Friday, December 28, 2007 12 comments ++[ CLICK TO COMMENT ]++

Berkshire Hathaway Enters the Bond Insurance Market

UPDATE: According to this news article, Berkshire Hathaway Assurance will be capitalized with $105 million, with more depending on business performance. If we go with a typical 100-to-1 par insurance value (Berkshire Hathaway Assurance may use a slightly lower value while charging a higher price), then it will be insuring around $10 billion. That's very small (Ambac's public finance total par value exposure is $300 billion, with Ambac writing around $20 billion of new insurance per year). So the Berkshire entrance won't be a giant gorrilla entering the industry; it will be more of a nimble start-up, likely working its way to bigger things.

UPDATE 2: A couple of interviews with Buffett by Fox News regarding his bond insurance move (Thanks to Reflections on Value Investing for the original mention).

Well, I have commented on the possibility before and it finally happened: Warren Buffett's Berkshire Hathaway is setting a bond insurance unit, Berkshire Hathaway Assurance, to insure municipal bonds (original WSJ story here (requires subscription)). I always thought there was a possibility of Berkshire Hathaway setting up a new business or buying out one of the existing bond insurers. There is good news and bad news in this for the other bond insurers--mostly bad news though.

The Good News

The good news is that this move gives credibility to the bond insurance business. There have been many stories of late saying that the bond insurance business is almost a scam and not needeed. The thinking by some of those who hold that view is that muncipalities, not to mention banks and others, will stop using bond insurance and simply issue uninsured bonds. Well, that argument has now been weakened by the fact that the best investor of all time actually thinks it is a viable business worth entering. Warren Buffett is a value investor so we can be sure that he isn't entering the market due to some short-term fad or trend.

The Bad News

The bad news is that this is going to be a huge competitive force to Ambac, MBIA, and the rest of the monolines. I actually thought about this competitive force (or one of the mega-reinsurers like Munich Re or Swiss Re entering) before so it isn't surprising to me. Berkshire Hathaway is one of the few corporations rated AAA so we can be sure that Berkshire Hathaway Assurance will likely be rated AAA as well. This means the big threat is to the AAA-rated monolines (eg. Ambac) and not the lower-rated monolines (eg. Radian). I suspect Berkshire Hathaway Assurance will not compete much against Radian and its sub-AAA peers.

Based on the news article, it seems like Berkshire Hathaway Assurance is interested in municipal bonds and not the structured products (like credit card debt, student loans, mortgage loans, and, of course, CDOs and CDO-squareds). I know the monolines have had a horrible experience with the structured products (especially anything mortgage-related) but it presents an opportunity to solidify their position in the structured product area--an area I believe holds the biggest potential in the future. It looks like Berkshire Hathaway Assurance will stay clear of structured products. This would be consistent with the fact that Warren Buffett doesn't like derivatives and other "fancy" products that are common in the structured product area. For instance, I'm not sure if Buffett would be comfortable with pay-as-you-go-type CDS contracts used by monolines for their structured product insurance. Having said that, there are experts within Berkshire Hathaway's insurance units that may have a good grasp and liking for structured finance products and may convince Buffett to enter this market (for example, how many Berkshire Hathaway investors would have thought that Berkshire would be the largest mega-catatrophic reinsurer right now? Buffett himself was probably convinced to enter this market by others like Ajit Jain (this is all speculation on my part but that's my feeling)). Similarly, the structured product market is an opportunity. This won't happen any time soon (not until Berkshire Hathaway Assurance establishes itself) but is a long-term competitive threat to Ambac, MBIA, FGIC, et al.

My Expectation

I considered the possibility of one of the big reinsurers, Berkshire Hathaway, Munich Re, or Swiss Re, entering the bond insurance business when I first thought about Ambac. My view now is the same as back then. Namely, Berkshire Hathaway Assurance isn't as big of a threat as it seems.

I think the market will be tougher but there is enough room for growth for all. This is definitely not a saturated mature market (emerging markets, not to mention developed countries like Japan, have very low bond insurance use). US municipal bond insurance is going to be far more competitive but there will be room in other areas. As I remarked above, structured products also will likely have low competition.

The bond insurance market seems to be an oligopoly-like business at the high-end (i.e. AAA-rated insurance). I believe it will be difficult for more than 4 or 5 companies to retain their AAA rating for a long period of time. Once the latest shakeout is over, it will be even more difficult to raise capital to maintain AAA rating (investors are going to steer clear of this industry for a while IMO).

It will take a while for Berkshire Hathaway Assurance, or other new competitors, to get set up in all of the American states. If the plan to go into Europe, it will also likely take some time to set up operations there. The big question for existing monolines is the value attached to their brands by their customers. I don't know enough about the industry to know if a customer actually discriminates between the differing, but similarly rated, bond insurers. The existing bond insurers, especially those that have been in business for more than 10 years, also likely have some expertise that cannot be easily duplicated by new entrants. A lot of the contracts that they write seem to be complicated and if you don't price the risk properly, you won't stay in business for long.

The other thing to note is that Berkshire Hathaway Assurance looks like it is going to charge a premium rate for high quality insurance. This will necessarily keep their market small, and the existing bond insurers may be able to do ok by undercutting for slightly worse brand recognition and support.

Buffett's Thought On Bond Insurers' Key Mistake

On a different note, in this article, Buffett says that bond insurers mispriced risk:

Buffett tells the Journal that for years bond insurers didn't charge enough to justify the risks they were taking on because they were so interested in getting new business. "We felt that in many cases, the prices that people (bond insurers) were charging were inappropriate. As long as people (debt issuers) were willing to accept that, there was no point in trying to offer something else." Now that the credit ratings of the old-line bond insurers are in jeopardy, Buffett sees an opportunity. "It could be tiny, it could be very large. It'd be nice if it were large, but we're not pushing for that."

If anyone wondered what the bond insurers did wrong, there you have it. They mispriced the insurance. This is actually an easy mistake for insurers to make. A lot of the smaller reinsurers who nearly went bankrupt after Katrina also made the same mistake.

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Thursday, December 27, 2007 2 comments ++[ CLICK TO COMMENT ]++

ACA Winds Down Operations

One of the smaler monolines, ACA Capital Holdings, is likely on its way to winding down whatever it can. Its stock was delisted last week(?) (didn't meet NYSE requirements) and today Maryland's insurance regulators started taking control of its operations. This move gives ACA Holdings some time to raise capital. Unfortunately, I don't think anyone is going to inject capital into ACA. Banks like CIBC, a big Canadian bank, have been thinking about providing some capital since ACA insured some of their bonds, but I suspect very little will be done in the end.

You can see the gravity of the situation by looking at ACA's potential losses under S&P's stress test here (read my original posting on the stress test here). As you can see, ACA has a capital base of around $600 million whereas S&P's stress test results in a loss of $2.1 billion. Given that ACA is a lesser known monoline, that is a huge loss (all of it in CDOs as well). In contrast, the bigger ones like Ambac and MBIA have big potential losses (in the billions) but they are far larger, have a stronger brand name, and seem to run their operations better. Very few people would be willing to provide money to ACA right now.

What kills bond insurers when they lose their rating are clauses like this:

n the SEC filing, ACA said that its insurance contracts typically include provisions that would have required it to post collateral in the event of a rating downgrade -- at least $1.7 billion in collateral based on its Sept. 30 obligations, ACA said. But, the company said it has received a waiver on those additional collateral requirements through Jan. 18.

I hope Ambac, MBIA, FGIC, and others, don't have to post collateral if they get downgraded (not sure what their contract says about downgrades). Any bond insurer that needs to post collateral will be toast since the par value exposure is massive compared to their actual capital on hand. That fact that bond insurers only have to pay out losses over time without posting collateral based on mark-to-market losses is what makes the business model work while seemingly everything is falling apart around them.

What happened to ACA is what will happen to the other bond insurers if they can't make it. The holding company will go to zero, and the actual bond insurer will be taken over by the insurance regulator. The underlying insurance contracts will likely survive until time expires in a decade or so from now...


Distress Investing Article by Martin Whitman

Thanks to some poster on a forum post on, I ran across this old article by Martin Whitman on distress investing: An Introduction to Distress Investing by Martin Whitman, 2002 (jump to the page numbered 3; or page 6 of the PDF). Since I'm trying to hone my contrarian skills (the verdict is still out on that :) ), distress investing is attractive to me. However, it is hard for small investors since equity generally gets wiped out and you have little say or resources at your disposal to challenge anything the company does. Nevertheless, it is a part of the investment world that is often ignored due to its complexity and danger.

Bond Insurance Article

On another note, Joe Mysak of Bloomberg thinks that bond insurers may be the big buys next year for the "brave" :) . I think it's nothing new for anyone that is bullish on the bond insuers and have been following them; but others may get a good quick bullish overview of the situation.

The Tribune deal closed (good luck to Tribune and Sam Zell) and I received my money, so I'm just bidding time waiting for a good entry point into Ambac (ABK).

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Monday, December 24, 2007 3 comments ++[ CLICK TO COMMENT ]++

Martin Whitman Comment About Bond Insurers on CNBC

Martin Whitman recently commented on the bond insurers and how he had increased his stake in Radian, MGIC, MBIA, and Ambac. He supposedly owns 10%+ of both Radian and MBIA (versus less than 3% in each early in the year). He isn't concerned with Bill Ackman's stance and thinks Bill Ackman understands neither the insurance business nor restructurings.

