W h o ’s ’s H o l d i n g t h e B a g ? May 2007
Pershing Square Capital Management, L.P.
Disclaimer Pershing Square Capital Management's ("Pershing") analysis analysis and conclusions in the presentation are based on publicly available available information. information. Pershing recognizes recognizes that there may may be confidential information in the possession of the Companies discussed in the presentation that could lead these Companies to disagree with Pershing’s conclusions. The analyses provided may include certain statements, estimates and projections prepared with respect to, among other things, the historical and anticipated operating performance of the Companies. Such statements, estimates, estimates, and projections projections reflect various assumptions assumptions by Pershing concerning anticipated results that are inherently subject to significant economic, competitive, and other uncertainties uncertainties and contingencies and have been included solely for illustrative illustrative purposes. No representations, express or implied, are made as to the accuracy or completeness of such statements, estimates or projections projections or with with respect to to any other materials materials herein. Actual results results may vary materially from the estimates and projected results contained herein. Funds managed by Pershing and its affiliates own investments that are bearish on MBIA and Ambac. These investments include credit-default swaps, equity put options and short sales of common stock. Pershing manages funds that are are in the business of trading - buying and selling - public securities. It is possible that there will be developments in the future that cause Pershing to change its position regarding the Companies and possibly increase, reduce, dispose of, or change the form of its investment in the Companies.
Agenda
Overview of credit market trends
What is driving growth in easy credit?
What has securitization wrought?
Who’s holding the bag?
W h a t ’ s H a p p e n i n g W i t h t h e Cr Cr e d i t M a r k e t s ?
Freely Available Credit
Relaxed lending standards
Financial “innovation”
CDO Demand
More Leverage / More Buyers Increasing Asset Values
Decreasing defaults
S u b -P -P r i m e : R e l a x e d L e n d i n g S t a n d a r d s Growth in higher-LTV loans fueled by lower verification standards Documentation of Purch ase First Liens with wit h Simultaneous Secon Seconds ds
S u b -P -P r i m e : F i n a n c i a l “ I n n o v a t i o n ” Interest-only products driving growth over last 3 years Fixed vs. Hybrid Hybri d ARMS (Wit (Withh and Without With out IO) IO)
$800 bn / qtr $8 qt r
S u b -P -P r i m e : M o r e L e v e r a g e a n d M o r e B u y e r s Second liens have grown as % of total issuance Total Issuance vs First L iens With Piggyback Issu ance
I n c r e a s i ng n g A s se set Val ues Home Price Index is 15% above the 30-year trend-line
Source: Office of Federal Housing Enterprise and Oversight, Deutsche Bank
Wh o i s B u y i n g T h e s e M o r t g a g e s ?
A B S M a r k e t P r o v i d i n g L i q u i d i t y f o r Or Or i g i n a t o r s Sub-prime and Second-lien ABS Issuance Volume
Source: Thompson Financial, Deutsche Bank
AB S F ue le d by C D O s ABS AB S / MBS / CMBS CMBS purc pu rchased hased by b y CDOs CDOs ($bn) $140
$131
$120 $98
$100 $80 $60
$53
$40 $20
$31
$27
$19
$0
% of total CDO Issuance
2001
2002
2003
2004
2005
2006
23%
40%
33%
43%
52%
49%
H o w D o e s a Se S e c u r it i t i za za t i o n w o r k ?
H o w D o e s a CD CDO w o r k ?
W h a t ’ s Wr W r o n g w i t h Ra R a t i n g A g e n c y M o d e l s? s?
Data set limited by favorable recent year trends
Low interest rates
Improving liquidity
Rising home prices
Strong economic environment
Product innovation
No payment shocks in existing data because borrowers have been able to refinance
Performance of securitizations benefited from required and voluntary removal of troubled loans
Rating Agencies assume limited historical correlation (20%-30% for subprime) will hold in the future
When the credit cycle turns, correlations could approach 100%
L i q u i d i t y f o r A B S d e p e n d s o n CD CDO Pe r f o r m a n c e $1 of equity invested in a Mezzanine CDO supports over $111 in sub-prime mortgages $
%
Dollars invested in BBB / Equity of Mezz CDO Senior Leverage in CDO Mezz CDO Assets
$ $ $
1.0 9.0 10.0
10.0% 90.0% 100.0%
BBB / Equity Tranche of ABS Securitization Senior Leverage in Securitization Total Collateral Purchased in Securitization
$ 10.0 $ 101.1 $ 111.1
9.0% 91.0% 100.0%
Total Leverage on CDO Equity
110.1 x
Poor returns for BBB / Equity CDO investors will have over 100:1 impact on demand for securitizations of primary assets
W h a t H a s Se Se c u r i t i z za at ion Wrought?
