Thursday, June 3, 2010

Long Book Review: Confidence Game (the "Ackman/MBIA book")

 Update (July 5th, 2010): I strongly recommend reading John Hempton/Bronte Capital's review of the bond insurers (it is not exactly a book review but Mr. Hempton provides an incredible personal perspective on several of the underlying themes in the book). 

In short, I recommend to anyone with an interest in finance to read Christine S. Richards’s Confidence Game, probably better known as “the Ackman/MBIA book.”

Since I enjoyed Mr. Einhorn’s book on his short position in Allied Capital (“Fooling Some of the People All of the Time”), I think that that drawing some comparisons is appropriate as it would help me flesh out the intrinsic worth of the new book. I have not read “The Big Short” and “The Greatest Trade” yet, so no parallels there. Also, the latter two are not about specific companies that turned on their critics, unlike MBIA and Allied. Please do read Dasan’s book review that was posted here a short while ago.

To better understand the significance of both Mr. Ackman’s and Mr. Einhorn’s roles in the crisis, one needs to understand the role that iconoclasts play in society. The term “iconoclast” derives from the old Greek/Byzantine movement against the use of icons in church services. They questioned the use of artificial, human-created objects of worship much like Moses many years earlier had objected to the Golden Calf as a man-made idol, an action that, at its time, was, well, iconoclastic. Later in history, other men would risk their lives to challenge the man-made status quo, men like Galileo and Copernicus. In other words, the iconoclasts, the people who challenged authority, with the appropriate intellectual backing, did more to advance the world than did millions of compliant, complacent men. Much along the same lines, this book is a story about having the intellectual wherewithal to question an edifice raised by man, the triple-A credit rating, AND to take the iconoclastic position financially AND to have the courage to see it through. Mr. Einhorn, for those who have not read his book, took on the privileged status of Allied Capital as a BDC, which, much like a top credit rating, enabled its holder to do things that would not be done if there were sufficient market discipline. Mr. Einhorn was also probably the loudest voice regarding Lehman Brothers’ troubles, and was viciously attacked by the Repo 105 crowd that in a normal country would be digging ditches in orange jumpsuits for life.

In addition to appreciating the important societal role of iconoclasts, I also had the benefit of having read Mr. Ackman’s original white paper on MBIA, along with having followed all of his public presentations on investment ideas, such as GGP, TGT, CXW, O, KFT, and FNM. These materials, along with a basic understanding of the principles of general finance, financial reporting, credit ratings, municipal bonds, structured finance and insurance operations, will make the book much more enjoyable.
On to the book itself. It starts out in 2002, when Mr. Ackman, then a manager at Gotham, established a very inexpensive position in MBIA CDS. MBIA had enjoyed a cozy position for many years, using its own triple-A rating to guarantee municipal obligations against default, for a certain fee. There were three problems with this. First and foremost was the dependence on MBIA’s own triple-A credit rating. Its single largest producing asset was not under its control. Second, the ratings agencies admittedly used a two-tiered bond rating system, which was much harsher on municipalities (from a default standpoint), meaning that the agencies were costing taxpayers billions of dollars in either extra interest because of the lower rating or in fees to MBIA/cronies. The third problem with MBIA was that it had practically no insurance reserves because it operated recklessly on the assumption that even if a municipal issuer were to get in trouble, they would get bailed out one way or another by the state as a “moral obligation.” When that was not likely, MBIA would muscle the states into shifting funds all over the place to cover the shortfalls so that MBIA would not have to incur losses. In other words, if the game were not rigged, there would be no underlying need for municipal bond insurance.

Since the muni business is so sweet (even Buffett got into it when the established players got in trouble), this attracts competition. Eventually, MBIA decided that they are smart enough to do insurance on other products, namely structured finance. This is where Mr. Ackman’s 2002 white paper comes in, well before subprime became word dujour. The white paper itself is not a Cassandra-style vision of the financial system or of the credit bubble, but rather a very interesting and thorough analysis specifically focusing on MBIA’s risk exposure, and its inconsistency with the company’s triple-A rating.