There is an important point that one needs to think about when considering Martin Whitman's views. As Martin mentioned in the video, he is looking at this as a restructuring play. I'm not really sure how a bond insurer fits into the "restructuring strategy". Typically the restructuring plays are conventional corporations with reasonably estimable losses and liabilities. The big problem with the bond insurers is the uncertainty of future losses. Martin Whitman emphasizes that this is a long term play, where he wants to be part of any restructuring. I don't really understand his point about restructuring. Is he talking about restructuring the bond insurer (like Ambac)? Or is he talking about restructuring the holdings of the bond insurer (i.e. underlying asset of the bond being insured)?

If Martin Whitman is trying to profit off the restructuring of the bond insurer, there is a risk to small investors from debt. It may be possible for bondholders to take over. Whenever someone mentions "restructuring" I get nervous. Generally shareholders are either heavily diluted or completely wiped out and bondholders end up running things. I hope this is not what Martin Whitman has in mind (I'm not sure how much of the debt he owns; Ambac had $1.8 billion of debt outstanding); However, I doubt this is the case because he also owns a huge chunk of the stock so it is unlikely that he will waste money buying shares if he is trying to play for the control of the company via debt. If you don't think Martin Whitman will do anything to benefit bondholders at the expense of shareholders, then he is one of the best people to have on your team for any restructuring issues. Martin Whitman is one of the best at investing in distressed situations.

I'm eagerly awaiting Third Avenue Fund's quarterly report (I'm guessing it will come out by the 3rd week of January).

Thanks to Neanderthal for this find.

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Saturday, December 22, 2007 5 comments ++[ CLICK TO COMMENT ]++

Test #3: Fitch Places Ambac on Ratings Watch Negative

Fitch, the last remaining rating agency without an opinion, released their updated rating review. It doesn't look like they are releasing any free excerpts so I'm not sure about the details. All I can go by is what the news sites say:

The AAA rating of Ambac's bond insurance unit was put of Rating Watch Negative by Fitch, which means the agency will downgrade to AA+ in four to six weeks unless the company can boost is excess capital levels before then.

A review by Fitch of Ambac's exposure to CDOs and residential mortgage-backed securities found that the insurer is roughly $1 billion short of the extra capital it needs to keep its AAA rating, the agency explained.

Can't say much without looking at the actual report but it seems like Ambac needs to raise $1 billion. We just need to wait and how Ambac actually raises money.

One piece of new information (at least to me) was the following:

The review included an assessment of a $3 billion commitment by Ambac to fund a pool of other structured finance CDOs as of Sept. 30, Fitch noted.

I'm not sure what that is referring to. If anyone can shed some light, feel free to leave a comment...

Friday, December 21, 2007 0 comments ++[ CLICK TO COMMENT ]++

Sold DFC for a Total Loss

Delta Financial filed for bankruptcy protection a while ago (read my post here). A total loss for me. I should have sold it off a few weeks ago to save a few hundread dollars (clearly a newbie mistake since I had no intention of holding on to it). DFC was small portion of my portfolio so it didn't hurt me as much as it could have (a loss is a loss though).

Speaking in hindsight is generally useless given that anything that works out looks good even if it is a bad investment, and anything that doesn't work out always seems bad. In my case, this was probably a bad decision from the beginning. It was somewhat of a rash decision (impatience strikes again) given that I never really understood the mortgage lending business very well. I started looking into it after reading that Mohnish Pabri viewed it favourably but this is one of his mistakes I guess. I thought Delta's low exposure to risky housing markets like California, as well as Delta's higher fixed-interest loans (typically results in lower defaults), would enable it to survive and do well but, alas, I was wrong. When the credit markets locked up, it was game over for Delta Financial since they couldn't secrutize anything.

Sale Price: $0.08
Purchase Price: $5.48

Total Return (CDN$): -99%

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Thursday, December 20, 2007 1 comments ++[ CLICK TO COMMENT ]++

Tribune Takeover Closes

The Tribune takeover closed successfully today. Tribune shareholders will receive $34 (not sure how soon) and I'm satisfied with how my strategy was executed. This deal basically saved me this year (I would be posting greater losses for this year otherwise).

Unfortunately--but this goes for almost 2/3 of my investments--the Canadian dollar appreciated quite a bit and shaved around 8% off returns. This is somewhat dissapointing but I'm not too worried because I think the US$ will start to strengthen some time over the next few years (there is a potential for capital flight if there is a crisis somewhere--often there is when the US economy slows). This was my first "good" risk arbitrage position and I'm glad to have learnt lessons about currency fluctuations and the takeover process. One thing I learned is that it is likely not worth considering risk arbitrage in foreign currencies unless the potential return is 15%+ (assuming you are not hedging to your currency (small investors like me generally won't)). I think I am improving my risk arbitrage strategies and hope to make it about 20% to 30% of my portfolio in the future. Future deals I'll be looking into include the BCE (BCE) takeover, Clearchannel (CCU) takeover, and the CommerceBankcorp (CBH) takeover.

Once I get the money, I'll face my next decision... and the next big decision may end up being the riskiest financial decision of my life in $ terms (in % of net worth terms, I have made scarier decisions before when I had less money :) ). I'm thinking of investing around 20% to 30% of my portfolio in Ambac (ABK). But I'm still uncertain. I'm also not sure whether I should only invest some money, with the rest later; or whether I should invest 15% or so, with the rest going to other opportunities I'm looking at (risk arbitrage, OCWAZ, PHM, Japan, etc).

TRB sale price (closing price): $34
Purchase price: varies (average around $28)

Total Return (US$ terms): 20%
Total Return (CDN$ terms): 13.67%

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Fortunes of Ambac and MBIA Diverge

When took a cursory look at MBIA a few months ago, it looked safer than Ambac. But, man, was I wrong. The fortunes of the two have diverged lately, and with the latest disclosure of seemingly higher CDO-squared exposure than market expectation, it looks like MBIA may indeed be a riskier pick. I think the analyst being quoted in the article pretty much nails the present situation:

"This new disclosure completely changes our view of MBIA being a 'more conservative underwriter' relative to Ambac," said the Morgan Stanley report, which was co-written by analysts Ken Zerbe and Yoana Koleva.

S&P losses for MBIA are also higher and here is the breakdown of their analysis (table 7 in the press release):

(source: S&P Detailed Results Of Subprime Stress Test Of Financial Guarantors, Dec 19 2007 (table 7) )

Based on the 9 bond insurers that S&P was reviewing, they are projecting an industry-wide loss of $10.8 billion. The verdict is still out on whether the bond insurers will make money on their venture into RMBS and CDOs. It looks like many investment banks will actually lose money with their mortgage-related businesses but I suspect the bond insurers will eke out a small profit.

S&P is projecting a loss of $1.8 billion and $3.2 billion for Ambac and MBIA, respectively. This compares with the bear case of around $4 billion for Ambac (superbear case is generally $7+ billion and involves bankruptcy but I don't find that reasonable). I think Ambac needs to raise $500 million to $1 billion to stay comfortable for the time being. The tricky thing is timing. Ambac will likely earn $700 million next year (ignoring mark-to-market charges) so they can try waiting. As S&P points out in their report, that's the luxury available to bond insurers (i.e. since they don't pay losses all at once or post collateral, they can just wait). But if someone is pursuing the waiting strategy, they need to make sure their ratings don't get cut and shareholders don't get angry since they won't see any profits (not that bond insurers pay out much in dividends or anything).

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Wednesday, December 19, 2007 6 comments ++[ CLICK TO COMMENT ]++

S&P Releases Bond Insurance Stress Test Results

I thought S&P would not release their stress test results so soon but they just did. It is mostly along the lines of Moody's report from last week. Two relevant press releases for the results are here and here. Here is the relevant info for Ambac:

We affirmed the 'AAA' financial strength and financial enhancement ratings of Ambac Assurance and the 'AA' debt ratings of Ambac Financial Group, Inc. but the outlooks have been changed to negative. The rating affirmations reflect the fact that Ambac's adjusted capital cushion of between $1,750 and $1,800 million is in line with its modeled stress losses. The announced reinsurance transaction with Assured Guaranty Re Ltd. was an important addition for Ambac, adding approximately $250 million on a risk adjusted basis to its capital cushion. The negative outlooks reflect the potential for further mortgage market deterioration relative to the company's marginally adequate capital cushion.

Ambac's outlook was cut to negative from stable. Well I guess we know how much that $29 billion reinsurance transaction provided: $250 million of capital. That's kind of low but it gives the kind of transaction that is required to raise capital. The next step is to wait and see how Ambac raises capital. It is really tough to issue shares alone (even if you issue 20% of market cap that will only bring in around $500 million) so there is likely to be multiple paths taken.

In another note, not too surprising to bond insurance market followers, ACA is on its way to winding down operations. It is in serious trouble and unless it gets more capital (CIBC and others holding insured assets are considering investing some money) it will likely have to close up shop. But it's likely game over for shareholders (any capital injection will likely wipe out shareholders).

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Sunday, December 16, 2007 6 comments ++[ CLICK TO COMMENT ]++

Ambac Margin of Safety Analysis

This post will capture the final piece of analysis I'll do before purchasing Ambac (still depends on how events unfold over the next few weeks). I initially evaluated Ambac a few months ago so read that to get details on Ambac's historical profitability and what it is capable of. The initial analysis, which occurred after the 1st sell-off in the stock but before the massive 2nd sell-off, didn't really go into valuation or risk. It quickly became obvious that valuation isn't the problem with Ambac (it's undervalued by almost any measure); instead, the real issue is risk.

