Saturday, January 26, 2008 15 comments ++[ CLICK TO COMMENT ]++

Ambac Conference Call & Other Thoughts

Ambac held their 4Q07 conference call on Tuesday and I was reasonably pleased with how Ambac handled the situation. I don't know if I have any insight to anything that was discussed but thought I would add my thoughts. The reason I say I don't have much insight is because nothing major has changed in my eyes. No doubt their risk models and underwriting have been poor but the real question is the actual losses that will materialize.

(You can find the conference call transcript from SeekingAlpha. It has a lot of typos but it's free so can't complain :) You can access the audio call from Ambac's site. )


I was going to quote some text but am, instead, just going to touch on the key points (not in any order):


  1. Holding Company Liquidity: One of the concerns is that cash flow from the insurance subsidiary will be cut off, resulting in the holding company going bankrupt. Management said they need $90 million for interest payment on debt; have $50 million cash right now; and can receive $200m without regulatory approval. So I think this shouldn't a concern of shareholders for the next few quarters.
  2. $1.1 billion Impairment: Nearly all of it is from CDO-squared, where the underlying CDO is mezannine sub-prime RMBS assets. The loss reserve is very large but it doesn't shock me (I would have been shocked if the loss was from a high-grade CDO or something--then Ambac's underwriting has to be questioned). My feeling has always been that the CDO-squareds, particularly with underlying mezzanine CDO as collateral, are going to be the big problem. What I would look for now is to see if there is further deterioration as we move forward. I expect this to be the worst so we need to see lower losses in the future. I do think that Ambac will book losses in the future but they should be smaller.
  3. Risk Model and Underwriting: Ambac says the increase in impairment was due to using a different methodology to evaluate losses--one that places more emphasis on the legal structure. This kind of makes me nervous. I mean, if their is a failure in the model for these CDOs and CDO-squareds, I wonder how their other models are (say, models and projected losses for ABS of auto loans). Nevertheless, they are trying to move to a better way of pricing risk and it remains to be seen how the future turns out. I always expected to see a large loss in 4Q07, while posting smaller losses as we move into 2008 (check below for the reason for my thinking (hope?) below*). Note that Martin Whitman also remarked that you are likely to see "staggering losses" being posted by MBIA (and others) (I'm sure he was talking about mark-to-market losses and not actual impairments).
  4. Management Change: It's hard to say if Michael Callen sugarcoated his words but, if what he said was close the truth, the situation isn't as bad as I initially perceived. When the announcement was made a few weeks ago, I thought Ambac was an imminent disaster and it looked like the captain was jumping ships at the last minute. But if Michael Callen has actually kept in touch and consults with Robert Genader, the prior CEO, at times, then it isn't really as bad as it seemed. The key disagreement seems to be over issuing equity or equity-linked notes. Robert Genader feels like he owes it to the long-term shareholders and didn't feel comfortable issuing equity. Ambac had a market cap around $1.5 billion at that time, and it would have diluted shareholders by 50%. The thing that I'm uncertain about is the alternative that was considered. Ironically, all of this may have been for nothing. I feel like the CEO resigned because he didn't want to issue stock, but in the end Ambac never issued stock because the stock price dropped so much. Anyway, the management change doesn't seem as bad as I initially thought.
  5. Future Strategy: Ambac said it did not seriously consider run-off and is going to try getting its AAA rating back. This was a surprise to me. It's going to be hard to do that while having shareholder interests in mind. There isn't much for me to say until we get some details. Ambac needs $1 billion and its market cap is below $1 billion. Not an easy place to be. Ambac doesn't have any meaningful physical assets it can sell off, although it can trying unloading a huge chunk of its insured muni bond exposure. This basically amounts to giving up the crown jewels to save the kingdom. A risk with raising capital is that if the rating agencies change their mind again(!) then you are screwed... In any case, a big risk for shareholders is that some vulture might swoop down and buy the company at a really low price. This seems unlikely given that the run-off value (even some midly bearish estimates from Goldman Sachs pegs the run-off value in the $15+ range). Management would have a hard time justifying a sale where the price is way below the run-off value.


