Friday, November 30, 2007 3 comments

Risk Arbitrage: BCE

One of the risk arbitrage plays that I have mentioned before is BCE of Canada (BCE; TSX: BCE). BCE is the largest telecom in Canada and it is being taken over by a consortium. The payment is in cash and is supposed to close early next year. Fabrice Taylor of The Globe and Mail has written a good column summarizing the details and the risks. Note that everything mentioned is in Canadian dollars. BCE also trades on NYSE.

f all goes well, BCE shareholders will get their money some time in the first quarter of 2008. Let's assume the last day of the quarter, March 31, to be conservative. The offer is $42.75 a share while the stock is quoted today at $39.20. The four-month return, then, is a little more than 9 per cent - and even more if investors get a dividend before the deal closes.

As the author suggests, you are looking at around 9% in 3 or 4 months. This is a low-risk arbitrage situation so that's a good return. If you are an American and are bearish on the US$ (I am not) then you may also get some positive return from currency gains if the US$ weakens further.

In terms of risks...

One risk is that more wireless competition will prompt the buyers to change their offer. BCE shares slipped yesterday on news that Industry Canada was making it a lot easier for new entrants to compete. Another is that BCE's bondholders are trying to thwart the deal in the courts. And finally, there's the risk that the buyers won't be able to raise the debt because of the credit crunch.

Some message board commentator on the site also points out a risk with the CRTC, which is the government agency responsible for media oversight in Canada. I think the CRTC issue is likely low risk given that owners are still mostly Canadian and nothing much is changing with the media structure.

If you do the calculation the way Warren Buffett looks at risk arbitrage, you will get:

probability of success (my guess): 90%
probability of failure (my guess): 10%
potential gain with successful closure: 9%
potential loss with deal collapse (my guess): -20%

Expected return = prob_success * gain - prob_failure * loss = 0.9*0.09 - 0.1*0.2 = 6.1%

If you annualize that, you are looking at around 20%+. Of course, I am guessing on the probabilities but that's how I see things.

I find this deal very attractive but I will likely pass on this for a few reasons. Firstly, the return is a bit too low for me. I am willing to take higher risk for higher return. Secondly, I don't have enough free capital (my portfolio is small) and I want to buy something around the tax-loss selling season. I am seriously thinking of Ambac (ABK); given that Owen's Corning (OC; OCWAZ) has dropped a lot, I'm also starting to look at it again. If the potential return increases to, say, 14%, I'll consider investing. (Having said that, I will likely take a position with my mom's portfolio :) ).

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Thursday, November 29, 2007 2 comments

Reggie Middleton: Ambac Insolvent

Well, anyone considering investing in Ambac (or others) should definitely look at the bear case. Reggie Middleton provides a super-bearish case saying that "Ambac is effectively insolvent". Take a look and form your own opinion. I haven't read it yet so I don't have anything to say.

For what it's worth, he is short Ambac and MBIA. Some people might think somone's report is nothing more than propaganda in light of that but I generally think the opposite. If anyone is putting their own money on their calls, I respect that...

The problem with Ambac for both shorts and longs is that this story may not end for at least 1 year. Some people think that the market will take a stand one way or another after the rating agencies release their rating evaluations but I suspect not. Every bad news is going to push the stock down and the occasional good news, along with short-covering, will push the price up. The stock has been moving almost 5% on a daily basis over the last few months. Daytrader heaven for sure...

Wednesday, November 28, 2007 1 comments

TRB: One Step Closer

The FCC, which is moving at a snail-like pace, indicated today that they will try to have a vote on the Tribune (TRB) acquisition by the end of Friday. The stock is still nowhere near the acquisition price of $34. If the FCC waiver is granted by Friday, the last remaining step is for the bankers to raise money for the deal.

On another note, I have noticed that the spreads on takeovers have widened again. Almost sure-bets like BCE (BCE; TSX: BCE) have dropped recently. Other bids worth monitoring are Clear Channel (CCU) and Credit First Boston (CBH). I haven't evaluated any of them deeply (except when I mentioned BCE in some posts several months ago) so none of these are concrete ideas. If I recall, all these deals close next year so if you like the prospects then you need to be willing to tie up your capital until next year. Given that December sometimes involves heavy tax-loss selling, it may be more attractive to buy beaten-down stocks instead of going for merger arbitrage deals.

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Bill Ackman Thinks Bond Insurers in Big Trouble

Bill Ackman supposedly thinks that MBIA and Ambac will be bankrupt by mid 2008 if they can't raise capital:

Bond insurer MBIA Inc could be insolvent as soon as the second quarter of 2008 if it were unable to access additional capital, according to a slide at a presentation by Pershing Square's William Ackman.

Ackman estimates MBIA will incur $2.2 billion of losses in the fourth quarter, and rival bond insurer Ambac Financial Group Inc will incur $4.2 billion of losses.

Nothing new from Bill Ackman, who has been bearish on the bond insurers since 2003 (based on some article I read back then (I think in Forbes). Since I'm bullish (although not bullish enough to take a position right now), this makes me uneasy. If he were not a so-called value investor, I would sort of brush it off but since he is a value investor (meaning he is likely basing his views on bottom-up approach*), it is something one should consider. I really want to get my head around where he is wrong. He has basically implied that the whole bond insurance business makes no sense. By claiming that MBIA, which is the leader and the least likely to be downgraded, he is attacking the whole industry.

He is supposedly presenting at the Value Investing Congress and if anyone can give me (or provide a URL link) to the presentation slides (assuming it's legal to do so), I would appreciate it.

CIBC and Barclays Vulnerable to Bond Insurance Collapse

I don't really understand this article. Supposedly CIBC and Barclays acted as counterparties to some of the riskiest bond insurance that was written. If the bond insurers fail to pay then the article is implying that CIBC and Barclays will be on the hook.

Bond insurers didn't used to put up collateral when doing business with Wall Street, but that all changed as they started insuring riskier products. As a result, Ambac and other monolines were required to find counterparties with strong balance sheets to back them up when they insured the exotic bonds that Wall Street cranked out in recent years.

Enter CIBC and Barclay's, relative newcomers to the bond insurance business. With sound balance sheets and lots of cash, they were eager to help guarantee these insurance contracts for a fee. Bond insurers even packaged and sold their own debt in the form of credit derivatives -- risks that CIBC and Barclay's took on as well.

...That's because, if the insurers are downgraded, their cost of doing business will become a lot more expensive, which means they'll have less money to meet their guarantees on troubled bonds. The responsibility for these guarantees will fall to the likes of CIBC and Barclay's.

