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Take a bet? Stock could double if litigation goes its way Add to ...

Down-on-its-luck MBIA Inc. is one of the most intriguing speculations on the stock market today, an outsized bet on the successful outcome of litigation stemming from the collapse of the U.S. housing market.

One bullish analyst estimates the stock price could more than double if things go right for MBIA. But doubters say the company has only modest potential for gains and warn that shareholders should look out below if things go wrong.

The shares are definitely not for the risk-averse, conservative investor, but anyone who craves an exciting gamble with high rewards should give MBIA a close look. One of the major institutional investors who believes the risk-reward balance is skewed toward profits is Bruce Berkowitz of Fairholme Capital Management, a well-known value hunter who has taken a large MBIA position.

MBIA is one of the financial companies that fell on hard times during the 2008 market panic, stumbling because it unwisely strayed from its low-risk business of insuring municipal bonds, and branched out into insuring mortgage-backed securities just before one of the worst housing market crashes in history.

It was horrible timing and the company has paid dearly for its huge error in judgment. In its most recent quarterly results, it said the subsidiary that insured mortgage securities is at “significant risk” of being seized by regulators if it can’t arrange a timely settlement to its litigation.

Because of huge payouts for soured mortgage securities, MBIA’s own credit rating has been slashed to junk levels, so the company can no longer write new insurance on municipal bonds, which requires a sterling credit rating. MBIA is thus in a kind of corporate coma, neither fully alive nor completely dead.

But what makes it an intriguing speculation is its litigation to recover much of the money it shelled out to cover losses on soured mortgage securities. Should it win, and the company comes close to recovering the $3.2-billion (U.S.) it thinks is merited, the stock should surge.

To date, MBIA has prevailed on almost all important legal points in the various court cases involved in the litigation. The key issue is who should be on the hook for the losses stemming from the mortgage meltdown – MBIA or the companies that originated the loans.

Most of MBIA’s legal battles have been with Bank of America Corp., which has found itself embroiled in the case because of its disastrous purchase during the financial crisis of mortgage provider Countrywide Financial, one of the worst-timed acquisitions in corporate history.

Even if MBIA loses the legal battle and its mortgage insurance subsidiary becomes a total writeoff, the book value in its municipal bond insurance unit is probably worth about $14 a share, about 40 per cent more than the current share price of about $10, says Mark Palmer, an analyst at BTIG, a New York-based financial research firm that caters primarily to institutional investors.

That suggests that investors have some downside protection in a worst-case scenario.

Assuming MBIA recovers a decent portion of its mortgage insurance payouts, either through a court victory or a negotiated settlement with banks, the stock has considerable room for gains.

Mr. Palmer has a target price of $22. “We feel that the shares are significantly undervalued,” he said in an interview.

MBIA’s various legal challenges are complicated and not well understood by investors, according to Mr. Palmer. (The ins and outs of the litigation are explored in a blog at mbibaclitigtion.blogspot.ca)

In the next few months, there could be a catalyst to resolve MBIA’s dispute with B of A. It takes the form of other litigation involving the bank.

B of A is embroiled in a case involving $108-billion in mortgage losses from Countrywide for which there is a pending settlement of $8.5-billion, or mere pennies on the dollar. A key supporting factor in that deal is the contention that B of A has no “successor liability” that would make it responsible for the supersized losses it inherited from Countrywide.

Mr. Palmer says B of A would be unwise to risk the second, larger case through a judgment against the bank in its MBIA dispute, and thinks a negotiated settlement favourable to the insurer is in its interest.

Not all analysts are as optimistic. Cathy Seifert, an analyst at S&P Capital IQ, recently raised her target price by $1 to $10. But she stresses that MBIA is a risky bet.

“This is a company in a very precarious financial situation whose fortunes could be heavily influenced by the outcome of litigation, and that does not make for a particularly stable business model,” she says.

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