Thursday, January 31, 2008 1 comments

BCE Merger Arbitrage Situation Very Attractive

The BCE merger situation is quite attractive right now. You are looking at around 17% return by the end of the 2nd quarter (I'm primarily looking at the Canadian stock price; US$ returns will differ based on currency fluctuations). The downside risk has been significantly reduced.

Andrew Willis of The Globe & Mail points out that the stock market is pricing in zero chance of the closure of the deal:

BCE shares touched lows of $33.30 yesterday. At that price, the company is changing hands at a price that reflects fundamentals, not the $42.75-a-share that the Teachers' consortium promised in July. It is now possible to play the world's biggest pending takeover with next to no downside.


There is still some downside risk since the stock ran up before the merger announcement. I would say the downside is around 5% while the upside is 17%.

Analysts figure that based on projected earnings, plus the $3.2-billion of cash coming from the Telesat sale, plus a scheduled dividend, plus the $1-billion break fee that the Ontario Teachers' consortium forks over if the buyout doesn't close, BCE should be valued at $32 to $33 a share (includes $5.20 per share in cash). That's the worst-case scenario.

Scotia Capital telecom analyst John Henderson took this view last week. He also argued that if Mr. Leech and Teachers leave the dance floor, Darren Entwistle from Telus will move deftly to take his place.

Joseph MacKay at Desjardins Securities crunched the numbers yesterday and arrived at the same fundamental price.


These analysts peg the value of the firm close to the current price. Do note that BCE is a stable business (telecom) with good cash flow. It won't be impacted as severely during an economic slowdown (it's also in Canada and the economic slowdown here is projected to be more mild). So it is unlikely that the BCE stock price will collapse if the deal falls apart.

Here is another story (a blog entry actually) by Boyd Erman pointing out that the credit markets still believe the deal will close (whereas the stock market doesn't think it will):

The stock market continues to bet against BCE Inc. actually being bought out at the agreed-upon $42.75 price by Ontario Teachers' Pension Plan and its partners. That's evident in BCE's market price: $35 today. One of the concerns is that a bondholder lawsuit underway in a Montreal court will succeed, scuttling the deal or forcing a renegotiation. The other major fear is that Citigroup and other lenders will pull the funding for the deal because the terms are no longer economical in today's market.

The bond crowd, however, doesn't seem to agree that the deal is in trouble. Spreads on credit default swaps remain stubbornly wide on BCE, well into LBO-target territory...

"We're still talking about spreads at levels that are all-time highs for BCE bonds, which is indicative of the fact that the credit market still expects that BCE will be a highly leveraged entity and therefore the deal will be consummated," said Dan Barrett, an analyst in New York at Tradition Group, a broker of credit default swaps and other derivatives products. CDS spreads would have to come in by about 50 per cent if the credit market thought the deal would be scuttled or renegotiated, he argues.


I think one of the factors that is causing the big takeover spread is the problem faced by merger arbitrage firms. As I mentioned in a prior post, some merger arbitrage specialists may have lost $1 billion on some of the failed takeovers late last year. With the huge sell-off in the markets in January, cash may be tight at many firms that simply dabble in merger arbitrage. It's very risky out there (since banks are having a hard time selling high yield debt) but it provides an opportunity for small investors to take advantage of unusually large spreads.

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The Monoline Circus: Time for the MBIA Act

It's really not funny when one is losing tens of thousands of dollars in an investment, but following the whole monoline industry crisis may end up being the most bizarre experience of my investing career. The latest bizarre act involves MBIA and Bill Ackman, who is trying to develop an "open source" methodology to evaluate how bad the losses will be. Not only are people to analyze the claims but they are to participate in developing better methods to determine how badly off the monolines are. He sent a letter to the insurance regulators and to the SEC (I read it was also sent to Ben Bernanke but not sure). I have no problem with shorts (they improve efficiency and allows the market to price assets better) but it's surprising that the media has given so much airtime to Pershing Square.

To make matters worse (in my eyes), MBIA isn't doing anyone any favour by holding a limited conference call, where questions are to be submitted in advance. Instead of asking questions live during the conference call, listeners are to submit in advance or electronically. If they are doing that to prepare a good answer for the questions, which are deep and complex, that's fine; but if it is to censor the questions, that's doing a disservice to shareholders. For what it's worth, management is fairly new so they may not be comfortable like the Ambac management, who has been with the firm for many years.

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Wednesday, January 30, 2008 6 comments

Do the Rating Agencies Know what They are Doing?

CLARIFICATION: DougM points out that Tom Brown says he or his affiliates have a position in MCO. I assumed it was a long position but this may not necessarily mean a long position.

Seriously. Do the rating agencies know what they are doing? I'm not even talking about their past ratings of structured products (that was a disaster but let's ignore that for now). I'm talking about the present. Here is Tom Brown commenting on how ridiculous it is for rating agencies to use "market sentiment" (thanks to seekingalpha.com for the original mention).

In theory, the agencies are supposed to be the disinterested players with the data and sophisticated models, who keep their heads when the markets are going crazy around them. No longer. Now Moody’s says it is taking “market sentiment” into account when it sets ratings on the monoline bond insurers. What’s market sentiment got to do with it? Either the insurers have the ability to pay claims in a worst-case scenario, or they don’t. By relying on sentiment as an input, the agencies create the upheaval and uncertainty that their ratings are designed to prevent.


This is a powerful comment from someone who is supposedly long Moody's. As I have discussed before (I think it was in the comments and not in an actual post), the rating agencies are under great pressure from Bill Ackman (and others) to use "market information" such as sentiment, current prices (on believe it or not, illiquid indices) and so forth. In fact, Ackman's letter to the rating agencies a few weeks ago was almost solely based on his push to get rating agencies to use market information.

I am not well versed in rating agency methodoloy or their history, but I don't think they have ever used market sentiment in any of their ratings. The main thing the rating agencies are supposed to do is to evaluate something from a credit point of view. By incorporating market information, which fluctuates wildly during stressful periods, they are not providing much of a value added service. If a bond credit rating, for example, simply follows the market price, what's the point of their rating anyway? Unfortunately that's the path the rating agencies are following.

I am starting to think that run-off is perhaps the best route for the monolines. All these wild rumours, not to mention the ridiculous propositions (eg. takes $200 billion to save the monolines), pretty much makes it impossible to raise capital. Either the monolines go into run-off or stay downgraded and somehow minimize costs and wait for one year. I think we will know the ultimate outcome of this subprime crisis by the end of the year.

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Thoughts on Ambac and Other Monolines

Maybe I'm making a newbie mistake, with my stubbornly bullish view, but I just don't see the Ambac problems everyone is talking about. Ambac can go to zero but I don't know how one can say that for sure right now.

Concern About Government Intervention

One of the risks for shareholders is that the insurance regulators may seize control of the insurance company from the holding company. Bill Ackman, and others, have been attempting to get the regulator to do this for a few years now but I don't see this happening any time soon. Ambac will either have to default on its obligations or it has to be fairly certain that losses are far greater than the claims paying ability. So far neither of that has happened. Of course, anything can happen when the government is involved but I'm comfortable with what is happening. The insurance regulators seem to be on good terms with the monolines (at least Wisconsin and New York seem to be) so I see low risk of any adverse action from them.

Splitting Muni Bonds from Structured Products

Although Ambac and others have fairly separate muni bond insurance and structured product operations, I highly doubt that they can be split up easily. Something like that may happen if and only if the government seizes the company from the holding company. Until then, it is unlikely. The parent company won't let that happen since the rating agencies and customers perceive the claims paying ability as that of the total entity. For example, when Ambac says it has something like $16 billion in claims paying ability, that should technically be for both the muni bonds and the structured products. You can't just allocate all of the capital to the muni bond; or even split it evenly between the two.

Capital Injection

I still feel that using reinsurance on the muni bonds is still Ambac's best bet right now. That alone won't be enough but that should be used along with other means. I have no idea how costly that would be right now but if we go with something similar to the Assured Guaranty deal ($25billion ceded for $250million in capital), Ambac may have to cede $50 billion to $100 billion of muni bonds. This is basically selling the crown jewels but at some point the jewels are less important than maintaining the kingdom. The problem is that I'm not sure who will be willing to provide that much reinsurance at a reasonable cost. Maybe if those private equity investors and vultures set up reinsurance operations instead of bond insurance firms.

Am I Just Being Too Stubborn--and Wrong?