From that point, all the way until MBIA’s collapse in 2008, Mr. Ackman and his team would uncover more and more problems with the company, while Mr. Ackman takes on the role of being the lone voice warning about the danger to anyone and everyone that would listen. Quoting Natalie Merchant, “a wild-eyed misfit prophet,” Mr. Ackman’s unstoppable zeal is described in full detail, including calls, letters and meetings with then-NY AG Mr. Spitzer, insurance commissioner Mr. Dinallo, the SEC, a number of analysts following the stock, the CEOs and chief credit officers of the ratings agencies, the board of directors of Moody’s, later on, the Warburg Pincus and Citigroup “rescue” financing teams, the auditors, and so on. Clearly Mr. Ackman had no shortage of courage, persistence and resourcefulness to bring the world to his viewpoint.

What makes this persistence even more admirable is that Mr. Ackman defacto took on “The Establishment” even as his original fund, Gotham, was falling apart because of an unrelated court decision on portfolio entities’ merger. It must not have been easy, particularly in the somewhat small and insular world of Wall Street. The bond insurers have been great fee generators to Wall Street, both via their own financing needs as well as their role in making sure that the municipal and structured finance machines keep churning. Obviously, the banks’ self-interest was not aligned with Mr. Ackman’s regardless of who was “right.” Additionally, companies and their management teams do not like having their stock shorted: it seems that many managers take this as a personal affront, and are classless enough to show it like MBIA’s CEO who demonstratively refused to shake hands with Mr. Ackman after threatening his career. MBIA goes on the offensive in many ways, some are direct, some are alleged, like having NYAG Spitzer (at the peak of his power) and the SEC investigate Mr. Ackman, or having undue influence on the court case regarding an unrelated Gotham investment. While it does not seem like MBIA went to the lengths that Allied Capital admittedly did (phone record theft, having his wife fired), MBIA and its management did engage in a number of unsightly and completely inappropriate tactics in their attack on Mr. Ackman.

Again, remember that this is a book about iconoclasm. Being a dissident in the financial world is not easy, because it is costly, the timing is very difficult, and simply, it is much harder to win against a large, entrenched member of the system. But, just like Goliath was taken down through leverage, so was MBIA taken down through its inadequate capital reserving, aggressive underwriting and greedy, myopic management. More contemporaneously, be alert when someone from the “establishment” blames market participants or critics for unfavorable development in the market, be it MBIA, Lehman Brothers or Greece. Ask yourself, why aren’t these “evil speculators” or “wolf packs” or “sharks” attacking the creditworthiness of Norway, Nestle or Exxon?

Unlike Mr. Einhorn’s book, which is written (predominantly, I assume) by the fund manager himself, the Ackman book is written by a journalist. While obviously edited/redacted by Mr. Ackman, the book is sorely lacking the true insight of what went on in the manager’s mind as well as the intricacies of the actual security analysis that went on inside the fund. Mr. Einhorn’s provides much of that, including the careful research of specific (fraudulent) properties backing the BDC financing, such as shrimp boats in Louisiana or gas stations in Detroit (yes, Allied, with its privileged tax status and SBA relationships, did lend against such “gems.”) The author here does describe only one specific situation uncovered by the fund, a hospital bankruptcy, along with several cases of municipal finance or collateral abuse that were investigated by herself in her own role as an MBIA reporter. While the journalistic gumshoe work is interesting, I found the lack of insight in the workings of Mr. Ackman’s funds’ approach to analysis quite disappointing.

Additionally, while very-well footnoted, the book is written with the grandeur vision of a classic novel, and, as a result, it does not have a single graph of MBIA’s stock price or its CDS! Not even as an appendix. I can probably blame the number-phobic liberal arts establishment for that, but I do hope that the soft cover would include at least a two y-axis time graph that plots the stock price and the CDS over the six or so years, along with notations of the major events in the book. That should not be that hard to do.

Finally, one should also remember Howard Marks’s maxim that being early is often indistinguishable from being wrong. Mr. Ackman’s vision of reality did lose money for the original investors in Gotham Credit, as they had a negative carry position in the MBIA CDS. People who stood by did eventually make a lot. So, much like the Dutch buying Manhattan for $600, timing is (nearly) everything, and Mr. Ackman’s campaign was, in my opinion, his way to accelerate the perceptions of the market participants towards his view, which, with the benefit of 20/20 hindsight, was absolutely correct.

(No Amazon commissions here, I purchased my own full-priced copy, I earn no compensation for writing this and I am not affiliated with the author, publisher or any of the characters in the book, save for the first Pershing analyst on MBIA, Mr. J. Bernstein, whom I knew only socially from a b-school committee we sat on; I was left with highly positive impressions of him.)

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