Table of Contents Praise Title Page Copyright Page Dedication Preface Acknowledgements Chapter One - The Meeting Chapter Two - The Short Seller Chapter Three - The Question Chapter Four - Backlash Chapter Five - The Worst That Could Happen Chapter Six - The Trouble with Triple-A Chapter Seven - Unanswered Questions Chapter Eight - Crimes and Cockroaches Chapter Nine - Turning the Tables Chapter Ten - Scrutiny Chapter Eleven - The Black Hole Chapter Twelve - The Court of Public Opinion Chapter Thirteen - The Insurance Charade Chapter Fourteen - When Crack Houses Become Collateral Chapter Fifteen - Storm Warnings Chapter Sixteen - An Uncertain Spring Chapter Seventeen - Apocalypse Now Chapter Eighteen - Parting the Curtain Chapter Nineteen - Ratings Revisited Chapter Twenty - The Panic Begins Chapter Twenty-One - Catastrophe and Revenge Chapter Twenty-Two - Time Runs Out Chapter Twenty-Three - Bailout Chapter Twenty-Four - Judgment Day Chapter Twenty-Five - The Nuclear Threat Epilogue Notes Index About the Author Praise for Confidence Game How a Hedge Fund Manager Called Wall Street’s Bluff by Christine S Richard Bloomberg News “Christine Richard’s Confidence Game is an insightful, timely, and fascinating high-speed drive into the often difficult-to-penetrate world of short sellers, with its particular focus on Bill Ackman and his campaign against monoline insurance giant MBIA.” SCOTT B MACDONALD SENIOR MANAGING DIRECTOR ALADDIN CAPITAL LLC AND COAUTHOR OF SEPARATING FOOLS FROM THEIR MONEY “How to head off the next crash? Listen to the dissidents now Christine Richard’s deeply researched and deftly written account of Bill Ackman’s high-stakes struggle with a leading pillar of a now-collapsed system is the right book at the right time, and a mesmerizing read.” DEAN STARKMAN EDITOR “THE AUDIT,” THE BUSINESS SECTION OF THE COLUMBIA JOURNALISM REVIEW “Bill Ackman’s battle with MBIA will be remembered as one of the great epics of Wall Street history, and no one followed the story more closely than Christine Richard.” BETHANY MCLEAN COAUTHOR OF THE SMARTEST GUYS IN THE ROOM “Finally, a financial crisis book with a hero It’s a compelling morality tale of how one man uncovered a massive fraud and then fought tenaciously to show the world he was right Richard had unparalleled access to the major players in this saga—from venal executives to incompetent regulators—and she weaves the threads of complex financial shenanigans into a page-turning narrative Ackman emerges as the Don Quixote of financial markets: you will root for him and a happy ending.” FRANK PARTNOY AUTHOR OF F.I.A.S.C.O., INFECTIOUS GREED, AND THE MATCH KING “Confidence Game is a lesson for all investors on the value of independent and exhaustive research It’s also a riveting story.” TODD SULLIVAN CREATOR OF VALUEPLAYS.NET AND A REGULAR CONTRIBUTOR TO THE STOCKTWITS BLOG NETWORK AND SEEKING ALPHA Copyright © 2010 by Christine S Richard All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data: Richard, Christine S Confidence game : how a hedge fund manager called Wall Street’s bluff / Christine S Richard p cm Includes bibliographical references and index Summary: “Confidence Game tells the story how hedge fund manager Bill Ackman’s warnings regarding bond insurer MBIA’s credit rating went unheeded as Wall Street careened toward disaster”—Provided by publisher eISBN : 978-0-470-87330-4 Municipal bond insurance—History—21st century Securities industry—Credit ratings—21st century Wall Street (New York, N.Y.)—21st century Global Financial Crisis, 2008-2009 I Title HG4538.52.R53 2010 368.8’7—dc 22 2010001831 For Dean Preface FOR NEARLY 10 YEARS, I covered the bond market as a Wall Street reporter, first at Dow Jones and later for Bloomberg News It was a period of enormous growth and innovation in the credit markets As the expansion peaked, Wall Street manufactured billions of dollars of debt every day, astonishing amounts of it considered triple-A or virtually risk-free For a while, this was accomplished with true financial innovation Later, the process was corrupted by delusion and dishonesty Of all the stories I covered, there was one that never seemed to go away: the battle between a company called MBIA and a hedge fund manager named Bill Ackman, who was obsessed with that company’s practices What is MBIA? It stands for Municipal Bond Insurance Association For years it was the largest of a handful of extraordinarily