Major MBIA Debtholder Sues Over 'Fraudulent Transfer'

One of the largest holders of MBIA Insurance Corp. surplus notes has sued the insurer over what it calls a "fraudulent transfer," adding to the legal challenges that have come out of MBIA Inc.'s restructuring.

Two investment funds managed by Third Avenue Management LLC own approximately $400 million of the $1 billion of surplus notes issued last January. Third Avenue's suit alleges the restructuring is "illegal" and seeks to "defraud" MBIA Insurance debtholders, according to the complaint filed in Delaware Chancery Court.

"We are now being improperly denied the benefit of our investment - namely, a well-capitalized insurance company that is able to conduct a profitable business of insuring municipal bonds," Third Avenue chairman Martin J. Whitman said in a statement. "MBIA has stripped that business away from us and left us with a run-off portfolio that is likely worthless."

MBIA in February announced that it had split its public finance and structured finance insurance portfolios. MBIA Insurance Corp. of Illinois - now National Public Finance Guarantee Co. - received about $5 billion as part of the transaction, including $2.89 billion for taking on responsibility of the public finance book.

"While we appreciate Third Avenue's past support of MBIA, we believe the allegations in the complaint are without merit and intend to defend it vigorously," chief executive officer Jay Brown said in an e-mailed statement.

Third Avenue's suit follows one filed last month by a group of hedge funds claiming MBIA's split favored public finance policyholders over structured finance policyholders, and a number of bank counterparties have complained to New York insurance regulators about the deal. MBIA executives have said the company can pay all expected claims as they come due and noted the transaction received approval from regulators in New York and Illinois.

Third Avenue, whose funds also own more than 10% of MBIA stock, considered the restructuring an "asset-stripping transaction" that both violates the terms of the notes and constitutes a fraudulent transfer. Without MBIA's "crown jewel" public finance business, MBIA Insurance noteholders are stuck with notes "in an insolvent, junk-rated company," the lawsuit says.

Moody's Investors Service rates MBIA B3 with a developing outlook and Standard & Poor's rates it BBB-plus with a negative outlook.

Brown disputed that MBIA has broken any terms of the surplus notes.

"We have complied with all of the terms and conditions of their investment," Brown said. "All payments on the surplus notes have been and, subject to regulatory approval, will continue to be made on time and in full."

Whitman, however, said MBIA "stripped away" the principal assets of MBIA Insurance to Third Avenue's "surprise" and "distress." Third Avenue purchased the surplus notes in January 2008, about one month before Brown rejoined the company and told shareholders that MBIA planned to set up separate operating entities for its public finance, structured finance, and asset management businesses within five years.

Third Avenue also said the MBIA "falsely claims" that the restructuring does not represent a "good bank/bad bank" split. It noted that MBIA chief financial officer C. Edward Chaplin last January said that a good bank/bad bank split was "possible, but very difficult" and an idea with "a lot of hair on it."

Third Avenue had been a proponent of MBIA, and Whitman supported the investment in the insurance company in a letter he wrote to shareholders last year. Whitman at that time said the company deserved triple-A stable ratings, but understood it might not get them. He believed the investment would be profitable even if the insurer had to enter run-off.

In the lawsuit, Third Avenue argued the split deprives it of the public finance business' high profits and positive cash flow.

Third Avenue also noted that MBIA's loss estimates on structured finance products continue to increase. Estimated losses on residential mortgage-backed securities rose to $2.1 billion as of Sept. 30 from $1.1 billion as of March 31, the lawsuit says.

"The parent company's public disclosures have, for over a year now, consistently understated loss projections for MBIA Corp.'s toxic structured finance portfolio - rendering any current claim by parent company and the defendants as to MBIA Corp.'s solvency completely unreliable," the complaint said. "Over and over and over again, MBIA has publicly disclosed loss projections that have quickly proven to have been too low."

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