Almost everyone was certain that bond insurers had found one of those safe places. As 2006 drew to a close, Ackman wrote to his investors: “MBIA is, by a large margin, our largest loser for the year.”
“Let’s hold off on more [credit-default swap] purchases,” Ackman wrote to Erika Kreyssig, the Pershing Square trader, in an e-mail in late 2006. “We are big enough in MBIA so that if it works, we will be happy.”
When Ackman wrote to investors in the early spring of 2007, he had never been more enthusiastic about the fund’s MBIA position. “For some time, I have believed that our investment in MBIA credit-default swaps offers the most attractive risk/reward ratio of any investment I have come across in my investment career,” Ackman wrote in a March 5, 2007, letter to investors. It cost the fund about $10 million a year to have a bet on MBIA in the credit-default-swap market. The potential payout in the event MBIA filed for bankruptcy was $2.5 billion.
“The price of CDS on MBIA today continues to imply that the market assesses the probability of the company defaulting to be nominal,’’ Ackman wrote. ‘‘We believe otherwise.”
On the same day, Ackman sent an e-mail to his investment team: “I think we should short some Ambac.” He had been reading Ambac Financial Group’s 10-K filing, and the second-largest bond insurer had “larger mortgage-backed securities and home-equity exposure than MBIA, at around $60-plus billion, or approximately 10 times share- holders’ equity.”
During the last week of July, Gerald Russello, the former lead investigator in the Securities and Exchange Commission (SEC) probe of MBIA, e-mailed Ackman a copy of an article headlined “MBIA Independent Review Finds No Wrongdoing.”
“I have lost confidence in the SEC,” Ackman replied.
When Ackman met again with the SEC later that summer, he lost his temper and told the government attorneys, “This company will implode, it will take the global capital markets with it, and you could have prevented it.”
The group took seats around a conference table and Ackman delivered the “Who’s Holding the Bag?” presentation he had given at the Ira Sohn Investment Conference in May. He described how the incentives to securitize and sell mortgages created enormous moral hazard in the mortgage market, how faulty structures allowed billions of dollars of doomed securities to be built out of the riskiest parts of bonds, and how small losses on $100 billion portfolios of collateralized-debt obligations (CDOs) could wipe out a bond insurer’s entire capital base.
Ackman argued. “There’s a huge crisis on the horizon, and it’s going to come sooner than you think,” he told the assembled group.
When the Pershing Square group got back to the office, others at the fund were eager to hear how things went. “Everybody would pile into Bill’s office for a recounting of events,” McGuire remembers. It was more than an investment-team event. Everyone was eager to hear about it: the investor-relations group, the traders, the tech guys, the assistants. “People appreciated the position, its significance to the firm and to Bill personally.”
“It was an incredible meeting,” Ackman told the group. Regulators were going to see that MBIA shouldn’t be taking any more money out of its insurance unit because policyholders are in jeopardy. “They’re toast,” Ackman concluded of MBIA.
Eventually, one of Ackman’s phrases for describing the success of his MBIA meetings was adopted around the office as shorthand for Ackman’s optimism. “Bill’s meeting? Ten out of ten?” “Yep. Ten out of ten.”
Ackman wrote to Pershing Square investors the same day: “In 2006, our short position in MBIA’s stock and our investment in credit-default swaps were a source of significant mark-to-market losses,” Ackman said. “We have more than recouped our previous mark-to-market losses on this investment.” Investors seeking to protect $10 million of MBIA debt against default for five years would have agreed to pay $16,000 a year in premiums on the day MBIA announced its settlement with regulators in January. That same insurance now cost $250,000 a year. “We believe that we are still in the early innings,” Ackman wrote.
As the summer drew to a close, Ackman attended the U.S. Open as a guest of JPMorgan. He made his way through the crowd at the Arthur Ashe Stadium in Flushing Meadows to the bank’s court-side suite. Inside, JPMorgan CEO Jamie Dimon and his wife chatted with guests. Dimon shook Ackman’s hand and mentioned that he’d seen the “Who’s Holding the Bag?” presentation. “Very interesting,” he told Ackman.