I still don't see big losses for the monolines. I keep thinking about where my thinking is wrong; I just don't see it. Let's revisit this issue (refer to Ambac's CDO document for reference; all charts and tables are from that document). Ambac has other exposures but I think we should just look at CDOs and CDO-squareds, since that is where the problems are.



The above charts break down the CDO exposure. The BBB and BIG exposures only amount to around $4.3 billion. Even if they were written down to zero (there should be some positive recoveries) you are looking at $4.3 in billion losses. How about the highly rated segments?

I am still maintaining my faith (to a large degree) in Ambac's internal ratings. As long as Ambac is still rating securities as A or higher, I think I am comfortable with them. Yes, they can--and some will--get downgraded but my thinking is that most of the bad events have already started unfolding. The following shows the securities that I feel are a big threat:



I highlighted some items that are worth noting. The big question marks are the CDO-squareds, which in total amount to $2.5 billion, and McKinley Funding III, which totals around $1.2 billion.

The CDO-squareds are going to be close to a total loss. The actual performance will come down to recoveries I think. The CDO-squareds have high attachment points but they are almost entirely mezzanine CDOs (as underlying collateral) so the picture is not so bright here.

The McKinley Funding III security is pretty big and is a concern. Analysts asked about this in the conference call and, well, all we can do is wait and see.

There are a whole hoard of others who have been deteriorating and are now rated around A. These will determine the future of the company. The reason I am still reasonably bullish is because until these drop into the BBB (or below) area, I just don't know how someone can say there are going to be massive losses.

The other thing to note is that the Markit ABX Home Equity indices are stabilizing--or at least it seems that way. The ABX indices likely indicate a worse picture than what the monolines are exposed to (since monolines should have some skill in picking lower risk over higher risk--that's what insurance companies do; and have higher attachment points). Nevertheless, we can look at it as a market pricing indicator.

Here are some Markit ABX index charts. I just picked a few from 2006 and 2007 to gauge the situation.













It's hard to say for sure but the 2006 stuff looks to be stabilizing, while the 2007 indices are still showing weakness. The BBB-rated indices, especially from 2007, shows massive losses. It remains to be seen what transpires over the next few months. There are some economic stimulus being directed at citizens that may lower the subprime default rates (eg. tax rebate, interest rate cuts). We just need to wait and see what happens with the economy.


Decision for Shareholders

If someone purchased one of the weak monolines recently, they have to make a decision on whether to sell and take a loss, or to hold. Some can also try hedging by buying puts but I don't know much about options and don't know how expensive they are. I entered late so I feel less of a panic and am willing to hold for the time being. My view has always been to wait for a few months and see how the subprime default situation unfolds. The big surprise to me was the fact that Ambac didn't raise the $1.5 billion I was expecting.

I hate to say it, but if the monolines recover, Neanderthal may have sold almost right at the bottom around $5 (actual bottom was around $4.50 I think). If one is to exit the position now, it should be based on the belief that things are going to deterioriate; don't do it just because it is getting scary. The fact that Bill Ackman will be releasing a new report should not influence your view much. He is an activist investor and will do things like that. If one is concerned, they can also come up with a hard limit and set a stop-loss order and forget about it. The stock has a possibility of gapping down but that's a risk you take.

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Sunday, January 27, 2008 3 comments

Japan Stock Research Tips

Well, it`s time to revisit Japan. If you need a reason, how about Marc Faber. It looks like Marc Faber shares similar views as me regarding Japan. He seems to be bullish on Japanese small-caps and the Yen (On a side note, this is probably the first time I have seen him suggest shorting emerging markets. He has been a superbull on EM and commodities so this is a major change in my eyes and something to watch out for).

I'm just a newbie when it comes to investing and thought I would write up some techniques and methods I'm using when researching Japanese stocks. I will primarily talk about researching stocks listed on Japanese stock exchanges. Some of these stocks may trade in New York or on the Pink Sheets but anyone that is as bullish as I am should probably consider opening up a brokerage account that allows you to buy directly on the Tokyo Stock Exchange (or one of the other exchanges in Japan) for a low commission. What I have done is to open up a Yen-denominated brokerage account at HSBC (I'm in Canada but it should be similar elsewhere). Since I am bullish on the Yen, what I have been doing is transferring money into the Yen account whenever I save a meaningful amount.

Before I say anything, note that some information can be out of date and/or misleading so you should double-check everything by reading official company documents. For example, some of the P/E ratios listed on the Tokyo Stock Exchange website were wrong because they didn't incorporate stock-splits that occured recently. I was looking at something that had a P/E of 3 but it was actually more like 9.


Company Website

If you know the company that you are intersted in, just Google for it on the web and go to their website. Many of the large-cap and mid-cap companies have English investor relations information. Annual reports, news releases, and so forth, can be found on their site.

Company Info from Reuters

I find reuters.com to be the best place to get stock information (eg. market cap, dividend, earnings estimates, etc) for Japanese stocks. Use the following suffix ".T" for Tokyo Stock Exchange listed stocks (other Japanese exchanges have different suffix). For example, enter "8564.T" in the search box at the top right on the main reuters site.



If you wait a while, the search result should list a box near the top with the stock info. Click on that box to go to the stock info page.


Japan Company Handbook

If you want something similar to a Stock Guide from S&P or Value Line, the Japan Company Handbook seems to fit the bill. You can buy it from Amazon or some bookstore. You may also be able to find it in your local library. I really haven't used it so I don't know how good it is. The samples on their website makes me think the data is very sparse and is only a starting point (similar to the S&P guides). I simply ran across it and thought some of you may find it useful. Unlike online stock information from Reuters, these guides generally have multi-year information and seem to have sales broken down by segment.

If you want to be the next Warren Buffett, you need to be thumbing through these books (or at least some online equivalent). Remember how Buffett said he was thumbing through Moody's stock guides (now called Mergent); or how he was looking through a book on Korean stocks a few years ago and found some flour mill with a P/E of 3 (or something like that). (oh, if you do become the next Warren Buffett, make sure to send me a small little check for my help. Don't be cheap and make sure it has a lot of trailing zeroes in the number ;) ).

Charting Japanese Stocks

If you want to plot Japanese stocks, I find bigcharts.com to be good for foreign stocks. Use the following prefix "JP: " when entering the symbol. For example, "JP: 8564" for Takefuji.

Researching Unknown Stocks from Index Listings

If you don't know what you are looking for (eg. if you want to look at small-cap consumer staples), one place to look is some of the popular Japanese indices. Since I'm looking at small-caps, here are two useful indices to look at:


  1. S&P Japan 250 Small Cap
  2. Russell/Nomura Small Cap Japan

I believe both of these have ETFs, so you should be able to get index constituents from the ETF website (if not, then you have to go to the index provider--I don't have those URL handy). You can also get ideas from Japanese mutual funds.

Once you go through the list, you should be able to pick off a few that you like (say, small cap retailers) and then Google for more information. Unfortunately, many small caps don't have English information so you either have to blindly buy a basket of stocks, a la Benjamin Graham, or look at mid-caps.

Researching Unknown Stocks at the TSE Website

I spent many months looking for a filter for Japanese-listed stocks. You know, something where I can search by low P/E or have a listing comparing Price-to-Book. Well, I didn't realize the Tokyo Stock Exchange's advanced search is good enough for my purposes. Go to the Tokyo Stock Exchange website and click on the 'stock price advanced search' buttom, as shown below:



Then pick the areas of the exchange you want to search. First Section is typically large-caps, while the Second Section is small-caps.



In this example, Here are the results where I filter for everything in the 1st and 2nd sections in the food industry:



You can flip through this list to find something that may interest you, then click on it to get some information and do further research. Always note the volume and price in order to avoid thinly traded stocks. I personally would only stay in the 1st Section given the need for English documents.

As I have mentioned in prior posts about Japan, most Japanese companies have low ROE (Return on Equity). In the results you will see that practically everything has an ROE around 5%. You will also notice that a lot of them are trading below book value. Anyone investing in Japan has this dilemma of low Price-to-book but very low ROE as well. Perhaps one solution is to find something with low P/E ratio in order to compensate for low ROE. Perhaps something with low P/B and P/E while having low ROE can be profitable. Anyone have any thoughts?


That's it for now... if anyone has any Japanese stock ideas, feel free to leave a coment...

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Saturday, January 26, 2008 15 comments

Ambac Conference Call & Other Thoughts

Ambac held their 4Q07 conference call on Tuesday and I was reasonably pleased with how Ambac handled the situation. I don't know if I have any insight to anything that was discussed but thought I would add my thoughts. The reason I say I don't have much insight is because nothing major has changed in my eyes. No doubt their risk models and underwriting have been poor but the real question is the actual losses that will materialize.