I never heard this being discussed anywhere before. I never knew that some banks, like CIBC, are somehow guaranteeing if the bond insurer fails. If you have a thought on what is happening, leave a comment below.

* Why Dissenting Value Investor Opinion Is Important In My Eyes

Admittedly I have no idea how much of a pure value investor Bill Ackman is. Generally most people consider him to be close to a pure value investor. Anyway, the reason it matters whether he is a value investor or not is because most value investors approach their investment decisions from bottom-up (i.e. starting with company specifics, then moving to industry, and so forth). So when he says that MBIA will be insolvent in 3 quarters if they can't raise capital, he is likely saying this from a detailed analysis of the company.

In contrast, note that other types of investors, such as those into sector rotation, or traders, or those making calls based on macro views, or whatever else, can easily say stuff because the mortgage market is falling apart and a lot of the structured products, like recent vintage CDO-Squared, are almost completely worthless. Although I consider these views, I give less weight to them. The reason is the same reason Warren Buffett ignores macro stuff. Consider the following:

Ten or twenty years ago, if you had looked at the macroeconomic trends for tobacco stocks and was able to predict exactly what transpired (very few can predict), you would have seen the following: declining tobacco use (especially among younger people), advertising ban (how are you supposed to sell your product if you can't advertise on any of the major media?), huge court settlements with governments that wiped out many years of profits, and an increased negative opinion by the public towards the companies. Tobacco would have looked like a bad investment... boy, would you have been wrong... tobacco stocks, such as Phillip Morris (aka Altria), ended up being some of the best investments in the last 20 years (not #1 but easily beat the market)...

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AccruedInterest On His/Her Calculations of Ambac's Losses

AccruedInterest posted a breakdown of the loss estimates that was used for Ambac in the prior blog entry. The author goes on describe the situation facing Ambac and others when it comes to raising capital. As I remarked in my prior post, reinsurance is the least dilutive but it will hit future earnings and I would guess that it will shave 2% to 3% off future ROE. But if a lot of capital needs to be raised then multiple methods may be needed, including issuing shares (the most expensive of all).

The tricky thing for those sitting on the sidelines is that we don't know how much dilution the market is pricing in (the knowledgeable experts may but newbies like me don't). My strategy, assuming my risk arbitrage position on TRB is closed successfully, is to wait until late December and see what the rating agencies say. You can try to outguess them by buying before their decision but that is very risky.

Tuesday, November 27, 2007 0 comments

Stock Market Returns for the World

Birinyi Associate's TickerSense posted the chart below showing stock market returns throughout the world (thanks to SeekingAlpha for the original reference):

(source: TickerSense, Birinyi Associates)

If you visit their site, you'll get a table showing the returns for individual countries. The top 5, in order, are China (135.18%), Ukraine (121.20%), Bangladesh (90.83%; who says poor countries suffering a crisis don't do well? ;) ), Romania (76.15%), and Slovenia (74.59%).

The bottom 5 are Ireland (-29.89%), Venezuela (-28.04%), Estonia (-14.41%), Japan (-12.14%), and Ecuador (-9.79%).

You can tell from the map that developed countries (USA, most of Europe, Japan) are posting negative returns, while the dark green areas with hig returns are high growth emerging markets. The middle green varies but you can easily tell that commodity countries are dominant.

What this map says--to me--is that the developed countries are slowing (none have entered a recession or posted less than 2% growth rate (except Japan, but Japan is generally low)) but their stock markets are looking forward and seeing bad things. The real question that is on many people's minds is whether the emerging markets will decouple. Interestingly China seems to have entered a correction, with their stock market down around 20% (20% isn't large for their highly speculative market).

My expectation is that things are not going to get any rosier than what's on the map right now. I suspect you will see more reds and pinks in about an year's time...


Ambac Says It Will Consider More Reinsurance

Ambac says that they will consider using more reinsurance in the future:

Ambac CFO Sean Leonard said the company will continue to defend its triple A rating, and added that there's a lot of opportunity for the company to reinsure its transactions. He said about 85 percent of the company's portfolio is non-mortgage related.

Go to Ambac's homepage to check out the presentation at the Bank of America conference. A PDF presentation can be found here. Well, the presentation is biased in favour of the bull case (what else is to be expected from management?) The strategies that Ambac will use to meet capital requirements are supposedly:

In order of preference:
  1. Reinsure block of current book
  2. Increase reinsurance on future business
  3. Alter mix of business to less capital-intensive transactions
  4. Debt or soft capital issuance – approximately $600 million of capacity
  5. Equity issuance

It looks like they are going the reinsurance route. It's not going to be cheap and will lower future returns but it is the least dilutive method. Issuing stock or debt will be extremely dilutive right now and I hope they don't go that route. Peak ROE was a market-leading 12% and if you use reinsurance I think ROE will probably decline to 8% to 9%. That number is just a guess on my part and if I were to consider Ambac right now, I would estimate the future based on an ROE of 8%.

Monday, November 26, 2007 0 comments

S&P Initiates Review of Bond Insurers

I was wondering what S&P was doing all this time but they finally initiated a review of the bond insurers. Recall that Fitch and Moody's have already initiated their review and are supposed to release their thoughts within the next month (timing is just an estimate). According to what Fitch was saying a few weeks ago when they started their review, Amabac has a moderate probability of their AAA rating being under threat, while MBIA had a low probability.

There is a huge gap in the equity analysts covering the bond insurers, not to mention the bloggers and other small investors like us. I only have access to the free analyst reports from my discount brokers so my analyst knowledge is limited. Morningstar thinks that the market is overreacting on Ambac (as well as other insurers). Based on the article referenced above, Citigroup analyst thinks the same:

Citi Investment Research analyst Heather L. Hunt expects the AAA ratings on Ambac, MBIA and Assured Guarantly Ltd. to be reaffirmed.

Further, she said stocks in the sector have fallen so far they already reflect a weaker credit rating. For example, she said the more than 70 percent decline in Ambac's stock this year seems to imply the market expects $7 billion in insured losses, which she said is unlikely.

Hunt cut her price target from $95 to $50, factoring in roughly $2.1 billion in losses.

Heather Hunt, the Citi analyst, expects $2.1 billion in losses. I can't remember but I think Morningstar was expecting $1 billion to $2 billion. And Accured Interest was expecting $2 billion to $3 billion.

The real question for Ambac shareholders--and those considering going long--is whether the market is already pricing that loss. The analyst seems to think that the market is pricing $7 billion in losses. Analysts, like all of us, are just guessing and I'm not sure how true that $7 billion is. One possible flaw with some bullish analyst estimates is that they may be valuing the business at historical norms (say, a normal price-to-book of 1.3 (the 10 yr average for Ambac is actually around 1.7)). If the market re-prices the whole sector, say from a p/bv of 1.3 down to 1, then the stock is never going to go bank to the original levels (at least for many years). I think analysts sort of realize this, as one can tell by them cutting target stock price from $100ish down to $50ish.

