MF! Ackman’s Greatest Short Ever Told Began With Handshake Refused
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By Christine Richard
March 24 (Bloomberg) -- As the taxi pulled away from Grand Central Station on a late November afternoon in 2002, Bill Ackman was bracing for a fight.
The 36-year-old co-founder of a hedge fund firm called Gotham Partners LP in New York had been summoned to a meeting with Jay Brown, the chief executive officer of MBIA. MBIA’s general counsel wouldn’t say what Brown wanted to discuss, but Ackman had a suspicion.
Gotham had placed a bet against the company that could make the fund $2 billion if MBIA filed for bankruptcy. The hedge fund planned to issue a critical research report questioning the bond insurer’s AAA rating. Ackman had described the situation in an October 2002 letter to his investors.
AAA Credit Rating
“Our newest and largest [short] investment is on an extremely highly levered, yet AAA-rated financial institution, which we believe has inadequate reserves, undisclosed credit- quality problems, aggressive accounting and substantial unconsolidated indebtedness contained in off-balance-sheet special-purpose vehicles,” he wrote. The position had the potential to generate a return of about five times the fund’s total assets if it was successful.
Though little known outside of Wall Street circles in 2002, MBIA ranked as one of the five biggest financial institutions in the country in terms of outstanding credit exposure. It shared that distinction with Bank of America Corp., Citigroup Inc. and government-sponsored mortgage lenders Fannie Mae and Freddie Mac.
Using its AAA credit rating, Armonk, New York-based MBIA had turned almost half a trillion dollars of securities into investments that rating companies apparently considered as safe as U.S. Treasuries. Bonds issued by a water and sewer authority in Mississippi, debt backed by loans on used cars to people with a history of not paying their bills and complex pools of derivatives held by a shell company in the Cayman Islands all became top-rated securities under the Midas touch of an MBIA guarantee.
High Leverage
Moody’s Investors Service, Standard & Poor’s and Fitch Ratings all assigned MBIA’s bond-insurance unit AAA or Aaa ratings. The credit-rating companies were the only ones outside of MBIA that supposedly knew everything the company had insured. Using computer models and historical default data, analysts at the rating companies had determined that MBIA could weather another Great Depression and still meet all of its claims.
Ackman wasn’t convinced.
MBIA held just $1 of capital for every $140 of debt it guaranteed. Although the company claimed it underwrote risk to a so-called “zero-loss” standard, its past performance hadn’t been free from error. The high leverage meant MBIA had virtually no margin of safety.
The company’s underwriting, transparency, accounting and track record all had to be beyond reproach. Ackman thought he saw problems with every one of these issues.
Credit Default Swaps
Ackman co-founded Gotham Partners in 1993 with one of his former Harvard Business School classmates, David Berkowitz, who had worked as an engineer. The duo increased the hedge fund’s assets from $3 million to more than $350 million by 2001.
The firm sought out companies with securities that were mispriced or misunderstood by the market. In MBIA’s case, the market believed in the permanence of the company’s AAA rating. If it hadn’t, then the bond insurer’s ability to write new business would have disappeared overnight.
Ackman had placed his bet against MBIA principally in the credit-default-swap market. Credit-default swaps, or CDS contracts, are derivatives that allow parties to buy and sell protection against a default on a security. The contracts are essentially life insurance policies on companies. The protection buyer -- in Wall Street parlance -- makes regular payments over the life of the contract to the protection seller, who promises to make a lump sum payment to the insurance buyer if a security defaults.
Shorting Stock
The cost of the insurance rises and falls minute by minute based on the market’s perception of the company’s credit quality. Default protection on a company with an AAA rating, which MBIA had in 2002, could be purchased cheaply because the market believed the chance of default was very low.
Ackman was not seeking protection against MBIA filing for bankruptcy; he was betting that the chance of the company defaulting on its bonds was more likely than the market believed. In addition to shorting tens of millions of dollars of MBIA stock, Ackman bought protection against a default on $2 billion worth of MBIA debt.
