[This review was published in the Winter 2012 issue of The Journal of Social, Political and Economic Studies, pp. 546-552.]
Confidence Game: How a Hedge Fund Manager Called Wall Street’s Bluff
Christine S. Richard
John Wiley & Sons, Inc., 2010
Many of the books about the recent financial crisis discuss the financial system in general and analyze the complex mixture of flaws and abuses that caused the debacle. Others approach the subject by telling the story of individual companies and personalities. Confidence Game is one of these, centering on a particular episode that serves as a microcosm that illustrates the whole. The story it tells is fascinating, notwithstanding this reviewer’s opinion that it is longer and more detailed than it needs to be.
In 1993, Bill Ackman and his fellow graduate of the Harvard Business School David Berkowitz co-founded the Gotham Partners hedge fund, starting with $3 million and increasing its assets to over $350 million by 2001. It appears that Ackman used the fund in part to engage in a rather odd but highly profitable pursuit. No one would expect the author of this book, Christine Richard, to match Victor Hugo stylistically, but as a bond market business reporter first for Dow Jones and later for Bloomberg News she has fashioned a readable, novel-like narrative that could well be described as the Les Miserables of the recent financial debacle. She follows Ackman from day to day as over several years he tormented – as in Hugo’s book police inspector Javert stayed on the tail of Jean Valjean – a giant quarry known as the Municipal Bond Insurance Association (MBIA). Predicting MBIA’s eventual downfall to all who would listen, Ackman shorted MBIA’s stock and purchased, at a cost of about $10 million a year, almost two billion dollars’ worth of “credit default swap” contracts (i.e., insurance contracts) that would pay off to his fund if MBIA took bankruptcy. In the end, as things came to smash during the financial crisis, his fund wound up making $1.1 billion from the shorting of the stock, as the credit-rating agencies stripped the MBIA of the triple-A rating that was essential to its business as a municipal bond insurer.
Ackman made constant complaints against MBIA – in an October 2002 letter to his investors explaining why he was massively shorting MBIA’s stock, to regulators, in talks with a Wall Street Journal reporter, in presentations to financial analysts, in a 66-page report, and, among other such contacts, in a letter to the board of directors of Moody’s, one of the three large credit-rating agencies. Ackman explained in his letter to his investors that the gist of his criticisms was that “we believe [MBIA] has inadequate reserves, undisclosed credit-quality problems, aggressive accounting, and substantial unconsolidated indebtedness contained in off-balance-sheet special-purpose vehicles.” A thread that runs through the book is the question of whether Ackman was trying to manipulate the market, causing MBIA’s stock to fall, so that his fund could profit from its decline. The somewhat surprising answer, as Richard explains, is that it is not unlawful as market manipulation to attack a company if everything that is said is true, even if the person making the attack and contributing to the company’s decline in the market stands to profit from doing so.
Although Richard focuses on Ackman’s dogged contrarianism, it is a necessary and valuable part of her book to explain the intricacies of the business of insuring municipal bonds. It turns out that she can hardly do this without also explaining the vast multi-trillion dollar web of financial relationships in several of the different dimensions of the financial world. Her explanations make this book a combination of a Hugo-type novel and a primer for laymen about the financial crisis, each aspect interwoven with the other. We simultaneously follow Ackman’s pursuit of MBIA and read Richard’s descriptions of the incredibly complex financial world that was constructed in the few years immediately prior to the crash in 2008.
If we are to understand all this, it is best to start by knowing just what sort of business MBIA conducted. As its name suggests, it was heavily involved in insuring the bonds issued by municipalities – towns, cities and counties. By being triple-A rated by the credit-rating agencies, its act of insuring the bond issues allowed those issues to themselves receive a triple-A rating. This greatly facilitated the financing of the various projects pursued by local governments. Because the triple-A rating was given to the bonds and they were backed by a triple-A rated insurance company, purchasers of the bonds were able to buy them with what was tantamount to complete assurance that they were risk-free. The triple-A rating was enough; counting on it, the buyers were relieved of the need to do a “due diligence” inquiry themselves into the credit-worthiness of the bond issue. This is worth mentioning because many trillions of dollars of financial transactions of all types came about through overlapping reassurances that – like a house of cards – created a false sense of confidence and encouraged the accumulation of enormous leverage (borrowing) without regard to whether the underlying fundamentals were sound. Hence, the name Confidence Game for this book.
What especially caught Ackman’s critical eye about MBIA’s role as an insurer of the bonds was that it sold the insurance with almost no reserve to stand behind it. “The Gotham report pointed out,” Richard says, “that MBIA was levered 139 to 1. The company had guaranteed principal and interest payments on bonds totaling $764 billion and had $5.5 billion of shareholders’ equity.” The rationale for its doing so was that there was virtually no chance any of the municipal bond issues would go into default. Why? Because experience had shown that the national government will not sit by to allow a state government to default, and state governments will in like fashion stand behind their local entities. This state backing meant, in effect, that the bond insurer (MBIA and others such as Ambac) was not a primary insurer, but rather a re-insurer who would have to pay only if the local entity didn’t and its state didn’t come to the rescue. The credit agencies gave bond insurers a triple-A rating despite the lack of reserve because they knew, just as the insurer did, that the insurance was granted to cover losses that would almost never occur.