Unless you were a super-long-term investor, I think a realistic target for Ambac is something like $50. If I were to take a position, I would invest with the expectation of around $50 (which is a 100% return from current price in the $25's). (note that from a longer term point of view, assuming the company doesn't go bankrupt, require massive capital injection, or take more losses from credit cards and other possible future debt problems, the stock price should be higher. From what I recall, Ambac earns around $750 million per year on existing policies so you are looking at a normalized P/E of around 3 at current price).

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Sunday, November 25, 2007 1 comments

Risk Arbitrage: Restoration Hardware (RSTO)

Not too sure about this one but I'm wondering whether I should take a risk arbitrage position in Restoration Hardware (RSTO). A management-led private equity buyout is in the works for $6.70 (deal expected to close in March 2008). The company has said it will solicit other offers until December 13th. It looks like Sears Holdings (SHLD), led by value investor Eddie Lampert, is thinking of bidding for the company. Speculation is that RSTO will be a good strategic fit for SHLD so a higher bid may come.

The shares are currently trading around $7, which is about 5% more than the original offer by the private equity group. The problem for anyone taking a position now is that no new offer may come from SHLD. Sears has bought up almost 14% of RSTO's shares so even if they don't offer anything, they will profit from the original bid; whereas if you buy the stock now, you will end up with a 5% loss. The motives of Sears isn't clear. The strategic fit argument would have a lot more merit if (i) Eddie Lampert wasn't a value investor, and (ii) the original offer wasn't such a big premium (the offer was a 100%+ premium). Value investors will forgo opportunities than overpay so I don't know how much Lampert thinks RSTO is worth. For instance, he might have liked it when the stock price was in the $4 to $5 range but I'm not sure how much higher than $7 he will pay.

The one positive going for RSTO risk takers is that strategic buyers will pay more than what private equity can these days.

I'll think about this... most likely I think I'll pass on this...

Saturday, November 24, 2007 0 comments

Adding Suruga Corporation to Watch List

(UPDATE: added a minor comment and fixed the market cap (should be $250m not $25m)

(UPDATE 2 (Sat@9:39 PM): I found out accidentally that bigcharts does have a log graph, so I updated the chart with a log graph)

I'm adding Suruga (TSE: 1880) Corporation from Japan to the watch list. I looked at this a while ago when I saw the P/E ratio of around 4 but it turned out to be a mistake due to a stock split. I was thinking of researching Japanese small cap retail, food, and real estate companies (anything to take advantage of strengthening Yen and a possible resurgence in consumption. I came across this again and saw that it has sold off quite a bit since early this year--practically the whole Japanese small cap area is down quite a bit (it might be one of the cheapest on the whole planet).

Just to quickly re-cap, Suruga is in the real estate sector. The whole real estate sector has been doing well over the last few years and Suruga is no exception. The question is whether it can keep it up if hte US economy slows, the Yen strengthens, and the JCB tightens. The chart below plots price and P/E ratio:


(NOTE: I found out that has a log-graph under their advanced settings so my comment about the flaw is incorrect. However, I'll still keep the original text because it points out something that people should be looking for in graphs:
ORIGINAL: has a big flaw with their charts so be careful. The flaw is that these are not log graphs so the graph can be misleading. For example, the move from, say, 500 to 1000 in 2004-2005 is just as big of a move as from 1500 to 3000, even though the latter price change looks massive on that chart. )

I use charts because it plots P/E ratios and dividend yield (can't find it on any other free chart that I know of). Also note that the P/E ratio shown is likely a mistake (should be around 10 not 3) due to stock split. Nevertheless you can see the historical trend. The price action and P/E ratio seem to be on the lower end. It isn't exactly a true contrarian stock but it isn't popular either.

Quick numbers on Suruga are as follows:

Market cap: US$ 250 million (Yen 25 billion)
Fiscal 07 P/E: 9.2 (approximately)
Fiscal 2008 Forward P/E (management estimate): 7.4
Fiscal 2009 Forward P/E (analyst estimate): 5.1
Price/Book: 1.33
ROE: 15%+


The numbers look attractive. Anything with a P/E below 8 is worth considering. The big risk is that it's not clear if the earnings numbers, as well as the valuation, are at a cyclical high.

If I feel like taking a position in this stock, I'll do a more detailed analysis. I think Suruga will become attractive if it drops another 20% to 30%, which will bring the forward P/E down to around 5. As I said already, I just don't know if this is a cyclical peak or not.

(If anyone reading this has some ideas for small cap or mid-cap Japanese stocks post them in the comments section. I'm basically looking for anything that will benefit from a strengthening Yen and improving local economy (this means no exporters and others levered to emerging markets))

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Friday, November 23, 2007 0 comments

Japan, the Yen, and Takefuji

General Thoughts on Japan

As I have remarked many times before, I am planning to focus my future investment research on Japan. Until I do more reading, I won't know for sure but right now it fits my profile and strategy. It is out of favour (can you believe it is actually negative for the year in US$ terms?), transparent (easy to get information for the large companies, and corporate governance is improving), relatively low valuations (on a P/E basis it is not cheap but if you think earnings are depressed then it isn't so bad; on price/book it is pretty attractive), etc. Not sure when I'll get to it but my goal is to read these two books in the near future: Japan on the Upswing, and Japanese Money Tree. Anyway, here are some articles I read on Japan recently (some of these articles are old and I only read them now)...

Barron's had this run down of the attractiveness of Japan. I liked the article but my thesis for investing in Japan is to avoid the 'China play'. I'm bearish on emerging markets and although I have been wrong all year long, I am staying away from anything dependent to them. The Barron's article lists a bunch of companies who are export-oriented and will get hit if China or USA slows down.

Sparx Group offers Japan mutual funds and provides some good commentary on Japan. Also if you want a quick glance at some economic indicators for Japan and other East Asian countries, you can find them here.

The most undervalued part of the Japanese equity market seems to be the small-caps. As is generally the case everywhere, when things are in favour small caps outperform and when everything is bearish small-caps get clobbered. The chart below shows illustrates how cheap small caps look on the surface in P/E terms:

(source: Can Japan's Small Caps Stand Tall Again?, Chester Dawson,
Sparx Investment & Research, September 2007)

Small-caps with a P/E of around 12 versus large-caps at 18 is a huge gap. Although small caps are risky, if you think about the fact that they tend to have much higher growth rates, that is an amazingly low multiple.

