Still Not Sure I Made A Mistake With Ambac
One of the toughest things to figure out in one's life is whether they are living in denial. This was the case with love for me; now I wonder if my investing mind is messed up or not. I still don't know if I'm in denial or if my original views are correct. It's still not clear that I made a mistake. Check out this Barron's article on MBIA to see why I am still sticking with my views (for the most part).
The article's views run parallel to what Martin Whitman was saying in his fourth quarter commentary, and my original investment thesis. The run-off value just seems so high compared to the stock price (to gauge run-off, I'm looking at book value (and for more optimistic scenario, adjusted book value)). If MBIA can actually maintain its AAA rating, their revenue will be very high compared to claims.
Ambac, now that they've lost their critical AAA rating, will have lower revenue so it isn't as rosy but the liquidation value still looks really high (at least $20+ per share). The revenue won't be as high as my expectation when I invested in the stock a few weeks ago (due to loss of muni bond insurance business). I'm trying to come up with some estimates of reasonable future revenue and potential payouts for Ambac. For example, Ambac earned around $400 million last year simply from their investment portfolio (conservatively managed; bonds-only with 85%+ AA or AAA rating, although a big chunk is in mortgage and ABS securities). I want to wait for Tuesday's conference call to get some insight on Ambac's future strategy.
What Can Go Wrong?
What can derail this thinking is if losses are much higher than what the rating agencies estimate, and what the bond insurers have marked on their books. Ignoring the specifics of an RMBS or CDO deal, the subprime default rate needs to pass 19% for these companies to go bankrupt. The rate was around 14% during the middle of last year and I'm not sure what the default rate was near the end of the year. Since the monolines almost completely stopped insuring the risky stuff by late 2007, our main concern should be the early to mid 2007 performance (as well as 2006).
The holding company can go bankrupt if the state regulator blocks payments from the insurance subsidiaries. Given how politicized the mortgage mess is becoming, this is actually a risk. If the government starts manipulating things, as Jim Cramer and others are pushing for, the shareholders of bond insurers may end up with nothing.
Lastly, it can take a long time to unlock the value of the insurer. In the worst case, as crazy a this may seem, it might take 30 to 50 years before the bond insurance subsidiaries pay off their claims (they only have to pay interest and principal as originally scheduled, and mortgage products have a long committment). Not only will shareholders be dead by then, the annualized returns will be negligible... In the best case, things may be resolved within three years. The subprime crisis will end by then and either the mark-to-market losses turn out to be too high (shareholders will get back the reserved capital) or is not enough (company goes bankrupt).
My Game Plan
I said this looks like Buffett's American Express but may be it is Buffett's Berkshire Hathaway, the original textile--one of Buffett's worst investments. The game has completely changed now that Ambac has lost its AAA rating. I don't think I'm going to make much money on this (although the possibility exists due to what I covered above). My plan now is to minimize losses. See what Ambac plans to do without their AAA rating and do more research to see how much business potential exists for below-AA muni bonds (looking at the 2006 annual report (p44), it looks like 64% were A or below. But I suspect revenue loss will be even greater because there may not be much benefit from enhancing something from A to AA).
Ambac management has a bunch of paths they can take but one of their big ones is whether to keep their existing AAA-oriented business model (in the hope of regaining the rating later in a few years), or to shelve that completely. If they decide to shelve the AAA model, they may sell off most of their muni bond business or shut it down. In the latter case, Ambac will have to take some charges related to layoffs, office closings, and the like.
The article's views run parallel to what Martin Whitman was saying in his fourth quarter commentary, and my original investment thesis. The run-off value just seems so high compared to the stock price (to gauge run-off, I'm looking at book value (and for more optimistic scenario, adjusted book value)). If MBIA can actually maintain its AAA rating, their revenue will be very high compared to claims.
Ambac, now that they've lost their critical AAA rating, will have lower revenue so it isn't as rosy but the liquidation value still looks really high (at least $20+ per share). The revenue won't be as high as my expectation when I invested in the stock a few weeks ago (due to loss of muni bond insurance business). I'm trying to come up with some estimates of reasonable future revenue and potential payouts for Ambac. For example, Ambac earned around $400 million last year simply from their investment portfolio (conservatively managed; bonds-only with 85%+ AA or AAA rating, although a big chunk is in mortgage and ABS securities). I want to wait for Tuesday's conference call to get some insight on Ambac's future strategy.
What Can Go Wrong?
What can derail this thinking is if losses are much higher than what the rating agencies estimate, and what the bond insurers have marked on their books. Ignoring the specifics of an RMBS or CDO deal, the subprime default rate needs to pass 19% for these companies to go bankrupt. The rate was around 14% during the middle of last year and I'm not sure what the default rate was near the end of the year. Since the monolines almost completely stopped insuring the risky stuff by late 2007, our main concern should be the early to mid 2007 performance (as well as 2006).
The holding company can go bankrupt if the state regulator blocks payments from the insurance subsidiaries. Given how politicized the mortgage mess is becoming, this is actually a risk. If the government starts manipulating things, as Jim Cramer and others are pushing for, the shareholders of bond insurers may end up with nothing.
