Monday, January 21, 2008 0 comments ++[ CLICK TO COMMENT ]++

The Most Important Conference Call in Ambac's History

Ambac will hold the most important conference call in its history tomorrow. When I made the investment in Ambac a few weeks ago, I never thought it will lose its coveted AAA rating. I never thought it will be the first AAA to be downgraded (always thought FGIC would be the first). It's all surreal given that Ambac was named monoline of the year as recently as a few months ago. Anyway, things haven't unfolded quite the way any Ambac shareholder was expecting and we need to deal with what we have. There will be a lot of things happening but key items to watch during the conference call include the future strategy of the firm, management change thoughts, and the $1.1 billion loss that was pre-announced.


Run-off?

The main decision that Ambac will have to make is whether to go into run-off or to operate as a AA-rated insurer. It doesn't necessarily have to make this decision right now but management needs to lean one way or another. Shareholders don't need anymore ambiguous strategies and I would prefer a solid decision. I'm sure employers and potential customers will also prefer some clarity. We definitely don't need the questions like they had with their capital raising plan. Half-hearted attempts at trying to run a AA--rated insurer is likely to be unproductive. Conversely, if the strategy is to go into run-off, they need to follow that path and contemplate selling assets, laying off employees, and so forth.

We don't know what future losses will be but run-off right now seems to have a positive value to shareholders (far above current stock price). There are several downsides with the run-off strategy. First of all, it can take a long time (could be many years to a decade) to unlock shareholder value. I think if Ambac shareholders approve a run-off, I am guessing shareholder value will be unlocked within 5 years or else they won't approve it. I can't see too many investors willing to hold this past 5 years. The other potential downside is if the insurance regulators block payments from the subsidiary to the holding company during a run-off. Since the parent company doesn't generate money on its own, blocking off the payments will bankrupt the company (for example, it won't be able to pay its roughly $1 billion debt outstanding). It is unlikely that the regulator will do anything without political interference from outside sources. Ambac hasn't defaulted on any obligations and its capital is above statutory requirements so it will be hard for the regulator to do something.

I would prefer if Ambac tries to survive with an AA-oriented business model but I don't know how easy that will be. With the loss of AAA, Ambac can potentially lose 75% of its business. It all comes down to the demand for AA-rated products. Given that credit spreads are widening like crazy, there may be some demand (far more than a few years ago) so it remains to be seen. Berkshire Hathaway Assurance has also indicated that they will demand premium fees so there is room for cheaper insurance.

(as an irrelevant side note, one of Ambac's subsidiaries, Connie Lee Insurance, has been in run-off for a while now)


What is Ambac Worth (A Crude Assessment)

Book value is a pretty good indicator of an insurance company's net worth. To the numbers I'll mention below, you probably should subtract $1 per share to $3 per share to account for costs associated with shutting down operations. One should also discount the return by the time period it will take to unlock the value (but we don't know what this will be--a wild guess of 5 years is probably reasonable).

Right now (after the earnings announcement) book value per share is around $21 and adjusted book value is in the $50's so that's the somewhat optimistic outcome during a run-off. This case is basically where you assume that all losses have been accounted for (with existing marks and loss provisions) and there will be no increase in losses in the future.

The bearish outcome is if losses increase in the future (i.e. what's on the books doesn't capture all future losses). The absolute worst case is bankruptcy. I say the stock price will be between $0 and $5 in the bearish scenarios.

The bullish scenario is if the booked mark-to-market losses turn out to be higher than the reality. In this case, each share is probably worth around $50 to $80 (this was Ambac's book value back in early 2007 eg. 3Q07 book value was $55.64 and adjusted book value was $88.07).


You can see why I invested in this stock as recently as 2 weeks ago! The book value is very high compared to the stock price. The problem is the uncertainty of future losses! It's sort of like investing in a reinsurer while you are in the thick of hurricane Katrina.


Senior Management

We need firm confirmation that the interim CEO, Michael Callen, will be running things as if he were the long-term CEO. I think this is the implicit assumption by everyone but the last thing we need is more waffling on this.

Michael Callen has been with Ambac since 1991, and had important board of director responsibilities, so he is very qualified to deal the matter at hand. He was an executive at Citigroup in the 80's prior to joining Ambac so I'm confident in his abilities.


Dividends

I think Ambac should cut its dividend to zero. There may be some merit in keeping a slightly positive dividend, in order to force dividend-oriented index funds from dumping the stock, but preserving cash is going to be important for the next year.


Loss Provision of $1.1 Billion

In the pre-earnings release, Ambac mentioned that it is taking a mark-to-market loss of $5.4 billion ($3.5 billion after-tax). That isn't a huge concern given that mark-to-market may or may not mean anything given the wild uncertainty in all assets right now. The real issue, however, is the $1.1 billion credit impairment they recorded. This $1.1 billion is from a mezzanine subprime CDO of ABS. I think this is what scared a lot of people and probably made Moody's re-evaluate everything. The more detail Ambac can provide about this billion dollar loss, the better. Perhaps it will also help investors if they describe what went wrong with this and whether it is an unusual transaction in any way. The writedown is massive but it isn't that shocking to me given that the underlying asset for the CDO is mezzanine RMBS (if this was a high grade CDO then I would seriously start to worry about Ambac's underwriting skills--not that a $1 billion impairment is anything to ignore).


S&P Loss Sensitivity

First thing to note is that any comment on losses is a guessing game. Bill Ackman is playing the guessing game; the market is playing the game; rating agencies are playing the guessing game; and I am playing it too. Going with the chess analogy I used in the past, the game keep going back and forth (if you are a football fan, pretend the ball is moving back and forth. Ambac is definitely pinned back in its 10 yard line). Although many have written off the game, I'm not so sure. What's unusual about me is that, unlike many out there, I had been watching the game go back and forth for many months and only took a position a few weeks ago. This could still turn out to be the biggest loss in my life but it's not so clear cut. Anyway, on to some thoughts about losses...

If anyone wants to know how sensitive losses are to subprime default rates, take a look at S&P's recent report (thanks to MBIA for providing the report before Ambac :) ). The S&P report shows their stress results after raising the subprime loss rate assumptions. The report looks basic but something I was thinking about is the increase in loss based on the upward adjustment of the loss rate.

Dec 19th stress test subprime loss rates:
2005 5.75%
2006 15.5%
2007 17%

Jan 17 test:
2005 8.5%
2006 18.8%
2007 17.4%

They basically raised the rates by about 3%. I also notice that the new test is projecting lower loss rates in 2007 than in 2006. I wonder if they are understating the 2007 losses but it's really hard to say. It's confusing because most monolines stopped writing insurance for 2007 RMBS or CDO assets by the middle of the year.

The outcome of the test on Ambac is (after-tax losses):

Dec 19 2007 test: $1.8489 billion (927.1 million RMBS + $921.8 million from CDOs)
Jan 17 test: $2.249 billion ($968.9 million from RMBS + $1.2801 billion from CDOs)

So the loss increases by about $400 million, with most of the increased loss coming from CDOs.

So in a rough sense based on the S&P model, a 3% increase in subprime loss rate causes $400 million in losses. This is all rough and may or may not be the reality but it gives some rough idea of what to expect if default rates keep going up.



Let's see what happens during the conference call...

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