(You can find the conference call transcript from SeekingAlpha. It has a lot of typos but it's free so can't complain :) You can access the audio call from Ambac's site. )


I was going to quote some text but am, instead, just going to touch on the key points (not in any order):


  1. Holding Company Liquidity: One of the concerns is that cash flow from the insurance subsidiary will be cut off, resulting in the holding company going bankrupt. Management said they need $90 million for interest payment on debt; have $50 million cash right now; and can receive $200m without regulatory approval. So I think this shouldn't a concern of shareholders for the next few quarters.
  2. $1.1 billion Impairment: Nearly all of it is from CDO-squared, where the underlying CDO is mezannine sub-prime RMBS assets. The loss reserve is very large but it doesn't shock me (I would have been shocked if the loss was from a high-grade CDO or something--then Ambac's underwriting has to be questioned). My feeling has always been that the CDO-squareds, particularly with underlying mezzanine CDO as collateral, are going to be the big problem. What I would look for now is to see if there is further deterioration as we move forward. I expect this to be the worst so we need to see lower losses in the future. I do think that Ambac will book losses in the future but they should be smaller.
  3. Risk Model and Underwriting: Ambac says the increase in impairment was due to using a different methodology to evaluate losses--one that places more emphasis on the legal structure. This kind of makes me nervous. I mean, if their is a failure in the model for these CDOs and CDO-squareds, I wonder how their other models are (say, models and projected losses for ABS of auto loans). Nevertheless, they are trying to move to a better way of pricing risk and it remains to be seen how the future turns out. I always expected to see a large loss in 4Q07, while posting smaller losses as we move into 2008 (check below for the reason for my thinking (hope?) below*). Note that Martin Whitman also remarked that you are likely to see "staggering losses" being posted by MBIA (and others) (I'm sure he was talking about mark-to-market losses and not actual impairments).
  4. Management Change: It's hard to say if Michael Callen sugarcoated his words but, if what he said was close the truth, the situation isn't as bad as I initially perceived. When the announcement was made a few weeks ago, I thought Ambac was an imminent disaster and it looked like the captain was jumping ships at the last minute. But if Michael Callen has actually kept in touch and consults with Robert Genader, the prior CEO, at times, then it isn't really as bad as it seemed. The key disagreement seems to be over issuing equity or equity-linked notes. Robert Genader feels like he owes it to the long-term shareholders and didn't feel comfortable issuing equity. Ambac had a market cap around $1.5 billion at that time, and it would have diluted shareholders by 50%. The thing that I'm uncertain about is the alternative that was considered. Ironically, all of this may have been for nothing. I feel like the CEO resigned because he didn't want to issue stock, but in the end Ambac never issued stock because the stock price dropped so much. Anyway, the management change doesn't seem as bad as I initially thought.
  5. Future Strategy: Ambac said it did not seriously consider run-off and is going to try getting its AAA rating back. This was a surprise to me. It's going to be hard to do that while having shareholder interests in mind. There isn't much for me to say until we get some details. Ambac needs $1 billion and its market cap is below $1 billion. Not an easy place to be. Ambac doesn't have any meaningful physical assets it can sell off, although it can trying unloading a huge chunk of its insured muni bond exposure. This basically amounts to giving up the crown jewels to save the kingdom. A risk with raising capital is that if the rating agencies change their mind again(!) then you are screwed... In any case, a big risk for shareholders is that some vulture might swoop down and buy the company at a really low price. This seems unlikely given that the run-off value (even some midly bearish estimates from Goldman Sachs pegs the run-off value in the $15+ range). Management would have a hard time justifying a sale where the price is way below the run-off value.


(* My expectation has always been for a big 4Q loss because most of the decline in the value of RMBS, CDOs, etc happened during that time. As a very rough measure look at the ABX index. Many of the ABX indices have dropped 60% to 70% (depending on what you are looking at) so it can only drop 30% to 40% more (from original price). It should also be noted that some physical assets (like houses) should have some positive value. What will end up being worth zero are HELOCs (home equity line of credit). I think direct RMBS (and CDOs, depending on their legal power) are not going to hit zero. For comparison, the $1.1 billion loss impairment supposedly represents 38% of the original par value. I do not expect to see losses anywhere near the 4Q numbers in the future. There will still be some sizeable losses but the peak needs to be the 4Q numbers. If I do see big numbers in the future then I am wrong with my original investment expectation and will start to wonder about Ambac's risk management... just to be clear, what I see happening is that loss reserves may go up (this is bad but to be expected to some degree) but I am expecting to see mark-to-market losses reverse or stabilize. This is a bullish view.)

Anyway, let's see how events unfold. The situation is really out of our hands (your only decisions are to sell the position at a loss; or hold)...


Back to the Past

It's always interesting to read historical articles and see how events unfolded. Here is a blog entry by ContraHour who was contemplating shorting the monolines back in 2005. It talks about MBIA and the huge potential losses they faced from Katrina. The risks the companies face now is somewhat similar. Back then, the worry by the blogger was that the monolines may lose their AAA rating. This is kind of the problem right now for bulls like me (the bears have a more pessimistic scenario of insolvency for the industry). I'm not implying that the current subprime debt insurance problems are the same size as the Katrina problems but it does shed some light on what happened just a few years ago. (Another big problem for some monolines was the Eurotunnel exposure.)


Is the Bond Insurance Industry Doomed?

One argument against monolines is the notion that the industry may dissapear. I respect GaveKal for their generally off-the-wall thinking and here is a thought on the monolines from them. I don't have access to their reports but here is an excerpt from a posting on their message board:

Steve Vennelli of GaveKal: PS- On monoline insurers: Maybe they go broke and the business model never returns. S&Ls sprang up after WWII to finance the construction of suburban America. By the 80s, when this had largely been accomplished, they got into golf courses, strip malls, etc. In other words, they ventured into new areas. After many failed in 1990, they never came back. The monoline insures are a similar story, having begun life as muni bond insurers and having gotten into insuring CDOs, ABCP, etc. The market has been pricing this along the way (note the chart below), but if/when the monoline insurers go bust, it could hit the banking system, as munis and CDOs have to be written down to reflect the elimination of the monocline credit enhancement.

It is a little bit of a mind-bender to think about a company going bankrupt because the present value of their contingent liabilities soar. They may be broke on paper, but that is only a function of discounted contingent liabilities. Talk about mark to model. For the big money buying into Ambac or MBIA, this is a call option on the housing bust not happening. PIMCO’s total return fund is now 65% in mortgages.


One of my key reasons for investing in the monolines is with the expectation that the industry survives. If that assumption is incorrect then this is a very bad investment indeed. Steve Vannelli, above, points out how S&Ls (Savings & Loans financial institutions) were very popular for many decades but then dissapeared with the housing bust in 1990.

I have always felt that the business model made sense and I think I am right but you just never know. The fact that Warren Buffett actually set up shop leads me to believe that the industry will exist in some form in the future. It's unlikely that Buffett does anything without a 10+ year time horizon.

Other other key thing that Steve Vannelli mentions is that investing in the monolines is basically a bullish bet on housing. I never looked at it that way but that is what it will ultimately come to. The monolines basically need the subprime housing default rate to stabilize or decline. So far, with the rate cuts and other government measures, things are looking up. Some articles indicate that mortgage rates are similar to, or even lower, than what they were an year ago. Homeowner refinancing is also up. This is probably one reason the homebuilder stocks are some of the best performing stocks this year... but we still have a long way to go before a trend is established.

As I have remarked many times, the key number to watch is the subprime default rate for 2006 and 2007 mortgages. It's a very rough measure but if that keeps increasing then we have problems; but if it stabilizes or starts declining, we may have seen the worst.


The Near-Term Future

Remember: the main problem for the bond insurers is not a cash crunch but the need for some capital to satisfy rating agency requirements and to stabilize the fear in the market. (I still think the broad market will still decline because of an economic slowdown but it won't be because of the monoline uncertainty). I don't know what Ambac is doing but a combination of ideas (eg. some share issuance, some reinsurance, etc) is probably the best in my view.

As far as Wilbur Ross and private equity investors are concerned, there is a risk that they will buyout the company at a low price. If they want to provide some capital, that's fine with me. Otherwise, I would prefer that they not even get involved. The dumbest thing ever is for the company to sell itself at a value far lower than the run-off value.

