Bruised bond giant puts on brave face

NEW YORK (Fortune) -- Bond insurance giant MBIA Inc.'s reported results Thursday that transcend the cliched "Going from bad to worse." Perhaps the ungrammatical "Going from worse to worser" is called for.

MBIA's fourth-quarter numbers were racked by $2.3 billion in writedowns for bonds that the company had guaranteed. Unfortunately, the Purchase, N.Y.-based behemoth can't take the easy way out of claiming these are one-time - or "kitchen sink" - charges, as even with that figure it booked $407.8 million in losses.

For the year, MBIA (MBI) lost $1.9 billion. Just a year ago, the company earned $161 million in the quarter.

Management, led by CEO Gary Dunton, trumpeted the fact that much of the eye-popping credit losses exist only on paper: The company has not actually unwound credit swaps or paid out settlements on most of them. That implies that the company's troubles are broadly manageable; with enough capital and patience, MBIA's credit analysis will weather the market turbulence.

On a conference call with analysts, Dunton took a fairly direct swipe at short-sellers. There's "fear mongering and the intentional distortion of facts by self-interested parties," he said. Dunton was almost certainly referring to Pershing Square Capital Management's Bill Ackman, who has been a vocal critic of MBIA for close to five years, and has a well-known short bet via credit default swaps.

Credit default swaps are contracts in which one company effectively insures another against a decline in debt defaults. In this case, the company doing the insuring was MBIA.

Dunton expressed outrage at the pricing of MBIA's credit default swaps, which at various times in the past two weeks have reflected investors' belief of a greater than 70% chance that MBIA will be forced to file for bankruptcy.

Recent pricing on MBIA's swaps can be said to have largely moved past the "assumption" stage of bankruptcy into the "likelihood" stage. This morning, swaps traders confirmed that MBIA protection was trading at 8.5% upfront and 5% a year. This implies that the cost to protect $10 million in MBIA debt against default for five years rose to an upfront payment fee of $1.85 million and $500,000 a year - a sharply more bearish sentiment than in previous weeks. The contracts trade upfront when investors see a risk of imminent default.

Dunton acknowledged, "We are paying for our mistakes." But he argued that with $16 billion in claims-paying resources, skepticism about MBIA's ability to meet its obligations was unfounded. As proof of MBIA's viability, Dunton touted a $500 million investment from private-equity titan Warburg Pincus as a vote of confidence in MBIA's strategy.

It is clearly a vote of confidence; it is also just as clearly, in the short-term at least, the single most uneconomic transaction in recent Wall Street history: Warburg this week closed a purchase of 16.1 million shares at $31 under the terms of a previous agreement. MBIA stock was at $15.39 in mid-day trading, up $1.39.

Press release hyperbole aside, the Warburg investment represents a stark bet on whether MBIA can keep its triple-A rating.

Moody's Investors Services announced in December that it was examining the company for a possible downgrade, a move the company said today on the call was "Somewhat surprising." A downgrade would escalate its current capital crisis to a full-blown liquidity crisis.

Last week, in its conference call, MBIA rival Ambac (ABK), which is in even worse straits than MBIA, said that a reduction of its AAA-rating to A would result in a need for $100 million in cash collateral to be posted in its investment management division. A downgrade to BBB however would require a $5 billion collateral infusion.

MBIA likely faces a similar scenario. It can probably absorb the former; the latter would almost definitely put it into so-called run-off, where new business would be prohibited.

MBIA is actively seeking additional capital, and although the exact amount hasn't been specified, it is probably close to $2 billion. Savvy investors, however, ought to be looking past ratings agency actions into how a future MBIA business would look.

There is little cause for joy.

For example, the profitable and stable - albeit slow-growing - municipal insurance portfolio is likely to suffer from the fact that high-rated and frequent municipal bond issuers are increasingly ignoring the once necessary triple-A wrap, or guarantee, from the likes of MBIA or Ambac. The credit woes are making it increasingly difficult for the company to attract new business. For instance, adjusted direct premiums - a measure of new business written - dropped 38 percent to $262.4 million in the fourth quarter.

Also, the specter of Warren Buffett's Berkshire Hathaway (BRK.A), whose triple-A rating is backed by $43.7 billion in cash and cash equivalents as of the end of last year, entering the Muni insurance space cannot be too comforting.

"It looks really bad for [MBIA]," said Whitney Tilson of T2 investors, who is short the shares of both MBIA and Ambac.

"It really matters very little what any investor says anymore, regardless of their take on the company. Bill Ackman's spreadsheet posting yesterday is the final word," Tilson said, referring to Ackman's posting of an investment bank's Collateralized Debt Obligation valuation model. The model charts the performance of every CDO guaranteed by Ambac and MBIA.

"Let a critic or supporter make their arguments for MBIA based on what that model says."

According to the spreadsheet, MBIA's loss exposure, based on the market inputs Ackman says are available, is $11.61 billion.