management pulled its offer for equipment company United Rentals, citing liability limits in the merger agreement instead of a MAC clause. The two sides are battling in court over the deal.

Bloomberg mentioned that a filing said the pending deal was “deal was contingent on performance-specific covenants and referenced a schedule of undisclosed conditions.”

It’s a no-brainer that Warburg Pincus will try to renegotiate the price, and MBIA does not have a lot of leverage. It needs the money post haste, and so the recourse of going to court is less useful to them than it would ordinarily be.

Analysts generally were critical, although there were exceptions. From Bloomberg:

“We are shocked management withheld this information for as long as it did,” Ken Zerbe, an analyst with Morgan Stanley in New York, wrote in a report yesterday. “MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors.”….

The “eleventh-hour” disclosure by MBIA “ignites concerns all over again about the prospect for future losses,” Kathleen Shanley, an analyst at bond research firm Gimme Credit in Chicago, wrote in a report. She said outside investors didn’t know about the CDOs-squared, which she called the riskiest type of CDO….

“How is confidence expected to return to the capital markets when these types of surprises continue to pop up?” said Peter Plaut, an analyst at New York-based hedge fund manager Sanno Point Capital Management…..

Potential losses from the CDOs-squared are “hardly the kind of hit that should cause severe spread widening or the stock to crash,” Barclays Capital credit analyst Seth Glasser said in a note to clients today. He said the CDOs MBIA disclosed yesterday may be less risky than investors are betting.

The securities industry cannot afford to have MBIA downgraded; the firms already are taking losses on mortgage securities and CDOs independent of any insurer downgrade. If MBIA loses its AAA, that will lead to forced selling by some entities that are required to hold only top-rated paper, which will depress prices further, leading to more writedowns.

I don’t know how it can come about, but expect a deux ex machina for MBIA. Bankers Trust officers told me the Fed played a role in its purchase by DeutscheBank, While there is precedent for regulators lending a helping hand, MBIA is not under the purview of any banking regulator, which raises the question of who might take it upon themselves to orchestrate a solution.