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A Lack of Rigor Costs MBIA

Floyd Norris

MBIA, the financial insurance company, used to hold itself out as a paragon of hard work and number crunching.


“Each transaction guaranteed by MBIA needs to pass a rigorous underwriting process proving no losses will arise under the worst probable case scenario,” the company said in a typical investor presentation just three years ago.

It added that its payouts for claims over 32 years came to less than $10,000 a year for every $100 million of insurance it wrote.

“We expect,” the company added, “to remain at that level or better.”

That expectation was wrong. MBIA’s once pristine AAA-rating has now turned into junk and no one wants to buy insurance from the company.

MBIA insists it is in much better shape than investors realize, but in making that case it assumes it will be able to collect at least $1.2 billion from Wall Street firms that it says swindled it. If it were to win all its pending suits, it could collect billions more.

MBIA is suing Merrill Lynch, which paid MBIA to insure securities backed by extraordinarily complex securities, among them collateralized debt obligations secured by collateralized debt obligations secured by collateralized debt obligations that were secured by mortgage-backed securities. Such a thing is known as a C.D.O. cubed, by the way.

In the suit, filed in state court in New York, MBIA details its underwriting process, which does not sound very rigorous.

“The due diligence standard for a monoline insurer, which MBIA followed,” did not involve looking into the quality of the securities underlying the securities being insured, MBIA said in its suit. Instead, it primarily relied on assurances by Merrill Lynch and on credit ratings by Moody’s and Standard & Poor’s.

And, MBIA added, Merrill knew that the rating agencies also would not bother to look at the performance of the underlying loans in issuing their ratings.

When I asked MBIA officials this week if they also understood that the rating agencies were not looking at the underlying loans, I got no answer, only a statement that the company could not discuss pending litigation.

In any case, MBIA argues, Merrill knew that MBIA could not afford to do much research, and took advantage of it by lying about things that it knew no one would check. “It would be enormously expensive, even if it were logistically feasible, for a credit insurer to investigate the health of these ground-level loans,” MBIA argued in a court filing, adding that if it did such research, it would have to charge much higher premiums. MBIA said its premiums were as low as $77,500 for each $100 million of insurance.

In other suits, MBIA claims that mortgage issuers like Countrywide and IndyMac lied to it by claiming they were making loans based on strict underwriting criteria, when in fact they were not. It wants Bank of America , which took over Countrywide, and the Federal Deposit Insurance Corporation, which closed IndyMac, to buy back mortgage loans that have defaulted.

Long after it wrote the insurance on those mortgage-backed securities, MBIA says it began to study the files of second-mortgage loans that had defaulted. It was clear from looking at the application files that more than 90 percent of the Countrywide loans had been improperly granted, and even more of the IndyMac loans clearly failed to meet the stated underwriting criteria.

MBIA claims it had no way to check such things before it wrote the insurance, and properly relied on assurances by the mortgage companies. By early 2007, MBIA was issuing insurance for hundreds of millions of dollars worth of mortgage securities within less than two weeks of first being told of the pending transaction. There was no time to do any real due diligence.

The defendants in the suits have denied doing anything wrong, and the cases are a long way from trial. But MBIA’s allegations raise an interesting question: How much of this mess could have been averted if everyone — from the companies that made mortgage loans to the rating firms to the monoline insurers — had been less trusting?

Or if they wanted to keep being so trusting, would it not have been nice if they had admitted they were doing so little work? Perhaps MBIA should have changed the word “rigorous” to “virtually nonexistent” in describing its underwriting process.

This week MBIA reported a third-quarter loss, disappointing some investors, and the stock slipped below $4. The company still says its “adjusted book value” is more than $39 a share, but it is clear that investors do not believe it.

To get to that figure, MBIA makes some interesting assumptions. Most prominent is the belief that current market prices for many assets are far below their intrinsic value. In other words, it assumes the market is very wrong. If that is correct, then MBIA will not have to pay nearly as much as some expect to honor its guarantees, and it will be worth a lot more than its current stock price would indicate.

Back when MBIA was flying high, its business model was essentially that the municipal bond market was wildly inefficient. For its product to be valuable, issuers had to be able to borrow for a rate low enough to more than offset the insurance premiums they were paying. By telling investors that it expected virtually no claims, MBIA was saying that it was selling insurance that was not really needed.

For many years, that seemed to work with municipal bonds. Investors in such bonds got comfort, and MBIA got profits. But the company’s expansion into structured finance proved to be disastrous.

Perhaps the problem was a simple one of economics: MBIA could sell the insurance only if it charged premiums so low that they assumed almost no chance of default, and allowed for little if any real due diligence to determine the actual risks.

It did not work.

“Since the fourth quarter of 2007, MBIA Corp. made $4.4 billion of cash payments” related to the types of securities covered in its suits, the company reported in a filing with the Securities and Exchange Commission this week. “As a result of the current economic stress, MBIA could incur additional payment obligations beyond these mortgage-related exposures, which may be substantial, increasing the stress on MBIA Corp.’s liquidity.”

For now, at least, MBIA can write no new insurance because its guarantee is not worth very much. It still collects premiums on old insurance, and the $39-a-share book value reflects the expectation that premiums on those policies will keep rolling in for many years.

The company has reorganized, separating its muni bond business from the rest, in the hope that it can eventually start selling muni insurance again. But the split is a messy one, being challenged in court by banks fearing that it could undermine the company’s ability to pay claims on the structured finance products.

If MBIA’s current models forecasting losses are even close to being right, the company is probably worth more than its current share price would indicate. But given the history, it is easy to see why investors are no longer willing to trust an insurer that did not bother to do any real investigation of the risks it was insuring.