He had also set up two additional funds, Gotham Credit Partners I and IA, to hold only CDS contracts on MBIA. Investors in these funds could earn nearly 40 times their money if MBIA filed for bankruptcy. Of course, investors would lose their entire investment if perceptions about MBIA’s AAA rating remained unchanged and unchallenged.
Toro Tuna
Ackman’s bet was spectacularly contrarian. He was wagering on the collapse of a company that the rating companies had awarded their highest AAA rating and that everyone else was counting on.
Before his meeting with MBIA’s CEO, Ackman had lunch with Michael Ovitz, the founder of Hollywood’s Creative Artists Agency and a longtime investor in his fund. As they worked their way through six different versions of toro, the Japanese fatty tuna delicacy, Ackman asked Ovitz’s advice about the upcoming meeting with Brown.
“It sounds like a very Japanese meeting,” Ovitz said. In other words, he said, “Just shut up and listen.”
Ackman’s taxi stopped on Third Avenue outside the building where MBIA’s attorneys, Debevoise & Plimpton LLP, have their offices. Together with Gotham’s general counsel, David Klafter, and one of the firm’s analysts, Greg Lyss, Ackman headed for the security desk in the lobby.
The group was sent upstairs, where Ackman told the receptionist they were there for the meeting with Jay Brown. She pointed Ackman toward a closed conference room door just behind the reception desk.
Jay Brown
Opening it, he found Brown seated at a conference table with a dozen other men. The conversation in the room came to an abrupt halt.
“I’m Bill Ackman. I’m here to--”
“Wrong meeting,” one man said as he jumped up to close the door. Ackman returned to the reception area, convinced he’d just interrupted a tired and frazzled-looking Brown in a meeting with his crisis-management team. The Gotham group was shown to another conference room and told to wait.
Fifteen minutes later, Brown joined them with MBIA’s general counsel, Ram Wertheim, whose first question to the Gotham group was whether it planned to record the meeting. Ackman told him no, then asked Wertheim whether he and Brown planned on recording. They did not, Wertheim said.
Brown got to the point. He had been in the insurance industry for years, and no one had ever questioned his reputation, Ackman remembers Brown saying.
‘Friends in High Places’
“No one has ever gone to my regulators without my permission.”
Ackman asked Brown whether he disputed any of the assertions Ackman had made about MBIA. Brown was aware of the issues in Ackman’s report from questions he had received from a Wall Street equity analyst with whom Ackman had shared his findings.
“This isn’t about the facts; it’s about process,” Ackman recalls Brown saying. “You’re a young guy, early in your career. You should think long and hard before issuing the report. We are the largest guarantor of New York state and New York City bonds. In fact, we’re the largest guarantor of municipal debt in the country. Let’s put it this way: We have friends in high places.”
In a follow-up letter to Ackman after the meeting, Wertheim reminded Gotham what was at stake.
Comparison to Enron
“MBIA is a regulated insurance company that operates in a regulated environment and acts in a fiduciary capacity for the benefit of our many constituencies. ... MBIA’s credibility and reputation in the market, and its AAA ratings, are critical to our continued ability to service these constituencies.”
In the meeting, Brown compared Gotham to Enron Corp., which had been accused of manipulating the California electricity market. Was Gotham seeking to manipulate perceptions about a regulated insurance company by taking positions in the unregulated CDS market? Brown also asked Ackman how long Gotham planned to hold its CDS position on MBIA.
Ackman explained that for the hedge fund to make money on its CDS position, it was going to have to be correct in its criticism of MBIA. Ackman told Brown that the CDS market was not liquid enough for Gotham to easily trade in and out of such a huge position.
Wertheim asked to see a copy of Gotham’s report before it was published so MBIA could check Gotham’s facts. Ackman countered that it was considered inappropriate for analysts to give advance copies of research reports to companies but again offered to discuss any findings at the meeting.
Rejected Handshake
The meeting ended abruptly. As the men filed out of the room, Ackman reached out to shake Brown’s hand.
“I don’t think so,” Brown said, refusing to extend his hand.
Confidence Game is available in stores in May. Bloomberg Press is an imprint of John Wiley & Sons Inc. Excerpted with permission. Copyright © 2010 by Christine Richard.
To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net
Last Updated: March 24, 2010 00:00 EDT
