Wednesday, January 16, 2008 19 comments ++[ CLICK TO COMMENT ]++

Horrible News from Ambac

UPDATE: Added some thoughts below

I would have to say this is not good news. Ambac gave some details about their earnings and how they plan to raise capital. The horrible news in all this is the fact that the CEO is being replaced. This is extremely negative news. One can argue that management should be held responsible for underwriting insurance on questionable CDOs but jumping ships in the middle of a storm is not generally good for the ship. Unlike Citigroup, Merril Lynch, or others, I don't think the CEO leaving is a good thing.

Here are the key tactics Ambac will undertake, along with my thoughts:


  1. 4Q07 loss of up to $32.83 per share; operating loss of up to $5.80 [pretty high but can't give a strong opinion until one looks at the details]
  2. new interim CEO [this is probably the worst item in the news release]
  3. $1 billion of share issuance and equity-linked notes [was expecting this]
  4. dividend cut to $0.07 from $0.21 [no surprise; dividend yield is very small in any case]
  5. increased loan-loss reserve by $143 million, mostly due to HELOCs [need to look at details; not as bad as MBIA's loan-loss reserve increase]
  6. loss on CDS portfolio of $5.4 billion ($3.5 billion after taxes; $1.1 in CDO of ABS) [you can see why the CEO left; loss is near the worst case numbers]


Overall, pretty bad news. It's worse than I thought and is close to the ballpark figure of the worse case that some were expecting. Need to look into the details to get a better understanding.


Additional Thoughts

Here is the press release in any case anyone wants to get it straight from Ambac.

The hardest thing for me, as a shareholder, to get over is the resignation of the CEO. The high losses were always possible but I didn't think there would be a management shuffle during a crisis. A board of director--a Cerberus private equity guy--also left. This likely means that there was some disagreement behind the scenes. We really won't know until the story of Ambac is written over the next few years.

Ambac will post $32.83 in losses. I guess it joins GM in the club with the dubious distinction of posting a larger loss than the share price :| Book value right now is around $55.64 so this will take the book value to $22.81. If the market is correct and if those mark-to-market losses are real, that's what the real book value will be. After the current plunge in the stock price, it will be trading around a P/B of 0.67.

The losses are higher than my expectation but they are not as shocking as they seem. I recall Martin Whitman saying that MBIA and its peers will post massive losses in the 4th quarter. If this was a game of chess, we just went through the opening and will hit the key mid-game stage soon. What will determine whether Ambac, or MBIA, or any of the other bond insurers, is a good investment is what happens this year. I believe that most of the losses have been accounted for, and most of the equity dilution will happen now, so we need to see if things stabilize or if they fall apart.

Details of the capital infusion are not clear. They really need to get that moving quickly. I believe Credit Suisse is their advisor and I hope they are working overtime hammering out a deal.

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19 Response to Horrible News from Ambac

Neanderthal
January 16, 2008 at 12:56 PM

This is not looking good. I have a lot riding on this, but I am thinking of pulling out and cutting my losses. The thing that trouble me is the fact that the CEO left at this critical juncture. I have lost over half of my investment but I don't want to loss the rest. If there is another threat of down grading, then there goes what little value the investors have.

John

Neanderthal
January 16, 2008 at 1:28 PM

What made you believe that most of the losses have been accounted for? It is quite possible that if the losses are significantly higher, they won't be able to report them since it would effectively wipe out the book value and potentially trigger their delisting.

John

January 16, 2008 at 1:54 PM

This is just an opinion from a newbie so take it for what it's worth:

Don't do it NOW!!!

The fact that you are down 50% with a big chunk of your savings is terrible but how much is Citigroup, something far more solid and lower probability of going bankrupt, down in the last few months?

If you pull out, you will be doing so at probably one of the worst time to sell!!! If you want to take a loss, you should do it after you think it through not after a big sell-off due to news.

To see what I mean, consider the fact that ABK is down 25% today but MBI is also down around 15%. I know this is a weird way of looking at it but it's almost as if ABK's news only took it down 10% versus MBIA. If you are confident in the sector then selling now would be bad.

If you do want to sell, do so after being totally confident that Ambac isn't going to retain its rating. The way I look at it, Ambac will likely do something by the end of next week. RE-EVALUATE the situation at that time.

