Unsettling Claim
Old Deal Bedevils
Key Player in World
Of Municipal Bonds

ARMONK, N.Y. -- In the summer of 1998, bad news pierced the calm, country-club atmosphere at MBIA Inc., a bond-insurance company that helps cities across the U.S. raise money. A Philadelphia hospital group had filed for bankruptcy protection, leaving MBIA on the hook to pay about $170 million to cover the group's debts.

MBIA prides itself on writing policies that don't produce claims, and never in its then-24-year history had it faced one like this. Executives responded with a move akin to buying insurance on a house as it burned, persuading three other insurance companies to pay the $170 million and promising in return to give them some new business. The deal, which raised few eyebrows at the time, helped MBIA maintain its reputation for steady, reliable earnings growth.

More than six years later, the deal has become a threat to MBIA's sterling reputation, which is essential to maintaining its elite triple-A credit rating. The turning point came in early March, when MBIA issued a mea culpa: It said a $70 million portion of the deal had probably included an oral promise to protect one of the reinsurers from most losses, which would render MBIA's accounting for part of the transaction improper. MBIA restated six years of financial results.

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The deal is a focus of investigations by the Securities and Exchange Commission, the U.S. attorney in Manhattan and the New York attorney general that stemmed from broader probes of insurance accounting. Investigators are looking at other MBIA dealings as well.

MBIA isn't just any insurer. It is a linchpin of the municipal-bond market. Thousands of American cities, counties and states rely on MBIA to insure repayment of their bonds and thus let them borrow money more cheaply for schools, bridges, airports and roads. MBIA insures about $400 billion of municipal bonds, about 20% of all such debt in the U.S. About two-thirds of that debt is owned by individual investors, directly or through mutual funds.

Analysts say MBIA's financial position remains very strong. Indeed, among municipal-bond specialists, its strength is an article of faith. Asked what would happen if MBIA should ever lose its triple-A credit rating, James A. Lebenthal, chairman emeritus of the Lebenthal & Co. municipal-bond brokerage house and a former MBIA director, says: "You're asking me to speculate on the divinity of the emperor. The emperor is divine."

Based in a modern stone-and-glass building on a wooded campus north of New York, MBIA has had a long run of growth and low-risk profitability. The business began in 1974, when the Municipal Bond Insurance Association, as it was first called, opened its doors to offer a largely untested product: a promise to make interest and principal payments on municipal bonds if the issuers couldn't.

This might have seemed redundant, since municipal issuers' power to tax meant they almost never missed payments. But the timing proved opportune: The following year, New York City spent several months on the verge of default, shaking investor confidence in muni bonds and making insurance on them attractive.

Since then, MBIA and other triple-A guarantors, such as Ambac Assurance Corp., Financial Guaranty Insurance Co. and Financial Security Assurance Inc., have made money by exploiting a difference in perception: Where the market sees some risk, the insurers see perfectly safe bonds. By wrapping the bonds in its triple-A rating, MBIA allays investor concern and thus lowers the interest rate the issuer must pay to attract bond buyers.

MBIA has long boasted of writing insurance to a "no-loss" standard, meaning it expects never to face claims. But on July 21, 1998, came an unpleasant surprise. The Delaware Valley Obligated Group, part of a big Pennsylvania nonprofit hospital chain called Allegheny Health, Education & Research Foundation, sought bankruptcy protection after expansion plans foundered.

That threatened MBIA with having to make future principal and interest payments on $256 million of bonds it had insured. The actual claim wouldn't be that large, in part because the payments were due over many years. A smaller amount could be set aside, producing sufficient income to make the bond payments when due.

MBIA assured investors all was well. Its $75 million in reserves "will be sufficient to meet anticipated losses arising from the bankruptcy," MBIA said. "The company does not expect losses from this insured credit to affect its earnings."

In reality, MBIA didn't know exactly what it would do, people familiar with the matter say. And soon, MBIA publicly pegged the claim's likely cost at $170 million. But Sean Whelan, then an insurance broker at a unit of Marsh & McLennan Cos., had an idea, MBIA confirms: It was to get reinsurance to cover the loss, offering the reinsurers future business in return.

