Three Stocks Tied to Risky Debt

During the first half of 2007, IndyMac was forced to repurchase $443 million in defaulted loans. It seems that it was able to fund much of this repurchase through a $491 million issue of preferred stock on May 30. I consider this the equivalent to putting a band-aid on the situation, and it only digs IndyMac closer to bankruptcy as it pays the 8.5% yield on this newly issued stock.

MBIA(MBI Quote), like MGIC, is an insurer of debt. Although it does not exclusively deal with mortgages, according to the company's Web site, the company has a direct exposure to $5.1 billion in subprime mortgages as of June 30.

Despite the fact that this exposure is through AAA-rated bonds, we have learned from the Bear Stearns hedge fund collapse that with the current market conditions, even these high-level investment grade securities are no longer safe. A presentation entitled "Who's Holding the Bag?" given in May by hedge fund manager Bill Ackman contends that MBIA does not have the financial reserves to withstand a catastrophic event on its insured subprime securities.

In a June 24 Barron's article, MBIA's management denied that its subprime exposure poses a major threat to the company. However, I would regard this denial with caution as management has a history of using creative accounting to cover steep losses.

The Barron's article points to a transaction in 1998 where MBIA disguised a loan to cover a $170 million loss as a phony reinsurance deal. It was later uncovered by a Securities and Exchange Commission investigation that the company secretly paid back the reinsurance loan through separate deals.

Also, Ackman's presentation notes other accounting irregularities, such as accounting standards that accelerate the recognition of deferred revenue. This has boosted short-term performance as compared to GAAP and inflates book value.

Most disturbing is the recent departure of several MBIA executives. On May 30, 2006, CFO Nicholas Ferreri resigned. On Feb. 16, 2007, Neil Budnick, president of MBIA Insurance, resigned. That same day Mark Zucker, the head of Global Structured Finance, also resigned.

Could MBIA be silently bracing for the unraveling of some unexpected subprime problems? We will see how this plays out in the very near future.