December 20 2007: 3:36 PM EST
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Bond giant's $8.1 billion surprise

That huge sigh of relief you heard from investors in MBIA after the bond insurer avoided a damaging downgrade? It didn't last long.

By Katie Benner, writer-reporter

(Fortune) -- Just hours after dodging a potentially devastating downgrade from ratings agency S&P, bond insurance giant MBIA disclosed late Wednesday a massive $8.1 billion exposure to the same risky investments that have been wreaking havoc on Wall Street in recent months.

It's unlikely now that MBIA can escape a ratings downgrade. The news could also jeopardize an offer by buyout firm Warburg Pincus to invest $1 billion in the beleaguered company.

MBIA's surprise announcement could rattle Wall Street at a critical time. If MBIA is downgraded or fails to secure financing from Warburg Pincus, then the bonds it guarantees will be downgraded, likely resulting in more losses for investment banks and prolonged turmoil in the credit markets.

Analysts said they were dismayed by MBIA's disclosure. "We are shocked that management withheld this information for as long as it did," wrote Morgan Stanley's Ken Zerbe and Yoana Koleva in a research note issued after Wednesday's writedown was announced. "This new disclosure completely changes our view of MBIA being a 'more conservative underwriter' relative to [competitor] Ambac."

MBIA (MBI) shares were down more than 25 percent in mid-afternoon trading Thursday.

MBIA, the country's largest bond insurer, revealed late Wednesday that the $8.1 billion is backed by collateral debt obligations (CDOs) and residential mortgage-backed securities, whose value has fallen steeply since credit markets seized up this summer. Of the total exposure, $5.1 billion was written in 2006 and 2007, when Wall Street firms were inking some of the riskiest loans.

The latest developments would spell even more trouble for MBIA and Ambac Financial Group (ABK). These so-called monolines have insured about $652 billion and $546 billion in debt, respectively, that could be downgraded and fall in value if those insurers are downgraded. Before MBIA's $8.1 billion disclosure, S&P estimated that MBIA faces $3.1 billion in losses on securities backed by subprime mortgages.

MBIA said it was establishing loss reserves of between $500 million and $800 million as protection against losses from its insured bonds. But that amount is woefully small compared to the value insured investments now at risk of crumbling. Too little capital combined with high-risk exposure is a problem that dogs nearly all of the monoline insurers, most of which are facing downgrades by S&P and Moody's.

MBIA would not be the first bond insurer to be downgraded. That honor goes to ACA (ACAH), which on Wednesday had its investment-grade A credit rating slashed to the junk rating CCC by S&P. Economists and Wall Street analysts worry that bond insurer implosions will ripple through the financial system as waves of bonds are downgraded and investment banks are forced to take more writedowns as a result. (See "Bond insurer defaults threaten big banks")

In part to stave off a meltdown, buyout firm Warburg Pincus offered Dec. 10 to buy $1 billion in MBIA shares and nominate two new members to the MBIA board. MBIA accepted the offer, but it still requires shareholder and regulatory approval. And given what appear to be serious problems at the insurance company, at least one high-profile investor doubts that the transaction will proceed.

Bill Ackman, who runs activist hedge fund Pershing Square, recently sent a letter to federal and New York state regulators challenging the Warburg deal. Ackman, who's been betting for years that MBIA shares will fall, wrote Dec. 14 that MBIA's press releases regarding the Warburg plan "are misleading" because they treat it like a done deal. Far from complete, Ackman said, key conditions are likely to derail it.

Ackman didn't elaborate because key terms of the agreement were not disclosed. But he went on to claim that MBIA misled investors about its capital and risk profile, and may already be in violation of agreements it made to Warburg.

MBIA and Warburg Pincus did not return calls seeking comment.

"Far from a vote of confidence in MBIA, the transaction appears to be a conditional contract....It does not appear to be a bona fide commitment to invest come hell or high water," wrote Ackman.

If Ackman's right, MBIA's problems could soon be Wall Street's too. To top of page

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