(* My expectation has always been for a big 4Q loss because most of the decline in the value of RMBS, CDOs, etc happened during that time. As a very rough measure look at the ABX index. Many of the ABX indices have dropped 60% to 70% (depending on what you are looking at) so it can only drop 30% to 40% more (from original price). It should also be noted that some physical assets (like houses) should have some positive value. What will end up being worth zero are HELOCs (home equity line of credit). I think direct RMBS (and CDOs, depending on their legal power) are not going to hit zero. For comparison, the $1.1 billion loss impairment supposedly represents 38% of the original par value. I do not expect to see losses anywhere near the 4Q numbers in the future. There will still be some sizeable losses but the peak needs to be the 4Q numbers. If I do see big numbers in the future then I am wrong with my original investment expectation and will start to wonder about Ambac's risk management... just to be clear, what I see happening is that loss reserves may go up (this is bad but to be expected to some degree) but I am expecting to see mark-to-market losses reverse or stabilize. This is a bullish view.)

Anyway, let's see how events unfold. The situation is really out of our hands (your only decisions are to sell the position at a loss; or hold)...


Back to the Past

It's always interesting to read historical articles and see how events unfolded. Here is a blog entry by ContraHour who was contemplating shorting the monolines back in 2005. It talks about MBIA and the huge potential losses they faced from Katrina. The risks the companies face now is somewhat similar. Back then, the worry by the blogger was that the monolines may lose their AAA rating. This is kind of the problem right now for bulls like me (the bears have a more pessimistic scenario of insolvency for the industry). I'm not implying that the current subprime debt insurance problems are the same size as the Katrina problems but it does shed some light on what happened just a few years ago. (Another big problem for some monolines was the Eurotunnel exposure.)


Is the Bond Insurance Industry Doomed?

One argument against monolines is the notion that the industry may dissapear. I respect GaveKal for their generally off-the-wall thinking and here is a thought on the monolines from them. I don't have access to their reports but here is an excerpt from a posting on their message board:

Steve Vennelli of GaveKal: PS- On monoline insurers: Maybe they go broke and the business model never returns. S&Ls sprang up after WWII to finance the construction of suburban America. By the 80s, when this had largely been accomplished, they got into golf courses, strip malls, etc. In other words, they ventured into new areas. After many failed in 1990, they never came back. The monoline insures are a similar story, having begun life as muni bond insurers and having gotten into insuring CDOs, ABCP, etc. The market has been pricing this along the way (note the chart below), but if/when the monoline insurers go bust, it could hit the banking system, as munis and CDOs have to be written down to reflect the elimination of the monocline credit enhancement.

It is a little bit of a mind-bender to think about a company going bankrupt because the present value of their contingent liabilities soar. They may be broke on paper, but that is only a function of discounted contingent liabilities. Talk about mark to model. For the big money buying into Ambac or MBIA, this is a call option on the housing bust not happening. PIMCO’s total return fund is now 65% in mortgages.


One of my key reasons for investing in the monolines is with the expectation that the industry survives. If that assumption is incorrect then this is a very bad investment indeed. Steve Vannelli, above, points out how S&Ls (Savings & Loans financial institutions) were very popular for many decades but then dissapeared with the housing bust in 1990.

I have always felt that the business model made sense and I think I am right but you just never know. The fact that Warren Buffett actually set up shop leads me to believe that the industry will exist in some form in the future. It's unlikely that Buffett does anything without a 10+ year time horizon.

Other other key thing that Steve Vannelli mentions is that investing in the monolines is basically a bullish bet on housing. I never looked at it that way but that is what it will ultimately come to. The monolines basically need the subprime housing default rate to stabilize or decline. So far, with the rate cuts and other government measures, things are looking up. Some articles indicate that mortgage rates are similar to, or even lower, than what they were an year ago. Homeowner refinancing is also up. This is probably one reason the homebuilder stocks are some of the best performing stocks this year... but we still have a long way to go before a trend is established.