The problem for small investors is that it is hard to get English information on the small caps. Some of them also trade on the smaller stock exchanges, like JASDAQ, and I'm not sure if I can even buy them through my brokerage. There are small-cap CEFs and ETFs in the US that you can use (like JOF) but unless you are making a sector-wide bet that is not so attractive. I would rather attempt to pick one or two stocks. The small-cap sectors that I find attractive are retailing, food, and real estate.

Yen Carry-trade Keeps Unwinding

The Yen carry trade keeps unwinding. There is an extremely high correlation between the Yen and the broad markets. I know I keep posting about the same thing but this has massive consequences. American investors, in particular, should start posting gains in US$ terms in the future even if the Japanese stock market doesn't go anywhere (as long as it doesn't drop a lot). For people like me in Canada, I haven't seen much positive impact since the Canadian dollar is still strong against the Yen. However, if I start shifting assets into Yen-denominated assets over the next few years, I will likely see some positive return simply from the Yen strength.

The strength in Yen is one reason I would be wary of Japanese exporters. Most people who invest in Japan seem to be overweighting the exporters but it may be time to look at those that benefit from a strong currency, such as importers, retailers, restaurants, real estate, and so forth.

As Shu Abe of Sparx Group comments here, the strengthening of the Yen--if it actually is for real (we've had many fake rallies many times in the past)--may finally kickstart the consumer. The Japanese economy has been improving for the last 5 years but that is primarily due to exports. This article from The Economist has a good run-down of the present economic status of Japan. If the consumer ever wakes up, Japanese deflation will end; if the consumer doesn't wake up, Japan is going to go into a recession if USA does.


I am a shareholder in Takefuji (down about 20% since purchasing early this year) but things are improving. So far, personal bankruptcies are holding up well:

(source: Takefuji)

That's just one measure but I sort of look at that to see how individuals are coping in Japan. The business still keeps deteriorating but at least the big write-offs are out of the way.

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Thursday, November 22, 2007 0 comments

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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Bond Insurer CIFG Raises Capital

CIFG, a bond insurer from France, just raised some capital in order to stave off a rating downgrade. It remains to be seen what happens to Ambac (ABK). A few weeks ago Fitch indicated that there is a moderate possibility of Ambac's rating being under threat (for reference, the smaller ones that are trying to raise capital have a high probability of losing their rating). It'll be interesting to see how the market reacts to any of this. The problem for companies like Ambac is that raising capital during a crisis, like now, is very expensive.

Wednesday, November 21, 2007 1 comments

Bill Miller Interview with GlobeInvestor Magazine

Canada's national newspaper, The Globe & Mail, has launched an investing magazine called Globe Investor. It seems to be tailored for Canadian investors and seems useful. The inaugural magazine cover story is an interview with Bill Miller. As I have remarked before, Bill Miller is an amazing investor because he is one of the few value investors who can analyze technology stocks properly. Here is some of the Q&A that I found interesting:

Q: Buffett or Graham would never dream of Google or at these kind of price-to-earnings ratios.

A: Actually, I disagree with that a little bit. Graham, in congressional testimony in the '50s, was asked about what he looks for when buying a stock and he said, well, stock prices depend on future earnings. And so, to the extent that one could actually make the judgment about future earnings, one would be able to know which prices were attractive.

There's two reasons Buffett doesn't buy [tech stocks]. Number one, he believes that in many cases, with businesses like that, it's very difficult to look five or 10 years down the road with any reasonable degree of accuracy. The second reason is that he believes that many of those businesses change so rapidly that they may be unanalyzable on their own.

While technologies change rapidly-a new microprocessor every 18 months, new networking stuff-technology market shares actually change much more slowly. If you look at Intel's market share, Cisco's market share, Microsoft's market share, and then compare that to Coke's market share or Nike's market share, they're far higher than those consumer products companies that are thought to be much more predictable. You see the same thing in [Internet] search. Once it's settled down, Google's got it locked up, no matter what Microsoft or Yahoo do.

Insightful way of looking at things. I guess what I need to do is to look at the big picture (margins, market share, etc) and see if that can be stable, while the underlying products change rapidly.

Q: At the beginning of the year, you said U.S. stocks were cheap. Do you still feel that way?

A: The answer at the beginning of the year was, "Stocks are really attractive if these bond rates are right. If the economic growth forecast consensus numbers are right, stocks would be 15% to 20% higher." What's happened is that people have changed their views about risk and they're pricing in much more risk in the market than they did before. [Credit] spreads have widened. That lack of availability of credit, based on behaviour, ought to slow the economy very dramatically.

But I think stocks are still very attractive. The Fed will now, because of the risk to the economy, take whatever actions are necessary so that it can try to fulfill its goals of price stability and employment. And the employment one is under severe question. I think that what you're looking at is a Fed funds rate that, based in theory, should be in the threes [between 3% and 4%]. But the underlying global economy looks okay.

I disagree with Bill Miller here. I think the US economy is going to drag down the rest of the world with it. Things look ok for the time being but I am expecting things to worsen.

Q: How much time do you spend thinking about macroeconomic themes, versus analyzing stocks and companies?

A: We don't make forecasts. The core of what we're doing is analyzing businesses. Our analysts are thinking zero about macro unless I tell them to think about macro.

Classic value investing answer: zero time spent on macro trends. However, do note that Bill Miller, like Warren Buffett and others, thinks about industry trends (eg. whether a company's market share will increase) but does not rely on macroeconomic trends (eg. emerging markets are going to demand more microprocessors). (note: I just made up those examples to illustrate the point.)

Q: You're a student of behavioural finance. How can an ordinary investor apply that stuff to their thinking?

A: If you're going to buy individual securities, you have to believe that you're going to earn excess return from doing that, and therefore that the market's wrong about something. I think most people don't even take that step and say, "What do I think-where is the market wrong about this thing?"

Behavioural finance relies on good evidence about how large numbers of people behave under well-defined circumstances. So they have demonstrated beyond a doubt that people are risk-averse-a dollar's worth of loss is twice as painful as a dollar's worth of gain. The second thing we know is that people over-emphasize the most recent information. A few years ago when a couple of German tourists were killed in Miami, attendance at Disney World fell way off, because that was dramatic-even though more people are killed driving to Disney World from Miami.

The point is that when you see events which are dramatic, recent and cause people to lose money, you can be sure that individuals will overreact. And therefore, they typically would provide good opportunities in the market.

Very important point about psychology. I like to imagine that half of investing is analyzing a company and thinking about it, while the other half is mastering psychology. The latter is extremely difficult. A good question for contrarians to keep asking themselves: "What is the market wrong about?" This is something that I think about all the time with Ambac (ABK).