Reinsurance is coverage that insurers themselves buy, to spread their risk. But they typically buy it when they write policies, not after a claim is looming. And indeed, a transaction usually wouldn't qualify as insurance under accounting rules if the exact amount of a coming claim was already known. For it to be insurance, there must be uncertainty about both the size and the timing of any claim, and the responsibility for paying must actually be shifted to the insurer.

Mr. Whelan and MBIA's chief financial officer at the time, Juliette Tehrani, began seeking companies willing to do a "retrospective" reinsurance deal, MBIA confirms.

MBIA received a warning about doing such a deal, say two people familiar with the matter. They say one company, Capital Re Corp., warned an MBIA executive that Capital Re's auditors at Ernst & Young LLP thought such a deal might not pass accounting muster. Capital Re, now Assured Guaranty Ltd., declined to comment. Ernst said its policy is not to comment on client matters.

In a written statement, MBIA says it isn't aware of having had any such warning. Ms. Tehrani declined to comment on the issue. Mr. Whelan, now at a unit of insurance broker Willis Group Holdings Ltd., declined to be interviewed.

By September 1998, MBIA had found three willing reinsurers: Zurich Reinsurance (North America), now a unit of Converium Holding AG; AXA Re Finance SA, known as ARF, which is a unit of AXA SA; and Münchener Rückversicherungs-Gesellschaft, called Munich Re. Converium covered $70 million of MBIA's loss. The other two provided $50 million each.

In return, MBIA has said, it promised to give the three enough reinsurance business over six years so they'd receive $297 million in premiums. Through a series of transactions, ARF took responsibility to pay any claims on most of Converium's part of that new business.

AXA has said it was subpoenaed by U.S. authorities and will cooperate. Coverium and Munich Re have said they accounted for the deals properly.

MBIA says the business it promised the three was no less risky than what it regularly gives to other reinsurers. If so, the three effectively paid $170 million for business their competitors typically got free. This, says MBIA's general counsel, Ram Wertheim, is exactly what happened. "It was kind of unique," he says. "AXA and Munich were extremely interested in getting into the financial-guaranty business in a big way."

Eight days before MBIA's Sept. 29, 1998, announcement that it was getting $170 million from the three reinsurers, Ms. Tehrani stepped down as chief financial officer, becoming "special assistant to the chairman." She didn't offer an explanation. Neither did MBIA, though last week it said the move was part of a realignment brought on by two acquisitions. Ms. Tehrani is no longer at MBIA.

Most analysts in 1998 viewed MBIA's deal positively. Still, its announcement didn't seal the deal, say people familiar with the situation. PricewaterhouseCoopers LLP, MBIA's auditor, initially hesitated, these people say.

The matter was referred to PwC's National Technical Services Group, a sort of internal arbiter for sticky accounting questions, the people say, adding that after considerable lobbying by MBIA's then-CEO, David Elliott, the accounting firm signed off in December.

PwC says its "audit conclusion was not influenced by anyone outside of the firm." Mr. Elliott, who stepped down as CEO in May 1999, declined to comment.

MBIA says in a written statement that its accounting for the deal "was reviewed and approved by the company's auditors." Also, at some point, MBIA says, Ms. Tehrani presented the deal to a committee of its board.

"We have full confidence in the guys who run this company -- they're very smart," says David C. Clapp, an MBIA director. "I think most of us would have said, 'Fine, good, go with God.' "

MBIA reported a profit for 1998 of $433 million. The board's compensation committee approved $36 million in bonuses.

Some of the first criticisms of the deal surfaced four years later, in a December 2002 report by New York hedge fund Gotham Partners. The private investment pool had placed a bearish bet on MBIA, contending its results had been boosted by various accounting and financial moves. For instance, Gotham said the reinsurance related to the faltering Allegheny bonds was "not in fact reinsurance, but rather a loss-deferral, earnings-smoothing device."

Some other issues Gotham raised have since become part of government investigations. Among them: how MBIA creates reserves against potential losses, and whether MBIA's accounting for advisory fees artificially boosted current earnings. The Gotham report claimed MBIA had failed to recognize billions of dollars in losses on complex corporate debt securities it had insured.

