Tuesday, November 13, 2007 1 comments ++[ CLICK TO COMMENT ]++

Stress Test Cases for Monolines

UPDATE: Ambac has posted some answers to frequently asked question in their FAQ section. It covers quite a bit about the nature of the risk at Ambac. For some reason the disclaimer button doesn't work in Firefox but it seems to be ok on Internet Explorer.

UPDATE 2: AccruedInterest has another great post, this time touching on how defaults in RMBS and CDOs impact insurers. The author is supposedly working on his analysis of Ambac and I look forward to checking it out. Anyone looking to invest in monolines should read the post.

Michael in a post to my prior blog entry on Ambac mentioned that the intrinsic value of Ambac (and others) will drop to zero if their ratings are cut. I sort of disagree on the possibility (read my response) but the rating cut is very important to consider. I thought I would show some diagrams of the capital adequacy according to Moody's and Fitch. Note that the diagrams below are dated (I think it was Fitch who said that some of these hypothetical cases have become the reality now).

One should read the full documents for definitions of the test cases:

Financial Guarantors' Subprime Risks: From RMBS to ABS CDOs - September 2007
Financial Guarantors Hypothetical Subprime Stress Test Results - September 2007

I'm not going to go into the details since all this is hypothetical and the situation has deteriorated much further. If the ratio in most of these cases drop below one, then the AAA rating is under threat.

You will also notice that Ambac does worse under some of the severe tests than MBIA. As I have remarked before, if you are interested in this industry but want slightly lower risk, then MBIA (MBI) is possibly a better bet. I like Ambac (ABK) better because its history is more attractive (best ROE in industry) and has more upside potential. I have no position in any of these companies right now.

If you are a skeptic, you should remember that some say that the rating agencies are in bed with the insurers (since they derive a lot of business from them). So the opinion of the rating agencies may be biased towards the positive. I personally trust the rating agencies like I do with with stock analyst firms. Namely, I listen to them and consider them but don't blindly follow them.

(For what it's worth, the latest rumour--almost likely pure speculation--is that Buffett is either interested in some bond insurers or is thinking of entering the market. I think Buffett will look at situations like this but I have a feeling that these companies are too small for him. He also has exposure to Moodys (MCO), which is down quite a bit, so I don't see why he wouldn't add to that position. I think he may provide capital injection if there is trouble (if there is downgrade of the monolines or losses are greater than expected), or he may provide reinsurance. I personally don't think the monolines should use reinsurance for the sake of using it because prices won't be favourable now. It's almost like an insurance company trying to sign a reinsurance contract in the middle of a hurricane (terms won't be good)).

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