Q: Let's talk about one of your mistakes-Eastman Kodak. [Miller's fund owns nearly 20% of the struggling company.]

A: Yeah, we were clearly wrong to buy it when we bought it, which was '99 or 2000, right around that time-and not because we didn't know that film was going away. Before Dan Carp became CEO, and we didn't own any Kodak, people arranged for him to come down and talk to me, not to convince me to buy it but to pick my brain on how the market thought about Kodak, what it thought about the curves of decline in film, that kind of stuff. They clearly understood that they had to change the business model. What I think we underestimated was how difficult that would be culturally. We should have recognized that sooner than we did."

That was then, this is now. Kodak, right now, has made the transition. It's actually doing well, the numbers are coming in better than people thought. Kodak actually told us a couple of weeks ago that they now have the highest number of requests from investors to come visit them, ever. [We] think it's a $45 stock. [At press time it was just below $28.]

I took a cursory look at Kodak a while ago and don't like it. I'm not sure what Bill Miller sees in it. The problem I see is that Kodak doesn't have any competitive advantage. Its brand, which used to be very strong, is slowly eroding.

Q: A lot of investors in Canada are obsessed with mining and energy. Why have you been a skeptic on commodities?

A: Well, we were wrong. There's two things. One of them is the secular case and the other's a cyclical case. Secularly, we have not been fans of commodities, broadly defined. That's because the empirical evidence and theory, both together, would indicate that commodity prices decline in real terms over time.

Extractive companies, by and large, don't earn their cost of capital over the cycle. They can be cyclically attractive-buy them when the cycle's bad and sell them when the cycle peaks---but generally speaking, they tend to be trading vehicles, versus investing vehicles. In trading vehicles, you've got to be right on both sides. We prefer things that we can invest in for five, 10, 15 years and earn large amounts of money.

The question now is, are we at a cyclical peak, or, as the bulls would argue, is it a secular change-that is, energy prices and copper prices and lead prices and wheat prices will now not decline in real terms from here. I think the jury's out on that.

This is probably the most important thing to learn for present investors given the current commodity boom. If you are influenced by value investing, commodities are a dangerous playground. As Bill Miller points out, commodity businesses have low returns on capital and commodity products decline over time. Investors like Warren Buffett have also shied away from commodities.

On top of the reasons that Bill mentioned, Buffett has mentioned how commodity businesses rarely have pricing power. They are generally price takers and customers can easily switch (this totally goes against Buffett and his preference for wide moat companies). Many commodity businesses only gain pricing power through M&A and trying to create a humungous monopolistic organization. Unfortunately for investors, many such mergers are done at high prices (which incidentally benefit bankers and insiders more than shareholders), generally near the peak of a cycle. In contrast, non-commodity businesses can gain pricing power through organic growth.

Of course, none of this means that you can't make a lot of money on comomdities; all that it means is that it is very cyclical and you have to get the cycles right. For what it's worth, I've been bearish on the whole commodity complex since 2006 (and have generally been neutral on gold since that time as well). My bearishness has more to do with my concern of China than commodities themselves (on a side note, China may be entering a correction (FXI is down quite a bit in the last few weeks)).

Q: How do you avoid value traps?

A: We don't, sometimes. But the nature of a value trap is when people confuse the cyclical and the secular. Toys "R" Us was a famous value trap from the last seven years before it finally went private. People would look at historical valuations and say, "Gee, Toys "R" Us always trades at a 15% or 20% premium to the market. It's the dominant toy retailer. So now that it's at the market multiple or a discount, it's attractive."

But with Toys "R" Us, it wasn't cyclical, it was secular. Wal-Mart, Target, people like that were systematically picking off their product array, and video games were taking away some of their demographic. Trying to avoid value traps means trying to understand what's in cyclical decline versus what's in secular decline.

I said the prior point may be the most important but I lied ;) I think this one is probably more useful to contrarians and value investors. Our biggest problem is value traps (aka catching a falling knife). I always think about what Bill said from Buffett's experience with Berkshire Hathaway (the original textile). If you are looking at beaten-down stocks, you need to be absolutely sure that the industry is not in a secular decline.

I am tracking AbitibiBowater (ABH; TSX: ABH), which is a forestry company with primarily newsprint production. I sort of put that on the backburner because it is not clear to me if we are in a secular industry decline. There is no point taking a position in this until the industry bottoms (or shows some growth). Otherwise, I can easily see the newsprint industry going almost down to zero (at least in North America and Europe). The confusing thing, of course, is that the forestry sector is a cyclical business. So it is very difficult to tell if the current suffering is a cyclical downturn or a secular decline.

I think a company like ABH can seperate the contrarians from the value investors. Most value investors would prefer to avoid these companies unless they are sure of its future earnings power. In contrast, contrarians may take a position simply due to strategies like "last survivor" or a reversal of Canadian dollar strength (would significantly boost earnings).

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Tuesday, November 20, 2007 0 comments

Muncipal Bond Insurance Market Still Looking Strong

Municipal Bond Buyers Still Using Bond Insurance

According to Joe Mysak of, the market is still receptive to bonds insured by the monolines.

At a time when nobody really knows if the nation's major bond insurers will still be rated AAA in a couple of months, municipalities are lining up to get their bonds insured. Investors, evidently, are buying them.

Last week, more than half of the issuers who sold bonds got their deals insured.

This is exactly the proportion of bonds that are normally insured during a given year, at least recently.

This means that the primary business of most monolines, which is to insure municipal bonds, is still functioning. One of the concerns for any monoline investor is whether sales will decline due to customer anxiety over their viability. According to this article, things are still looking good. If I were to invest in Ambac (ABK), one of the things I would want to be certain with is that customers don't avoid the market. Some bears claim that bond insurance is not needed and these companies should go to zero but I obviously disagree.

Insurance On Top of Insurance

The author also goes onto to mention that some customers are insuring on top of existing insurance:

An especially interesting phenomenon is occurring in the secondary market right now. Last year at this time, seven blocks of bonds that hadn't been insured at all when they were first sold, were insured in the secondary market, by MBIA, according to Bloomberg data. Getting bonds insured in the secondary doesn't happen a lot, but it's not unheard of.

Especially now. So far this November, 64 blocks of bonds have been insured in the secondary market, only now it looks like some investors are getting their already-insured bonds insured by someone else, just to make absolutely sure they stay AAA.

MBIA insured three blocks of bonds insured by FGIC; the bulk of the business, however, was done by FSA, which has insured more than 50 blocks of bonds already guaranteed by Ambac and FGIC.