As I have remarked many times, the key number to watch is the subprime default rate for 2006 and 2007 mortgages. It's a very rough measure but if that keeps increasing then we have problems; but if it stabilizes or starts declining, we may have seen the worst.


The Near-Term Future

Remember: the main problem for the bond insurers is not a cash crunch but the need for some capital to satisfy rating agency requirements and to stabilize the fear in the market. (I still think the broad market will still decline because of an economic slowdown but it won't be because of the monoline uncertainty). I don't know what Ambac is doing but a combination of ideas (eg. some share issuance, some reinsurance, etc) is probably the best in my view.

As far as Wilbur Ross and private equity investors are concerned, there is a risk that they will buyout the company at a low price. If they want to provide some capital, that's fine with me. Otherwise, I would prefer that they not even get involved. The dumbest thing ever is for the company to sell itself at a value far lower than the run-off value.

A huge risk for shareholders have been the view that the regulators may seize control of the insurance subsidiary and prevent any money from flowing to the holidng company, hence bankrupting the publicly-listed corporation. I think this is highly unlikely for the time being. Wisconsin, which regulates Ambac, as well as New York, are on good terms with the monolines (they also likely don't have the expertise to run things so I'm sure the last thing they want is to take over these companies). Furthermore, my non-legal opinion is that they likely have no legal basis for seizing control until they can prove that losses are going to be too high and the insurance subsidiary can't afford to pay out dividends to its parent. I'm not too worried about that (as Ambac indicated in the conference call, they also have non-regulated money coming in so the holding company should be ok for the time being).

Ultimately, it will come down to the real losses. If they are high, the bond insurers will go bankrupt; if not, then they won't and all of this will seem like distant memory.

Believe it or not, I am totally against government bailout of any sort--the bond insurance industry lobby group has a similar view. I will lose a huge chunk of my savings if Ambac goes bankrupt but shareholders should take the losses. We all invest with the expectation of making a profit on risk and if things don't go our way, we need to accept our losses and move on! Speaking as a free market guy, profit and loss should accrue to the investors. Socialism for the rich is just going to end up with fascism for everyone!

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15 Response to Ambac Conference Call & Other Thoughts

cak
January 27, 2008 at 3:34 PM

Great post Siv, as usual. Ran across this CNBC interview from Friday with Janet Tavakoli. She is a structured finance expert (has her own firm/website) She has not been a friend to Ambac & MBI but she brings up an issue we touched on briefly a couple of weeks ago - fraud. Unfortunately, Gasparino is also in the interview so her thoughts do not run there course - as opposed to Gasparino who was on CNBC no less than 10 times Friday dissing the fg's.

Tavakoli

cak
January 27, 2008 at 3:45 PM

NYT

January 27, 2008 at 4:45 PM

I don't know what's going to happen if fraud is discovered (which is pretty much a certainty in some cases). I don't think the legal system has ever dealt with insurance on RMBS and CDO tranches before. I just hope Ambac and others wrote into their contracts to absolve themselves of any claims if fraud was committed.

Sometimes I wonder why I got myself involved in Ambac. Life would have been so much easier if I had gone with one of those other beaten-down financials like Citigroup or Merril Lynch or something :)

CAK, I never asked you this but why did you invest in Ambac in the first place?

cak
January 28, 2008 at 9:15 PM

WASHINGTON, Jan 28 (Reuters) - JPMorgan Chase & Co disclosed on Monday that it has raised its stake in bond insurer AMBAC Financial Group Inc to 7.7 percent from 5.4 percent.

The bank reported in a filing with the U.S. Securities and Exchange Commission that it has increased its passive stake to 7.4 million shares.

January 29, 2008 at 10:09 AM

The JPM investment seems to be a passive investment so I wouldn't read much into it... I think the longs and shorts have staked out their position and will be waiting to see what happens...

MBIA has their big $500m rights offering soon. Performance of that will impact all the monolines...

cak
January 29, 2008 at 10:33 AM

I have to say that the level of urgency in this saga is really, really beginning to boil. It is as exciting as it is nerve wracking.