Although the situation is getting dire, the arguments I will make for not selling are:

* the whole sector is being sold off (that looks irrational to me)

* the stock is trading below book value, even after this huge loss. If you think that Ambac is writing off as much as possible now then losses should decline in the future (unless Ambac is indeed going bankrupt)

The bear case is obvious. Do you actually believe the bear case or are you selling due to huge stock price losses?


Anyway, sorry to know what you are going through. I am sticking with my position--I wouldn't have taken it if I didn't believe in it. I think Ambac will keep its rating. It's just that there is going to be huge dilution. However, Ambac isn't giving up as much future profit potential as MBIA by issuing debt (actually Ambac may issue some debt or use reinsurance but it doesn't look like it will be anywhere near the $1 billion MBIA used).

January 16, 2008 at 1:59 PM

NEANDERTHAL: "What made you believe that most of the losses have been accounted for? It is quite possible that if the losses are significantly higher, they won't be able to report them since it would effectively wipe out the book value and potentially trigger their delisting."

These are just guesses from my part since no one really knows how CDOs will behave, but here is my thinking.

Your theory that losses may be higher but they choose not to report it is, although possible, highly unlikely. Management and board of directors will be liable to massive lawsuits and could end up in jail. Furthermore, the external accountants won't sign off on that. That's just plain fraud if losses are really higher and they make up a smaller number. The derivatives are hard to price but the accountants (especially the external auditors) will use their best estimates (from suppliers or models or whatever). Yes, there is some leeway but I don't think they will just make up a number.



CONTINUED ON NEXT POST

cak
January 16, 2008 at 2:30 PM

The stock is down 35% now & trading like it will lose its rating. I'm surprised they did not announce any capital plan within the pre-announcement. This is very ugly and not much fun.

January 16, 2008 at 2:34 PM

Anyway, I think most of the losses may be written off now because:

(i) kitchen sink theory (minor reason): sometimes businesses write off as much as they can in one quarter to clean the books as much as possible. Who knows if that is the case here but it is plausible to some degree.

(ii) I don't know the details of the booked losses but it is possible that most of those are from the 2006 and 2007 CDOs. If you look at the markit ABX indices, it is possible that the pricing may be stabilizing. If you check the 2006 AAA charts, they are still trading fairly well. The AAA 2006-1 is in the 90's and the AAA 2006-2 is in the 80's. My guess is that the ABX index is far worse than what any of the bond insurer wrote (since you would expect insurers to have some expertise in picking some good deals with lower default rates). If the losses are indeed from the questionable 2006 and 2007 CDOs, then how much worse can it get? Yes, there could be far more losses but it's a judgement call you have to make. Looking at something like the ABX index also doesn't take into account loss recovery (monolines generally have super-senior rights and can accelerate the RMBS recovery)

(iii) what could kill Ambac (or MBIA or others) is the CDO-squared stuff. I have no idea what is going to happen with that! Not only can recovery be zero but a lot of the AAA rated CDO-squareds have mezzanine CDOs as underlying collateral (I have low confidence with the mezzanine tranche). There is a possibility this can get worse. This is a risk that any shareholder will take.

(iv) I know the market doesn't believe any of this but these are still mark-to-market losses. It's tricky investing in these insurance companies but unlike the Wall Street banks, the losses can reverse. I'm not saying there won't be any losses but there is a chance of some recovery.

(v) I think the key number is the subprime default rate. If you think that is going to go higher, especially above 19% (which is what some rating agencies used to model their stress tests), then you may want to bail. Otherwise, you have to make a judgement call.


Anyway, it's your call... whatever you do, I say wait and see what happens by the end of the week. If you really can't tolerate more losses (not sure if 10% more would be bad given that you are already down 50%), set a stop loss at a low value that is your absolute minimum.

(even if you wait one more week, you have to make a big decision. I suspect Ambac will raise money but the stock price won't move up. What will you do in that case?)

January 16, 2008 at 2:42 PM

Concrete capital plans would help but I'm still thinking they can get the billion that they need. The problem is the price. Raising $1 billion when the stock price is $1.5 billion is tough to swallow...

cak
January 16, 2008 at 3:08 PM

Fitch affirmed MBI and bumped to 'stable' from negative watch. But the stock is getting hit due to ABK.