Well, there is the good news; and the bad news. The bad news is that the market, at least the bond buyers, really perceive a risk of some collapse in the bond insurers. Buying insurance for already insured bonds seems like the dumbest thing ever but... the positive in this is that, as I mentioned above, the market really sees a need for bond insurance. Maintaining a AAA rating is really valued by the market (this shouldn't surprise anyone given that some institutional investors can only own AAA-rated bonds). Contrary to what some bears claim, the long term future of this industry looks strong. The only question is the near-term outlook--and who will survive?

Warren Buffett & Bond Insurance

The author also goes on to say that Warren Buffett should enter the municipal bond insurance business. This would present a huge competitive force to the existing monolines but it is a possibility. The spreads on risky assets are rising and insuring them is right up Warren Buffett's alley. I still think that Warren Buffett may end up writing reinsurance for some of the monolines if their rating is under threat. Backstopping the monolines seem to offer an easier route for Buffett than entering a market with low brand recognition (I'm not familiar with Berkshire Hathaway but I believe they don't write much, if any, bond insurance) and human capital (people matter in this business).

All I know is that if Buffett ever gets involved in this sector, the stock prices of Ambac, MBIA, etc, are going to skyrocket. It will signal to the market that writing new business is worthwhile. It still won't solve the existing, potentially disastrous, exposure to MBS, CDOs, and so forth, but it will provide some clarity for the future. But it will be a slight negative in the long-run since it will introduce a formidable competitive foe. If Ambac and/or others survive, I think the long term future potential is large. Hardly anyone uses bond insurance outside North America and Europe (and possibly Japan--not sure). I can see it being endorsed in developing countries in Asia and Eastern Europe, among others, for infrastructure projects. Investors not too trusting of foreign governments may want the wrap protection of the monolines.

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Paul Krugman: Weak US$ Ain't So Bad

Paul Krugman, who has been bearish the US$ for ages, is of the opinion that it isn't so bad. He makes an entry in his blog about this.

The US economy is going to suffer from housing, but apart from that, I also share some of Paul Krugman's views. I don't see how a weak US$ is bad for USA per se. The weak US$ should reduce the current account deficit, by increasing exports and weakening imports. We have actually seen this for the last year or so, with current account deficit declining.

All throughout the 90's, the Canadian dollar declined quite a bit yet the economy was doing well. I think USA will end up in a similar situation. This is one reason that, although I'm bullish on Japan, I am not too sold on their exporters. The market is bearish on Japan (in fact the Nikkei is the worst performing major index, with negative returns this year) but those that do like Japanese stocks tend to favour the exporters like Toyota, Sony, Nintendo, and so forth. If the Yen carry trade unwinds as I expect, the real story is definitely not going to be the exporters. (I will note, however, that exporters look attractive if you believe in the China-to-da-moon theory--I don't).

Most of what I have said above is about the economy and not the equity market. It is quite possible for the US economy to do ok (after the near-term slowdown) while the stock market does poorly. Depending on how much the US$ declines, foreign investors could be taking massive losses on the currency.

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Monday, November 19, 2007 0 comments

Swiss Re Takes Losses on MBS CDO

Swiss Re just reported a 1.2 billion CHF (swiss franc) mark-to-market loss on their credit products. This is important because Swiss Re is an insurance company so their losses may be more similar to what monolines face. Anyone looking to invest in monolines should take note of potential losses (but read my comment below questioning whether they are similar to monoline contracts). According to their presentation on the losses, here are some bullet points:

  1. Transactions are structured as CDS protection on MBS portfolio
    managed by third party
  2. First was written in 2006, second in 2007
  3. Originally structured to attach at super senior level, with risk of loss considered remote
  4. Underlyings are MBS, both CMBS and RMBS (in prime, midprime and subprime form) and CDOs

Their losses are from the CDS protection they wrote. It is not clear to me whether these CDS transactions are similar to what CDS transactions monolines write. The presentation mentions that their monoline division doesn't see any losses yet (but most of it is in municipal bonds whereas Ambac has greater exposure to CDOs). I fired off an e-mail to their investor relations and hopefully they'll provide some clarity on whether the CDS that resulted in the losses is anything similar to CDS that monolines write. I suspect that the losses are from straight ABS contracts, rather than the ABS protection that monolines write.

Thursday, November 15, 2007 3 comments

Articles and Thoughts on Bond Insurers

If you are not familiar with the current situation regarding bond insurers and want a quick article that summarizes the present situation, check out this overview by I think this news article pretty much sums up the Street's view.

Reggie Middleton in his blog presents the bearish case for the bond insurers (LOL dig his humourous diagrams). He uses Bill Ackman's presentation to make his points on why MBIA is going to zero. He calculates that a 104 bps (basis points) change in CDO spread wil wipe out MBIA's capital. I'm not really sure how he calculates that so I can't really comment much.

One thing to realize about going into these monolines is that you are going up against Bill Ackman of Pershing Square. I don't know much about him but he seems to be a value investor with a good track record (something like 27% annual return for many years). Bill seems like a smart investor and I have to think about where he is wrong and why. All I know is that he has been bearish on companies like MBIA for over 5 years and was wrong all this time, until this year of course...

David Dreman also warns people to stay away from monolines (he labels CDOs toxic waste). I highly respect Dreman (he is one of the top contrarian investors ever) but his strategy involves holding hundreads of high quality stocks so I am not entirely sure his comments apply to focus investors...

On the bullish side we have Martin Whitman, who, as of last published report, is long Radian (a AA-rated insurer), MBIA (sizeable stake), and Ambac. He took his position early this year and it remains to be seen what he thinks of them given what has happened in the last few months. I'm eagerly awaiting his annual mutual fund report (likely released in January) to see what he thinks. Unfortunately I may take a position before that.

One other thought that is running through my head is why Bill Miller, who I highly respect, said homebuilders, mortgage lenders, etc are worth buying. One thing that one needs to figure out is how bad the housing situation will end up being. If it can get much worse, as some bears claim, one should steer clear of a lot of these housing-related stocks. But why does Bill Miller still like them? Someone who is smart and skilled like him must clearly understand the nature of the situation. So does he think that things should flatten out at some point?

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Tuesday, November 13, 2007 0 comments

Do we need bond insurers?

Really... do we need bond insurers? That's the question being asked by many, the latest being Joe Mysak at Bloomberg. With the chaos in the bond insurance market, this is a good question to ponder if one is thinking of investing in the bond insurers. After all, one shouldn't invest in something that has no viable business plan and is actually worth zero. Joe Mysak goes on to comment about what has been happening in the bond markets lately.