profitable companies that together guaranteed more than $2 trillion of debt issued by entities ranging from the Cincinnati school system to a shell company in the Cayman Islands Insurance transformed lower-rated bonds into triple-A-rated securities Business boomed, giving MBIA some of the highest reported profit margins of any publicly traded company in the United States—even higher than Google and Microsoft If there was something about this business that was too good to be true, few people had any reason to point it out Then in late 2002, Ackman, who ran a hedge fund called Gotham Partners, issued a research report titled Is MBIA Triple-A? in which he questioned just about every aspect of MBIA’s business Before he made his views public, Ackman bet against the company by purchasing derivative contracts called credit-default swaps, which would make his fund billions of dollars if MBIA filed for bankruptcy Ackman’s research report was the opening shot in what became a long and bitter Wall Street feud between him and MBIA From the start, MBIA was determined to silence Ackman’s criticism, and he was no less determined to see MBIA leveled Ackman was investigated at MBIA’s urging by Eliot Spitzer, then New York’s attorney general, and the Securities and Exchange Commission (SEC) followed suit For more than five years, the hedge fund manager questioned nearly every aspect of MBIA’s business, bringing his research to the attention of rating companies, regulators, reporters, and investors He cornered the chief executive officer (CEO) of PriceWaterhouseCoopers, MBIA’s auditors, at a charity function, broached the issue with a bullish equity analyst at a funeral, and wrote to board members of Moody’s Investors Service, warning them they could be held personally liable for inaccurate ratings Eventually, Ackman turned the tables on MBIA, getting regulators to probe MBIA’s business practices Big names have dominated the headlines during the credit crisis Bear Stearns was the first major financial institution to collapse American International Group required a $180 billion government rescue, a larger commitment in inflation-adjusted dollars than the Marshall Plan that rebuilt Europe after World War II Lehman Brothers was the financial failure felt around the world Before all of this happened, another crisis played out Little known outside of Wall Street, MBIA made hundreds of millions of dollars a year selling its triple-A credit rating At the same time, it boasted to analysts and investors that it insured bonds on which it saw no chance of loss In the lobby of MBIA’s headquarters in Armonk, New York, visitors were greeted by a large photo of sunlight pouring through trees The image is one you might expect to see on an inspirational greeting card—the sunlight, a symbol of some higher power “We help our clients achieve their financial goals by providing AAA credit protection,” read the message alongside the photo The sanctity of MBIA and the permanence of its triple-A credit rating were articles of faith on Wall Street Brash, blunt, almost neurotically persistent, Ackman was the perfect foil to the bond insurance business Even among his friends and colleagues, Ackman is known for being a font of not-alwayswelcome forthrightness He will tell people straight out that their hairstyle is unflattering or they ought to consult with his nutritionist about losing some weight Ask him about his candor, and he says he gives people honest advice and that’s a rare thing in this world The first time I spoke with Ackman was December 9, 2002, the day he issued his report on MBIA “The more I looked, the more I found,” he told me, and he just kept finding more We spoke about MBIA and bond insurance on and off for more than five years Persistence had its price Eventually, nearly every analyst who covered the company refused to take my calls But MBIA was intriguing I found the line that summed up the intrigue and contradiction of MBIA in a presentation Ackman made to Moody’s Investors Service: “Management integrity has been compromised to uphold the ‘no-loss’ illusion.” Someday, I thought, this conflict over a triple-Arated company that was not as safe as it appeared would make a great story, one that might prove bigger than Ackman and MBIA How was it that MBIA could write insurance on hundreds of billions of dollars of debt and yet tell its investors that it guaranteed only bonds on which it