MBIA vigorously protested the hedge-fund report, aggressively defending its practices. Its stock slid as a feud between it and the fund went on for weeks. The New York attorney general's office sought in 2003 to determine whether Gotham Partners had issued the report in a bid to manipulate the market. The probe brought no sanction or settlement.

The brouhaha eventually waned and MBIA's stock rebounded. But some of Gotham Partners' criticism of the Allegheny deal proved prophetic.

MBIA says its management became aware of a problem with the Allegheny hospital-bond deal only last year. It says one of the reinsurers, ARF, came to it with a surprising claim: that MBIA had orally promised to end ARF's reinsurance role by October 2005. That is, MBIA would take over the responsibility ARF had assumed for most losses on Converium's slice of the deal.

Such a promise would have significantly reduced the risk transferred to ARF. Thus, it would have made the $70 million MBIA received in 1998 look less like an insurance payment and more like the proceeds of a loan. The distinction is key because a company can't use loan proceeds to offset losses on its income statement.

MBIA says that last October, before any subpoenas arrived, its audit committee hired an outside lawyer to investigate the 1998 deal. MBIA initiated the inquiry at about the time it was sued by AXA over the issue, MBIA confirms -- adding that it has settled the suit. MBIA says its outside lawyer concluded that an oral promise "more likely than not" had been given to AXA's ARF unit.

So early this March, MBIA said it had reclassified the $70 million as a "deposit" rather than insurance proceeds, and restated its results from 1998 through 2003. (Even with this setback, says MBIA, it has had to make good on only 0.03% of principal and interest payments of bonds it has ever insured.)

PricewaterhouseCoopers says it "was unaware of any alleged oral understanding related to the transaction" when it audited MBIA's books for 1998.

A person familiar with the 1998 transactions asserts that Ms. Tehrani and Mr. Elliott were aware of the oral agreement with ARF at the time. Documents from a reinsurer on the deal support that contention, according to someone familiar with the material. Ms. Tehrani denied knowledge of an oral agreement but wouldn't comment on anything else. Mr. Elliott declined to comment.

MBIA says that "if there was an oral agreement or understanding, Julie Tehrani is the person at MBIA who would have made it." And its audit-committee probe found "no evidence that Ms. Tehrani advised any other executive or employee of the existence of any oral agreement," MBIA says in a statement.

MBIA's acknowledgment in March that it appears an oral promise was given -- after insisting for six years that the 1998 deal was proper and properly booked -- has dented some people's confidence in MBIA management. Another factor in this is a broadening of the probe.

In early April, investigators began looking into a reinsurer that MBIA owns part of and that does all of its business with MBIA. That company, Channel Reinsurance Ltd., is headed by the former MBIA chief, Mr. Elliott. MBIA says its dealings with Channel Re, based in Bermuda, are all proper, and suggests that the scrutiny is just a natural outgrowth of today's broad look at dealings with offshore reinsurers.

"A breach of trust has occurred to such a degree that it may be difficult for shareholders to rely on [MBIA] management's statements going forward," wrote Kayla Platt, lead analyst at proxy advisory firm Glass Lewis, in an April 13 report. Ms. Platt recommended that shareholders withhold votes from three key MBIA board members.

However, another proxy advisory firm, Institutional Shareholder Services, supported all the board members. And both Moody's and Standard & Poor's affirmed MBIA's triple-A ratings, saying the issues under investigation would have little material effect on MBIA's financial position. This is in contrast to insurer American International Group Inc., which has been downgraded a notch amid widening investigations.

"The only thing that is going to possibly lead to a rating change" at MBIA "is a severe economic depression," says David Veno, a Standard & Poor's analyst.

MBIA has a close relationship with the big credit-rating firms. It shares information on troubled policyholders with them, and two former Moody's executives have served on MBIA's board. The rating firms and MBIA say the insurer gets no special consideration.

If MBIA faced more difficulties, its management could take various steps to ward off a downgrade, including shoring up its capital. "The company and the board recognize the importance of the triple-A rating," says MBIA's Mr. Wertheim, "and will do everything to make sure we maintain that triple-A rating."

Write to Mark Whitehouse at mark.whitehouse@wsj.com and Theo Francis at theo.francis@wsj.com

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