Ambac News... It's Crazy Out There
(update: added presentation by Pershing Square at the bottom)
Well, it has certainly been a wild ride for monoline insurers lately. I'm not sure how shareholders of Ambac and other monlines are coping these days. Here are some happenings in the world of Ambac...
Conference Call
I'm not sure where to start but Ambac management will be holding a conference call on Wednesday. The call is supposed to shed some light on CDOs and how the mark-to-market process impacts Ambac. I believe this is a prudent move by management to clarify the situation. There is certainly a lot of rumours swirling around.
I'm not an expert but I think a lot of people are making the mistake by looking at these monolines as if they were a typical investment bank or hedge fund. In particular, a lot of people just seem to take the outstanding par value and divide it by the capital and end up with some ridiculously scary number. There is between $1 trillion and $3 trillion of debt that is insured by all the monlines (there are only like 5 stand-alone companies of any size) but the total net capital of all these firms probably isn't even $100 billion (but these monolines have assets that are worth a lot more). So, if you took the notional value of all the debt and divided by the capital, as you would to say a bank if you wanted to calculate the debt-to-equity ratio, this would produce a very large number. In essence, you would have a few companies worth tens of billions insuring trillions of debt (just for reference, even a tiny regional conventional bank would be worth tens of billions). But I believe this is all misleading and the actual risk is much lower.
I will note that there is a material risk here but I also think there is a lot of speculation, rumours, and misunderstanding of what these insurers do.
Ambac Rebuttal of Morgan Stanley Analyst Remarks
Ambac also released a rebuttal of Morgan Stanely's analyst comments from late last week. Well, at least management is fighting back.
Potential Disaster from a Monoline Insurer Collapse
Reuters just touched on the impact of a monoline insurer collapsing:
If anyone is thinking of taking a position in one of these monoline insurers, it is absolutely critical that they invest in something that is not going to get downgraded. If your company loses its rating, it is going to be a disaster. The AAA rating is the #1 competitive advantage of companies like Ambac. If they lose that, they won't be able to insure many of the municipal bonds since most of those are A or AA rated (insurance is supposed to raise the rating of the underlying bond to that of the insurer's capability).
Even if a rating downgrade impacts one of Ambac's competitors, it can result in another round of sell-off on the stock market. If you thought there was uncertainty now, wait until some debt insurer gets downgraded. I think the possibility of Ambac or MBIA getting downgraded is slim right now.
The reason the market is very panicky is because the notional amount of bonds insured is very large. Furthermore, any loss the high ratings will cause a chain reaction and force those who actually own the CDOs, MBSes, etc to take further losses. What Merril Lynch and others wrote off will be a joke compared to what all the mutual funds, hedge funds, etc would write off if muncipal bonds dropped from, say, AAA to A.
For those looking at the sector, the above comment sort of indicates the risk level in each of these firms. MBIA, for example, is safer than Ambac. That's why Ambac's stock price of ABK is down much more than MBIA. I haven't compared the two deeply but a quick glance shows that ABK has far more CDO exposure than MBIA. CDOs are what David Dreman calls "toxic waste".
The author of the article finishes off by citing some of his concerns:
If you are thinking of taking a position in these monolines, one should consider the cited potential issues. Furthermore, being someone who is pessimistic and expecting a weakening US economy, one other thing I would watch out for is weakening credit card debt. No one has brought that up yet but given that many Americans and Canadians are living outside their means, things can deteriorate on that front in the future.
Update: For those that may or may not be familiar, some funds, such as Pershing Square have been bearish on bond insurers for a while. Here is a presentation that they made early this year. If one were to consider taking a position in bond insurers, they need to convince themselves that the arguments in the presentation are not correct or the downside won't materialize.
Well, it has certainly been a wild ride for monoline insurers lately. I'm not sure how shareholders of Ambac and other monlines are coping these days. Here are some happenings in the world of Ambac...
Conference Call
I'm not sure where to start but Ambac management will be holding a conference call on Wednesday. The call is supposed to shed some light on CDOs and how the mark-to-market process impacts Ambac. I believe this is a prudent move by management to clarify the situation. There is certainly a lot of rumours swirling around.
I'm not an expert but I think a lot of people are making the mistake by looking at these monolines as if they were a typical investment bank or hedge fund. In particular, a lot of people just seem to take the outstanding par value and divide it by the capital and end up with some ridiculously scary number. There is between $1 trillion and $3 trillion of debt that is insured by all the monlines (there are only like 5 stand-alone companies of any size) but the total net capital of all these firms probably isn't even $100 billion (but these monolines have assets that are worth a lot more). So, if you took the notional value of all the debt and divided by the capital, as you would to say a bank if you wanted to calculate the debt-to-equity ratio, this would produce a very large number. In essence, you would have a few companies worth tens of billions insuring trillions of debt (just for reference, even a tiny regional conventional bank would be worth tens of billions). But I believe this is all misleading and the actual risk is much lower.
I will note that there is a material risk here but I also think there is a lot of speculation, rumours, and misunderstanding of what these insurers do.
Ambac Rebuttal of Morgan Stanley Analyst Remarks
Ambac also released a rebuttal of Morgan Stanely's analyst comments from late last week. Well, at least management is fighting back.
Potential Disaster from a Monoline Insurer Collapse
Reuters just touched on the impact of a monoline insurer collapsing:
Fitch Ratings said on Tuesday that it may cut the AAA ratings of bond insurers after an upcoming review of their exposure to complex collateralized debt obligations.
