Accrued Interest: Ambac Likely Needs Capital Injection

Accrued Interest has just posted an analysis of Ambac's potential losses. The news isn't good for Ambac shareholders. The final conclusion is that Ambac needs capital injection of around $2 billion to $3 billion. If you are interested in Ambac (or other monolines), you should read the full post at that blog rather than my selective quotation.

First let's consider what AMBAC needs to do to retain a AAA rating. All three of the major ratings agencies have a similar methodology for bond insurers. They need to survive a Great Depression-type scenario. The agencies then estimate how much capital an insurer would need to survive such a scenario. As long as the agencies has capital above this minimum, they get their rating.

Currently AMBAC has between $1.1 billion and $1.9 billion in "excess" capital over what's needed to retain a AAA/Aaa rating, depending on the agency.


That's sort of what Ambac needs from a rating agency point of view...

Regardless, I think the way to attack AMBAC's capital adequacy is to consider how much in principal losses their ABS and CDO portfolios are likely to eventually suffer...

AMBAC's biggest problems will be in their CDO portfolio. I estimate they will suffer $4 billion in losses from their CDO portfolio. This will be almost all in the ABS CDO and CDO of CDO portfolios, which will suffer from the structured squared problem. Losses in other types of CDOs would seem to be within typical historical levels.

Losses in direct RMBS positions look to be in the $2 billion area.


These numbers are not surprising to me. Given that Ambac has the largest exposure to CDOs, it will be at the forefront of any big losses in the CDO arena.

So how much in capital would they need to retain their rating? Probably at least $2 billion. They have about $1 billion in either loss provisions or mark-to-market losses they've already realized. They should have earnings of around $800 million/year. If we figure that the $6 billion in losses is spread over 3 years, that's about $3.5 billion in internally generated capital. Plus they have about $1 billion in "excess capital" over what they need to retain their rating. That leaves us $1.5 billion short.

You'd assume that AMBAC would want to raise more capital than the bare minimum, so I'm figuring $2-3 billion.


Raising $2 billion to $3 billion will be very expensive for Ambac shareholders. Ambac's market cap right now is around $2.5 billion and you are basically looking at diluting the shareholders by 50%! But do note that this is with the stock trading at around half its book value, so the dilution may not be as great (how you raise the capital also plays a role).

My Thoughts

If you ever wanted to know the power of communication on the Internet or blogs in general, the post by Accrued Interest illustrates it clearly. Anyone thinking of Ambac (or other monolines) now have a starting point to consider for their risk analysis of Ambac. You never would have had access to such analysis in the past--not to mention the fact that it is free :)

The final conclusion doesn't surprise me given that I have commented on the possibility of a need for capital in some of the my recent posts. My feeling, which was just a wild feeling, was not based on some rigorous analysis as Accruded Interest has done but more on the fact that Ambac only had 1.05x the required capital under Fitch's hypothetical stress test a few months ago, and Fitch said that the hypothetical has become the reality now.

However, the amount of expected loss according to Accrued Interest's analysis--and hence the capital needs--is much higher than I had expected. Needing to raise $2+ billion is a tough pill to swallow. My guess (hope?) was for $1 billion.

Unlike the author of Accrued Interest, I do not think raising capital will be difficult. As the author points out, people like Warren Buffett, or perhaps other insurance companies may provide some capital. The real problem is the dilution!

Couple of Things

Do note that the analysis performed by Accrued Interest does not take into account Ambac's management experience. It is quite possible that Ambac has written written policies on mostly good cases and ignored some really bad mortgage debt. However, we should be pessimistic and I would give zero benefit of the doubt to management's ability to pick good CDOs.

Another thing to note is that rating agencies have more detailed information about Ambac's CDOs. The rating agencies will do a more accurate analysis with greater "granularity". Given that slight changes in assumption and numbers can result in massive differences in the output, one cannot assume the rating agencies will say the same thing.

My Strategy

I am still interested in Ambac as an investment but now I will wait until the rating agencies release their thoughts (expected in December). Initially, I was thinking of possibly investing in Ambac (or others like MBIA) by December but now I'm going to wait and see what the rating agencies say and how Ambac raises capital. Overall, I'm still interested in this sector and something like MBIA is still a potentially worthwhile investment (MBIA doesn't have as much CDO exposure).

In case you are curious on why I am still interested in Ambac, it's because none of this changes my view on the distant future of this business. Assuming Ambac can raise capital, they will still keep going. We are not looking at a situation where the company is going to go bankrupt (it's a possibility but no concrete signs yet). Instead, the issue is the amount of shareholder dilution. To see what I mean, imagine that Ambac's stock didn't sell off and it faced the current situation. In that case, you are looking at raising $3 billion for a company with a market value of $10+ billion. A preferred share issuance plus possibly a convertible bond issue will easily raise the capital with only moderate dilution. Obviously that isn't reality but the point is that it is a dilution issue. At least that's how I see things!

I'll wait and see how things stand in January. If there is heavy dilution and new convertible bonds are issued, it is worth considering those (if they are available to regular investors). It may also be worth looking at the existing exchange traded preferred shares: AKF and AKT.

Benjamin Graham said preferred stock is generally a bad idea (it has the downside of a common stock (zero) and the upside is capped at around par value (it may trade slightly above par if interest rates drop)) but it will pay for waiting. The current yield on AKT is around 9% but if it increases to, say, 12% then it may look attractive (overall it will still be a bad bet for the reason Benjamin Graham indicated)... If you don't like equity, the best bet will be convertible bonds. Warren Buffett has used them successfully in the past with Gillette and Level 3 Communications (not entirely sure if the Level 3 bonds were convertible)... Of course all this is assuming that you don't think the company is going to go bankrupt.


(On a side note, anyone thinking of wading into the bond insurance business may also want to consider the possibility of increasing commercial real estate defaults, as well as increased defaults on credit cards, car loans, and the like. I'm not sure who has exposure to those things but since the US economy is clearly slowing, it's something to consider. You know the credit monster is slaying everyone in sight when Cerberus, the private equity firm symbolized by the hound that guards hell, and is generally considered to be one of the savviest and most knowledge group, is supposedly running into problems.)

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