Margin of Safety

Before I say anything, I should note that Ambac has a chance of going to zero! As Mark Sellers (don't know who he is but just saw the interview at The Motley Fool), says in this interview, a company like MBIA can go bankrupt so he doesn't invest in it. So if you can't afford a total loss, none of the bond insurers are for you. If you want a beaten down financial that won't result in a total loss, something like C, BAC, MER, etc should be investigated. I know Warren Buffett's rule #1 is never to lose money but I'm willing to face the possibility of a total loss (note that even Benjamin Graham has implied that adverse events can bankrupt anyone).

shares outstanding: 101.55 million

market price: $22.81 ($2.32 billion)
book value per share: $55.64 ($5.65 billion)
adjusted book value per share: $88.07 ($8.94 billion)

2006 earnings (CASE I): $876 million
Pre-2004 5yr median earnings (CASE II): $433 million


  1. Most numbers from Yahoo Finance as of Dec 16 2007; balance sheet data from end of Q3

  2. Adjusted book value is "stockholders’ equity (book value) and adding or subtracting the after-tax value of: the net unearned premium reserve; deferred acquisition costs; the present value of estimated net future installment premiums (discounted at 5.6% and 5.4% at September 30, 2007 and December 31, 2006, respectively); and the unrealized gain or loss on investment agreement liabilities." (Ambac 3rd quarter 2007 quarterly operating supplement) This is basically what the company is truly worth if it doesn't go bankrupt in an optimistic scenario.

  3. For earnings, I'm picking a superbullish case (2006 earnings) and a reasonable case (pre-2004 5yr median). The 2006 number is likely peak earnings for the time being so I would not rely on that. I expect income from structured products to drop off significantly over the next few years (US CDO market is toast). Wit low income from structured products, Ambac's earnings would be similar to the $433 million it earned in 2001 and 2002.

The way I'm going to look at Ambac is treat the current crisis it is facing with RMBS and CDO losses as a one-time issue. From an investment point of view I think it is fair to treat it as a one-time issue. In reality, however, the losses will be spread out over time, with likely large losses in 2007 and early 2008 with losses declining in 2008 and 2009.

First I'll ignore the one-time loss and see what the company would be worth if it lost a big chunk of its structured products business. Pretend that this was 2000, before the big run-up in CDOs. If Ambac can handle the losses it will incur over the next few years, this is the value of Ambac.

After that, I'll look at how much loss is being priced in by the market.

Earnings Valuation

A very rough guide (ignoring company specifics, industry valuations, interest rates, etc) to picking an earnings multiple is to use the following Benjamin Graham formula for growth stocks:

value = current_(normal)_earnings x [8.5 + 2 x expected_annual_growth_rate]

For a zero growth company, the P/E ratio should be 8.5. Let's assume Ambac has zero growth. If we use Case I (2006 earnings), then Ambac's P/E is 2.64; with case II, it is 5.34. Or another way of looking at it, if the P/E ratio should be 8.5, then Case I yields a market cap of $7.4 billion and Case II yields market cap of $3.4 billion. You can clearly see that Ambac is cheap.

Case II implies around 50% appreciation potential from current prices. This means that, ignoring the current one-time loss issue, if the company earned what it did 7 years ago then it is 50% undervalued. The appreciation potential is higher if you use more optimistic scenarios. For instance, if you think earnings won't drop off to 2000 levels then the potential is even higher. Furthermore, if you think earnings can grow (instead of being flat) then the valuation would be even higher. But I like to be pessimistic so my view is that the potential is around 60% if earnings were back to the 2000 levels before the recent CDO boom.

Book Value Valuation

The stock is currently trading 60% below book value and 75% below adjusted book value (non-GAAP measure). I'm just a newbie but I think book value and adjusted book value are good indicators of the true value of Ambac. Unlike other types of companies, there isn't inventory, plant & equipment, intangibles like brands or patents, or other assets that can overstate the book value. With an insurance company, what you see is sort of the value of the firm. What is unknown is the potential for losses on the insurance that was written. Ignoring the RMBS and CDO of MBS insurance (loss on these are clearly not accounted for and I'll look at that below), I would imagine that management took proper loss reserves for the rest of the underwritten insurance. So looking at the market price should tell us what losses are expected by the market.

To sum up my thinking... I am assuming that the stock should trade at exactly equal to book value or adjusted book value (historically it has always traded above book but we can't be sure that the market will give it the same multiple in the future (highly unlikely)).

What the stock price says is that the market is pricing in $3.33 billion in losses from a book value point of view; and $6.62 billion in losses from an adjusted book value point of view.

Let's assume a reasonably pessimistic bear case generally has Ambac losing $4 billion. Note that a superbear case can be made for bankruptcy, but everything I read likely implies that is unlikely. Things will have to be extremely severe and/or Ambac's underwriting has to be truly incompetent.

Based on the numbers above, I believe the market is discounting something close to the worst case of $4 billion. If you go with the book value number and a $4 billion loss (meaning short by $600 million), then the stock can drop even more (-30%). But if you go with the adjusted book value then the stock can go up (+113%).

Of course, if the loss is less than $4 billion then the numbers will look even better. Or if the losses are spread out over time (meaning present value of losses is slightly lower) then the upside will be slightly better.

What all this means to me is that Ambac's stock is pricing in a loss approximating the bearish estimates (but not the superbearish bankruptcy scenario). Another way of looking at it is that the market is pricing in a lot of shareholder dilution so the price is unlikely to drop with further dilution (this is what happened with MBIA, where the stock actually jumped even though they announced a $1 billion dilutive deal).

Do note that we don't know what the actual loss will be. If it is, say, $7 billion as some superbears suggest, then even the current adjusted book value is not pricing in any of that.

To Sum Up...

If you think the losses will be around $4 billion or less, the stock looks to be pricing in the losses... If you think that the company can survive the current crisis then the company should be worth at least $3.4 billion under reasonably pessimistic scenarios (eg. long term income of $400 million with zero growth rate).

Is Ambac Buffett's American Express in 1963?

I have a habit--possibly a bad one--of trying to fit present opportunities into something that successful investors like Warren Buffett encountered. I also have a habit of looking at Buffett's AMEX investment in 1963 but I think it offers a good template for contrarian investing. Ambac looks like American Express in 1963, when Buffett bought after the infamous Salad Oil scandal. I can be wrong but there seem to be some similarities.

In both cases, there were massive one-time losses (in the AMEX case, it wiped out shareholder equity to zero) and some thought bankruptcy was a possibility. AMEX's bankruptcy threat wasn't as severe as Ambac. AMEX only dropped around 40% whereas Ambac is down 75% from peak.

Buffett also looked at whether AMEX's future earnings were impaired. He came to the conclusion, after observing AMEX customers at a restaurant, that AMEX still retained its brand and customers didn't flee the company. Ambac's impact on customers is hard to decipher but some articles I have read seem to imply that the market is still using bond insurance (not necessarily from Ambac but that was before the rating agency reviews). One thing to note though is that earnings from structured products (big chunk of Ambac's earnings) will likely be lower in the future (but even that is uncertain because the rising spreads on risky assets mean that Ambac will earn higher premiums).

Buffett was also comforted by management honesty and, although I can't tell from the distance, Ambac's management seems to be clean. They did try to combat misleading statements in the press, as well as buying some stock with their own money.

I hope this turns into something like AMEX back then :)

Once the Tribune (TRB) takeover closes (likely December 20th) then I'll redeploy that capital into Ambac. My investment in Ambac will be very large (25%+ of portfolio) but my portfolio is small. I'm switching to focus investing and would ideally have 4 holdings of 25% or 5 @ 20% each. Ambac will likely determine a big chunk of my portfolio performance over the next 3 years. If the original investment thesis holds and if Ambac dilutes shareholders early next year, I'll likely add (I will look favourably upon any exchange-traded convertible bonds or warrants). I may always change my mind but that's my plan for the time being.

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Friday, December 14, 2007 3 comments ++[ CLICK TO COMMENT ]++

Criticial Few Days for the Monolines... Test 1

The next few days will probably impact the monolines more than anything in the next 2 years. It's like when you were in school and were writing a test that you had to do well in order to go to the university of your liking. The world doesn't end if you fail the test but it makes life more difficult and alters your path in life--forever. I don't think I'm overstating the situation faced by the monolines.

If you don't know what all my blabbering is about, it is the rating agency decisions that will be delivered over the next few days. I can't understate the signficance of these ratings. Of all the industries in this world, the monolines depend on it more than anyone else. The whole business model depends on getting good ratings and for companies like Ambac (ABK) and MBIA (MBI), in having nothing less than AAA.

S&P initiated their review a bit late so they may not have anything by next week but Fitch and Moody's will provide an opinion.