The municipal market hasn't worried about this situation. I took a look at last week's negotiated and competitive bond sales calendars to see if the current whirlwind surrounding the insurers has made a dent in their ability to win business, at least in the municipal market...

Of the 150 transactions on the negotiated calendar last week, 68 carried insurance. That's more than 45 percent of the number of deals. During the same week last year, 71 of the 149 negotiated deals were insured -- almost 48 percent. A handful of these were school bonds guaranteed by the state of Texas's Permanent School Fund, but still. What's going on here?

Well, for one thing, negotiated deals are usually set up pretty far in advance. The hysteria over the bond insurers only reached fever pitch a couple of weeks ago. In a negotiated transaction, bond issuers choose the underwriter of their bonds, and the underwriter gets to work selling them. On the actual day of sale, the bonds are already entirely sold, in most cases.

The market still seems to be using the bond insurers in the market where bond deals are negotiated ahead of time. The real question mark is the market where investors bid for the bonds:

On the competitive side of the calendar, where issuers set a date and underwriters bid for the bonds at auction, the situation was different. Of the 84 issues on the calendar, only 34 carried insurance -- about 40 percent.

In the negotiated market, the issuer usually pays for bond insurance; at auction, it's the underwriter who usually pays.

And now the clincher: On the competitive calendar for the same period last year, 57 of the 91 transactions were insured -- almost 63 percent.

At auction, then, there seems to be some reluctance to use insurance. This development bears watching.

It looks like the usage of bond insurance has declined. Since this is simply anecdotal evidence, it is questionable how much any of this means. For instance, some of the decline might actually be due to the insurers themselves cutting back. Given that bond insurers are trying to preserve capital, this wouldn't surprise me. Nevertheless, it is worth pondering if the credit crisis will permanently destroy the need for bond insurance. I suspect not but it will be interesting to see what happens if one of the bond insurer gets downgraded.


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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Monday, November 12, 2007 2 comments

Analysis of Ambac by jckhoury at

A poster by the name of jckhoury at has posted an investment review of Ambac (ABK). He/she provides an overview of the situation and comes up with some estimates of the intrinsic value of Ambac. The author's optimistic scenario results in a price of $83.74, while the pessimistic case ends up being $15.75. Note that the pessimistic case results in a price below the current stock price. If you are thinking of Ambac or one of its competitors like MBIA, it's worth reading as many opinions as you can so do check out the article.

In my opinion, the real issue with Ambac is pinning its risk to some dollar figure. The valuation seems pretty attractive under most scenarios but the risk of some serious adverse result is highly uncertain. Any success or failure with Ambac will come from correct determination of its risk.

Saturday, November 10, 2007 0 comments

Random Thoughts

Here are some random thoughts running through my head...

Housing Stuff

There is a lengthy 5-page article on Countrywide Financial (CFC) at New York Times. I glanced at it and it runs over the history of CFC and some of what happened in the lending industry recently. Pretty good article for anyone that is thinking of investing in CFC or learning about what the lenders were doing in the last couple of years.

One of the big risks for anyone like me dumb enough ;) to consider investing in debt insurers is the chaos that may be unleashed if some mortgage insurers fail. I am still working through my examination of Ambac (ABK) and it seems that it should survive, but I am not so sure about the smaller companies that insure mortgages. News articles like this makes me think that there could be further sell-offs in the debt insurers if one or more of the mortgage insurers collapse. Although value investors generally don't try to time stuff, I'm not a value investor and I don't want to invest too early and face further sell-offs. One of the reasons I decided to add to my short-term risk arbitrage position in Tribune (TRB) instead of buying something like Ambac right now is because I would rather give up some upside in order to minimize further downside. In other words, I don't mind buying ABK after it goes up 10% or 20% if I'm sure that I can avoid, say, a further 10% drop.

Japan & the Yen Carry-Trade

As is generally the case, the Yen strengthens whenever the broad markets sell off. Last week was no different:


The US$ keeps weakening but it's going to get a lot interesting pretty soon--if the US economy weakens. As I was expecting, the trade deficit has been shrinking lately due to the weak US$ (US imports are down (especially if you strip out oil&gas); US exports are up). We may be hitting a peak in commodities. I know I felt that way early this year and have been completely wrong--and suffering with my portfolio for that, but this may be it. US oil imports in terms of quantity is actually down compared to last year (but it is up in US$ terms). Many of the supermajors also missed their earnings and we are clearly facing demand contraction.

I haven't checked lately but I believe the Japanese stock market is the worst performing major index this year. But if Yen flows back into the country, it must go somewhere and we may be setting up for a mini-bull market next year.

Having said that, Japan's economy has weakened considerably of late. Some of the estimates coming out there (I think I was looking at their leading indicator) basically implies zero nominal growth, and slightly positive real growth (due to deflation). I'll be concentrating on Japan during my lonely :( Christmas holidays and I would really like to get my head around their economy. I'm really not sure what they are going through. They clearly went through a deflationary bust in the 90's but I'm wondering if they are in a deflationary boom now. Basically, as long as Japan holds the current economic level (i.e. grows 0%), they will still have positive real growth if there is actually deflation. Deflationary booms have been rare in the last 100 years so I'm still not sold on it yet but, of all the countries, Japan probably has the highest probability of unleashing a deflationary boom.

Some Intriguing Articles

I bookmarked and printed a bunch of articles a while ago but am just going through them now. I'll link some of the ones I found interesting below. Most of these biographical stories on investors or some unorthodox issue facing businesses:

If you are interested in Sam Zell--and I definitely have been ever since I started looking into Tribune--here is a lengthy biographical sketch courtesy of The New Yorker: Rough Rider by Connie Bruck, November 12, 2007. Sam Zell is a real estate tycoon whose is is one of the most contrarian investors I have encountered.

Here is another excellent one from The New Yorker with a behind-the-scenes look at the rise and fall of Victor Nierderhoffer: The Blow-Up Artist by John Cassidy, October 15, 2007. For those of you who have never heard of Victor Nierderhoffer, he is an intellectual financial speculator. He collapsed after the Asian Financial Crisis in 1998 and he seems to have fallen again recently, after the credit crisis that is enveloping the markets these days.

Piracy is something that always interests me and here is a September article from The New Yorker sort of touching on that issue. It covers the rampant copying of clothing fashion. Here is one from The Economist talking about how India and China copy rather than innovate.

For something totally different--and I'll warn the politically sensitive that is is an opinionated--here is an article from the New York Times that says that Iraqi bonds are predicting a dismal future for Iraq. I personally think that capital markets are wrong quite often. I especially hold this view for the futures market (the FedFunds Futures market hardly ever predicts anything until the decision date) but the bond market is something that is more correct. Bonds are long term investments and I think the market prices in risk much better than for equities or derivatives.