NEW YORK, Jan 16 (Reuters) - Fitch Ratings on Wednesday affirmed its ratings for bond insurer MBIA (MBI.N: Quote, Profile, Research) after the company completed a $1 billion surplus note sale to shore up its capital base, the rating company said.

Fitch also said it now has a stable outlook for the insurer, meaning the company does not expect a rating change over the next two years.

MBIA Insurance Corp, the insurance arm, has a top rating of "AAA," while MBIA Inc has a long-term rating of "AA," the third highest. (Reporting by Walden Siew; Editing by Dan Grebler)

cak
January 16, 2008 at 3:14 PM

MBI sported a mkt cap of 1.5 when they announced the note offer.

Neanderthal
January 16, 2008 at 3:24 PM

Siv,

Thanks for your wisdom. I will take a few days to think about this.

I did not think about selling because I had big losses in my position. My concern is that the company may not survive in the future and if it did, share holder equity getting wiped out.

I like to believe this is the bulk of the losses, however, just a couple of months ago, the company's position was that they would not take any losses. The truth is, nobody knows one way or another.

Before this, I thought that having a new round of funding will secure their future. I am not sure that would be the case now. All it takes is for the rating agencies to request more capital, and the share holders will be wipe out.

Having said that, I do believe I have a couple of months to make up my mind as the situation would probably not change much once they retain their ratings.

Another question for you. Why do you believe that this round of funding would be less dilutive than the one in MBI?

John

cak
January 16, 2008 at 3:44 PM

While I'm somewhat irked & confused as to why the company pre-announced today without mention of new capital, I'll give them benefit of the doubt and assume they will outline a plan during formal earns release Tues Jan 22. The fact that they bumped up that release a week from Jan 29 gives me hope that they want to get something done within the Fitch time frame.

Hope springs eternal, I guess.

January 16, 2008 at 4:08 PM

Neanderthal,

Thanks for the post. My portfolio may be smaller than yours but I'm sure all of us are in the same boat. Given by working-class salary, I'm looking at several years worth of savings riding on the line. It's good to hear others' thoughts so I appreciate everything you, and CAK as well, post.

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"I like to believe this is the bulk of the losses, however, just a couple of months ago, the company's position was that they would not take any losses. The truth is, nobody knows one way or another."

Things have deteriorated from August but my impression has not changed much since October (or thereabouts). The numbers that Ambac posted are in line with what AccruedInterest and some other bears were predicting.

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"Before this, I thought that having a new round of funding will secure their future. I am not sure that would be the case now. All it takes is for the rating agencies to request more capital, and the share holders will be wipe out."

If you are sure that more capital will be needed, then bailing and taking a loss may be prudent. I personally am ok with the current capital needs but will become more concerned if there are more issues later in the year (say by spring 08).

I view the 4Q07 losses as THE big write-off. Concurrent with these big mark-to-market losses, the big capital dilution will be now. Beyond that my expectation is for lower losses. If Ambac starts taking more losses in, say, 1Q08 or 2Q08 then my investment thesis will be called into question.
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"Having said that, I do believe I have a couple of months to make up my mind as the situation would probably not change much once they retain their ratings."

Ratings just means that a few shorts may cover... but the real issue is future losses. Will the situation get worse? It seems like you are now thinking that this is going to get worse and worse. If that is the case, there is no point holding this company. (I also don't think that will happen because it will get more difficult to raise capital if things keep getting worse).

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"Another question for you. Why do you believe that this round of funding would be less dilutive than the one in MBI?"

I didn't mean to imply dilution (I know I keep using that word and shouldn't); what I meant to say is that future earnings have not been sacrificed to the same degree as MBIA. But given the continuous drop in share price and potential for Ambac to still issue debt, I can't say for sure.

Share issuance is a one-time hit whereas debt or debt-like securities are continuous drain. I would rather take a big hit now than end up paying interest every year. The debt market will demand high compensation right now (because they won't place the same value on Ambac as potential or existing shareholders). In contrast, if Ambac taps shareholders, they may be able to get a slightly better deal (especially with existing shareholders). It's sort of like if you were a junior miner or a biotech start-up. These companies usually issue shares than debt because, apart from the fact that some of them don't have any income, the debt market demands high compensation whereas shares are cheaper.