M o r t g a g e L e n d i n g i n t h e Ol O l d Da Da y s Business Strategy: Lend & Hold
Local S&L lends to local Home Owner
Lender has direct knowledge of borrower
Lender profits from performance of loan over time
Borrower plans to pay down mortgage over time
High transaction costs
M o r t g a g e L e n d i ng n g T o d a y : L e n d & S e c u r i t i ze ze Originator
“Mortgage.com” or “1-800-MORTGAGE”
Models-based issuance, questionable actuarial data
ABS
Originator recognizes income upon loan sale or securitization
Bank earns fee for underwriting ABS
CDO
Rating Agency arbitrage allows CDO originator to book profit at closing
CDO Manager makes nominal investment, receives recurring fees
CDO Buyers / Insurers
Ultimate risk holder relies on ratings; minimal visibility to underlying credit
M o r t g a g e L e n d i ng n g T o d a y : L e n d & S e c u r i t i ze ze
Moral Hazard: Everyone is paid up front, including the rating agencies, except for ultimate holder of risk
R a t i n g A g e n c i e s a s De D e Fa Fa c t o “ Re g u l a t o r ”
R a t i n g A g e n c i e s A r e N OT O T Re Re g u l a t o r s
Rating Agencies are for-profit businesses
Earn fees for writing opinions
Rating Agencies have adverse incentives
Only paid if and when financing closes; ratings “shopping”
“Fairness opinion” where only paid if determined to be fair
More issuance = More fees
Structured Finance is over 40% of revenues with fees ~4x that of traditional debt ratings
Rating Agencies have conflicts of interest
Concentrated customer base, sources of fees (Bond Insurers)
Guarantors offer lucrative career path for agency executives
Rating Agencies have reputational risk with structured finance ratings
Slow to adjust credit opinions
R a t i n g A g e n c i e s Cl C l a i m N o L i a b i l i t y f o r B e i n g Wr Wr o n g
Distinction “…between investment advisers with a fiduciary relationship to their clients and those who simply publish impersonal commentary on some aspect of a security…investors [might] mistakenly assume that a credit rating represented advice as to whether they should buy, sell or hold a security, or that they could rely on a credit rating agency as fiduciary, neither of which is true.”
Standard & Poor’s, SEC Public Hearing, 2002
W h a t H a p p e n s i f t h e Ra Ra t i n g A g e n c i e s A r e Wr Wr o n g ?
T h e Cy C y c l e A l s o Wo W o r k s i n Re Re v e r s e Less Leverage / Fewer Buyers
Catalyst: Unexpected Defaults
Reduced Availability of Credit
Decreasing Asset Values Increasing Defaults and Reduced Recovery Rates
Tighter lending standards
No more financial “innovation”
Reduced CDO Demand
A l r e a d y H a p p e n i n g i n Su S u b -P -P r i m e
Defaults have been higher than rating agency predictions
Rating Agencies have begun to adjust models and downgrade tranches
Tighter standards for securitizations / CDOs
Acknowledging likelihood of higher than expected correlation
Lack of new ABS CDOs dramatically reduces demand for new mortgages
Banks pulling warehouse lines
Originator bankruptcies / exiting business (~50 in last 15 months)
Home price depreciation predicted by National Association of Realtors
Upcoming payment shock will make things worse
Borrowers can’t refinance because of tighter standards Rising inventories and smaller pool of qualified buyers reduces value and liquidity of properties
A l r e a d y H a p p e n i n g i n Su S u b -P -P r i m e More loans are experiencing early defaults Early Early Defaults Defaults in Subprim Subp rimee Mort Mortgage gagess