expected to pay no claims? In an article for Bloomberg Markets magazine called “The Insurance Charade,” Darrell Preston and I exposed part of the secret by looking into various public projects that weren’t supposed to be obligations of the taxpayer Yet when the insured bonds issued to finance these projects threatened to default, taxpayers were called on to cover the losses MBIA had a nearly perfect track record in the municipal bond market because it wasn’t the real insurer of the debt: Taxpayers were So what would eventually shatter this no-loss illusion? Bond insurers expanded into the structured finance market, the epicenter of Wall Street innovation In this market, where all types of loans and securities were bundled into new securities, the game was not rigged in MBIA’s favor In writing Confidence Game, I was able to draw from a wealth of source material that is contemporaneous with the events described in the book Ackman gave me a CD-ROM containing every e-mail he had written or received that mentioned MBIA as well as years of appointment calendars and access to an office filled with more than 40 boxes of documents he’d collected in researching MBIA He encouraged colleagues, advisers, and friends to talk with me and spent hours answering my questions Ackman waived attorney-client privilege with Aaron Marcu, the attorney who represented him in the New York attorney general’s investigation of Gotham Partners, so that McLean, Bethany McCulley, Paul McDaniel, Raymond McDonald’s McGuire, Mick advises Ackman on MBIA position McKee, Brittany McKiernan, Anthony McMullen, Keiran Media Bistro (mediabistro com) Mele, Chris Memorial Properties, LP Merkel, David Merkin, Ezra Merrill Lynch ARS and Bank of America purchase of CDOs and CDSs and largest loss in company history (2007) mortgage crisis and rescue proposals for bond insurers and Microsoft Minor, Marc Mischel, Howard MIT (Massachusetts Institute of Technology) Mitchell, John Mitsubishi Estate Moloff, Andrew Money Market One monolines, defined Monte Carlo simulations, defined Moody, John Moody’s Investors Service AHERF and Ambac and Assured Guaranty and bond-default studies business described Capital Asset Research Management and CDOs and CIFG and congressional hearings on bond ratings and “Credit: Man’s Confidence in Man” (giant bronze frieze) FGIC and FSA and GICs and Gotham Partners / Ackman and MBIA and mortgage crisis and municipal-bond ratings system Pershing Square / Ackman and rescue proposals for bond insurers and review of bond insurers announced (November 2007) XL Capital and Moradi, Mohamed al moral-obligation bonds, defined Moreland Act Commission Morgan Stanley CDOs and Financial Guarantors on the Knife’s Edge Gotham’s Concerns—Warranted or Not? mortgage crisis and rescue proposals for bond insurers and Morgenson, Gretchen Moriarty, Michael Morrison, Cohen & Singer mortgage crisis ABX Index ACA Capital and Ambac and American Securitization Forum Assured Guaranty and Bear Stearns and CDOs and CIFG and Citigroup and Congress and FGIC and FICO scores Fitch Ratings and FSA and housing market and Lehman Brothers and MBIA and Merrill Lynch and Moody’s and Morgan Stanley and Pershing Square / Ackman and size of subprime market Standard & Poor’s and UBS and vintage (time frame) of loans Wachovia and XL Capital and Munger, Charlie Munich Re (Muenchene Rueckversicherung-Gesellschaft) “Municipal Bond Insurance Riddle, The” (Angel) MuniServices Murphy, Kevin Namvar, Ali Nash, Jack National Association of Attorneys General National Association of Real Estate Editors National Association of Securities Dealers (NASD) National Indemnity National Public Finance Guarantee Corporation Natixis Nazareth, Annette negative basis trade, defined Nester, John Neuberger Berman Neumann, Michael Neustadt, David New Century Financial Corporation New Republic New York City, rated by Standard & Poor’s New York State Martin Act moral-obligation bonds and Supreme Court of New York State attorney general’s office See also Spitzer, Eliot AHERF andAIG and Capital Asset Research Management and Farmer Mac and Gotham Partners / Ackman and Investor Protection Bureau MBIA and Pershing Square / Ackman and New York State Insurance Department (NYSID) AHERF and Ambac and Capital Asset Research Management and congressional hearings on bond ratings and Gotham Partners / Ackman and insurance law “2604,” MBIA and Pershing Square / Ackman and rescue