A huge risk for shareholders have been the view that the regulators may seize control of the insurance subsidiary and prevent any money from flowing to the holidng company, hence bankrupting the publicly-listed corporation. I think this is highly unlikely for the time being. Wisconsin, which regulates Ambac, as well as New York, are on good terms with the monolines (they also likely don't have the expertise to run things so I'm sure the last thing they want is to take over these companies). Furthermore, my non-legal opinion is that they likely have no legal basis for seizing control until they can prove that losses are going to be too high and the insurance subsidiary can't afford to pay out dividends to its parent. I'm not too worried about that (as Ambac indicated in the conference call, they also have non-regulated money coming in so the holding company should be ok for the time being).

Ultimately, it will come down to the real losses. If they are high, the bond insurers will go bankrupt; if not, then they won't and all of this will seem like distant memory.

Believe it or not, I am totally against government bailout of any sort--the bond insurance industry lobby group has a similar view. I will lose a huge chunk of my savings if Ambac goes bankrupt but shareholders should take the losses. We all invest with the expectation of making a profit on risk and if things don't go our way, we need to accept our losses and move on! Speaking as a free market guy, profit and loss should accrue to the investors. Socialism for the rich is just going to end up with fascism for everyone!

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Friday, January 25, 2008 7 comments

Are swaps the future for hedge fund value managers using concentrated portfolios?

I know I'm on the opposite trade from Bill Ackman when it comes to the monolines (grr, I wish he would cover his position and take his 90% profit. I know MBIA probably screwed him over before but personal vendettas can be deadly), but he is considered to be a savvy investor who is supposedly a value investor so I pay attention to him. I noticed Bill Ackman's strategy of using swaps in parallel to his stock purchases/sales (thanks to Todd Sullivan's Value Plays for the mention).

In this example, Pershing Square is taking a long position in the stock of Borders Group (BGP) (i.e. buying the stock), while also entering into bullish swap positions that will yield a profit if BGP's stock price rises. Bill Ackman is basically leveraging himself without buying more stock. He is also using CDS (credit default swap) alongside his short positions in MBIA and Ambac.

Swaps such as CDS are one of the fastest growing part of the derivatives world. If you are a value investor who runs a concentrated portfolio (Ackman would fit this bill, just like Buffett, Munger, etc), is it the future for these investors? These investors are very confident with their call so does it make sense for them to leverage returns further by betting in the same direction as their main stock holding? Note that Warren Buffett has often used convertible bonds alongside his stock positions. The classic example is GEICO, where he owned both the stock and the convertible bond (if I'm not mistaken). Is the use of swaps something similar or not?

I'm curious how all this will work out in the end. The big difference with derivatives obviously is that you have no direct economic interest or control over the underlying entity. Pershing Square seems to always buy a stock (in the case of BGP) or short a stock (in the case of MBIA) while entering the swap positions, so they still have control over the business. But their potential profits and losses are far greater than their economic interest (i.e. stock position). If the stock declines, a conventional equity-only investor can sit and wait for the situation to improve; someone using swaps (bullish position) are going to take big losses if the stock price drops. In the cited example, if BGP drops below $9.99, the stockholders can wait and hold, but Pershing Square will take losses.

Or is this strategy (i.e. using swaps alongside stock positions) only a fancy scheme for activist investors? Note that many activist investors only take a small position in a business while attempting to project influence far greater than their ownership position. So leveraging any positive result from small changes is very attractive for them.

It remains to be seen if other "value" investors start using derivatives in the future?



(On another note, if I feel like it I'll critique his letter to the rating agencies about the monolines in a future post. The big thing I notice is that, although his criticism is strong and worth considering, he is using market prices to draw conclusions (completely against Whitman and Eveillard were saying in my prior post). Rating agencies are supposed to evaluate the credit quality of a company. The fact that, say, MBIA's surplus notes plunged after issuance means little (MBIA got the capital; it's down to what they can do with that)).

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Wednesday, January 23, 2008 2 comments

Morningstar Conversation: Martin Whitman and Jean-Marie Eveillard

Thanks to gurufocus.com for mentioning this Morningstar Advisor conversation piece between Martin Whitman and Jean-Marie Eveillard. For those not familiar, they are highly successful value investors who run the Third Avenue Value Fund (Whitman) and the First Eagle Fund (Eveillard). It`s an entertaining read, with a humourous Martin Whitman. Here are some things I found insightful:

(MW=Martin Whitman; JME=Jean-Marie Eveillard)

MW: ...We buy and hold long term. Markets go down, we take advantage. We sort of operate under the implicit assumption that if we don't know more about the situation than the market, we wouldn't be there. They operate under the assumption that the market is sending me messages; the market knows more than any individual. It's just the opposite...

JME: That's right. I think it's Seth Klarman who said, "The biggest edge that value investors have is their long-term orientation," which I think jives as well with Ben Graham saying, "Short term, the market's a voting machine; long term, it's a weighing machine"...

JME: So many investors are always looking for the information that the others don't have. And as you said, we have the same information, which is readily available. We try to use it better than the others. It's in the interpretation, in a sense, and the reading of the available information.


There are some big advantages that small investors with a value-orientation have over the street. Many small investors think that we are at a disadvantage to the Street but that's not really true. We don't have to follow the market. We can be long-term whereas everyone on the Street has a narrow focus.

MW: Absolutely. For conventional people, there is a primacy of the income account. In what we do, there is no primacy of the income account. If there is a primacy of anything, it's the quality of the financial position. That governs what we do. I think it governs what you do. It's a matter of weight to information. If somebody else is going to emphasize earnings per share, and we're going to emphasize quality of the balance sheet, we're going to weigh the information very differently.

As a matter of fact, on this primacy of the income account, I know from what you did in Bank for International Settlements that our basic emphasis is on wealth creation, not earnings from operations, knowing that earnings from operations and cash flow from operations is just one method of creating wealth. And usually, it's the least desirable method of creating wealth. We have alternatives.

JME: That's right. And you have done so much with real estate-related securities. Of course, that's a case where the earnings per share simply do not.

MW: Measure anything.


Value-oriented investors tend to value the balance sheet more than the income statement. Investors like Warren Buffett give weight to the income statement, but others like Martin Whitman are on the extreme end where he primarily looks at the balance sheet. If one focuses on the balance sheet, I think they are best off reading the strategies of Martin Whitman, Benjamin Graham, and the like.

From my perspective, if you don't get the balance sheet right, it's hard to have confidence in the value of anything. Who knows if Ambac will turn out to be a disaster but one of the reasons I had confidence in it--with it down 70% within one week of me investing a huge sum--is because it looked clean from a balance sheet point of view. Similarly, one of the reasons I'm willing to venture into Japanese stocks, even though the macro picture is poor and the Street is bearish on it, is because most stocks are trading at a low price-to-book-value.

Overall, you should try to figure out what you are good at: looking at the value via the balance sheet, or the earnings through the income statement. Of course, if you nail both of them, you will become a superinvestor :) A lot of newbies look at the income statement (i.e. earnings) because it looks easier to analyze. After all, you just think about what the growth rate is going to be, and if a product is going to do well in the market. But the earnings are so sensitive to projections. One percent off here and there and it can turn into a disaster.

JME: In your April quarterly, you wrote something that intrigued me. You said the entry point into a stock is important, and the entry point must be at a bargain level. Because once you hold the stock, you're a buy-and-hold investor, and accordingly, you do not sell the stock, even if it's fairly valued; you only sell the stock if you think you've made a mistake, or if you think the stock is grossly overvalued.

MW: Or for portfolio reasons.


Pretty straightforward but thought I would quote it...

MW: I must say one thing. You and me, we like to look at what's wrong with what we're doing. And let me say what's wrong most of the time with what we do in buying into very well financed companies at a discount from readily ascertainable net asset value, which is 90% of our portfolios.

First, most of the time, the near-term earnings outlook sucks. That gives us the price.

Two, we're in bed with highly conservative managements, who most of the time are willing to sacrifice return on assets and return on equity in order to get the insurance policy of a strong financial position.


Martin Whitman tends to favour a super-strong balance sheet at the expense of growth. I'm just a newbie but I personally don't. I usually avoid companies with low ROE, the most important measure for Buffett (it's actually either ROE or ROIC for him).

JME: One thing you say that I've always liked, Martin, is, "Hey, we're value investors, but we have nothing against growth." What we don't want is what you call "generally recognized growth." In a sense, I suppose what you are saying is, "We're all for growth, but we don't want to pay for it."

