Fairholme Capital Management’s motto is “Ignore the Crowd,” and the hedge fund is sticking close to that maxim with its roughly $200 million investment in MBIA.
MBIA isn’t quite the Mecca of the stock market these days. Its share value is down 88% since its January 2007 peak; its insurer subsidiaries haven’t written new policies in more than two years; the company is engaged in numerous legal battles, both as plaintiff and defendant, against major Wall Street firms.
Bruce Berkowitz, founder and chief investment officer of Miami-based Fairholme, says each of these apparent headwinds actually is a reason why the investment firm chose to purchase 22 million shares of the company the past few months.
He indicated that MBIA has been tested by adversity and now appears to be poised for growth.
“Look what they’ve been through — they’ve been checked out with a microscope,” he said. “When you start shrinking over a year or two, everything comes out of the woodwork — you can’t hide anything.”
The investment, disclosed to the Securities and Exchange Commission on July 12, gives Berkowitz an 11.1% stake in MBIA, making Fairholme the company’s second-largest investor.
Since that disclosure, share value in MBIA has risen more than one-third.
Shares closed Thursday at $8.72, receiving a boost after MBIA announced Wednesday that it was acquiring, for $40 million, the remaining 83% of Channel Re Holdings and Channel Reinsurance that it didn’t already own.
Berkowitz said his investment is based on studying MBIA’s books, understanding the auditing process, believing in the company’s leadership, and understanding what happens during very difficult times. Growth can obscure a bad future, he said, noting that MBIA has had a couple years with no growth.
When Fairholme looked at how MBIA could fail, it found few convincing arguments.
“At Fairholme, there are a couple of things we do: we ignore the crowd, we base everything about the cash we count, and we turn things upside down,” Berkowitz said. “Instead of asking yourself, 'how much can I make,’ you should ask yourself, 'how can I die, financially, with this investment.’
“So we try to kill it. And if it’s pretty tough to kill it, we think, 'okay, maybe this is a good investment.’ And then we let the upside take care of itself.”
Berkowitz concedes his bet on MBIA isn’t based on daily observance of the municipal market, where the company insures nearly $500 billion of bonds, according its first-quarter earnings statement.
Rather, it’s part of a much larger bet on the recovery of the financial industry, which he said is necessary for the overall economy to bounce back.
He’s confident in part because of the “tremendous” job the government has done to help the economy.
“It’s not just MBIA,” Berkowitz said. “We’re the largest shareholder after the government now of AIG.”
Fairholme owns 24.3% of the global insurer and has major stakes in Citi, Goldman Sachs, and Bank of America Merrill Lynch.
“We are very big now in the financial services,” Berkowitz said. “This is our sweet-spot. This is where I started my career.”
His argument for a major recovery might not be popular, and he admits that friends in the industry think he’s crazy, but it’s hard to discount his views after a quick glance at the foundation of his reputation and track record.
Fairholme Fund, Berkowitz’s $15 billion mutual fund, has averaged 12.83% annual returns since inception in late 1999. An investor who placed $10,000 in the fund at its start would have had $35,544 at the end of last month, compared with $8,519 for a similar investment in the S&P 500.
With cumulative returns of 255%, the fund outperformed virtually all its competitors and solidified Berkowitz as Morningstar’s top fund manager for the last decade.
Berkowitz describes himself as a value investor who avoids diversification because of its tendency to earn average returns. Instead, he said he takes riskier, long-term bets on a focused portfolio. His strategy, according to documents on Fairholme’s website, is to “silently partner with exceptional-owner managers who have demonstrated success, honesty, and integrity.”
Berkowitz said the exceptional figure at MBIA is chief executive officer Jay Brown, who he has followed for 30 years.
“I looked at his five-year transformation plan and thought, 'this makes sense, he’s done it before, he has a good paper trail, and he has his money where his mouth is,’ ” he said.
Berkowitz, who grew up in Chelsea, Mass., first encountered the MBIA executive when Brown was at the Fireman’s Fund Insurance Co. Brown, who started his career there as an actuary in 1974, worked his way up to become chief financial officer in 1984, and eventually to chief executive officer in 1991.
For six years beginning in 1992, Brown worked to resuscitate the insurance operations of Xerox Corp., which underwent a restructuring and was renamed Talegen Holdings.
Berkowitz invested in the Fireman’s Fund and MBIA while working as a banker and portfolio manager for Merrill Lynch, Lehman Brothers, and Smith Barney. He was an interested observer when Brown took the helm at MBIA in May 1999.
Brown led the Armonk, N.Y.-based holding company for five years before handing it off to Gary Dunton in May 2004. He served as executive chairman for three years before retiring in May 2007.
Massive troubles soon emerged as the global credit crunch took hold. By early 2008 the triple-A ratings bestowed on the top bond insurers by Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings were in jeopardy.
Brown’s retirement transformed into a short hiatus. He returned to MBIA as chairman and CEO in February 2008, citing “the most serious challenges in its 34-year history,” and initiated a five-year transformation that caught Berkowitz’s attention.