Share buyers will also have their interests aligned with existing shareholders whereas debtholders may have diverging interests. This could become a problem if new capital needs to be raised (covenants and things like that may make it difficult to issue new capital, not that I'm expecting this).


---

I'm really curious to see where their losses came from. Earnings call (next Tuesday) will give us more clarity. If you look at page 3 of this presentation (updated to Dec 31 07), they only have $2.4 billion of CDO-squared. The rest, except some being considered for downgrade, are still rated pretty high by Ambac and the rating agencies.

The thing to keep in mind is that, book value is still positive. Even with the big write-off, stock price is below book value. This may not provide much comfort for you since your purchase price may be higher. However, I still don't think this is worth zero. If you look at adjusted book value (which includes things like premiums collected but not earned), the company is nowhere near zero. Ambac can still take a few more minor hits and keep going. (I'll admit that shareholders can't unlock this value if the company goes bankrupt but it gives me some notion of intrinsic value).

Neanderthal
January 16, 2008 at 4:53 PM

Siv,

"Share issuance is a one-time hit whereas debt or debt-like securities are continuous drain. I would rather take a big hit now than end up paying interest every year. "

I would think the opposite is true. When the share prices of a company is way down but its ability to pay debt is still in tact, as seem to be the case here, debt issuance allow the company to cede part of its cash flow for a few years, as with MBI, in exchange of staffing off share dilution in the worst possible moments. Unless you think that the stock is headed lower.

John

January 16, 2008 at 5:10 PM

There is a big IF in you statement (although that is something neither of us are expecting): IF it can service the debt.

Debt will continuously drain cash flow whereas with a share issuance there is more certainty. For example, say the company has two bad quarters and ends up with zero earnings. If it had debt and had to make interest payments, it'll be in big trouble. In contrast, given that there is no obligation to shareholders to pay anything, it grants more flexibility. (but I will note that insurers have a steady income stream so this isn't likely but you never know).

Raising new capital in the future may also be difficult if the company already has debt.

But at some point share issuance becomes extremely expensive. The stock is down so much today (almost 40%) that the advantages of a share issuance are quickly dissapearing (but I would argue that issuing debt now will also be way more expensive than 2 weeks ago).

I don't know. I still don't have a good handle on dilution and cost of capital. When I studied it in school (finance was an elective/minor for me), equity has the highest cost but at times debt can surpass equity (if few tangible assets, if equity investors' perception was different from debt investors, etc). In situations like this, I just don't know for sure what is the cheapest. (note that Martin Whitman also said that equity issuance is the best and possibly non-dilutive to him, which I still don't understand fully)...

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On a different note, this BusinessWeek article runs down the day's events quite well. The amazing thing is that some analysts still have a buy rating. I know that analysts are often wrong but generally they cut the ratings when the stock drops. So far some of them are holding still...

January 16, 2008 at 5:13 PM

Not only do hte analysts still have reasonably positive ratings, they are still expecting around $2+ in earnings for 2008.

cak
January 16, 2008 at 5:42 PM

"Not only do the analysts still have reasonably positive ratings, they are still expecting around $2+ in earnings for 2008."

That may change tmw, or Tuesday, after they start crunching the numbers.

Neanderthal
January 16, 2008 at 6:01 PM

I was looking at the chat room for ABK and one guy said that S & P is going to re-examine the monolines and will have a report in a week. I was not able to find the actual article.

John

January 16, 2008 at 7:24 PM

HEre is an article talking about S&P reviewing their stress test.

Certainly nervous times for shareholders and we don't know what the outcome will be, but I suspect they are just catching up to Fitch. They are going to raise their subprime default rate to 19% from 14% (hard to say what effect it has).

The original S&P report had Ambac with $1.8b losses, with Ambac having a capital cushion of 1.55 to $1.6 billlion (and an additional $255m from their reinsurance deal). As long as the new S&P stress test comes in lower than $1 billion more (for a total of $2.8 billion in losses), it should not materially impact anything (but the market may perceive something else and it wouldn't surprise me if the stock tanks tomorrow).

All these loss numbers are after-tax. Ambac booked $3.5 billion in losses (after-tax) today. So the financials of Ambac will start to resemble what the rating agencies are modelling in their stress tests. The real question is what happens after all this...in the next year or two...

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