MW: The second largest holding in the Third Avenue Value Fund is Toyota Industries, which is the founder of Toyota Motor TM and still a 5% or 6% shareholder of Toyota Motor. Under Japanese accounting, on the balance sheet, Toyota Motor and other portfolio companies have to be carried at market. Toyota Industries' common is selling out at 30% discount from net asset value.

However, under Japanese and U.S. accounting, all Toyota Industries picks up in earnings from Toyota Motor is dividends paid by Toyota Motor, not the retained earnings of Toyota Motor.

If you look at GAAP, Toyota Industries is selling around 21 times earnings. However, if you adjust the earnings to pick up Toyota Industries' equity in the undistributed earnings of Toyota Motor, it's selling around 6 or 7 times earnings.

We, over many years, thought Toyota was a growth stock, and we thought we were buying it under 10 times earnings. And I think, essentially, we're right. But that's how I think. You and I, Jean-Marie, both try to buy growth and try not to pay for it.

JME: But also what you did, Martin, by buying Toyota Industries as opposed to Toyota Motor, is to look at Toyota Industries in an unconventional way. Looking at just the multiple of earnings is the wrong way. There is a number of securities where you have to be careful how you look at them, and where you may not want to look at them in the conventional manner.

We've been a shareholder in Rayonier RYN, which basically owns timberlands, for more than a decade. Timberland is a bit like real estate. Price to earnings does not apply.


Two good examples of why these guys are some of the best on the planet... looking at things in an unconventional manner...

JME: Exactly. And also, the other angle--which neither you nor I care about--is that Toyota Motor, the stock, is in the big index. Toyota Industries, which is the holding company for Toyota Motor, is not in the big index.

So people who pay a great deal of attention to index weightings will sacrifice the 30% discount, which they could get if they bought Toyota Industries as opposed to Toyota Motor, just because Toyota Motor is in the big index.


This provides an argument against passive investors (aka indexers). If you can somehow do okay, you'll avoid these problems. I personally don't like passive investing for another reason: if a company totally sucks, you still end up bying it because it's in the index. Having said that, if I figure out I don't know what the hell I'm doing and not cut out to invest on my own (will know within 2 years given my concentrated portfolio strategy), then passive indexing is the way to go.

MW: Let me just talk about private equity, limited partnerships and tell an old story.

A limited partnership is a business or investment association where, at its inception, the general partner brings experience to the situation, and the limited partners bring money.

At the end of the limited partnership, the general partner has the money, and the limited partners have the experience. [laughter]


LOL :)

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Ambac Posts First Loss Since Going Public

Hate to say it but I didn't listen to the 4Q earnings conference call in full. I don't have time right now but I'll go through the transcript on my subway ride home tonight. One of the best features from SeekingAlpha.com is their free transcripts. Check out Ambac's transcript here.

You can read news articles all over the web to get the scoop on what happened in the conference call. Ambac basically posted their first loss since they went public more than 10 years ago. It is also a weird situation, which I'm sure threw people like Cramer off, in that the loss is higher than the share price (this happened without causing bankruptcy because the book value is much higher and the loss isn't a cash loss). As crazy as this may sound, Ambac actually posted negative revenue for 2008 (minus $4.18 billion). Fortune had a somewhat humourous take on this, pointing out that this makes Ambac the smallest big company on the Fortune 1000 list. The Fortune 1000 is sorted by revenue so that puts Ambac dead last even though there are a whole hoard of small caps that are much smaller than Ambac. Not exactly a laughing matter for shareholders but I have a good sense of humour and I'm still confident that Ambac is worth way more than what it is trading at.

I'm not going to post my thoughts on management's strategy until I go through the full conference call. For what it's worth, I think the media has covered all the main points. I'm not sure what I can add.

What we can be certain is that Ambac is trying to stay AAA. The question is how big of a dilution this will entail. Contrary to some people's opinion, the company is solvent but it needs capital and the share price is low. Management also said it is not pursuing run-off so that's off the table for now. I personally view a run-off as the last scenario and don't like it that much (the reason is because you can be stuck in this state for at least 2 or 3 years).

There is still the risk of government intervention--not necessarily in favour of Ambac shareholders, but in favour of insurance buyers, the industry, banks, and the government itself. I see any hostile action against the shareholders as having a low probability. This is the great thing about investing in a country (USA) where property rights are strong. It will be hard for anyone to seize assets or mandate things when Ambac hasn't defaulted on any of its payments or is out of cash. Note that liquidity is not the issue (there is enough cash to pay claims for several years); rather, the issue is the capital required to stay above statutory and rating agency requirements.

One new thing was the revelation that Ambac needs to post collateral if its rating was cut deeper on some of its investment transactions (read the last few paragraphs of this article or check the conference call transcript). This has nothing to do with bond insurance and shouldn't be an issue. My understanding is that Ambac invests some of the money from municipalities and other involved parties on their behalf into low-risk short-term bonds. The simply need to liquidate the assets (very liquid and high-quality) and post that as the collateral (or unwind the investment operation if it's legally possible).


I mentioned a while ago that one risk with this stock is that stock analysts were still positive. Well, the opinions are coming down, with the latest being Goldman Sachs cutting Ambac's price target to $10 and 2008 earnings to $2.15. That still puts Ambac at a current P/E of around 5; for people who bought this stock at $30, that's still a P/E of 15 (not cheap but not outrageously expensive either).

The stock price has been crazy lately and I wouldn't draw anything from that (just like how the initial drop was wild speculation as well). The real risk to shareholders is the possibility of being bought out for cheap or diluted like crazy. As I said, Ambac hasn't missed any payments so it's not quite an extreme distress situation where they are at the mercy of creditors (in these situations the shareholders end up beaten up pretty badly).


(Not related to this but Warren Buffett's investment in Swiss Re is a good thing. Not exactly related to bond insurance but it shows that some people are willing to put capital into insurance. I don't know how costly it will be but Ambac can still unload a chunk of its muni bond portfolio to one of the reinsurers.)

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Tuesday, January 22, 2008 1 comments

Wild Day

Wild day and not sure what to say... A lot of stuff happening all over the world... Most of Asia has been clobbered over the last two days. Some markets, like Hong Kong, Japan, and India are down quite a bit (Indian market supposedly hit circuit breakers and trading was halted for one hour)... Europe isn't doing so well either... commodities are also down. The key commodity to watch is Dr. Copper. Copper corrections are thought to be a good indicator of economic weakness...

Having said all that, the US market is stabilizing and showing strength. Not sure if these gains will hold in the afternoon...

The Federal Reserve rate emergency cut, which takes at least 6 months to work its way through the economy, won't save equity prices if the underlying economy is indeed weak. However, it will mitigate the economic slowdown and should help consumers, particularly the stretched homeowner whose ARM is resetting. I think this is what is giving some push to the financials.

Bank of America announced a bunch of stuff but I think it was drowned out by all the other news floating around...

The big news for me is the Ambac conference call. I will post thoughts later tonight but key things that stick out are... Ambac plans to retain its AAA rating. I thought this was gone but maybe not. The question is how dilutive any method will be for Ambac shareholders. Ambac says it has some interested parties but what is the cost to shareholders? A possibility is for Ambac to unload a chunk of their municipal bond assets... Ambac also indicated that it is not pursuing run-off. Management didn't spend any serious time on this possibility...

All the monolines are up sharply... Ambac and MBIA are up around 30%, but were up as much as 40%... The rest of the sector is on fire as well...


(source: finance.yahoo.com)

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Monday, January 21, 2008 3 comments

Talk About a Sea of Red

Americans taking the day off will be welcomed with a sea of red across all the major stock markets of the world... Practically everything is red. Check it out (source is Wall Street Journal Markets Data Center--a very good overview of all things financial):

(note that some of the markets were closed so some numbers are from Friday; coincidentally, my former home country, Sri Lanka is the only one green in the pics below ;) Trust me, nothing good is happening in that country :( ).

Major World Markets


Selling Started Off in Asia...


Infected Europe...


And Clobbered the Americas...



Commodities were also down but the US markets were closed so US commodity prices aren't available. One of my calls was for the Japanese Yen to strengthen and it looks like it is happening. There is also a possibility of US$ strengthening if the sell off continues.

The performance of US markets tomorrow will set the mood for all the other markets. One of the big events tomorrow is the Bank of America conference call. Any bad news from them and watch out. As for me, the Ambac conference is what I'll be watching.

