Ackman targets 3rd bond insurer

Unlike MBIA and Ambac, FSA has preserved its AAA credit rating.

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NEW YORK (Fortune) -- Bill Ackman, the activist investor best known for his scorched-earth campaign against MBIA and Ambac, has trained his sights on yet another municipal bond insurer: Financial Security Assurance.

Ackman told a crowd of about 100 hedge fund managers in New York Wednesday evening that, like MBIA (MBI) and Ambac (ABK), FSA is an "example of what happens when you start with a low-risk business, then add more risk to get higher returns. A company will keep doing that until it does something stupid." His remarks were delivered following a panel discussion on the convergence of private equity, real estate funds and hedge funds that was hosted by the law firm Jones Day.

Since FSA was purchased in 2000 by the French bank Dexia, Ackman isn't shorting a stock, as he did with MBIA and Ambac. Instead he is buying credit default swaps on FSA's bonds. This means he is purchasing a type of insurance against the event of default. If the market were to decide that FSA was troubled, the value of that insurance would rise as people rushed to buy the swaps.

FSA is the nation's third largest muni bond insurer, also known as a monoline insurer, just behind MBIA at number one and Ambac at number two. However, the term monoline is now a bit of a misnomer, as these companies long ago plunged into the much riskier business of guaranteeing complex structured bonds. And to simplify Ackman greatly, this is why these companies are in trouble.

Traditionally, monolines insured municipal bonds, which had very low default rates. The insurance made it a bit cheaper for local governments to borrow money, and in turn the insurance companies had sterling reputations and the very highest credit ratings. This allowed them to ink a lot of contracts and keep a relatively low amount of cash on hand.

But structured finance has proven to be a very risky business with plenty of defaults, and now Ackman says FSA, like its competitors, does not have the capital necessary to make good on its riskiest contracts.

While Standard & Poor's has downgraded MBIA and Ambac, it has preserved FSA's AAA credit rating.

"The market has not woken up to FSA because people still depend on the ratings agencies to do due diligence," says Ackman. He adds that the only legitimate bond insurance company working today is Berkshire Hathaway (BRK-A).

It seems peculiar that Ackman might choose now to go after FSA (particularly since there's no stock to actually short) given that he has studied the monolines carefully since 2002.

When asked about this lag, Ackman said that it takes time to find the hard information he needs to decide to take a short position. While that may be the case, it's worth noting that his decision to highlight possible problems at yet another monoline brings more scrutiny to bear on a group of companies that he wants to see trade lower.

In response to Ackman's comments, FSA said that it had "avoided the pitfalls of the current market," and that it would "do what it takes to maintain and build our position."

Ackman, the founder of hedge fund Pershing Square Capital Management, rose to prominence as one of the first people from any corner of Wall Street to say that MBIA would run into severe problems because of its decision to move beyond its core municipal bond insurance into guaranteeing structured securities.

His predictions about insurers like MBIA, Ambac and Financial Guaranty Insurance Co. (FGIC) were made long before asset-backed securities began to default. Ackman's saber rattling began long before the credit maelstrom that has destroyed banks, wiped out profits and seriously damaged the bond insurers. He said that the monolines didn't have enough money to cover the insurance contracts they had written on structured finance products.

But Ackman was clearly onto something. Since January of 2002, MBIA shares have plummeted to $6 from $54; Ambac has plunged to $2 from $60. Ackman says he'll give the money he's made shorting these stocks to Pershing Square's charitable foundation. Though he has made a bundle, he continues to hammer them.

The ratings agencies, always slower than the market to react to a company's changed fortunes, are starting to catch on. In the past few weeks, Standard & Poor has cut its rating on MBIA and Ambac from AAA to AA; and Moody's has put both companies on review for a possible downgrade. FGIC, which was AAA just this January, was downgraded to BB by S&P.

Ratings downgrades on the monolines are particularly troubling since they impact the prices of anything the companies insure. In addition to creating kinks in the municipal bond market, the downgrades have an even more severe impact on structured bonds, securities that are much harder to rate than the health of a city or county.

"In our view, the impact of the downgrades on the structured finance market is widespread," says S&P in a report released this month. "Roughly 1,600 tranches, representing around $350 billion of original issuance, are affected. Securities supported by MBIA account for 40% of the issues and 44% of the dollar amount, while securities supported by Ambac account for the remaining 60% of the issues and 56% of the dollar amount."

Well-respected as he is in many circles for his call on the monolines, Ackman has not always been a golden boy. After he published his MBIA findings, then-New York Attorney General Eliot Spitzer investigated whether Ackman had engaged in manipulative trading on the stock. The Securities and Exchange Commission followed with its own investigation. Both cases were dropped without any finding of wrongdoing.

More recently, he has made big long bets on under-performing companies including Target (TGT, Fortune 500) and Sears (SHLD, Fortune 500), saying that all of them are misunderstood and undervalued by Wall Street. Target has treaded water since the beginning of the year and Sears has fallen from $106 to $80.