Source: Moody’s
S u b -P -P r i m e F a l l o u t : I t i s G o i n g t o G e t Wo Wo r s e … ~$800 Billion of sub-prime mortgages to reset We ar ar e here
Sources: LoanPerformance, Deutsche Bank
H i gh g h e r Lo L o s se s e s d ue u e t o L o w e r H om o m e A p pr pr e c i a t i o n
L e v e r a g e d L e n d i n g M i r r o r s Su S u b -P -P r i m e Sub-Prime
LBOs
Higher LTVs
Higher Debt / EBITDA
I/O, Negative amortizing loans
Covenant lite & PIK toggle notes
Cash-out Re-fi
Dividend Re-Cap
“Liar” loans, limited documentation
Credit for “pro forma” cost savings
0% down
Lenders providing equity bridges
Home Appreciation
Purchase multiple expansion
B u y o u t L e v e r a g e : M i r r o r i n g S u b -P -P r i m e T r e n d s Record buyout activity… $400
LBO LB O Vol Volum umee (EV) (EV) ($Bn) $362
$350
$300
$250
$200 $147
$150 $115 $100 $59 $42
$50 $20 $0 2001
2002
2003
2004
2005
2006
B u y o u t L e v e r a g e : M i r r o r i n g S u b -P -P r i m e T r e n d s …at higher purchase multiples… Average EV / EBITDA
10.0x 9.0x
8.6x 8.2x
8.0x 7.1x 7.0x
7.4x
6.5x 6.1x
6.0x 5.0x 4.0x 3.0x 2.0x 1.0x 0.0x 2001
2002
2003
2004
2005
2006
B u y o u t L e v e r a g e : M i r r o r i n g S u b -P -P r i m e T r e n d s …driven by more leverage…. 8.0x
Avg. Av g. Total Debt / EBITDA EBITDA
7.0x
7.1x 6.5x
6.1x 6.0x
5.0x
5.6x 4.9x 4.6x
4.0x
3.0x
2.0x
1.0x
0.0x 2001
2002
Source: JP Morgan Note: Represents Represents top top 20% 20% of levered levered loans by Debt Debt / EBITDA
2003
2004
2005
2006
B u y o u t L e v e r a g e : M i r r o r i n g S u b -P -P r i m e T r e n d s …supported by growth in CLOs Leverage Leveragedd Loan L oan Arbitrage Arbi trage CLO CLO Activity Acti vity ($Bn) ($Bn)
120
$97
100
80
60
$53
40 $25 $16
20 $9
$12
0 2001
2002
2003
2004
2005
2006
C o m m e r c i a l Re R e a l Es E s t a t e M i r r o r s Su S u b -P -P r i m e / L B O
Loan-to-Values of > 100%
Negative debt service coverage
Non-recourse financing on projected NOI in years 5 & 6
Dividend Yield on U.S. Real Estate Index declining from high of ~8.0% in September 2002 to 2.8% today
Credit market supported by CMBS and CDO bid
W h o ’s ’s H o l d i n g t h e B a g ?
W h o ’s ’s H o l d i n g t h e B a g ?
First losses borne by BBB and equity investors in CDOs C DOs / securitizations
Combined position represents only 5-10% of total collateral
At ~9% losses, all capital through BBB is worth zero
Moody’s currently estimating 6-8% cumulative losses for 2006 subprime issuance—higher than initial expectations
Senior tranches typically guaranteed by Bond Insurers
Bond Insurers sell credit protection on senior tranches of ABS & CDO securitizations
Bond Insurers and CDO Buyers perceive low risk and accept nominal yield
W h o ’s ’s H o l d i n g t h e B a g ? Financial Guarantors are unique counterparties
They don’t don’t put put up capital. They simply simply sign their name name
One of few counterparties in derivatives market not required to post collateral on decline in value of contract
Only counterparties not required to post collateral even eve n in the event of a downgrade in their credit rating
Wh o A r e t h e B o n d I n s u r e r s ? Financial Guarantors are inadequately capitalized to withstand a negative credit event 100x
94.1x 80.8x
75x
Face Value Bond Guarantees / Statutory tatutory Capit apital al
50x
25x
0x
Reserv Reserves es / Guarantees
3.15 b p s
3.93 b p s