That little article about JPMorgan adding to the position is, I think, an indication that Wall St. thinks something beneficial is on the way. (Wouldn't you know that, suddenly, this morning rumors are circulating that JPMorgan will suffer significant derivative losses this qtr. Hmmm)

Reading back on Wilbur Ross' big play in the steel industry, Ross just happened to buy LTV, Bethlehem Steel & Weirco(?) a few weeks before President Bush 1 signed tariff legislation on foreign imports of steel.

IMO, a very smart player with big pockets could walk into the office of Dinallo and make him an offer he couldn't refuse. Financial backing by a private party would settle down bank fears and loosen them up for some kind of bridge loan. With the NY Fed giving their tacit approval via the NY Dept of Insurance, if they were willing to give that 3rd party a guarantee that the fg's will not be broken up and sold off, then a lot of money could be for the taking.

Dinallo is putting a hard press on the ratings agencies to hold off on downgrades. At the same time we are seeing a freakish hustling to grant Buffett a world wide license to steal (obviously, FSA & AGO don't exist) as if his shop has the capability to do a 10 year ramp up in 3 months!

Things are heating up!

cak
January 29, 2008 at 10:38 AM

I wonder if the Pincus deal will close on the 31st when MBI posts numbers.

cak
January 29, 2008 at 10:57 AM

Despite ABK seeing some spec buying and short covering here are the this mornigs last 3 headlines for the stock, indicating how dismal sentiment continues to be -

Vegas Monorail may Default (was downgraded 6 notches today)

Monoline Bailout to Late

Cramer-9. Ambac (ABK - Cramer's Take - Stockpickr - Rating): I would avoid this stock like the plague, takeover rumors or no. Most professional investors have no clue to what is on the books of this bond insurer, and if they do, I seriously doubt they have any idea to their value. I reiterate what I said last week: everything about the bond insurers is under scrutiny, including their ability to remain solvent. And there is the key word, solvency. Why would you want to get involved with any stock that has "solvency" as a primary concern? Why go down this potential road to ruin if you don't have to? -- SELL

January 29, 2008 at 11:03 AM

The stock is up 15% right now on big volume without any news (actually all the published news is negative)... wonder what's happening behind the scenes...

cak
January 29, 2008 at 11:32 AM

DJ UPDATE: Bond Insurer AGO: Industry Bailout Cost Overstated

The anxiety over the fate of bond insurers who overloaded their businesses with subprime-backed securities has gotten a little out of hand, bond insurer Assured Guaranty Corp. (AGO) President and Chief Executive Dominic Frederico said Tuesday.

"This is a crisis of confidence, but at the end of the day I see no one not getting paid," said Frederico at the Citigroup Financial Services conference, which was Web cast. He said some estimates of the size of the problem were overblown. "I saw one estimate that the cost to recapitalize the industry would be $200 billion. That is not even close," he said. "The number is manageable."

Frederico said that he was "besieged daily" with calls from capital providers who want to get "into this space," he said. "If we are getting these calls so is everybody else."

As evidence of new capital coming into his business, on Monday, hedge fund SAC Capital Advisors reported a 8.9% passive stake in Assured Guaranty. Passive stakes are for investors who don't seek to change or influence a company's operations.

Frederico spoke of the problems faced by some of Assured Guaranty's competitors who find their crucial triple-A credit rating under threat as they face rising losses on their subprime mortgage investments.

Among the various proposals to bail out the industry are talks being brokered by insurance regulators in New York and Wisconsin who are proposing a bank-led bailout that will make $15 billion in capital available to the two largest bond insurers, MBIA Corp. (MBI) and Ambac Financial Group (ABK).

Frederico refused to handicap the odds of that New York/Wisconsin plan coming to pass, but he said he had "high confidence" that a solution of some type would be reached, and he said he sees the largest companies surviving. "You will see some unique solutions being provided."