proposals for bond insurers and XL Capital and New York Times Farmer Mac and Gotham Partners / Ackman and MBIA and Pershing Square / Ackman and Spitzer scandal and New York University School of Law Nightingale Nixon, Richard Nocera, Joe Noland, Doug Nomura Securities Company Northcross, Mark Northern Illinois University NTL Octonion CDO Limited O’Driscoll, Fiachra Odyssey Partners O’glove, Thornton O’Neal, Stan O’Neill, Leo One Up on Wall Street (Lynch) Onyx Acceptance Corporation Open Source Model (Credit Suisse) orphaned transformers, defined Ortseifen, Stefan Oswald, Lee Harvey Ovitz, Michael Pandit, Vikram Paulson, Hank Paulson, John Paulson Credit Opportunities Fund Pelling, Kendall Peretz, Marty Pershing Square, Bill Ackman and AHERF and Ambac and annual dinner (2009) Assured Guaranty and Barron’s and “Bond Insurers: The Next S&L Crisis?” Capital Asset Research Management and “Caulis Negris” (“Black Hole”) deal and CDSs and Citigroup and Congress and Council of Economic Advisers and Fannie Mae and Farmer Mac and FDIC and Federal Reserve and financial success for Fitch Ratings and founding the firm (2003) Freddie Mac and FSA and House Financial Services Committee and “How to Save the Bond Insurers,” investment team, building the letters to his investors Leucadia National investment in mark-to-market and MBIA and Moody’s and mortgage crisis andNational Association of Attorneys General and New York Times and notice of discontinuance received from SEC NYS attorney general’s office and NYS Insurance Departmant and Open Source Model (Credit Suisse) used by rescue proposals for bond insurers and “Saving the Bond Insurers,” “Saving the Policyholders” (Pershing Square / Ackman) SEC and Security Capital Assurance and at Sohn (Ira) Investment Conference Spitzer and Squawk Box interview Standard & Poor’s and U.S Department of the Treasury and at Value Investors Conference Wall Street Journal and “Who’s Holding the Bag?” Pershing Square Foundation Peter, Greg Pierre-Louis, Lydie PIMCO (Pacific Investment Management Company) Pinnacle Peak CDO Limited Piper Jaffray Pitt, Harvey Pittsburgh Community Reinvestment Group Pittsburgh Gazette Pizza Hut Plaut, Peter PNC Bank PNC Financial Services Group Poiset, Matthew Pollice v Capital Asset Pork Magazine Port Authority of New York and New Jersey bonds Powell, Lynn Pre-Paid Legal Services Press, Joel Preston, Darrellrice WaterhouseCoopers Priore, Thomas Progressive Farmer Purtill, Sabra Putnam Investments Quality of Earnings (O’glove) Quick, Becky Raiter, Frank Ramos, Charles Ram Re Rankin, Al Rawlings, Steve Reinke, Winfried Renfield-Miller, Douglas Reuters Rhineland Funding Ricciardi, Christopher Ridgeway Court Funding II Ltd Rockefeller, David Rockefeller, Nelson Roseman, Alan Rosner, Joshua Ross, Wilbur Roth, Paul Rothschild, James de Rouyer, Stan Royal Indemnity Corporation Rubin, Robert Russello, Gerald Rutherfurd, John Ryan, Rob Saad, Ramy Sagittarius trustee report Sallie Mae Salomon Smith Barney Saluzzi, Joseph S&P See Standard & Poor’s San Joaquin Hills toll road (California) bonds, MBIA and Sanno Point Capital Management, Saqi, Vinay Sard Verbinnen “Saving the Bond Insurers” (Pershing Square / Ackman) “Saving the Policyholders” (Pershing Square / Ackman) Schonfeld, Mark Schroeder, Alice background of Scoby, Joseph Schultz, David Scion Capital LLC, Securities and Exchange Commission (SEC) AHERF and Ambac and Bear Stearns and Capital Asset Research Management and CDSs and Fannie Mae and Farmer Mac and Freddie Mac and Gotham Partners / Ackman and Madoff and MBIA and - notice of discontinuance sent to Ackman Pershing Square / Ackman and short sales banned by securitization, risks of See also collateralized-debt obligations; mortgage crisis asset-backed securities (ABS), defined Security Analysis (Graham and Dodd) Security Capital Assurance Limited Fitch Ratings and Pershing Square / Ackman and triple-A credit rating Selz, Bernard Semerci, Osman Sender, Henny shadow banking system, defined Shanker, Joshua Shanley, Kathy Sharma, Deven Sharma, Sanjay Shell Shulman, David Siefert, Roger Siffert, John Sierra Club Silverstein Properties SIVs See structured-investment vehicles Smith, Dick Snowball, The: Warren Buffett and the Business of Life (Schroeder) Ira Sohn Investment Conference Sonkin, Mitch Soros, George special-purpose vehicles (SPVs) “Caulis Negris” (“Black Hole”) deal defined “Havenrock II,” Loreley Purchasing Companies market