A m b a c i s e x p o s e d t o Su S u b -P -P r i m e L o s s e s Ambac’s exposure to Sub-Prime mortgages, both direct and through CDO’s, is significant relative to book value and reserves
ABK Sub-Prime Exposure Exposu re ($ billion)
% of Stat. Capital
$ Total Sub-Prime Exposure Direct Sub-Prime Rated BBB Direct Sub-Prime Below-Investment-Grade Below-Investm ent-Grade Sub-Prime in High-Grade CDO's Sub-Prime in Mezz CDO's
$
18.7
284.4%
4.3 0.8 7.8 1.0
64.7% 12.0% 118.7% 14.9%
G r o w i n g St S t r u c t u r e d Fi Fi n a n c e Ex Ex p o s u r e MBIA Structured Finance Guarantees as a % of total Guarantees have more than doubled over the past 10 Years
2006
1996 S t r u c t u r e d Fi Fi n a n c e
S t r u c t u r e d Fi Fi n a n c e
14% 86%
Pu b l i c Fi n a n c e
68%
Pu b l i c Fi n a n c e
32%
G r o w i n g St S t r u c t u r e d Fi Fi n a n c e Ex Ex p o s u r e MBIA has increased exposure to Structured Finance during period of rapid innovation and lower lending l ending standards MBIA: Net Par Par Insur Ins ured ed 75.0%
70 59.5
60
66.5% 47.6
50
$ insured (bn)
46.7
42.1
53.0%
40 30
55.0%
25.2 44.3%
20
65.0%
45.0%
42.1%
38.7%
35.0%
10 25.0%
0
2003
2004
2005
2006
Q1 '07
% of total
M B I A Co C o m p a r e d t o Ci Ci t i g r o u p
Credit Rating
Aaa, Aaa, AAA AA A
Aaa, Aaa, AA+ AA +
Regulator
NYS NYS Ins Insur urance ance Dept Dept
Federal Reserve, OCC, FDIC
Leverage
94:1
12:1
(Net Par / Capital)
(Risk Adj. Assets / Tier 1 Capital)
Credit Exposure
$635 $635 billi bil lion on
$1,1 $1,107 07 bill bi llio ionn
Capital
$6.8 $6.8 billi bil lion on
$127 $127.0 .0 bill bi llio ionn
3 bps
96 bps bp s
Reserves / Credit Exposure
M i n i m a l L o s s e s Wi W i l l I m p a i r M B I A ’s ’ s Ca Ca p i t a l B a s e Total Guaranteed Portfolio Public Finance Structured Finance
$635.2 Billion 421.8 $ 213.4 Billion
CDO Exposure Mortgage Exposure Other ABS Exposure Direct and Pooled Corporate Exposure Total Structured Finance Exposure
108.6 52.0 26.9 25.9 $ 213.4 Billion
(1) Estimated "Excess" Capital over AAA (1) Losses to eliminate excess capital
$
0.5 Billion 23 bps
Total Statutory Capital Base SF Losses to eliminate all capital
$
6.8 Billion 316 bps
(1) Excess Capital estimate assumes $1.5B of excess capital at 12/06 reduced by two $500M dividends in 12/06 & 4/07
M B I A : S i g n i f i c a n t CD CD O E x p o s u r e CDO Exposure (Net of Reinsurance):
Collateral Type
Net Par Outstanding
Investment Grade High Yield Multi-Sector CMBS Emerging Market Total
$ 50.7 12.2 22.7 23.0 0.2 $ 108.8
$ Value of Mezz CDO Exposure (12/31) Mezz CDO as % of Statutory Capital
$
5.0 73.5%
Large exposure to mezzanine CDOs with underlying collateral rated BBB or worse
M e z za z a n i n e CD C D O S p r e a d s Wi W i d e n i n g Si Si g n i f i c a n t l y Spreads for AAA A AA tranch t ranches es of Sub-Pri Sub-Prime me CDO CDO Index 800 704 700 600
bps
500 400 300 200 100 0
Source: Morgan Morgan Stanley
261 195 132
BBB-
BBB
BBB-
BBB 2/16/07
5/4/07
TABX.HE.07-1.06-2 BBB & BBB-
M B I A : “ E x c e s s” s ” C a p it it a l ? Is ~$500M a sufficient cushion to the minimum capital required to maintain AAA rating? High-Risk Credit Exposures: ($ billion)
$
Excess Capital as %
Direct and Indirect Sub-Prime Exposure Below-Investment-Grade Exposure Mezzanine CDO Exposure (12/31)
$
7.8 11.9 5.0
6.4% 4.2% 10.0%
High-Risk Credit Exposure
$
24.7
2.0%
Remaining Exposure to Other Guarantees
$ 610.6
H o w D o e s M B I A A c c o u n t f o r Wi W i d e r Sp Sp r e a d s ?
