Thursday, November 8, 2007 0 comments ++[ CLICK TO COMMENT ]++

Information on Monoline Insurers

I have been reading up on monoline insurers (i.e. debt insurers) recently. I just received Ambac's investor package in the mail yesterday (I like reading the printed stuff, although it might out of date to some extent) and will be working through that. Hopefully I'll have enough understanding to make a final decision by December. I'm planning to put a huge chunk of my portfolio into Ambac (ABK) some time in December or January. If someone is attracted to this industry and wants a lower risk profile, they should consider MBIA (MBI) instead of Ambac (ABK). Ambac's CDO exposure is much higher than anyone else out there (but that also means its stock price is down much further).

Articles/Thoughts on Debt Insurers

If you want some history of the monoline insurance, check out this document.

I also ran across this technical article on the industry. The document is really talking about something else but the first few pages are quite useful (I haven't read it yet).

This article from Quant Investor also covers some reasons for buying the preferreds. The discussion by some respondents touches on why preferreds may or may not be good. I personally would not buy Ambac preferreds. The return is not high enough compared to the common. This company is either going to be "almost bankrupt" or rise up sharply. In either case, the common provides a better return. The advantage of a preferred is that you get paid (I think the yield is like 8% now) for waiting. (As is generally the case, as Benjamin Graham remarked, only buy preferreds if they are trading below par value.)

Nick Nejad of Rational Angle takes a critical look of the industy on his blog. I don't really agree with it but there is definitely a high uncertainty and I don't think anyone knows what will happen. The way I look at it, like any other type of insurance, the whole business is based on probabilities. The industry obviously tried to minimized their risk (cut down 06 and 07 RMBS vintages; insure AAA-rated* tranches; etc) but you just can't know in advance. I'm not an expert on insurance but this industry is very similar to reinsurance in my eyes (as a side note, there are debt reinsurers and they are even more risky than MBIA, Ambac, etc). You just never know, with reinsurance, whether a big storm is going to materialize and result in huge losses. Similarly, the bond insurers are really playing with probabilities. If you take a position in one of these companies, you are basically betting that the employees of the firm have taken the proper amount of risk.

* Note about CDO credit ratings

Note that a AAA rating for a CDO does not have the same risk as a AAA straight bond. Furthermore a lot of the ratings are being downgraded. The following diagram, courtesy Fitch's September 2007 report titled, Financial Guarantors' Subprime Risks: From RMBS to ABS CDOs - September 2007, illustrates how a AAA rating in a CDO is not the same as a AAA rating in other structures:

(source: Financial Guarantors' Subprime Risks: From RMBS to ABS CDOs, Fitch, September 2007)

The most confusing is the AAA-rated tranche of a mezzanine CDO, which is generally very risky even though it's rated AAA. But to complicate matters most monolines typically write with higher subordination for the mezzanine CDOs. So, in the end, one can never be sure what is actually risky. It's too late now but it would have been preferable if rating agencies had developed some unique rating system for derivatives.)

Ambac Conference Call

Ambac management had a conference call yesterday to clarify their situation. I haven't heard it fully but will do so in the future. Ambac indicated that they will disclose more details about their CDO exposure so check their website frequently to see if that helps your investment decision. For what it's worth, ABK is already providing a lot of transparency but no one still knows what the risk is with any of the underlying collateral--perhaps the passage of time is how anyone will ever know.

I sat through the 2+ hour earnings call from a few weeks ago but everything is still murky. Although management seems confident that they have not taken too much risk, one should be cautious. The internal Ambac ratings seem to be more conservative but some rating agencies are cutting three notches for even AAA-rated tranches within CDOs so even a conservative Ambac rating may be a bit high.

(as a side note, is a free site where you can listen to teleconferences.)

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