This matters a lot, because the bond insurance companies, such as Ambac and Financial Guaranty Insurance Company, have insured a collective $2.5 trillion of bonds and structured financings...
It could also touch off another round of writedowns by banks, insurance companies and others who hold instruments insured by these companies.
It could hit the staid municipal bond market especially hard, as about $1.6 trillion of the bond insurance in force is municipal. The rest is asset-backed debt of various types, including subprime.
If anyone is thinking of taking a position in one of these monoline insurers, it is absolutely critical that they invest in something that is not going to get downgraded. If your company loses its rating, it is going to be a disaster. The AAA rating is the #1 competitive advantage of companies like Ambac. If they lose that, they won't be able to insure many of the municipal bonds since most of those are A or AA rated (insurance is supposed to raise the rating of the underlying bond to that of the insurer's capability).
Even if a rating downgrade impacts one of Ambac's competitors, it can result in another round of sell-off on the stock market. If you thought there was uncertainty now, wait until some debt insurer gets downgraded. I think the possibility of Ambac or MBIA getting downgraded is slim right now.
"What if the bond insurers default? You could think it does not matter because they are small companies," Credit Suisse analyst Guillaume Tiberghien wrote in a note to clients...
"The current LBO and CDO write-downs experienced by the banks during the third quarter would appear very small in comparison."
While Tiberghien cautions that what he lays out is a very gloomy scenario, fear of it is probably a large factor behind the recent market sell-offs.
The reason the market is very panicky is because the notional amount of bonds insured is very large. Furthermore, any loss the high ratings will cause a chain reaction and force those who actually own the CDOs, MBSes, etc to take further losses. What Merril Lynch and others wrote off will be a joke compared to what all the mutual funds, hedge funds, etc would write off if muncipal bonds dropped from, say, AAA to A.
Fitch said it would take four to six weeks to review the situation and if needed give any companies facing a downgrade a month to raise capital or take other steps.
Given that the rest of the world has taken a bit of notice of how badly subprime and some CDOs are performing, that wouldn't be easy.
Fitch said that CIFG Guaranty, owned by French bank Natixis, and Financial Guaranty Insurance Co, the bond insurer whose owners include private equity firm Blackstone Group, had a "high probability" of facing erosion of their capital cushions.
AMBAC and Security Capital Assurance faced a "moderate probability" and MBIA Insurance (MBI.N: Quote, Profile, Research) had a "low probability."
For those looking at the sector, the above comment sort of indicates the risk level in each of these firms. MBIA, for example, is safer than Ambac. That's why Ambac's stock price of ABK is down much more than MBIA. I haven't compared the two deeply but a quick glance shows that ABK has far more CDO exposure than MBIA. CDOs are what David Dreman calls "toxic waste".
The author of the article finishes off by citing some of his concerns:
But two points make me very cautious, if the Fitch review passes without issue.
First, a spreading of contagion into municipal debt is likely to bring up another round of unforeseen and unmeasurable consequences, few of them good.
Second, the housing, subprime and prime, that is causing the problem in the first place is worth less day by day, is falling farther and faster than credit committees could reasonably have expected, and will continue to fall for quite some time.
If you are thinking of taking a position in these monolines, one should consider the cited potential issues. Furthermore, being someone who is pessimistic and expecting a weakening US economy, one other thing I would watch out for is weakening credit card debt. No one has brought that up yet but given that many Americans and Canadians are living outside their means, things can deteriorate on that front in the future.
Update: For those that may or may not be familiar, some funds, such as Pershing Square have been bearish on bond insurers for a while. Here is a presentation that they made early this year. If one were to consider taking a position in bond insurers, they need to convince themselves that the arguments in the presentation are not correct or the downside won't materialize.
Having read the analysis from Purshing Square, it struct me as somewhat broad and lacking in detail. At least regarding ABK. There is no question that during the time of the analysis, at $90, it was going down, if only due to market panic. He made his money shorting the stock. The question that is relevant is, Will ABK survive? I think from reading the various detail analysis, the answer is, Yes. Once that is determined, the valuation should eventually be restored. Two things that I have not considered before and are thinking about now.
ReplyDelete1. What happens if one of its competitors got down graded, while this will be a painful event in the short term, it is good in the longer term.
2. I did not realize that MBI management actually left the company. This would be a cause for concern. Good thing we are not seeing this yet in ABK.
John
I assume you are already an ABK shareholder. Why did you pick ABK instead of MBI?
ReplyDeleteAnyway, I agree with you that the Pershing Square analysis seems broad. They are literally dividing the total amount of bonds insured by the capital. Also, a lot of people seem to miss the fact that the CDS written by monolines generally don't require posting collateral. So even if there is a loss, the monolines simply need to pay it out over a long period of time.
Having said that, Bill Ackman of Pershing is supposed to be a smart VALUE investor. I have no problem betting against a typical investor but value investors generally have a fundamental case. But do note that Pershing Square was bearish back in 2003 (from what I can gather)...
Yep, MBI management change is bad. If same thing happens to Ambac, it is time to head for the exits--at least for some investors...
Your point 1 (about downgrades) is one of the big dangers in these stocks right now. There could be panic selling even if one of the lesser ones (even those rated AA like Radian) were downgraded. There is also the possibility that Ambac may need to raise capital (Fitch's original stress case had Ambac only staying barely above their worst case:
http://can-turtles-fly.blogspot.com/2007/11/stress-test-cases-for-monolines.html).