Test #1: Moody's

Well, Moody's just released their opinion on the bond insurance industry:

New York, December 14, 2007 -- Moody's Investors Service has updated its evaluation of US mortgage market stress on the ratings of financial guaranty companies, and has considered those companies' plans for strengthening capitalization, as well as their developing strategies. The following actions are the result of that evaluation. The Aaa ratings of Financial Guaranty Insurance Company and XL Capital Assurance Inc. were placed on review for possible downgrade. The Aaa ratings of MBIA Insurance Corporation and CIFG Guaranty were affirmed, but the rating outlooks changed to negative. The Aaa ratings of Ambac Assurance Corporation, Assured Guaranty Corp, and Financial Security Assurance Inc. and the Aa3 rating of Radian Asset Assurance were all affirmed with a stable outlook.

Ambac somehow manages to keep its rating without any adverse implications. I am not knowledgeable enough to know how much they gave up with their $29 billion reinsurance transaction (anyone have any numbers? some guy on the Yahoo Finance message board said it will shave $0.50 off earnings but that seems kind of low. Ambac's (likely peak) EPS from last year was $8 per share, and its historical average earnings for the last 10 years is around $4 per share. I'm guessing they had to give up a lot more than 15% of their historical earnings with that reinsurance transaction).

I am actually shocked that MBIA was placed on negative watch! When I was evaluating Amabac a few months ago, I was comparing it against MBIA, I felt that MBIA had a bigger capital cushion and was safer. If there was one company that was going to need massive amounts of capital, it was going to be Ambac...or so I thought. Ambac has massive CDO exposure whereas MBIA doesn't have high CDO exposure. However, clearly, the RMBS held by MBIA is doing worse (relatively speaking) than the CDO held by Ambac. Either that, or some big deal insured by MBIA must be really risky and posting big losses under these stress tests. MBIA probably has to take on more reinsurance.

I wonder if Moody's model isn't as tough as it can be when evaluating CDOs. I'm really curious to see what Fitch will say. Fitch's prior evaluation clearly had Ambac in a worse off situation in their stress test.

Here is what Moody's said in their press release regarding Ambac:

Ambac -- Affirm Aaa Rating with Stable Outlook.

In Moody's opinion, Ambac's current capitalization is adequate for its rating level in both the base case and stress case described above. Moody's does note that there exists meaningful uncertainty with regard to the ultimate performance of the firm's insured mortgage-related portfolio in the current environment, particularly with respect to the three insured 2007 vintage CDO-squared transactions, which exhibit significant modeled losses in our stress scenario. Nonetheless, the affirmation of Ambac's Aaa insurance financial strength rating with a stable outlook reflects Moody's view that the company's capital position is adequate to deal with such uncertainty, in the context of likely further capital strengthening measures and considering the company's robust franchise in the financial guaranty insurance sector. Ambac's announcement that it has entered into a commitment to cede $29 billion in par exposure to Assured Guaranty Re Ltd. (insurance financial strength at Aa2) is considered a positive in that regard.
When I look at Ambac as a potential investment, I'm basically assuming their CDO-squared stuff will mostly be a loss. Ambac will likely build reserves over the next few years for their CDO-squared exposure.

Ambac shareholders, as well as those sitting on the sidelines, need to realize that there will likely be future capital injections. The question, obviously, is how much dilution is going to occur and we really won't know in advance. Although equity is more costly than preferred shares, I think it may make sense to issue shares. A $500 million share offering doesn't sound bad to me (Ambac shareholders may not want to see another 20% drop in stock price but it's not severe).

After the Marks are in for Test #1

I think some bears will dismiss all this as rating agencies being in bed with the bond insurers. I don't feel that is the case and personally put weight in the rating agency opinions. As with any rating, it's simply an opinion and one shouldn't blindly do anything based on it. However, unlike equity ratings or other ratings services, the whole raison d'etre for rating agencies is to rate bonds and bond insurers. They messed up with CDO and ABS ratings, so their whole business rests on getting it right and avoiding past problems. If you thought the bond insurers would go to zero if they lost their ratings, well, the rating agencies will turn to zero even more quickly if the market lost faith in their ratings.

Expect a massive short covering rally next week in Ambac... if the other rating agencies also issue favourable views.

None of these companies will be out of the woods for many months. The next big issues--incidentally no one seems to care about them now--will be credit card debt and student loans. A sizeable chunk of Ambac's insurance is student loans so that is something one should consider. Having said all that, I will note that all these other asset types pale in comparison to the size of municipal bonds and mortgage-related debt (MBS and CDO of ABS).

Thursday, December 13, 2007 1 comments ++[ CLICK TO COMMENT ]++

Ambac Takes On Reinsurance from Assured Guaranty

Ambac announced today that it is going to use reinsurance from Assured Guaranty. Some details:

The portfolio totals approximately $29 billion of net par outstanding and will be ceded under an existing master facultative reinsurance agreement with AG Re. Pursuant to the commitment, AG Re has agreed to provide reinsurance under the terms of Ambac’s current surplus share treaty program that expires March 31, 2008. Ambac has also agreed to offer AG Re the opportunity to provide reinsurance under the terms of Ambac’s surplus share treaty programs that commence April 1, 2008, 2009 and 2010.

There isn't much information in that press release but I would guess that the $29 billion reinsured is from their high quality municipal bond portfolio. I don't know how the rating agencies calculate these reinsurance contracts when determining capital requirements. The way I look at it, Ambac will end up holding all the high risk CDOs (it's hard to insure them at good prices and it's not worth it for shareholders) and its future will largely be dictated by that. I still see Ambac holding onto its AAA rating.

Fitch reaffirmed Assured Guaranty's AAA rating on Wednesday so there is little risk of it losing its rating and causing any problems in the future for Ambac. Assured Guaranty issued $300 million in stock to fund these reinsurance transactions. Anyone sitting on the sidelines can certainly consider Assured Guaranty (AGO) as an investment (they stopped writing CDOs in 2004 if I'm not mistaken and have low exposure to risky MBS) but they don't have the brand strength of Ambac or MBIA.

Expect more moves from Ambac... new stock or preferred issuance still likely IMO... Estimates have them needing between $1 billion and $4 billion. My guess is somewhere around $2 billion.


Sam Zell: Things Not As Bad As Believed has a good summary of Sam Zell's comments during a luncheon in Chicago. I hate quoting almost the whole article but all the points in the article are worth considering. Sam Zell thinks the situation won't be as bad as the general consensus seems to think.

He told those in attendance that "we're not in a liquidity crunch," but instead that the economy is going through "a significant repricing of risk."

Zell has said this before and I find it interesting that he sticks with that view (i.e. market repricing risk, and not a liquidity risk) when the consensus is the opposite. As for me, I'm not sure what to make of all this. I definitely believe the market is re-pricing risk but am not sure if that is all there is to it.

And he had harsh words for the way some asset holders are treating their mortgage assets, saying "accounting is taking over for reality."

Pointing out that the mark-to-market process has produced huge writeoffs, not cash losses, Zell said he'd been offered some assets that had been discounted to zero value on balance sheets, even though they were still paying out income.

What Sam Zell points out is a very important thing to remember. Companies have an incentive right now to mark everything down based on market pricing (that's the simplest thing for accountants and auditors to do, and for CEOs to start with a clean slate). But some of the market prices may be due to irrational pricing of some assets. If one can find something that fits Zell's characterization of what is happening (i.e. asset worth almost zero even though cash flow is positive) then it's likely worth purchasing.

What Zell says reminds me of what Benjamin Graham was saying in the 40's, when companies with positive net current asset value were being valued as if they were worth nothing. Now, instead of asset value, the "discrepancy" seems to be with cash flow versus market price. The reason things like this happen is obvious. Essentially, the market thinks that there are going to be future losses that will wipe out the seemingly positive situation. In the 40's, the market obviously felt that future operating losses will wipe out the positive net current asset value; presently the market obviously thinks that the cash flow from the asset (whether it is MBS, CDO, or credit card debt, or land, or house, or whatever else) will turn into zero when people default. The difficulty for investors is that one needs to discriminate between the good and the bad. Unfortunately, newbies like me don't know what we are doing and have a hard time pinning a reasonable value to an asset.

If one is looking at bond insurers, Zell's comments should provide some support. It is quite possible that some assets are being marked down severely even though the asset may produce cash flow. I doubt that Zell was looking at CDOs (CDOs are a huge risk for anyone right now) but what he says may very well apply to RMBS.

When it comes to real estate, he figures the recovery in housing will come in early 2009, and he predicts that current commercial real estate owners will benefit from the fact that the crunch has halted many developments, cutting into future supply.

I quoted him in prior posts where he has said that 2009 may be the start of the recovery for real estate. If he is right, and if you link that with John Neff's view that you should be 6 to 8 months (or something like that) before the turn, then mid to late 2008 is a good time to investigate real estate.

Wednesday, December 12, 2007 0 comments ++[ CLICK TO COMMENT ]++

Bond Insurance News: Security Capital'a AAA Rating Threatened

Fitch indicated today that Security Capital (SCA) doesn't have enough capital for its AAA rating. It is short by $2 billion, which is very large for its present market cap of around $400 million.

The company's capital is at least $2 billion below what it needs to retain the AAA following downgrades of collateralized debt obligations the insurer backs, Fitch said. SCA has four to six weeks to come up with ``firm capital commitments'' to meet the guidelines, or the rating will fall two levels to AA, Fitch said.

I suspect it is going to be awefully difficult for SCA to raise $2 billion. Bill Ackman thinks this will be the first bond insurer to go bankrupt.