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Thursday, November 8, 2007 0 comments

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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Tuesday, November 6, 2007 2 comments

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:

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.

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Beazer Cuts Dividend and Workers

Quick housing update...

Not a surprise to anyone but Beazer (BZH) eliminated its dividend and cut 25% of its workforce.

Beazer Homes USA Inc., the home builder that has been rocked an investigation into its mortgage-origination business in addition to the housing pullback, has suspended its quarterly dividend in an effort to firm up its capital position...

Last month, the builder said it found evidence that workers in its mortgage business violated Housing and Urban Development regulations. Its probe also uncovered evidence of other accounting irregularities that will lead to expected restatements, Beazer said.

On Tuesday, Beazer said it was unable to report its fourth-quarter and fiscal 2007 results but was providing preliminary, unaudited data. It has negotiated waivers of default from its lenders due to its failure to report financial results on time...

Beazer said it let go about 650 workers, or 25% of its staff, during October.

As you can see, Beazer has a whole hoard of problems on top of the housing collapse.
I don't like Beazer very much. It's very risky and might not survive. However I am following it because it has 90%+ of its shares shorted. I have never seen that for a company that actually has a chance--albeit small chance--of surviving.

If someone is interested in Beazer, perhaps the best bet is if you can find a convertible bond. I'm not sure if Beazer ever issued any convertible bonds but those are worth looking into assuming you are confident that their balance can withstand the shock of the housing collapse.

Monday, November 5, 2007 0 comments

FCC Moving Slowly on the Tribune Deal

Financial Times covers the logjam at the FCC over the Tribune (TRB) deal. As is the case with anything to do with politics, nothing is ever rational and one can never be sure what is going on in the backroom.

Tribune has warned the FCC that the takeover is at risk of collapsing if it does not receive regulatory clearance in the next two weeks.

But Kevin Martin, the Republican chairman of the commission, in private conversations, has said he is unwilling to address the matter before December 18, the date he has set for a vote on industry-wide changes to media ownership rules.

Putting it off until mid-December seems to be a political strategy:

Instead, in a move that some say reflects Mr Martin's reputation for being a calculating political operator, the commission chairman is pressing forward the broader media ownership overhaul.

People close to the FCC say they believe Mr Martin is holding up the Tribune deal for political reasons.

The transaction has won the backing of a handful of Democrats and they say Mr Martin believes delaying the deal will divide the Democrats and prevent them mobilising against the Dec-ember 18 vote on media ownership, which would negate the need for a separate Tribune waiver.

Mr Sheehan said: "The Democratic majority is butting up against the regulatory objectives of the Republican chairman of the FCC. My very real concern is [Tribune] being thrown overboard in that very macho stare-down."

According to what is stated in the article, Tribune is saying it needs 20 days from approval to close the deal. The deal needs to close by the end of the year or else there are all sorts of repercussions and the deal may fall apart.

As you may already know, I took a speculative risk arbitrage position a few months ago. I decided to add to that position today. Potential return is around 17%. I think it is a bit risky to add at this level because if the deal were to be re-negotiated, it would happen around this price (probably around $28 to $30). However, the broad market is down and I am not sure if the stock price will drop further.

TRB purchase price: $28.61 to $28.63

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Sunday, November 4, 2007 0 comments

A Revelation for Me: Housing Inventory May Not Matter As Much

I read a very good analyst report from HSBC (When will the homebuilding bust end? by Ian Morris and Ryan Wang, HSBC (Nov 2 2007)) where they try to shed some light on when we might hit the bottom of housing. Every single Wall Street analyst has been guessing and been wrong for over an year (recall the somewhat infamous calls in late 2006 for the bottom, which turned out to be completely wrong!)

The analysts identify 4 prior housing corrections where residential construction has declined for 4 or more quarters. The prior 4 construction declines were in 1966, 1973, 1981, and 1990. They look at a bunch of different metrics, ranging from unemployment rate, to GDP contribution from housing, to % of gross domestic demand, among others. Using these metrics, they compared the current correction to the prior ones and tried to determine when we might see the bottom.

Perhaps the most bearish way of looking at it is if you look at housing share as a percent of GDP. Using this metric, HSBC estimates a bottom in Q3 2008 if nominal residential construction declines 20%; if annual nominal construction decline is 15%, they estimate the bottom is in Q4 2008; and if annual nominal construction decline is 10% then they peg the bottom in Q2 2009.

Anyway, one of the points that they present in the report radically changes my view of housing. All this time, when I was evaluating homebuilders and other housing-related stocks, I paid a lot of attention to housing inventory. The inventory number is very high and looks scary for a homebuilder. However, they point out in the report that new home sales and building permits bottom out at the same time:

How can things bottom out
when we know that new home supply is still very
high? The months’ supply of new homes hit 9.0 in
August, a cyclical high.

Although it is popular to use months’ supply as a
barometer for future construction activity, it does
not do well in practice as a forecasting tool.
home sales and building permits tend to bottom
out at pretty much the same time that months’
supply of new homes peak (see chart 8...).

(source: HSBC, modified by Sivaram Velauthapillai of Can Turtles Fly)

Note that the blue additions in the chart above are mine. You can clearly see that if one wanted to capitalize on a recovery, one can't wait for inventory to get to comfortable levels. Inventory, as measured by months supply of homes, starts to decline but never really hits a low level until well into a boom. I guess this is obvious if you realized that housing is cyclical like commodities but it never occurred to me. Just like how cyclicals have low P/Es during a peak and not at a trough, if housing inventory is very low then we are probably near the end of the cycle.

What I learned from this is that I should watch something like new home starts or permits instead of waiting for a comfortable level of housing inventory. By the time inventory hits a comfortable level, one probably already missed the big portion of a bull market.

The homebuilders may not be in as dire straits as it seems if we are close to the absolute bottom. None of this means that you will hit the profit levels of a few years ago, when things were booming; however, it does mean that homebuilders will stop bleeding red and should see a decline in write-offs. This somewhat less-bearish picture is probably what makes Countrywide Financial (CFC) come out and say they may make money next quarter.

Having said all that, note that one of the cases put forth by the housing super-bears is that what happened in USA is unprecedented in terms of housing. We have never seen such a huge housing boom throughout almost the whole of America (incidentally there were also housing booms in other parts of the world). The risk with wading into housing any time soon (soon means up to middle of next year in my books) is that we may be seeing something new this time. If it's anything like Japan, it's going to be a disaster for a long time. This is one reason I'm partial to the Pulte bonds instead of equity.

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