“Make sure you don’t have any bond-insurer exposure,” Ackman told Dimon as the matches played on.
By November 2, CDS rates jumped to $470,000; one day later, the cost stood at $510,000.
On November 28, 2007, Ackman took the stage at the Value Investors Conference in Manhattan.
For the first time, Ackman had hired security guards to accompany him to a presentation. Many people believed Ackman was fanning a dangerous fire with his criticism of the bond insurers. During a Barclay’s Capital conference call on the financial guarantors earlier in the month, one caller prefaced his question by stating that he believed those writing and speaking negatively about the bond insurers were “financial terrorists.”
For years Ackman had asked regulators, reporters, and just about everyone he spoke to about MBIA to see no contradiction in shorting a company and being a decent person. It is an idea that many people simply can’t accept.
When Ackman had testified at the Securities and Exchange Commission in 2003, this issue of doing good by short selling had come up. Ackman had said it was one reason he decided to short Farmer Mac. “I prefer investments where I’m not fighting against the country. You know, where there’s public policy on my side instead of against me,” Ackman had told the investigators.
But the SEC attorneys had been skeptical. Wasn’t he really interested in Farmer Mac because he was seeking to profit from the company’s collapse?
“I’m a bit idealistic so it isn’t only a profit motive, but there was a profit motive, absolutely,” Ackman had responded.
Now Ackman asked the packed auditorium of investors to believe that he had devised a plan that would both hasten the collapse of a company he was betting against and do some public good in the process. Not many people would try to pull that off, but Ackman had his unrepentant idealism.
Ackman’s 146-page presentation was titled ‘‘How to Save the Bond Insurers,” and it laid out his plan for conserving capital within the insurance subsidiaries of MBIA and Ambac.
Ackman also announced that—at least as far as his personal profits were concerned—he was now shorting the bond insurers for charity. “We are going to make hundreds of millions of dollars on the failure of the holding companies,” Ackman concluded. “So I’m pledging to give my share of the profits to the Pershing Square Foundation.” Ackman had set up the foundation to provide funding for education and other charitable causes.
“He may be aggressive, he may be over the top, he may not be able to speak in short sentences,” New York Times columnist Joe Nocera concluded following the presentation. “But he’s doing the hard work, and thinking the hard thoughts that they refused to do for so long.”
Ackman seized the moment to remind some people of that.
The letter was also addressed to the three New York SEC staff attorneys with whom Ackman had met over the years: Alan Kahn, Steve Rawlings, and Chris Mele. But the real barbs were directed to those higher up at the SEC. “My sense is that it’s more likely that the responsibility for the lack of pursuit of these issues lies at the highest levels of the SEC including Chairman Cox,” Ackman wrote.
“You cannot kick our chief regulator in the nuts without consulting with me first.” Ackman agreed, and Katzovicz stayed.
Einhorn wasn’t so sure. “I need to figure out how Bill does meetings,” Einhorn joked, adding, “I always feel like those kinds of meetings are a waste of time.”
Not Ackman. “Bill was optimistic every time,” McGuire remembers.
The MBIA position had taken Ackman years to build, buying $10 million blocks of protection day after day. The lowest price he agreed to pay in premiums was 13 basis points, or $13,000 a year, and the highest was 700 basis points, or $700,000 a year. Most of the position was bought for less than 60 basis points. With MBIA 5-year credit-default swaps trading at around 450 basis points, there was a strong argument for taking profits.
When Ackman met with the advisory board to give his views on the MBIA position, he repeated what he’d been telling investors for years. Despite the 30-fold rise in the value of MBIA CDS contracts, he remained convinced that Pershing Square should continue to hold its short position: “I have never seen such a good risk-reward opportunity in my entire career.”
In late January 2007, when MBIA announced that it was settling the regulatory probe the cost of protection was quoted as low as 13 basis points. Now it was approaching 1,300 basis points.
The magnitude of change in MBIA CDS prices between January 2007 and January 2008 was equivalent to a $13 stock rising to $1,300.
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