The rating agencies will provide their guidance for Ambac and others soon. Although SCA is one of the weaker AAA insurers, the potential rating downgrade shows how severe the deterioration in the ABS and CDO market has been in just a few months. If you look at my prior post where I showed the chart of capital under various stress tests, you can try to estimate potential loss for Ambac. Fitch marked SCA as having 1.05x required capital under a normal scenario, and 1.04x under their previous stress scenario. Ambac was shown to have 1.11x under a normal scenario and 1.05x under the stress scenario. It's truly amazing to see SCA lose so much and there is a potential for Ambac to get hit badly as well. The rating agencies have details of the securities that were insured, and they are doing a thorough analysis (their reputation depends on it) so extrapolating from that original chart is very rough. Nevertheless it provides some guide.

There are 7 AAA-rated monolines right now and I am guessing we may just end up with 3 when all is said and done. I think MBIA will one of them... not sure which other...

Tuesday, December 11, 2007 3 comments ++[ CLICK TO COMMENT ]++

House Price-to-Rent Chart

A commonly used valuation measure for stocks is the P/E ratio. Well, the comparable ratio for housing is the home-price/rent ratio. It's not exactly comparable and the drivers of stocks and housing are somewhat different but, nevertheless, it's a good ratio to use for newbies like me. Since I'm trying to pick a bottom in housing--or at least avoid a falling knife--I think looking at the home price to rent ratio is worthwhile as a crude measure.

The Wall Street Journal has the following chart of the home price to rent ratio (thanks to Paul Krugman's blog for the initial mention of Barry Ritholtz's blog, who references the WSJ chart :) ):

This is a scary looking chart. It could take a while for that ratio to go back to historical norm. Similar to Paul Krugman, charts like these is what made me believe that housing was in a bubble. People simply won't be able to afford houses when the ratio expands. This ratio was put into practical terms when I started reading stories about young couples with jobs couldn't afford a starter home in San Francisco or New Jersey.

I should note that, similar to P/E ratios, this ratio can stay elevated if some factors work in their favour. For instance, P/E ratios can be high if interest rates are low. What can make the home price to rent ratio stay high is if income rises. But, unfortunately, American worker compensation has been flat for many years. My guess is that worker compensation as a percent of GDP will rise in the near future, while corporate profits as a percent of GDP declines, but even that may not be enough to keep the house price to rent ratio elevated.

Housing Boom Started in Early 90's

On a sidenote, anyone who thinks the housing bull market started in 2000's is sorely mistaken. Although you can't really tell from this chart, the boom started in early 90's. What this chart does tell you is that the price/rent ratio started expanding around that time as well. Some people like to pin the blame on the Federal Reserve's lowering of rates in 2003 for the bubble but the reality is that housing was already in a boom by then. What happened in 2003-2005 is that, as is the case during the final stages of any bull market, the shady deals, questionable transactions, and rapid price appreciations started materializing.

You made almost as much money from 1992 to 1999 as you did from 2000 to 2007 (I'm talking about housing-related stocks and not house prices, although both are strongly correlated to each other). This chart of Countrywide (CFC), a leading mortgage lender, and Pulte Homes (PHM), a leading homebuilder, shows the move I'm talking about (note that this is a log graph so equidistant spaces mean equal percentage gain). The 90's increase was around 1000% (10x) versus around 800% (8x) in 2000's. I suspect if you bought a house, as opposed to a stock in a housing-related company, you probably also made more money from the bottom in 1991 to 2000 than from 2000 to 2007 (I don't have a chart handy and am guessing here).

Monday, December 10, 2007 3 comments ++[ CLICK TO COMMENT ]++

MBIA Raises $1 Billion

MBIA has raised $1 billion in capital from Warburg Pincus, a private equity firm. The market likes the move (most bond insurers are up 8%+) but the real question now is whether it is enough. Here is what Warburg Pincus is doing:

  1. Buying 16.1 million shares for $31 ($500 million)
  2. 7yr warrants to purchase 8.7 million shares @ $40 and 7yr "B" warrants to purchase 7.4 million shares @ $40 (total $500 million)
  3. 2 seats on the BOD (out of 13)

Heavily dilutive but it isn't a bad deal in my eyes. About $500 million for warrants that only have value if price goes above $40. Given that the current price is around $33, Warburg Pincus clearly thinks that the stock go up 30% from here within the next 7 years. Pretty bullish statement from Warburg Pincus. Shareholders face the full brunt of the dilution but that is to be expected.

The real question is whether this is enough and whether this will be the end of capital funding activities. If MBIA, and other bond insurers, have to raise even more capital then the situation isn't so attractive.

MBIA also said that mortgage securities keep deteriorating and that it is earmarking $800 million in additional reserves. So MBIA will likely take a bigger loss in the 4th quarter than in the 3rd.

Thoughts on Ambac Based on MBIA's Moves

I think the situation with Ambac would be worse because ABK has a much more CDO exposure (it has the largest CDO exposure of any insurer). But the stock market has priced in a lot of that (ABK is down a lot more than MBI). Based on loss reserves taken by MBIA, I think it's reasonable to expect Ambac's losses to be 2x to 3x what it was in the last quarter.

I think Ambac likely needs to raise $1 billion to $2 billion. MBIA has clearly decided to dilute the shareholders while retaining its future profitability. I think Ambac should do something similar. Diluting the shareholders may be better than using reinsurance and giving up future potential. Issuing preferred shares, which is sort of in-between equity and bonds, is another choice. Of course, there is nothing to stop one from using multiple options.

If warrants are issued and they trade publicly, they are worth considering for those bullish on the stock. Although derivatives like warrants are risky (can go to zero), I think they are a better bet than preferred shares. If Ambac announces that they are going to have a public rights offering, and if I decide to invest in it (still not sure), then I would seriously consider the warrants. The beauty of the warrants is that they have massive leverage while having long life.

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Beginning of the End of the Subprime Mess

UBS Quantifies Subprime Losses

UBS, the Swiss bank, just quantified the losses from subprime to an additional US$ 10 billion (in addition to the $3.4 billion taken a few months ago). This is a huge loss no doubt but I think this is a sign of the the beginning of the end of the subprime mess.

In addition to taking the loss, the company announced that it will raise capital by:

  1. Selling a 9% stake (11 Billion Francs) via mandatory convertible notes to Singapore government's investment arm
  2. Selling roughly a 1.6% stake (2 billion Francs) via mandatory convertible notes to a Middle Eastern entity (speculated to be the government of Oman's investment arm)
  3. Plan to convert the cash dividend to a stock dividend (yikes!)
  4. Re-sell 26.4 million shares held in treasury that were to be cancelled

Sizeable dilution for shareholders but shoring up capital is a primary need for the financial companies. The stock is actually up around 2% today (on NYSE in US$ terms) after all that massive dilution (although note that this is a megacap and has a market cap of around $100 billion so the capital injection probably only shaves off 15% of market cap).

You can tell that the market has priced in a lot of the negative news already (that's why the stock actually went up). This tells me that we are basically near the end of the write-offs. If the US economy slows down, profits may decline due to other reasons (like lower trading income; asset management; M&A; etc) but the subprime uncertainty seems to be priced out right now in my opinion.

Risk Has Indeed Been Shared

Some critics don't think secrutization of risky assets, like subprime mortgages, was beneficial to society but I have always felt that it helped the capital markets and economies in general. We see the benefit of risk being spread across the world when European investors and banks take losses from US assets. It is clear from the subprime situation that the risk has indeed been spread to multiple parties--and this is a good thing! Instead of one US bank completely collapsing, we have multiple investors and banks getting hit for a little bit.

Bond Insurers May be Near a Bottom

My thinking on bond insurers parallels that of the investment banks with subprime losses. I suspect most of the subprime losses are priced into the bond insurers. However, there are a few unique issues with the bond insurers.

First of all, the market cap is so low that any means of raising capital can seriously hurt the shareholders. When Citi or UBS raises $10 bilion, it's only around 10% of market cap; whereas Ambac raising $1 billion would be 30% of market cap (although the way the stock is surging today on news of MBIA capital injection, things won't be so bad).

In addition, I think one or more bond insurers may not make it. Any big problems likely means that someone will buy out the insurer but equity holders will lose big. Just because a company survive means nothing if your shares are bought out at a low price. In contrast, I find it hard to believe that one of the big investment banks, brokerages, or commerical banks, will go bankrupt.

The two above risks are what makes bond insurers interesting--and attractive. If someone wanted a contrarian bet on financials, something like BAC, C, MER, or BSC, is the easy choice; but ABK, MBI, and others, likely provide higher upside potential (with potentially big downside as well).

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Thursday, December 6, 2007 0 comments ++[ CLICK TO COMMENT ]++

Delta Financial (DFC) To Ride Off Into the Valley of Death...aka Bankruptcy

Well, it isn't much of a surprise shareholders or anyone following the company but Delta Financial (DFC) said that it will seek bankruptcy protection. Quick notes from MarketWatch:

Delta Financial Corp. said on Thursday that it plans to file for bankruptcy protection, becoming the latest mortgage lender to succumb to the subprime crisis that's swept the industry this year.

DFC announced last month that it was getting help from hedge fund firm Angelo Gordon & Co., but that agreement depended on the company selling roughly $500 million of loans on to other investors in a securitization, or arranging other financing for the loans.

On Thursday, Delta said it couldn't complete the securitization. Warehouse lenders, which provided short-term financing for Delta's loans before they're securitized, have now told the company it has defaulted.