Supposed to mark to market any losses on derivatives
MBIA provides protection by selling CDS on CDO tranches
MBIA’s CDO guarantees are held to maturity and do not trade
With no market price, MBIA “marks to model”
MBIA’s internal model incorporates rating agency inputs
Rating Agencies have not downgraded senior tranches, therefore MBIA has not recognized any MTM losses
W i d e r CD C D O S p r e a d s W i l l I m p a i r Ca Ca p i t a l B a s e
CDO Exposure
$ 108.8 Billion
Est. "Excess" Capital over AAA Total Statutory Capital Base
$ $
Eliminates "Excess" Capital (bps)
Eliminates All Capital (bps)
9
125
0.5 Billion 6.8 Billion
Note: Assumes 5-yr avg. life of credit protection
If exposures were marked to market, slight movements in credit spreads would impair or eliminate MBIA’s capital base
W a i t , T h e r e ’s ’s M o r e …
M B I A I s On On e o f t h e M o s t Pr o f i t a b l e U S Co m p a n i e s ? We have the highest profit margin of any financial company in the Forbes 500 with over a billion in sales. --Joseph W. Brown, Chairman of MBIA “
”
Net Income Margins of Several Highly Profitable Companies
D e c r e a s i n g U n a l l oc o c a t e d Re Re s e r v e s MBIA’s unallocated reserves, expressed in bps of net par outstanding, have dwindled to only 3.2 basis points of total exposure (as of 3/31/07) MBIA’s Unal nallocated Rese Reserves rves (bps of ne nett pa parr outstandi outstanding) ng)
7.0
6.2bps
6.0bps 5.7bps
6.0
5.5bps
5.4bps
5.0
4.0
3.6bps
bps
3.5bps 3.2bps
3.0
2.0
1.0
2000
2001
2002
2003
2004
2005
2006
Q1 '07
A c c e l e ra r a t e d Re R e v e nu n u e Re Re c o g n i t i o n MBIA s current methodology accelerates revenue recognition and inflates book value ’
MBIA recognizes deferred premium revenue on an accelerated basis
Company claims that the appropriate method for recognizing deferred premium revenue is in proportion to “the expiration of related risk”
MBIA insures discrete, not continuous risks
MBIA effectively guarantees a stream of payments. Therefore, risk expires only when payments are made
New FASB Proposal, dated 4/18, requires MBIA to recognize revenue in proportion to risk expiration ex piration (scheduled payments), not the passage of time
M B I A Cu C u r r e n t M e t h o d o l o g y v s . F A SB SB A p p r o a c h Example 1:
5-year $500mm, 5% 5 % coupon debt issuance, amortizing 20% annually.
A l l o c a t i o n o f Pr Pr e m i u m b y Y e a r Year 1
Premium Revenue Recognized as % of Total Proposed Methology Current Methodology Difference
Year 2
Year 3
Year 4
Year 5
21.7% 45.7%
20.9% 25.7%
20.0% 15.7%
19.1% 9.0%
18.3% 4.0%
-23.9%
-4.8%
4.3%
10.1%
14.3%
I m p a c t o f FA F A SB S B ’s ’ s Re R e v e n u e Re R e c o g n i t i o n De De c i s i o n
Cumulative write-down of book value
Increased leverage ratios and lower ROE
Reduced earnings power
Reduced earnings growth rate
Adverse impact on contribution of new business
Higher P/E and book value multiples at current price
M o o d y ’s ’ s I n t e r p r e t a t i o n o f FA F A SB S B Ch Ch a n g e
“…would result in a significant deceleration of the earnings pattern typically seen among guarantors under existing accounting policies, and reduce shareholders' equity due to the cumulative effect adjustment necessary at adoption … the accounting change could result in a reduction of shareholders' equity in excess of 10% for some firms, with a similarly significant impact on GAAP net income."