Lastly, it can take a long time to unlock the value of the insurer. In the worst case, as crazy a this may seem, it might take 30 to 50 years before the bond insurance subsidiaries pay off their claims (they only have to pay interest and principal as originally scheduled, and mortgage products have a long committment). Not only will shareholders be dead by then, the annualized returns will be negligible... In the best case, things may be resolved within three years. The subprime crisis will end by then and either the mark-to-market losses turn out to be too high (shareholders will get back the reserved capital) or is not enough (company goes bankrupt).
My Game Plan
I said this looks like Buffett's American Express but may be it is Buffett's Berkshire Hathaway, the original textile--one of Buffett's worst investments. The game has completely changed now that Ambac has lost its AAA rating. I don't think I'm going to make much money on this (although the possibility exists due to what I covered above). My plan now is to minimize losses. See what Ambac plans to do without their AAA rating and do more research to see how much business potential exists for below-AA muni bonds (looking at the 2006 annual report (p44), it looks like 64% were A or below. But I suspect revenue loss will be even greater because there may not be much benefit from enhancing something from A to AA).
Ambac management has a bunch of paths they can take but one of their big ones is whether to keep their existing AAA-oriented business model (in the hope of regaining the rating later in a few years), or to shelve that completely. If they decide to shelve the AAA model, they may sell off most of their muni bond business or shut it down. In the latter case, Ambac will have to take some charges related to layoffs, office closings, and the like.
This Tuesday's conference call may well be the most important in the co's history. There's no point pretending the gun at their head is a toy and continue the sorry state of denial that has been their m.o. the past 6 months.
ReplyDeleteObviously it will be imperative that they are forthright and honest. They must face reality and whatever plans they have for survival are credible. If they blah blah blah about doing whatever it takes to regain the AAA it will only further enforce that they are living in a dream world. It never ceases to amaze me how management can become so disconnected. And they get paid big bucks for what?
One of the major problems going forward will be holding onto those smart and talented risk managers on the muni side that are probably in a state of shock and feeling totally betrayed by superiors they once respected. What do they have to look forward to? What is their incentive to stay?
And what about other products that may feel the heat of an economic downturn? The credit card, auto loan, mobile home paper? I believe David asked about that. What is their exposure there? It's not just subprime. A 19% stress seems to imply defaults in prime paper as well. Or am I missing the mark?
You have written some great analysis on Ambac. You and AI, and others have really done heads up work over the past few months. It's too bad Ambac didn't listen. A deer in the headlights. They should sit down with Evercore & Marty whitman and get some advice. It sure wouldn't hurt.
Great post as usual CAK. I totally agree that Ambac is likely entering one of its most important periods in many decades--if ever! As you say, I also hope management actually fleshes out their strategy instead of leaving everything hanging. One of the biggest mistakes the company made was not announcing a solid capital funding plan last week, when I think they actually had something. All else is history.
ReplyDeleteIt's unfortunate that everything is falling apart, not just for shareholders like us, but also the employees. It's a cruel irony that all the problems are from the structured products side yet the employees who will face the uncertain job prospects are on the municipal bond side.
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The 19% figure being thrown around is generally for the subprime stuff. The thing is, we should have a good idea of what the reality is within 6 months. If the economy has entered a recession, as some have said, subprime defaults will likely peak within 6 months (or maybe within 3 quarters). Now that Ambac has lost its AAA rating, it should just focus on developing a business with an AA rating, and waiting to see what happens by the end of this year. It can also lose that rating but it is supposedly a lot easier to maintain it (from what I understand).
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As for other ABS, I looked at it before I took my position in Ambac and it didn't seem like a huge worry to me. The big exposure was in auto loans and student loans (credit card debt, etc was small).
You WILL see increased defaults in auto loans and student loans. Itès to be expected given that the economy is slowing. But one would expect Ambac to have taken prudent risks. Thatès what insurers are supposed to do.
Autos and student loans have a longer history (and didnèt see the same massive boom as housing). People are also less likely to default on them. For example, people need a car for work so they need something. As for student loans, I read somewhere (unrealiable source) that it is hard for new grads to default on student loans (supposedly some canèt default at all--not sure how true that is).
If there is a worry with thse non-housing stuff, itès the fact that car loans have mostly BBB-rated collateral (check Ambac website: selected exposures on the menu). But the BBB rating was the original Ambac rating so I assume that they priced it as if they were really BBB and risky (in contrast, note that most of the mortgage stuff were rated AA or AAA before being downgraded).
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The ABSOLUTE BEST THING that can happen to us is if Martin Whitman takes a stake in Ambac (he has a tiny one but we need something big enough to influence Ambac). He is perhaps one of THE BEST distress investing specialists on the planet!!! In my opinion, he is even better than Warren Buffett in distress situations (Buffett usually does not touch distress assets except some rare cases via convertible bonds). If he canèt maximize shareholder value when the ship is sinking, very few others can.
I was just going through Bill Ackman's presentation again and was thinking of scenarios where he may have been right and where he may be wrong.
ReplyDeleteI think where he may be wrong is if the bond insurers purposely give up their AAA rating and try to operate at a lower rating. Some of his analysis looks at excess capital of Ambac (and MBIA) as being around $1 billion, but this is above the AAA-required level. The excess capital above AA requirement will be higher. He is basically betting that a downgrade is the death of the company.
I don't know how easy it is going be for Ambac to survive with AA but that's what they have to do. Live without AAA for the first time since the early 70's (if I'm not mistaken). Let's see if Bill Ackman is right...