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The Most Important Conference Call in Ambac's History

Ambac will hold the most important conference call in its history tomorrow. When I made the investment in Ambac a few weeks ago, I never thought it will lose its coveted AAA rating. I never thought it will be the first AAA to be downgraded (always thought FGIC would be the first). It's all surreal given that Ambac was named monoline of the year as recently as a few months ago. Anyway, things haven't unfolded quite the way any Ambac shareholder was expecting and we need to deal with what we have. There will be a lot of things happening but key items to watch during the conference call include the future strategy of the firm, management change thoughts, and the $1.1 billion loss that was pre-announced.


Run-off?

The main decision that Ambac will have to make is whether to go into run-off or to operate as a AA-rated insurer. It doesn't necessarily have to make this decision right now but management needs to lean one way or another. Shareholders don't need anymore ambiguous strategies and I would prefer a solid decision. I'm sure employers and potential customers will also prefer some clarity. We definitely don't need the questions like they had with their capital raising plan. Half-hearted attempts at trying to run a AA--rated insurer is likely to be unproductive. Conversely, if the strategy is to go into run-off, they need to follow that path and contemplate selling assets, laying off employees, and so forth.

We don't know what future losses will be but run-off right now seems to have a positive value to shareholders (far above current stock price). There are several downsides with the run-off strategy. First of all, it can take a long time (could be many years to a decade) to unlock shareholder value. I think if Ambac shareholders approve a run-off, I am guessing shareholder value will be unlocked within 5 years or else they won't approve it. I can't see too many investors willing to hold this past 5 years. The other potential downside is if the insurance regulators block payments from the subsidiary to the holding company during a run-off. Since the parent company doesn't generate money on its own, blocking off the payments will bankrupt the company (for example, it won't be able to pay its roughly $1 billion debt outstanding). It is unlikely that the regulator will do anything without political interference from outside sources. Ambac hasn't defaulted on any obligations and its capital is above statutory requirements so it will be hard for the regulator to do something.

I would prefer if Ambac tries to survive with an AA-oriented business model but I don't know how easy that will be. With the loss of AAA, Ambac can potentially lose 75% of its business. It all comes down to the demand for AA-rated products. Given that credit spreads are widening like crazy, there may be some demand (far more than a few years ago) so it remains to be seen. Berkshire Hathaway Assurance has also indicated that they will demand premium fees so there is room for cheaper insurance.

(as an irrelevant side note, one of Ambac's subsidiaries, Connie Lee Insurance, has been in run-off for a while now)


What is Ambac Worth (A Crude Assessment)

Book value is a pretty good indicator of an insurance company's net worth. To the numbers I'll mention below, you probably should subtract $1 per share to $3 per share to account for costs associated with shutting down operations. One should also discount the return by the time period it will take to unlock the value (but we don't know what this will be--a wild guess of 5 years is probably reasonable).

Right now (after the earnings announcement) book value per share is around $21 and adjusted book value is in the $50's so that's the somewhat optimistic outcome during a run-off. This case is basically where you assume that all losses have been accounted for (with existing marks and loss provisions) and there will be no increase in losses in the future.

The bearish outcome is if losses increase in the future (i.e. what's on the books doesn't capture all future losses). The absolute worst case is bankruptcy. I say the stock price will be between $0 and $5 in the bearish scenarios.

The bullish scenario is if the booked mark-to-market losses turn out to be higher than the reality. In this case, each share is probably worth around $50 to $80 (this was Ambac's book value back in early 2007 eg. 3Q07 book value was $55.64 and adjusted book value was $88.07).


You can see why I invested in this stock as recently as 2 weeks ago! The book value is very high compared to the stock price. The problem is the uncertainty of future losses! It's sort of like investing in a reinsurer while you are in the thick of hurricane Katrina.


Senior Management

We need firm confirmation that the interim CEO, Michael Callen, will be running things as if he were the long-term CEO. I think this is the implicit assumption by everyone but the last thing we need is more waffling on this.

Michael Callen has been with Ambac since 1991, and had important board of director responsibilities, so he is very qualified to deal the matter at hand. He was an executive at Citigroup in the 80's prior to joining Ambac so I'm confident in his abilities.


Dividends

I think Ambac should cut its dividend to zero. There may be some merit in keeping a slightly positive dividend, in order to force dividend-oriented index funds from dumping the stock, but preserving cash is going to be important for the next year.


Loss Provision of $1.1 Billion

In the pre-earnings release, Ambac mentioned that it is taking a mark-to-market loss of $5.4 billion ($3.5 billion after-tax). That isn't a huge concern given that mark-to-market may or may not mean anything given the wild uncertainty in all assets right now. The real issue, however, is the $1.1 billion credit impairment they recorded. This $1.1 billion is from a mezzanine subprime CDO of ABS. I think this is what scared a lot of people and probably made Moody's re-evaluate everything. The more detail Ambac can provide about this billion dollar loss, the better. Perhaps it will also help investors if they describe what went wrong with this and whether it is an unusual transaction in any way. The writedown is massive but it isn't that shocking to me given that the underlying asset for the CDO is mezzanine RMBS (if this was a high grade CDO then I would seriously start to worry about Ambac's underwriting skills--not that a $1 billion impairment is anything to ignore).


S&P Loss Sensitivity

First thing to note is that any comment on losses is a guessing game. Bill Ackman is playing the guessing game; the market is playing the game; rating agencies are playing the guessing game; and I am playing it too. Going with the chess analogy I used in the past, the game keep going back and forth (if you are a football fan, pretend the ball is moving back and forth. Ambac is definitely pinned back in its 10 yard line). Although many have written off the game, I'm not so sure. What's unusual about me is that, unlike many out there, I had been watching the game go back and forth for many months and only took a position a few weeks ago. This could still turn out to be the biggest loss in my life but it's not so clear cut. Anyway, on to some thoughts about losses...

If anyone wants to know how sensitive losses are to subprime default rates, take a look at S&P's recent report (thanks to MBIA for providing the report before Ambac :) ). The S&P report shows their stress results after raising the subprime loss rate assumptions. The report looks basic but something I was thinking about is the increase in loss based on the upward adjustment of the loss rate.

Dec 19th stress test subprime loss rates:
2005 5.75%
2006 15.5%
2007 17%

Jan 17 test:
2005 8.5%
2006 18.8%
2007 17.4%

They basically raised the rates by about 3%. I also notice that the new test is projecting lower loss rates in 2007 than in 2006. I wonder if they are understating the 2007 losses but it's really hard to say. It's confusing because most monolines stopped writing insurance for 2007 RMBS or CDO assets by the middle of the year.

The outcome of the test on Ambac is (after-tax losses):

Dec 19 2007 test: $1.8489 billion (927.1 million RMBS + $921.8 million from CDOs)
Jan 17 test: $2.249 billion ($968.9 million from RMBS + $1.2801 billion from CDOs)

So the loss increases by about $400 million, with most of the increased loss coming from CDOs.

So in a rough sense based on the S&P model, a 3% increase in subprime loss rate causes $400 million in losses. This is all rough and may or may not be the reality but it gives some rough idea of what to expect if default rates keep going up.



Let's see what happens during the conference call...

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Montpelier Re Thought: Reinsurance Pricing Likely Weak

A few weeks ago, the Wall Street Journal supposedly (I don't have access to it) speculated that Berkshire Hathaway's stock was down because reinsurance pricing was weak (here is a link to the CNBC reference to the article).

It blames "a soft market in one of (Berkshire's) core businesses -- reinsurance." Writer Liam Pleven says prices are "weakening quickly" on property-catastrophe reinsurance policies as they come up for their annual renewals around this time of year. Marsh & McLennan's reinsurance-brokerage unit reports an average decline of 9 percent for January 1 renewals...

A shift away from reinsurance, says the Journal, could hurt Berkshire's profits this year, although "it might not have to payout as much if a big storm does hit this year."


Although Montpelier Re (MRH), one of my holdings, is not quite the same as Berkshire Hathaway or Marsh & McLennan, the pricing trends are likely the same. MRH will likely see weaker revenue over the next year. MRH's earnings call is scheduled for mid-February and I'm curious to see what their thoughts are for the last quarter and upcoming year. None of this is a surprise given that we had a benign hurricane season. Like most insurers, declining premiums is not necessarily a bad thing since losses are likely lower as well.

