2/11/2008: MBIA: Is Fair Value Accounting a Good Deal for Investors?

Excerpt from MBIA: Is Fair Value Accounting a Good Deal for Investors?
by Christopher Whalen

In the January 31, 2008, press release included in the 8-K dropped on that date, MBI includes the following statement:

"The decline in net income for the year was primarily due to the previously announced pre-tax net loss which amounted to $3.5 billion, or on an after-tax basis, $2.3 billion or $18.04 per share, on financial instruments at fair value ("mark-to-market") and foreign exchange. Significantly wider spreads and ratings downgrades of securities backing Collateralized Debt Obligations ("CDO") during the fourth quarter adversely affected the mark-to-market valuation of the Company's insured credit derivatives portfolio. As MBIA previously announced on January 9, 2008, the Company estimates a credit impairment of $200 million included in the pre-tax net loss of $3.5 billion on its insured credit derivatives portfolio for three CDO-squared transactions on which the Company expects to incur actual losses in the future. MBIA continues to believe that the balance of the mark-to-market losses are not predictive of future claims and, in the absence of further credit impairment, the cumulative marks should reverse over the remaining life of the insured credit derivatives. Additionally, the mark-to-market does not affect rating agency evaluations of MBIA's capital adequacy, except to the extent of impairments."

Notice that MBI's headline-grabbing loss of $3.5 billion comes as a result of a "fair value" accounting adjustment, not an actual cash loss. The cash "impairment" is just $200 million in the most recent reporting period. Unlike a credit default swap contract, where the obligor must immediately compensate the covered party for the full principal amount of the loss (net of recovery value), bond insurance requires only that the underwriter guarantee timely interest payments and, as contracted, the eventual repayment of principal -- eventual meaning upon maturity.

Notice too that the MBI statement anticipates a "bounce" in the future and, as a result, advises investors that yet another adjustment to the "fair value" of its insured credit derivatives book is likely. On similar terms, MBI also wrote down the value of its 17% equity stake in Chanel Re from $85.7 million to zero, but likewise states that an additional adjustment is possible.

As with Citigroup (NYSE:C), Merrill Lynch (NYSE:MER) and other financial institutions which have taken huge, non-cash "fair value" losses due to the collapse of the market for private label securitizations containing subprime assets, MBI might in the future take a gain on these very same positions. Thus while the GAAP "fair value" accounting suggests that MBI is badly decapitalized, in cash terms the impairment to date appears relatively minor.

Sabaziotatos says:

For more comments from Chris Whalen, see Accounting Rule Jeopardizes Bear Stearns, Lehman, Whalen Says

Marty Whitman of Third Avenue also weighs in on MBI and fair value accounting:

"[Bill Ackman's] publications argue that prices, as determined by marks to market, or mark to model, always deserve 100% weight. This is arrant nonsense. Market prices do deserve dominant weight in an analysis where the portfolio consists wholly of common stocks and non-performing loans held in trading accounts. Market prices deserve little or no weight, when the portfolio consists of performing loans, and in force policies, to be held to maturity. FASB 133 requires marks to market and marks to model, in accounting for derivatives under GAAP, and changes in market are reflected in the reported income account. FASB 133 is pretty much irrelevant for MBIA – a buy-and-hold investor in performing instruments. Paul Samuelson, the Nobel Laureate economist, had it about right for most markets when he said, “the market has correctly predicted nine of the last five recessions.” MBIA’s losses will be determined not by market prices but, rather, by what percent of obligations default and how these defaults are worked out."