The fate of Delta Financial is no differen than the countless other mortgage lenders that have gone bankrupt this year. I decide to take a small position in DFC because their clients seemed safer, with more fixed-rate loans and away from bubble areas like California.

The deal with Angelo Gordon is now off and Delta said it will stop taking new mortgage applications and file for bankruptcy protection from its creditors. Delta offered mortgages to subprime, or less creditworthy, borrowers. However, the company focused on fixed-rate loans, rather than more exotic adjustable-rate products.

The problem for Delta was that the credit market dried up and they couldn't secrutize their loans. The thing about mortgage lenders is that their business will cease to exist if they can't sell loans. It's one of those businesses where there really isn't anything to do if business dries up or you can't offload your loans. This is a risk with homebuilders as well. Homebuilders can literally turn to zero if they don't build new homes.

Here is what I wrote when I took my position in Delta (it was around 2% of my small portfolio):

In any case, I decided to take a very small speculative position in DFC @ $5.50. The stock is already down 20% but it can move in either direction quickly. This is the type of position that can go to zero or go up 100% very quickly. It's totally dependent on news and credit market conditions. I am wondering whether I should add to the position. It's definitely very risky but has the market oversold the danger?

I guess we now know the answer to question I posed huh? I said this is the type of stock that can go to zero and it actually did turn into the most important number in mathematics: zero. I had been pondering what to do with DFC for a while. Since my position was very tiny, I didn't feel compelled to do anything. My biggest mistake is probably just going into it without understanding their business very well. I've been looking into mortgage lenders and I just don't understand them.



Tribune Lowers Debt in Takeover Plan

With Tribune lowering the amount of debt financing for the LBO, it is one step closer to closing its deal.

Tribune said it has told the lead arrangers of its second-step financing that it intends to use up to $500 million of its cash to cut its bridge loan commitment to $1.6 billion from the original amount of $2.1 billion.

The stock was up 7.8% but is still around 6% below the takeover price of $34. The market still thinks there is a decent chance of everything falling apart.

Tuesday, December 4, 2007 3 comments ++[ CLICK TO COMMENT ]++

Ambac Reinsurance Notes

Neanderthal wondered about Ambac's reinsurance situation in one of the comments to a prior post of mine. His point, which is raised in the Pershing Square presentation, is whether reinsurers will be able to pay if there are massive losses. I did a quick search (the world is so much more productive with electronic PDF documents that you can search :) ) and here is what I found.

I looked at the 2006 annual report so the info is not exactly up to date. However, we are just trying to get a rough idea and although the reinsurance agreements may have changed materially in the last few months, it's probably the best info out there (unless the info is contained in some of Ambac's presentation slides or something). You can find information about reinsurance starting on page 17 in the 2006 annual report.

Ambac's Reinsurance

As of Dec 31, 2006, the largest reinsurer accounted for 1.8% of gross par outstanding. Given that the total outstanding insured amount is roughly $519 billion, you are looking at around $10 billion with one reinsurer. It looks like the total amount of reinsurance being used is 8.6% of par ($48.5 billion), so the largest reinsurer is responsible for about 25% of the reinsurance. If I understand it correctly, the table below shows reinsurance broken down across various types of obligation.

(source: Ambac 2006 Annual Report, page 18)

As you can see, there is very little reinsurance for the questionable segments like "mortgage-backed and home equity" and "pooled debt obligations". Ambac is pretty much on its own here. But it does have quite a bit of reinsurance for the "asset-backed and conduits".

Ambac's primary reinsurers are:
  1. Assured Guaranty Corporation
  2. Blue Point Re Ltd.
  3. FSA Guarantee
  4. MBIA
  5. Radian Asset Assurance Inc.
  6. Ram Reinsurance Company, Ltd.
  7. Swiss Reinsurance Company
  8. Sompo Japan

Well, that above list should be scary to Ambac shareholders. One might have seen a similar list elsewhere. It doesn't take long for one to realize that almost all the monolines are using the same reinsurance companies and they even reinsure each other (MBIA doing Ambac and vice versa for example). I think that's what Pershing Square was concerned with, and it's a real risk.

If there is low correlation between the monolines then a concentrated group of reinsurers isn't a big deal. For example, when MBIA had problems with Eurotunnel, other monolines had no problems (at least related to that). But when it looks like everything, including the strongest two, MBIA and Ambac, are getting hit with potential mortgage-related structured product losses, then it is fair to question whether these reinsurance companies actually will be able to pay out claims for any losses.

Risk of Reinsurer Rating Cut

On page 68, in the risk factors section, Ambac also discloses the S&P financial strength ratings of its reinsurers. Around $20.7 billion of reinsured par is with companies rated AAA and $27.7 billion are with AA-rated reinsurers. A risk to consider is what happens if the reinsurer ratings are cut. On top of the question of whether the reinsurer will be able to pay losses, it also causes a decline in Ambac's claims-paying capital amount. The reason is because highly rated reinsurance is counted at full value (100%), while those with lower rated reinsurers are counted at less value (eg. 70%). So a significant cut in a reinsurer rating may result in Ambac needing more capital to require rating agency and regulatory requirements.

Final Thought

Based on my analysis here I don't think the existing reinsurance is going to save the bond insurers. The stuff that is questionable doesn't seem to have much reinsurance. So whether these reinsurers blow up or not isn't a huge concern in my eyes.

Instead, reinsurers will play a crucial role with new reinsurance that is used. If the bond insurers need capital, they are going to have to offload their muncipal bond guarantees--needless to say, this is their most lucrative business and underpins the reason for owning the bond insurers in the first place--and what happens to this future reinsurance will have a huge impact. If they can't get enough reinsurance on decent terms then you are looking at massive share dilution (Ambac can already issue $800 million of preferred stock to a committed party but they may possibly need more (in the worst case)).

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News of Canada's Decoupling from USA Greatly Exaggerated

Well, I think today's surprise interest rate cut by the Bank of Canada pretty much puts a nail in the coffin of the Canada decoupling from the US theory--a theory I never really believed. I put a lot of emphasis on this move because Canada isn't showing as much stress as the US (export-oriented industries and manufacturing are getting hit badly but it's not that bad yet; real estate really didn't develop into a huge bubble here; etc). So a cut really means that the Bank of Canada, which is highly respected and generally considered to be more transparent than many other central banks, really feels that there is a big crisis that's unfolding.

The next dominoes to fall in the decoupling argument will be Europe, followed by Latin America (particularly Brazil) and then China. Once all this is done, everyone throughtout the world will know the word "subprime"...

The interesting thing is that, due to the huge run-up in cyclicals and comodities, equity investors really aren't feeling any real pain. Even with all the chaos in the derivatives, mortgage companies, financial firms, and so forth, the S&P 500 is still positive for the year (in US$ terms).

Monday, December 3, 2007 3 comments ++[ CLICK TO COMMENT ]++

Bill Ackman's Super-Bearish Presentation on Bond Insurers

Thanks to Rational Angle for providing the link to Bill Ackman's presentation on bond insurers at the Value Investing Congress. I have been looking for this and didn't realize it was posted at the official site of the forum.

The presentation pretty much covers nearly all the bearish items to be made regarding the bond insurance industry. The presentation raises some interesting points that I didn't pay attention to (such as whether the reinsurance companies themselves will be able to pay out losses if there is a blowup). I didn't read it fully yet and may post my views if I want to rebut anything.

I find some elements of the presentation to be superficial. For instance, the title is pretty much doublespeak. The presentation is titled "How to Save the Bond Insurers" when in fact Pershing Square is short the bond insurers and pretty much offers suggestions to bankrupt the bond insurance holding companies. This is no different than people who are short homebuilders or mortgage lenders offering suggestions to "fix" the housing mess.

One of the bizarre arguments from the bears in my eyes--who is mildly bullish on the bond insurers although I have no position--is the notion that this industry is not viable. I'm not sure how anyone can make that argument when companies like MBIA and Ambac have been in the same business since the early 70's. One can argue that structured products are not viable, or that some of these companies made tragic business-ending moves, or whatever, but I don't get the 'industry not viable' argument.

I also see a flaw in people arguing that bond insurers are heavily leveraged or only make money off a few basis points. All that is true but it doesn't mean that an industry can't exist. I am just a newbie and don't really understand everything but isn't the catastrophic insurance business the same thing? Or how about reinsurance, with the big companies like Swiss Re, Munich Re, Berkshire Hathaway, and so on? A lot of the catastrophic reinsurance companies also have very low capital compared to the massive damage that they have to pay out (I know because I own Montpelier Re (MRH), which got hurricaned ;) and nearly went bankrupt after Katrina--of course, being a contrarian I bought it after its crisis).

Insuring high par value isn't a big deal if the probability of loss is low. That's how these bond insurers were able to stay in business for many decades (municipal bonds don't default often). The real question for anyone looking to invest in the bond insurers is whether their "quest" into structured finance was a bit too adventuresome for these insurance knights. Although the stock prices say something else, the verdict is still out. So far, I am confident that the bond insurers will make money, even on subprime mezzanine CDOs, from 2000-2004 vintages. The 2005 vintage stuff is questionable, and 2006/2007 are likely losses.