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Sunday, January 20, 2008 4 comments

Merger Arbitrage Blowing Up

Felix Salmon of Portfolio magazine comments about some blow-ups in the merger arbitrage world. He wonders whether Sam Heyman, who runs a merger-arbitrage hedge fund, has lost $1 billion with his bet on the Sallie Mae takeover by Chris Flowers. That deal fell apart and is the poster child of a failed merger. It's working its way through the courts so who knows what will happen in the end but, whatever the ultimate outcome, the merger arbitrage investors likely lost money. I looked at the Sallie Mae merger but didn't want anything to do with mortgage, finance, housing, or other related companies at the time (Sallie Mae is in education finance). I went with the Tribune risk arbitrage instead.

On top of hedge funds not disclosing details, it's difficult to say how much a merger arbitrage fund actually loses. The sophisticated funds will likely hedge their strategies. Who knows if Heyman shorted some financial stocks or some index to hedge their risk? What's working against some merger arbitrage firms is the fact that they use a lot of leverage. Leverage is a double-edged sword.

An ominuous thought from Felix:

In any case, it seems that merger arbitrage might be the new statistical arbitrage: a strategy which performed very well, until it didn't.


A thought like this is what makes me kind of scared of risk arbitrage right now. But then again, it's time like these when you actually get big spreads (15%+).

The way Warren Buffett seems to look at merger arbitrage is from a statistical probability point of view (I get this impression from Robert Hagstrom's Warren Buffett Portfolio. Assuming I'm not mixing up this book with another, there is a bit that talks about Buffett's merger arbitrage strategy). If the expected return is higher than his benchmark (generally risk-free interest rate; but I never use that as my benchmark), he takes a position. The fact that you can lose money on some deals is not a huge concern. The reason is because merger arbitrage is not a concentrated bet (at least not for the investors who use it as their primary strategy--this doesn't apply to small investors like me who don't have enough money to enter a large number of positions). Instead, it is a bet on many events. If you enter 50 to 100 positions in a period of 5 years, a few losses here and there don't matter. It's sort of like operating a casino. The fact that you lose on some bets doesn't mean much as long as your expected profit over thousands of bets is positive.

Having said that, one extremely point I note from Buffett is that he basically implies that the merger arbitrage deals need to have independent probabilities. I intrepret this to mean that you should be taking positions in different industries with different characters making the deals.

Of course, the difficulty with merger arbitrage is that you have to come up with the probability of success and failure (deals are generally a binary choice). A business may be good but the takeover party may (legally) back off so how do you gauge the probability of doing that...


My plan was to allocate 15% to 20% of the portfolio to risk arbitrage but the situation is very dicey right now. You know there is huge uncertainty when BCE's stock is trading way below its takoever price. BCE is a blue-chip Canadian telecom company with an interested takeover party so I have always viewed this as having an 85%+ chance of being completed. However, the market is getting concerned, especially given that this will be the biggest takeover in Canadian history and will involve a lot of debt. If you are interested in taking a position, you should check to see who is providing the bridge loans (I can't recall off the top of my head). If the loans are mostly from Canadian banks, I think financing is safe; if most of the money is from Wall Street firms, it's a risk. The Canadian banks, except CIBC, have been spared the big hit from the US subprime problems so they are more willing to finance deals. The debt buyers will still be more nervous than an year ago but BCE, like most of the big telecoms, is a solid company with a continuous stream of profits.

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Saturday, January 19, 2008 3 comments

Still Not Sure I Made A Mistake With Ambac

One of the toughest things to figure out in one's life is whether they are living in denial. This was the case with love for me; now I wonder if my investing mind is messed up or not. I still don't know if I'm in denial or if my original views are correct. It's still not clear that I made a mistake. Check out this Barron's article on MBIA to see why I am still sticking with my views (for the most part).

The article's views run parallel to what Martin Whitman was saying in his fourth quarter commentary, and my original investment thesis. The run-off value just seems so high compared to the stock price (to gauge run-off, I'm looking at book value (and for more optimistic scenario, adjusted book value)). If MBIA can actually maintain its AAA rating, their revenue will be very high compared to claims.

Ambac, now that they've lost their critical AAA rating, will have lower revenue so it isn't as rosy but the liquidation value still looks really high (at least $20+ per share). The revenue won't be as high as my expectation when I invested in the stock a few weeks ago (due to loss of muni bond insurance business). I'm trying to come up with some estimates of reasonable future revenue and potential payouts for Ambac. For example, Ambac earned around $400 million last year simply from their investment portfolio (conservatively managed; bonds-only with 85%+ AA or AAA rating, although a big chunk is in mortgage and ABS securities). I want to wait for Tuesday's conference call to get some insight on Ambac's future strategy.


What Can Go Wrong?

What can derail this thinking is if losses are much higher than what the rating agencies estimate, and what the bond insurers have marked on their books. Ignoring the specifics of an RMBS or CDO deal, the subprime default rate needs to pass 19% for these companies to go bankrupt. The rate was around 14% during the middle of last year and I'm not sure what the default rate was near the end of the year. Since the monolines almost completely stopped insuring the risky stuff by late 2007, our main concern should be the early to mid 2007 performance (as well as 2006).

The holding company can go bankrupt if the state regulator blocks payments from the insurance subsidiaries. Given how politicized the mortgage mess is becoming, this is actually a risk. If the government starts manipulating things, as Jim Cramer and others are pushing for, the shareholders of bond insurers may end up with nothing.

Lastly, it can take a long time to unlock the value of the insurer. In the worst case, as crazy a this may seem, it might take 30 to 50 years before the bond insurance subsidiaries pay off their claims (they only have to pay interest and principal as originally scheduled, and mortgage products have a long committment). Not only will shareholders be dead by then, the annualized returns will be negligible... In the best case, things may be resolved within three years. The subprime crisis will end by then and either the mark-to-market losses turn out to be too high (shareholders will get back the reserved capital) or is not enough (company goes bankrupt).


My Game Plan

I said this looks like Buffett's American Express but may be it is Buffett's Berkshire Hathaway, the original textile--one of Buffett's worst investments. The game has completely changed now that Ambac has lost its AAA rating. I don't think I'm going to make much money on this (although the possibility exists due to what I covered above). My plan now is to minimize losses. See what Ambac plans to do without their AAA rating and do more research to see how much business potential exists for below-AA muni bonds (looking at the 2006 annual report (p44), it looks like 64% were A or below. But I suspect revenue loss will be even greater because there may not be much benefit from enhancing something from A to AA).

Ambac management has a bunch of paths they can take but one of their big ones is whether to keep their existing AAA-oriented business model (in the hope of regaining the rating later in a few years), or to shelve that completely. If they decide to shelve the AAA model, they may sell off most of their muni bond business or shut it down. In the latter case, Ambac will have to take some charges related to layoffs, office closings, and the like.

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Friday, January 18, 2008 7 comments

Dumbest Comment of the Year: Cramer Wants to Nationalize the Monolines

This is getting bizarre. I know shareholders like myself have been clobbered, not to mention those who have owned the companies for longer. But the dumbest thing to come out is Jim Cramer's recent suggestion that the government should nationalize the bond insurers. (here is an article on it and here is a video)

These companies, Cramer warned, could go "belly up" in weeks, if not days. If that happens, he predicts, the banks could quickly run out of capital, and the Dow could plunge as much as 2,000 points.

Cramer said the crisis could be avoided if the federal government steps in and purchases the four failing insurers and then pays out 50 cents on the dollar to the banks for the failed loans.

Under the current scenario, he points out, the banks get nothing and the whole economy suffers if the insurers fail.

With Cramer's plan, a single $250 billion injection could cure the entire problem and establish a bottom for the financial stocks. If this step is taken, he predicts, the Dow could rally as much as 2,000 points instead of losing 2,000 points.


I don't know who has been feeding information to Cramer but most of his views on the bond insurers are completely misleading. First of all, monolines don't go "belly up". They go into a run-off process that can actually take decades. SCA has been in an almost "belly up" state for many months now and nothing happened. SCA was cut to CCC while Ambac (and others) will be at AA.

Futhermore, the stress tests that are used by the rating agencies use an extreme case to gauge the probability of paying claims. None of the monolines have paid out any big claims. They may but that can take years (since monolines typically pay principal and interest over time, as originally scheduled). Maybe Cramer is looking 3 years ahead--I doubt it--but the current situation is nothing like he is describing.

What I see happening is that people are looking for a scapegoat. The bond insurance industry is the ultimate scapegoat right now. They are too small (no strong lobby group; market cap small, even in the glory days; etc) and are in the middle of the alphabet soup from ABSes to CDOs.