collapse of (2007) MBIA and orphaned transformers Rhineland Funding Triple-A One Funding Speyer, Jerry Spiegel Spier, Guy Spitzer, Eliot See also New York State attorney general’s office AHERF and Ambac and Congress and Gotham Partners / Ackman and as governor MBIA and Pershing Square / Ackman and prostitution ring scandal rescue proposals for bond insurers and at Wall Street Hedge Fund Forum Wall Street research and SPVs See special-purpose vehicles Squawk Box, Ackman on Stacey, Eve Stafford, Erik Standard & Poor’s ACA Capital and Ambac and bond-default study business described CDOs and congressional hearings on bond ratings and FGIC and Gotham Partners / Ackman and MBIA and mortgage crisis and NYC rating from Pershing Square / Ackman and rescue proposals for bond insurers and review of bond insurers announced (November 2007) S&P 500 Index Triple-A One Funding research report Standard Oil St Denis, Joseph Steel, Robert Stein, Mark Steinberg, Joseph Steingart, Bonnie Structured Finance and Collateralized Debt Obligations (Tavakoli) structured-investment vehicles (SIVs) defined Nightingale Student Finance Corporation bonds Target Corporation Tarnoff, Jerome Tavakoli, Janet Teach for America Tehrani, Juliette Thain, John Themis Trading LLC, TheStreet.com Third Avenue Management Third Point LLC, Thomson Financial Thompson, Anthony Thomsen, Linda Thoreau, Henry David David W Tice & Associates Tilley, Christopher Tilson, Whitney background of NYS attorney general’s office and Tim Hortons Tishman Speyer Touby, Laurel Trinity College Triple-A One Funding Trump, Donald Turner, Lynn T2 Partners Tyco UBS Investment Bank / UBS Securities ARS and CDOs and mortgage crisis and rescue proposals for bond insurers and Unger, Laura United Airlines University of Michigan University of North Carolina University of Pittsburgh Medical Center (UPMC) University Center for Social and Urban Research U.S Congress AIG and Ambac and bond-ratings hearings CDOs and CDSs and FGIC and Fitch Ratings and House Capital Markets Subcommittee House Financial Services Committee MBIA and Moody’s and mortgage crisis and Pershing Square / Ackman and rescue proposals for bond insurers and Senate Agricultural Committee Spitzer and Standard & Poor’s and U.S Department of Agriculture U.S Department of Justice U.S Department of the Treasury Pershing Square / Ackman and rescue proposals for bond insurers and USF&G Value Investors Conference Veno, David Wachovia Wachtell, Lipton, Rosen & Katz Wako, Juichi Waldman, Roger Waldorf Demolition Wallis, David Wall Street Hedge Fund Forum Wall Street Journal AHERF and Capital Asset Research Management and Farmer Mac and Gotham Partners / Ackman and MBIA and Pershing Square / Ackman and Warburg Pincus MBIA, investment in Wasden, Lawrence Washington, Wilbert Washington Mutual Watergate scandal Weaver, Karen Webster, Charles Webster, Daniel Weill, Richard Weinstein, Boaz Wendy’s International Wertheim, Ram Wessel, Andrew White, Oliver Whitehouse, Mark Whitman, Marty “Who’s Holding the Bag?” (Pershing Square / Ackman) Wien, Byron Williams, James WMC Mortgage WorldCom Xerox Corporation XL Capital Assurance CDSs and Moody’s and mortgage crisis and NYS Insurance Department and rescue proposals for bond insurers and XL Capital Ltd Yahoo Finance Zerbe, Ken Ziff family About the Author Christine S Richard is a reporter with Bloomberg News She has covered financial markets in Washington, Hong Kong, Singapore, and New York Her reporting on the bond insurers received awards from the Society of American Business Editors and Writers, the New York Society of Certified Public Accountants, the National Association of Real Estate Editors, the New York Press Club, the Newswomen’s Club of New York, and the Deadline Club She lives in Frenchtown, New Jersey, with her husband, Dean, and their daughter, Sophie ... S Confidence game : how a hedge fund manager called Wall Street’s bluff / Christine S Richard p cm Includes bibliographical references and index Summary: Confidence Game tells the story how hedge. .. About the Author Praise for Confidence Game How a Hedge Fund Manager Called Wall Street’s Bluff by Christine S Richard Bloomberg News “Christine Richard’s Confidence Game is an insightful, timely,... there was one that never seemed to go away: the battle between a company called MBIA and a hedge fund manager named Bill Ackman, who was obsessed with that company’s practices What is MBIA? It