Wallace Enman Moody's Senior Accounting Analyst
4/19/2007
M o v i n g t h e Go G o a l Po Po s t
Enhanced uniformity in reporting may nevertheless result in some guarantors' reported financial statements appearing stronger or weaker relative to peers than under current reporting standards. The implementation of the proposed guidance would alter reported financial leverage, coverage ratios and profitability metrics going forward, and as a result, Moody's may adjust certain rating metrics to recognize the effect of these accounting changes on its overall methodology.
Moody’s Press Release 4/19/2007
O n g o i n g Fr Fr a u d I n v e s t i g a t i o n Independent Investigator reviewing improper transfers of value from MBIA Insurance to Holding Company
In search of growth, MBIA aggressively expanded into non-traditional, high-risk asset classes such as defaulted property tax liens
As the value of the tax-lien portfolio deteriorated, the Holding Company advanced capital to meet margin calls and avoid recognizing losses
Holding Company improperly transferred losses to Insurance Subsidiary by causing it to guarantee bonds backed by tax liens at inflated valuations
MBIA has led the market to believe that investigations are behind them. Independent Investigator will release initial initial findings this summer.
I s M B I A Pr Prepared ? How is MBIA preparing for the deterioration in credit markets?
December 2006: Received permission from NYSID and paid $500M special dividend from Insurance Subsidiary to Holding Company
February 2007: Announced largest largest share repurchase program program in company history ($1 Billion)
April 2007: Received permission from NYSID and paid yet another $500M special dividend from Insurance Subsidiary to Holding Company
May 2007: Disclosed share repurchases of ~$300M in Q1 equal to 3.4% of total shares outstanding
I s M B I A Pr Prepared ? What is MBIA management doing to prepare for the upcoming deluge?
Resigned (5/30/06): Nicholas Ferreri, Chief Financial Officer
Retiring (1/11/07):
Resigned (2/16/07): Neil Budnick, President of MBIA Insurance Co.
Resigned (2/16/07): Mark Zucker, Head of Global Structured Finance
Jay Brown, Chairman of Board of Directors
R i s k i s H i d d e n i n Gu G u a r a n t o r Po Po r t f o l i o s
Moral Hazard in the Structured Finance process pr ocess combined with a flawed Rating Agency function has overstated credit quality for hundreds of billions of dollars of guaranteed bonds
Guarantors have no margin for error
Massive on- and off-balance sheet leverage
Exposure to risky, untested categories
Negligible reserves
Aggressive and fraudulent accounting
Credit Market participants believe they have transferred risk to AAArated Financial Guarantors
Guarantors’ counterparties are unsecured and have no right to collateral even in the event of a downgrade
When losses hit, these guarantees will have no value, and counterparties are left holding the bag
Ou r Re c o m m e n d a t i o n s Insurance Subsidiaries are effectively insolvent in our view and need to be recapitalized
Holding Companies must fund capital shortfall at subsidiaries
Dividends from subsidiaries to holding companies should be terminated
Removal of Executives Responsible for Fraudulent Activity
Current CEO of MBIA supervised failed investment in tax lien business and subsequent scheme to hide losses
Executives appear to have made false and misleading statements to analysts and investors
MBIA Insurance subsidiary needs independent Board of Directors
Conflict of Interests: Holding company is extracting capital from insurance subsidiary to fund share repurchases and special dividends
Independent Board is needed to ensure that transactions between holding company and insurance company are done on arms’ length basis
Ri s k v s . Re w a r d : Wh a t ’s t h e d o w n s i d e ? Financial Guarantors are trading near or above their reported Adjusted Book Values $120
$100
$95 $89
Share price $77
$80 $69
Adj. Book Value Value $60
$40
$20
$0
W h a t I s Ou Ou r I n t e r e s t I n T h i s ?
We believe that capital must be returned to the insurance subsidiary in order to protect policy holders from future losses
Our interests are aligned with bondholders bondholders and the capital markets generally
We are short the common stock and own credit protection for MBIA, Inc. and Ambac Financial Group, Inc., the holding companies of the bond insurance companies
W h a t A r e We W e Do Do i n g A b o u t T h i s ?
We are in the process of identifying additional violations of NYS Insurance Laws. Stay Tuned
We are meeting with the relevant congressional and regulatory authorities to focus attention on the problem