What purpose did the bond insurance serve, then, in exchange for the premiums paid for it? In substance, none; but quite a substantial purpose as a significant strand in the ensuing confidence-based web of financial structures. As we have seen, the municipal bond issues were given triple-A ratings by virtue of the extra veneer given to them by being insured by a triple-A insurance company. It was this that made the bonds – almost three-quarters of a trillion dollars’ worth – readily saleable.
What also caught Ackman’s eye was that MBIA, in addition to its bond-insurance business, acted through a “special-purpose vehicle” (SPV) to sell billions of dollars’ worth of “credit default swaps” (CDSs) to stand behind “collateralized debt obligations” (CDOs). A CDS, despite its obscure name as a “swap,” is actually a contract insuring a security. The CDOs that were insured by such contracts were pools of securities that were ultimately based on the subprime mortgages that the crisis showed to be so shaky. The CDO structure was almost beyond belief: as many as 1,000 mortgage loans would be bundled into a bond, and a hundred of these bonds would go into a CDO. To create what was called a “CDO-squared,” 50 of the CDOs were bundled together. An insurer or a buyer of a CDO or CDO-2 certainly couldn’t make a “due diligence” examination of the many tens of thousands of underlying loans, but instead had to rely on the triple-A rating given them by the rating agencies. Ackman called “the triple-A ratings Moody’s has placed on subprime mezzanine CDOs” an “absurdity.” One of his criticisms of MBIA was that it had “set aside only $10 million of reserves for losses against its entire $65 billion [CDO] portfolio” [our emphasis]. (MBIA did hedge against its lack of reserves by getting re-insurance from other companies against its own insurance obligations. This manifests still another layer in what was quite a Byzantine web.)
As we have seen, the credit-rating agencies stood at the center of this web. The weakness of their business model accordingly played a key role in bringing about the financial crash. Richard points to a “basic flaw”: “Credit-rating companies insisted on diversification: a range of loan originators and servicers, wide geographical distribution, and various loan sizes… What [they] overlooked was the time frame, or the so-called vintage, in which the loans were made. Vintage turned out to be the single most important factor… Loans made in 2006 and 2007 were made to people who borrowed as much as they could to purchase houses they couldn’t afford when prices were peaking.” This meant that the agencies were “underestimating correlation risk” [i.e., the risk that seemingly unlike things would wind up acting alike, such as defaulting at approximately the same time]. Moreover, “faulty statistical models [were used by the financial industry] that rely on the past to predict the future,” according to Ackman’s report. Richard says that models were built “to predict the future performance of mortgages using just five years of data, and data taken from a period of strong economic growth, no less.” A remarkable example of how far off the models could be was provided by Ackman when he pointed out that “historical data-based models considered the 1987 stock market crash an event so improbable that it would be expected to happen only once in a trillion years.”
Sociologists will long marvel at how so many super-intelligent people – “lawyers, auditors, credit-rating analysts” and others, including regulators, bankers, mortgage brokers and hedge fund managers – could, in Richard’s words, go together “to construct rickety financial structures.” Indeed, there was much more to it than we have been able to suggest here. The “structured finance market” became “the epicenter of Wall Street innovation.” The financialization of the American economy is graphically described by Richard when she says that “financial sector debt – at $17 trillion – had grown from about 15 percent of gross domestic product in 1976 to 120 percent in 2008.” She goes on to say that “this explosion of debt transformed Wall Street into a place of extraordinary wealth, where even those far down in the ranks came to expect multimillion-dollar bonuses.”
It is reassuring to know, even though Richard herself does not say so, that this is past history. Confident in the wisdom and virtuous self-restraint of our fellows, we have reason to believe that the lessons have been learned and that the future will bring no repetition of such venality and over-cleverness. This means we can accept Confidence Game as comfortable bed-time reading, and have sweet dreams afterwards.
Dwight D. Murphey
 Tellingly, Richard recounts an instance in which Oklahoma showed reluctance to stand behind a county bond issue, but was in effect forced to do so when MBIA threatened to withhold insurance for all other issues in the state.
 Since the credit-rating agencies knew the insurance really wasn’t needed, they could just as well have granted triple-A status to the bond issues even in the absence of the insurance, but they didn’t. Instead, they “massively underrated” the bond issues, according to Richard, making the insurance necessary.
 The reason, Richard says, for MBIA to go through a special-purpose vehicle was to get around a legal restriction on insurance companies’ engaging in derivative transactions. It was held to be lawful, however, for an insurance company to be the re-insurer of the special-purpose vehicle’s obligations. By serving as the re-insurer for the SPV, the MBIA made it an entity with which the buyers of the CDOs were willing to deal.
 The term “mezzanine CDO” refers to a CDO made up of bonds that have only a middle priority in terms of receiving payment from the loans that feed into the bonds. There are bonds that have a higher priority for payment, occupying a “senior tranche” in the slicing and dicing that went into the creation of mortgage bonds; and there are other bonds with a lower priority.
 The immense size of the financial bubble is strikingly illustrated when Richard points out that the U.S. government’s $180 billion bailout of American International Group (AIG) (just part of the total late-2008 bailout package) was “a larger commitment in inflation-adjusted dollars than the Marshall Plan that rebuilt Europe after World War II” [our emphasis].