Assured Guaranty has gotten involved in providing some capital to its competitors by reinsuring a portion of rival Ambac Financial's portfolio. Frederico suggested the company was interested in doing other deals that might provide capital to a rival and help strengthen the industry as a whole.

Frederico also said that despite widespread reports that governmental bond issuers have shied away from insuring their bonds as the troubled bond insurance industry has seen five of seven triple-A rated insurers either lose their rating or undergo review, Assured Guaranty is seeing strong interest.

Any hesitancy in obtaining bond insurance or wraps on municipal bonds is primarily directed to the weaker bond insurers.

He said that as of Friday, Assured Guaranty had nearly a 16% market share of U.S. public finance, an increase from previous quarters, and that pricing and terms are improved over past months.

"The pipeline is very good," said Bob Mills, the company's chief financial officer, during the conference.

Berkshire Hathaway's (BRKA BRKB) entry into the industry with its own startup municipal bond insurers did not trouble him.

"There are challenges. You need a strong infrastructure, with multiple disciplines," he said. "I don't see them with that infrastructure." He said it will take time for Berkshire Hathaway to develop expertise in the industry.

Although Assured Guaranty has seen its share price decline over the last several months, and is down 9.2% so far this year, there have been signs of increased investor confidence in the sector recently.

Shares of Assured Guaranty recently rose 7% to $24.05.

-By Lavonne Kuykendall, Dow Jones Newswires; 312-750-4141; lavonne.kuykendall@dowjones.com

(END) Dow Jones Newswires
January 29, 2008 11:04 ET (16:04 GMT)
Copyright (c) 2008 Dow Jones & Company, Inc.- - 11 04 AM EST 01-29-08

cak
January 29, 2008 at 1:30 PM

More analysts no's.

From Bloomberg-

" Losses at MBIA may reach $8 billion and those at Ambac may climb to $11.4 billion, according to JPMorgan analysts Chris Flanagan and Kedran Garrison Panageas in New York. Such a scenario would consume 80 percent of claims-paying resources at Ambac and about 50 percent at MBIA, they wrote in a Jan. 25 research note.

Bond insurers' total losses may be as high as $65 billion, according to Independent Strategy, a London-based financial consultancy set up in 1994 by David Roche, a former head of research at Morgan Stanley. The estimate assumes a loss rate of 18 to 22 percent on $250 billion of credit derivatives linked to U.S. property, plus $90 billion of insurance on foreign real estate.

The insurers will need about $130 billion to cover the losses and to recapitalize, and the cash will have to come from taxpayers, Independent Strategy said in a statement today.

cak
January 29, 2008 at 3:09 PM

News & rumors are non stop

ambac

cak
January 30, 2008 at 1:38 PM

Ackman's new idea is a state "bankruptcy" plan - forcibly slicing off the muni bond business and letting the rest go under.

cak
January 30, 2008 at 2:05 PM

I have to admit, I'm a razor thin hair away from the exit. I've had my fair share of losers before, taken the hit and moved on. But never in my life have any of those losers been so overwhelmingly crushed day after day by the media as this/these stocks have. It truly is beyond belief. I swear, I don't know how Marty Whitman does it. Even he must be a little confused by what's going on.

If it were were a fair and open discussion of the issues that would be one thing. But these atrocious, constant, bear camp 2 minute poundings are really taking their toll.

I could post 20 of these from CNBC just this week. Here's one from an hour ago. Sorry for being such a bring down.

CNBCackman

January 30, 2008 at 2:53 PM

It's tough for all the shareholders. I have no idea what is going to happen but one clearly needs to decide whether to take a loss and quit; or to hold. Just remember that, unfortunately, Neanderthal sold almost at the bottom ($5). I don't know how much the current price vs $5 matters to him (he was already down a lot) but just don't make an irrational decision.

I'm just curious why you picked Ambac instead of, say, Bear Stearns (that was beaten up a bit). Has your investment thesis changed materially or is it still uncertain?

Maybe I'm just stubborn with my mistake but I still don't see some of the problems that people are citing. Let me make a new post about it.

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