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Sunday, December 2, 2007 0 comments ++[ CLICK TO COMMENT ]++

FCC Gives Approval for Tribune Takeover

Late Friday, FCC gave approval for the Tribune (TRB) takeover. Media companies are not allowed to own newspapers and television stations in the same market, and Tribune had a waiver that allowed it to do so. Upon change of ownership, the waiver needs to be re-approved and that is what everyone was waiting for the FCC to do.

Now it is up to the bankers to raise the debt to finance the takeover by Sam Zell. The stock price trading way below the takeover price of $34 pretty much says that the market thinks there could be some issues with the debt financing. I took a position in TRB with the belief that the deal will go through--and I don't think anything has changed (even with the credit market problems). Given the interest by Sam Zell (he talks as if he already owns Tribune) and the steps taken by Tribune to facilitate the deal (including increased leverage to buyback shares earlier this year as part of the deal), I think there is a high chance of the deal going through. If there are issues with financing, the deal may be re-negotiated down to, say, $30 range (from $34).

Saturday, December 1, 2007 0 comments ++[ CLICK TO COMMENT ]++

Bill Ackman & MBIA

Joe Nocera of the New York Times has an article describing Bill Ackman's pursuit of MBIA. For those not familiar, Bill Ackman is an investor that has been bearish on bond insurers for many years. He recently gave a presentation at the Value Investing Congress implying that companies like MBIA and Ambac are insolvent if they can't raise capital. Let me quote some key comments in the article:

Mr. Ackman is an emerging star in the “shareholder activist” division of the hedge fund big leagues. In the last few years, he has taken aim at McDonald’s, Wendy’s and, most recently, Target, usually emerging from these tugs of war with profits for his hedge fund.

His firm, Pershing Square Capital, which he founded in 2004, now bulges with over $6 billion in assets. “If I think I’m right, I can be the most persistent and most relentless person in America,” he says. But for sheer, obsessive doggedness, nothing he has ever done can compare with his pursuit of a company called MBIA Inc. In fact, I don’t think I’ve ever seen a fund manager grab a company by the tail and simply not let go the way Mr. Ackman has done with this once-obscure holding company, whose main subsidiary, MBIA Insurance, is the nation’s largest bond insurer.

Though he says he is not typically a short seller, Mr. Ackman has been shorting MBIA’s stock since 2002...

He purchased credit default swaps as a way to profit in the event of a bankruptcy by the holding company.

The impressive thing about Bill Ackman is that he has stuck to his original thesis. It would have been extremely difficult for an average person to be bearish and short MBIA since 2002. The stock, along with other monolines, have run up so much in the last few years that most people would have been tempted to change to their opinion and move on to other investments.

For most of that time, his efforts have come to naught. Despite the fact that MBIA, at one point, had to restate five years of earnings — after being tripped up on an accounting problem that Mr. Ackman brought to light — its stock continued to do well...

And then came the subprime crisis, which in recent months has wreaked havoc on MBIA’s stock price, and raised questions about its business model. Sean Egan, the co-founder of Egan-Jones, an independent bond rater, believes that MBIA and the other big bond insurers will be saddled with billions of dollars in losses as collateralized debt obligations stuffed with subprime debt — so-called C.D.O.’s — they have insured continue to go south. So does Mr. Ackman, who believes that as losses pile up and the bond insurer has to pay them off, it will have to shut off the supply of money it sends to the holding company.

At the investor presentation he held this week, Mr. Ackman predicted that the holding company could be bankrupt by February, which MBIA says is preposterous.

Clearly everyone, whether a bull or a bear, are staking out their position and have a good case for their thesis working out.

There’s no doubt about what drives Bill Ackman crazy about MBIA. For all the many issues he has raised, his objection really comes down to a single fact: MBIA has a triple-A rating, the highest any company can get — indeed, a rating more normally associated with Treasury bills, which are backed by the full faith and credit of the federal government. And it’s not just the fact of MBIA’s triple-A rating that drives Mr. Ackman batty; it’s its transcendent importance to the company’s business.

I think the monoline superbears, such as Bill Ackman, Reggie Middleton, and others, clearly think that the whole bond insurance business makes no sense. A key reason many of these people are extremely bearish (you can't get more bearish than saying a company may be insolvent without it actually being right now) is that they don't think insuring a bond to a higher rating, say AAA, from AA, is a viable business.

The author of the article goes on to point out that wrapping municipal bonds to AAA may make sense but the others (like structured finance products) are too risky and not a viable business. People who are bullish, like me (although I have no position in any of the monolines), don't buy that view. In any case, whatever the case may be, it is up to the market to indicate whether this a viable business or not. I think we will know for sure in 5 years, when the market refuses to buy AAA wrapped insurance on bonds, or, instead, still keeps paying for the insurance. Of course, for contrarians like me, that's well after the investment opportunity in monolines has passed.

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Friday, November 30, 2007 3 comments ++[ CLICK TO COMMENT ]++

Risk Arbitrage: BCE

One of the risk arbitrage plays that I have mentioned before is BCE of Canada (BCE; TSX: BCE). BCE is the largest telecom in Canada and it is being taken over by a consortium. The payment is in cash and is supposed to close early next year. Fabrice Taylor of The Globe and Mail has written a good column summarizing the details and the risks. Note that everything mentioned is in Canadian dollars. BCE also trades on NYSE.

f all goes well, BCE shareholders will get their money some time in the first quarter of 2008. Let's assume the last day of the quarter, March 31, to be conservative. The offer is $42.75 a share while the stock is quoted today at $39.20. The four-month return, then, is a little more than 9 per cent - and even more if investors get a dividend before the deal closes.

As the author suggests, you are looking at around 9% in 3 or 4 months. This is a low-risk arbitrage situation so that's a good return. If you are an American and are bearish on the US$ (I am not) then you may also get some positive return from currency gains if the US$ weakens further.

In terms of risks...

One risk is that more wireless competition will prompt the buyers to change their offer. BCE shares slipped yesterday on news that Industry Canada was making it a lot easier for new entrants to compete. Another is that BCE's bondholders are trying to thwart the deal in the courts. And finally, there's the risk that the buyers won't be able to raise the debt because of the credit crunch.

Some message board commentator on the site also points out a risk with the CRTC, which is the government agency responsible for media oversight in Canada. I think the CRTC issue is likely low risk given that owners are still mostly Canadian and nothing much is changing with the media structure.

If you do the calculation the way Warren Buffett looks at risk arbitrage, you will get:

probability of success (my guess): 90%
probability of failure (my guess): 10%
potential gain with successful closure: 9%
potential loss with deal collapse (my guess): -20%

Expected return = prob_success * gain - prob_failure * loss = 0.9*0.09 - 0.1*0.2 = 6.1%

If you annualize that, you are looking at around 20%+. Of course, I am guessing on the probabilities but that's how I see things.

I find this deal very attractive but I will likely pass on this for a few reasons. Firstly, the return is a bit too low for me. I am willing to take higher risk for higher return. Secondly, I don't have enough free capital (my portfolio is small) and I want to buy something around the tax-loss selling season. I am seriously thinking of Ambac (ABK); given that Owen's Corning (OC; OCWAZ) has dropped a lot, I'm also starting to look at it again. If the potential return increases to, say, 14%, I'll consider investing. (Having said that, I will likely take a position with my mom's portfolio :) ).

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Thursday, November 29, 2007 2 comments ++[ CLICK TO COMMENT ]++

Reggie Middleton: Ambac Insolvent

Well, anyone considering investing in Ambac (or others) should definitely look at the bear case. Reggie Middleton provides a super-bearish case saying that "Ambac is effectively insolvent". Take a look and form your own opinion. I haven't read it yet so I don't have anything to say.

For what it's worth, he is short Ambac and MBIA. Some people might think somone's report is nothing more than propaganda in light of that but I generally think the opposite. If anyone is putting their own money on their calls, I respect that...

The problem with Ambac for both shorts and longs is that this story may not end for at least 1 year. Some people think that the market will take a stand one way or another after the rating agencies release their rating evaluations but I suspect not. Every bad news is going to push the stock down and the occasional good news, along with short-covering, will push the price up. The stock has been moving almost 5% on a daily basis over the last few months. Daytrader heaven for sure...

Wednesday, November 28, 2007 1 comments ++[ CLICK TO COMMENT ]++

TRB: One Step Closer

The FCC, which is moving at a snail-like pace, indicated today that they will try to have a vote on the Tribune (TRB) acquisition by the end of Friday. The stock is still nowhere near the acquisition price of $34. If the FCC waiver is granted by Friday, the last remaining step is for the bankers to raise money for the deal.

On another note, I have noticed that the spreads on takeovers have widened again. Almost sure-bets like BCE (BCE; TSX: BCE) have dropped recently. Other bids worth monitoring are Clear Channel (CCU) and Credit First Boston (CBH). I haven't evaluated any of them deeply (except when I mentioned BCE in some posts several months ago) so none of these are concrete ideas. If I recall, all these deals close next year so if you like the prospects then you need to be willing to tie up your capital until next year. Given that December sometimes involves heavy tax-loss selling, it may be more attractive to buy beaten-down stocks instead of going for merger arbitrage deals.

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Bill Ackman Thinks Bond Insurers in Big Trouble

Bill Ackman supposedly thinks that MBIA and Ambac will be bankrupt by mid 2008 if they can't raise capital:

Bond insurer MBIA Inc could be insolvent as soon as the second quarter of 2008 if it were unable to access additional capital, according to a slide at a presentation by Pershing Square's William Ackman.