If Cramer's plan goes through (very low probability but he does have political influence with high levels of government it seems), the shareholders of the 4 companies that he wants nationalized MBIA, Ambac, PMI Group, and MGIC, will probably lose everything. Although it would really be a bizarre situation where a company with a positive book value with no immediate cash crunch ends up being bought out by the government. I am also not sure what would happen to bondholders of these companies, not to mention the shorts or the CDS buyers who are betting on a default (since I doubt the government buyout would count as a default). I don't think Cramer knows what he is suggesting. The monolines play a complex intermediary role, with commplex relationships with market prices and market perception of risk, and you just can't save the situation by nationalizing them. I am sure Cramer and his friends at some of the banks are taking huge losses but the government can't solve this by throwing money at the problem.


I'm a free market guy (left-leaning liberal-libertarian) but this is nothing more than socialism for the rich. He wants the government to give $250 billion to the banks, instead of Bush's plan of giving them to middle and working class (Bush's plan is dumb too but it's better). Furthermore, this is gross manipulation of the markets and is bound to fail. Does he really think that $250 billion will avoid the market forces that are cleaning the system?

Word to Jim Cramer: stocks don't always go up. I may lose my investment in Ambac but it was a calculated risk and I'm willing to take the loss. Similarly, all the other equity investors in other companies know that they are taking a risk. Trying to bail out the financials is ludicrous. What happens when commodity stocks collapse next? Time to pump another $300 billion into them?

I don't know if Jim Cramer is ever going to realize that the economy is more important than the stock market. The Dow dropping 1000 points is not the end of the world. Similar drops have happened before and the world didn't end!

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Fitch Downgrades Ambac to AA

Well, what I thought never would happen, finally happened. Fitch downgraded Ambac to AA.

Credit rating agency Fitch Ratings downgraded bond insurer Ambac Financial Group Inc. to "AA" from "AAA" on Friday, which could force the company to stop writing new insurance...

The rating also remains on negative credit watch for a further downgrade.


Fitch also adjusted the ratings on 137,990 municipal bonds and 114 non-municipal issues as needed (higher of the underlying rating or Ambac├Ęs new AA rating).

I invested in Ambac with the expectation that it will retain its AAA rating. However, that is not what happened and I'm forced to consider the situation as it has unfolded. Losing the AAA rating is a big disappointment to me given that one of my reasons for investing in Ambac was with the thought that it would retain its rating while others were downgraded. This is going to get complicated (I hope Ambac fleshes out some strategy in the conference call on Tuesday) but it essentially means the following in my opinion:


  1. Its municipal bond business will literally go to zero. Ambac may still be able to write some credit enhancement for A or lower rated muni bonds.
  2. Customers will lose faith in Ambac. Ambac's brand has been permanently tarnished. Getting back the AAA is out of the question for years--if ever.
  3. Ambac needs to come up with a completely new strategy for its raison d'etre (i.e. reason for being). It has little expertise in writing AA insurance.
  4. It seems likely that nearly all the other monolines, except Assured Guaranty, Berkshire Hataway Assurance, and a select few, will be downgraded as well. I think MBIA will be downgraded (although there is a possibility it may not). If there is widescale downgrades, the competitive advantage of Ambac does not diminish as much. Nevertheless, AGO, BRK-B, and others, will take away business.
  5. Those holding Ambac-insured AAA bonds will see the value of their bonds fall to its underlying rating or AA (whichever is higher). You should see some sell offs in the muni bond market, which tends to be sensitive to AAA ratings (some investment funds, banks, and others, only hold AAA-rated bonds). Structured products, and others, will also see some price erosion. This will likely cause mild write-downs at investment banks, hedge funds, and others who hold AAA-rated Ambac-insured bonds with lower underlying rating.


The fact that Ambac has an interim CEO right now doesn't help matters. There is little more to be said than what CAK said when he lost respect for the former CEO due to his abrupt resignation. Anyway, the new interim CEO has been on the Ambac board for a while and has good experience in other financial institutions so we need to wait and see what transpires.

The run-off value still looks to be much higher than the share price. I have been thinking about this all day and will see if I have any concrete thoughts on this later. Ambac is going to be a long-term investment whether you like it or not.

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Thursday, January 17, 2008 12 comments

I Agree with Evercore Asset Management: Ambac Should Forget About the AAA Rating

Given the massive drop in the share price of Ambac, I don't think issuing shares is viable anymore. One of Ambac's shareholders, Evercore Asset Management, is urging management to avoid purusing the AAA rating at all costs (here is their full press release (thanks to Housing Wire for the mention)). Evercore has supposedly been urging Ambac to give up its capital infusion strategies for several months. So this is not a last-minute opinion. For me, it is a last minute opinion. I only came to this conclusion after seeing the share price drop today. I think raising $1 billion to $2 billion is acceptable to me when the market cap is around $2 billion. Given that Ambac is only worth $633 million right now, you will basically give away the company in order to maintain the rating. This is clearly not maximizing shareholder interests.

I'll quote some of the points that I find useful from Evercore's press release:

We are long-term oriented, contrarian investors, with a typical holding period measured in years. We advise on more than 700,000 shares of Ambac on behalf of our clients. We wrote to you last month to express our opinion, as a co-owner of the company, on the undesirability of raising costly capital to preserve Ambac's triple-A rating.

The notion of issuing equity with the stock now at a small fraction of that late December price is simply absurd. It is impossible for the value of future business to even come close to offsetting the dilution that will occur. Municipalities are wrapping their bonds at the lowest rates in years, and Berkshire Hathaway is entering the business. Even if these things were not happening, it would still be impossible for new business to be sufficiently profitable to justify raising new capital...The sale of $1 billion or more of new equity amounts not so much to raising capital as it does to a sale of the company at an extremely depressed price.


I totally agree. The thing to remember is that most of the AAA benefit is for enhancing municipal bonds (just to make it clear to those not familiar, these aren't just bonds issued by municipalities. They can also be public-private partnerships, for-profit quasi-government entities, and so forth). Although muncipal bonds are Ambac's core business--the business it founded--it is simply not in a position to maintain it.

It is time for Ambac to recognize that, in entering the structured finance business, the company gambled its triple-A rating and has now lost that bet. Attempting to buy back the triple-A rating by giving away most of the company makes no sense. The business of triple-A guarantees must now be left to those whose previous actions have not saddled them with both a need to raise capital and a perception of potential losses of the magnitude that now causes Ambac to be priced at a small fraction of its book value. All that can be done now is to maximize the value of the existing book of business for the benefit of Ambac's shareholders.


If Ambac follows this strategy, it will almost completely exit from the municipal bond business. The only business it will be able to write are if the underlying bonds are below AA.

Unless Ambac is still massively under-reserved for eventual claims, there is substantial economic value to be captured even in a runoff scenario. Adding back the mark-to- market losses that the company still claims do not predict future losses, adjusted book value (which fully recognizes net unearned premiums and the present value of future installment premiums) stands at roughly $86 per share. Against that alternative, a proposal to sell a significant amount of stock at the current price is unconscionable.

Even if claims ultimately amount to a multiple of Ambac's current reserves, the value realized in runoff will far exceed the current stock price.


If you support this strategy (of not maintaining the AAA rating), you need to realize that this is the end of the muni bond business--at least for many years. You are essentially betting that the quality of Ambac's underwriting in the past is good enough to avoid losses and result in a higher value than the current stock price. This is something that I have believed for a while and is why I don't think Bill Ackman is right. His view basically gives zero credence to the underwriting skills of the monolines. The super-senior AAA tranches in CDOs; the highly paid, highly competent, insurance specialists working for Ambac; the 30 years of business culture and experience; etc; should all mean something. Shouldn't it? They should take lower losses than what the market perceives based on investment bank write-offs (investment banks don't have the same expertise in trying to pick good risk over bad--Goldman Sachs excepted ;) ).

From the standpoint of Ambac's current shareholders, the owners of the company, there is absolutely nothing to be gained from continuing to attempt to maintain a triple-A rating. It would be far preferable to go either into a period of "hibernation" during which time the company would not actively pursue any new business where a triple-A rating from all three agencies is required or into outright runoff. Under either scenario, current shareholders could expect to receive considerably more value for their shares than they would if they are massively diluted by an attempt to maintain triple-A status.


Completely agree!!! I urge all shareholders to support this strategy. Issuing $1 billion (or who knows how much) when the market cap is $633 million is giving away the business and fleece the current shareholders.


Having said all that, if the stock price rises to a much higher level soon (a highly unlikely proposition) then I would consider the share issuance as being back on the table.

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