With MBIA’s business model in doubt, the timing wasn’t right to start investing. S&P stripped MBIA Insurance Co., the company’s main insurer, of its 'AAA' ratings in June 2008.
The downgrades continued until September 2009 when it was dropped to 'BB+', a junk rating it maintains today. Moody’s gives the insurer a considerably lower rating of 'B3'.
MBIA’s chaotic fall from grace received additional attention because Bill Ackman, hedge fund manager at Pershing Square Capital Management and MBIA’s prime adversary for years, profited $1.1 billion for his investors by shorting MBIA equity and accumulating credit default swaps — insurance-like contracts that rise in value when a company verges towards bankruptcy.
Berkowitz and Ackman are acquaintances and share an investment interest in General Growth Properties, a Chicago-based real estate investment trust that filed for bankruptcy last year.
The future of MBIA would seem to be a topic the two investors would have opposing positions on, but Berkowitz isn’t sure that’s the case.
“Bill had tremendous points — about the past,” he said, arguing there’s a big distinction between MBIA’s management before and after Brown was reinstated in February 2008 as chief executive officer.
“Clearly, there’s a reason why that had to change,” he said. “But from what I see today, I like what I see.”
Berkowitz also pointed out that while Brown and Ackman may be adversaries — MBIA’s chief executive once accused Ackman of systematically trying “to destroy our franchise and our industry” — their ideas for how to move MBIA forward were similar.
In February 2008, Ackman presented a restructuring plan to New York’s then-Gov. Eliot Spitzer which would have sheltered MBIA’s public finance portfolio from its structured finance holdings.
One year later, Brown initiated a plan that did just that. The structure of the two plans had their differences, but Berkowitz said each were good ideas and he found them “very similar.”
After the split, MBIA’s public finance portfolio was transferred into a newly-created muni-only insurer called National Public Finance Guarantee Corp. MBIA Insurance was left with the more volatile or “toxic” products.
Despite having the approval of its regulator, the New York Insurance Department, MBIA’s split spawned a series of ongoing lawsuits from banks that are worried MBIA Insurance will not have the funds to pay all its claims.
At the end of the first quarter this year, National had statutory capital of $2.1 billion and claims-paying abilities of $5.6 billion.
MBIA Insurance held $3.5 billion in statutory capital with $6.1 billion of claims-paying resources. Their parent, MBIA, posted a first-quarter loss of $1.5 billion.
One thing Berkowitz likes about National is its return to a more simple business model. He argued that once National resolves its litigation and is able to re-emerge in the muni market, MBIA’s value will be re-verified.
“Once it becomes clear that National is walled-off, you have a tremendous amount of uncertainty gone,” Berkowitz said.
He’s also optimistic that MBIA will be successful in multiple lawsuits where it is suing a number of large banks in the hopes of recovering billions of dollars.
MBIA said these banks “fraudulently induced” its insurer subsidiaries to back risky residential RMBS that failed to meet typical underwriting standards and guidelines.
The alleged fraud caused MBIA to absorb deep losses that pummeled its stock and trashed its credit ratings, driving it out of the municipal bond insurance business.
“The real value will show in 2011 if MBIA shows the world that everything wasn’t perfect with the kind of securities inputted into the securitizations,” Berkowitz said.
Fairholme’s investment in MBIA is not dependent on the outcome of that litigation, he said.
“Investing is about comparing the price you pay, comparing what you give to what you get,” Berkowitz said. “And if you take a look at the expected runoff of MBIA’s business, then I can’t see how an investor loses money.”
The nature of bond insurance is that issuers pay up front for insurance, while the insurers invest that cash and amortize it into earnings each quarter. That allows National to continue earning revenue even without writing new business.
In the first quarter of this year, the company amortized nearly $150 million into earnings.
Over the next few decades, even without new business, National will amortize more than $3 billion into earnings, according to the company’s first-quarter operating supplement.
Rescuing the balance sheet and resolving legal issues is phase one of MBIA’s recovery, Berkowitz said.
Phase two is when market sentiment on municipal bond insurance changes from thinking it is worthless to understanding the value it has played during the economic recession.
The bond insurance industry was heavily criticized during the financial turmoil of 2008, when downgrades caused the market value of insured bonds to plummet.
But the insurers never guaranteed liquidity, and to date MBIA has lived up to its promises to guarantee timely principal and interest payments.
“They have kept their word,” Berkowitz said of MBIA. “Over time people will be more appreciative of that.”
He said that if MBIA continues to keep its word their franchise will remain and muni bond investors will realize the value in having insurance.
If sentiment does change, there is plenty of room for bond insurance to grow.
Before the financial crisis, bond insurers commonly guaranteed more than half of all new issuance in the market. For the last two years, less than 10% has been insured by two platforms run by a single company, Assured Guaranty.
Arguments go back and forth as to whether the industry will ever revive. Berkowitz offered no detailed projection, but preferred to boil it down to the most basic level.
“I believe there is tremendous value,” he said. “I know people aren’t looking at it that way, yet, but it’s very simple: would you rather have it or not have it? Well, you’d rather have it. Then the question is: how much is it worth?”