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).