Ackman estimates MBIA will incur $2.2 billion of losses in the fourth quarter, and rival bond insurer Ambac Financial Group Inc will incur $4.2 billion of losses.

Nothing new from Bill Ackman, who has been bearish on the bond insurers since 2003 (based on some article I read back then (I think in Forbes). Since I'm bullish (although not bullish enough to take a position right now), this makes me uneasy. If he were not a so-called value investor, I would sort of brush it off but since he is a value investor (meaning he is likely basing his views on bottom-up approach*), it is something one should consider. I really want to get my head around where he is wrong. He has basically implied that the whole bond insurance business makes no sense. By claiming that MBIA, which is the leader and the least likely to be downgraded, he is attacking the whole industry.

He is supposedly presenting at the Value Investing Congress and if anyone can give me (or provide a URL link) to the presentation slides (assuming it's legal to do so), I would appreciate it.

CIBC and Barclays Vulnerable to Bond Insurance Collapse

I don't really understand this article. Supposedly CIBC and Barclays acted as counterparties to some of the riskiest bond insurance that was written. If the bond insurers fail to pay then the article is implying that CIBC and Barclays will be on the hook.

Bond insurers didn't used to put up collateral when doing business with Wall Street, but that all changed as they started insuring riskier products. As a result, Ambac and other monolines were required to find counterparties with strong balance sheets to back them up when they insured the exotic bonds that Wall Street cranked out in recent years.

Enter CIBC and Barclay's, relative newcomers to the bond insurance business. With sound balance sheets and lots of cash, they were eager to help guarantee these insurance contracts for a fee. Bond insurers even packaged and sold their own debt in the form of credit derivatives -- risks that CIBC and Barclay's took on as well.

...That's because, if the insurers are downgraded, their cost of doing business will become a lot more expensive, which means they'll have less money to meet their guarantees on troubled bonds. The responsibility for these guarantees will fall to the likes of CIBC and Barclay's.

I never heard this being discussed anywhere before. I never knew that some banks, like CIBC, are somehow guaranteeing if the bond insurer fails. If you have a thought on what is happening, leave a comment below.

* Why Dissenting Value Investor Opinion Is Important In My Eyes

Admittedly I have no idea how much of a pure value investor Bill Ackman is. Generally most people consider him to be close to a pure value investor. Anyway, the reason it matters whether he is a value investor or not is because most value investors approach their investment decisions from bottom-up (i.e. starting with company specifics, then moving to industry, and so forth). So when he says that MBIA will be insolvent in 3 quarters if they can't raise capital, he is likely saying this from a detailed analysis of the company.

In contrast, note that other types of investors, such as those into sector rotation, or traders, or those making calls based on macro views, or whatever else, can easily say stuff because the mortgage market is falling apart and a lot of the structured products, like recent vintage CDO-Squared, are almost completely worthless. Although I consider these views, I give less weight to them. The reason is the same reason Warren Buffett ignores macro stuff. Consider the following:

Ten or twenty years ago, if you had looked at the macroeconomic trends for tobacco stocks and was able to predict exactly what transpired (very few can predict), you would have seen the following: declining tobacco use (especially among younger people), advertising ban (how are you supposed to sell your product if you can't advertise on any of the major media?), huge court settlements with governments that wiped out many years of profits, and an increased negative opinion by the public towards the companies. Tobacco would have looked like a bad investment... boy, would you have been wrong... tobacco stocks, such as Phillip Morris (aka Altria), ended up being some of the best investments in the last 20 years (not #1 but easily beat the market)...

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AccruedInterest On His/Her Calculations of Ambac's Losses

AccruedInterest posted a breakdown of the loss estimates that was used for Ambac in the prior blog entry. The author goes on describe the situation facing Ambac and others when it comes to raising capital. As I remarked in my prior post, reinsurance is the least dilutive but it will hit future earnings and I would guess that it will shave 2% to 3% off future ROE. But if a lot of capital needs to be raised then multiple methods may be needed, including issuing shares (the most expensive of all).

The tricky thing for those sitting on the sidelines is that we don't know how much dilution the market is pricing in (the knowledgeable experts may but newbies like me don't). My strategy, assuming my risk arbitrage position on TRB is closed successfully, is to wait until late December and see what the rating agencies say. You can try to outguess them by buying before their decision but that is very risky.

Tuesday, November 27, 2007 0 comments ++[ CLICK TO COMMENT ]++

Stock Market Returns for the World

Birinyi Associate's TickerSense posted the chart below showing stock market returns throughout the world (thanks to SeekingAlpha for the original reference):

(source: TickerSense, Birinyi Associates)

If you visit their site, you'll get a table showing the returns for individual countries. The top 5, in order, are China (135.18%), Ukraine (121.20%), Bangladesh (90.83%; who says poor countries suffering a crisis don't do well? ;) ), Romania (76.15%), and Slovenia (74.59%).

The bottom 5 are Ireland (-29.89%), Venezuela (-28.04%), Estonia (-14.41%), Japan (-12.14%), and Ecuador (-9.79%).

You can tell from the map that developed countries (USA, most of Europe, Japan) are posting negative returns, while the dark green areas with hig returns are high growth emerging markets. The middle green varies but you can easily tell that commodity countries are dominant.

What this map says--to me--is that the developed countries are slowing (none have entered a recession or posted less than 2% growth rate (except Japan, but Japan is generally low)) but their stock markets are looking forward and seeing bad things. The real question that is on many people's minds is whether the emerging markets will decouple. Interestingly China seems to have entered a correction, with their stock market down around 20% (20% isn't large for their highly speculative market).

My expectation is that things are not going to get any rosier than what's on the map right now. I suspect you will see more reds and pinks in about an year's time...


Ambac Says It Will Consider More Reinsurance

Ambac says that they will consider using more reinsurance in the future:

Ambac CFO Sean Leonard said the company will continue to defend its triple A rating, and added that there's a lot of opportunity for the company to reinsure its transactions. He said about 85 percent of the company's portfolio is non-mortgage related.

Go to Ambac's homepage to check out the presentation at the Bank of America conference. A PDF presentation can be found here. Well, the presentation is biased in favour of the bull case (what else is to be expected from management?) The strategies that Ambac will use to meet capital requirements are supposedly:

In order of preference:
  1. Reinsure block of current book
  2. Increase reinsurance on future business
  3. Alter mix of business to less capital-intensive transactions
  4. Debt or soft capital issuance – approximately $600 million of capacity
  5. Equity issuance

It looks like they are going the reinsurance route. It's not going to be cheap and will lower future returns but it is the least dilutive method. Issuing stock or debt will be extremely dilutive right now and I hope they don't go that route. Peak ROE was a market-leading 12% and if you use reinsurance I think ROE will probably decline to 8% to 9%. That number is just a guess on my part and if I were to consider Ambac right now, I would estimate the future based on an ROE of 8%.

Monday, November 26, 2007 0 comments ++[ CLICK TO COMMENT ]++

S&P Initiates Review of Bond Insurers

I was wondering what S&P was doing all this time but they finally initiated a review of the bond insurers. Recall that Fitch and Moody's have already initiated their review and are supposed to release their thoughts within the next month (timing is just an estimate). According to what Fitch was saying a few weeks ago when they started their review, Amabac has a moderate probability of their AAA rating being under threat, while MBIA had a low probability.

There is a huge gap in the equity analysts covering the bond insurers, not to mention the bloggers and other small investors like us. I only have access to the free analyst reports from my discount brokers so my analyst knowledge is limited. Morningstar thinks that the market is overreacting on Ambac (as well as other insurers). Based on the article referenced above, Citigroup analyst thinks the same:

Citi Investment Research analyst Heather L. Hunt expects the AAA ratings on Ambac, MBIA and Assured Guarantly Ltd. to be reaffirmed.

Further, she said stocks in the sector have fallen so far they already reflect a weaker credit rating. For example, she said the more than 70 percent decline in Ambac's stock this year seems to imply the market expects $7 billion in insured losses, which she said is unlikely.

Hunt cut her price target from $95 to $50, factoring in roughly $2.1 billion in losses.

Heather Hunt, the Citi analyst, expects $2.1 billion in losses. I can't remember but I think Morningstar was expecting $1 billion to $2 billion. And Accured Interest was expecting $2 billion to $3 billion.

The real question for Ambac shareholders--and those considering going long--is whether the market is already pricing that loss. The analyst seems to think that the market is pricing $7 billion in losses. Analysts, like all of us, are just guessing and I'm not sure how true that $7 billion is. One possible flaw with some bullish analyst estimates is that they may be valuing the business at historical norms (say, a normal price-to-book of 1.3 (the 10 yr average for Ambac is actually around 1.7)). If the market re-prices the whole sector, say from a p/bv of 1.3 down to 1, then the stock is never going to go bank to the original levels (at least for many years). I think analysts sort of realize this, as one can tell by them cutting target stock price from $100ish down to $50ish.

Unless you were a super-long-term investor, I think a realistic target for Ambac is something like $50. If I were to take a position, I would invest with the expectation of around $50 (which is a 100% return from current price in the $25's). (note that from a longer term point of view, assuming the company doesn't go bankrupt, require massive capital injection, or take more losses from credit cards and other possible future debt problems, the stock price should be higher. From what I recall, Ambac earns around $750 million per year on existing policies so you are looking at a normalized P/E of around 3 at current price).

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