Wednesday, January 30, 2008 0 comments ++[ CLICK TO COMMENT ]++

Thoughts on Ambac and Other Monolines

Maybe I'm making a newbie mistake, with my stubbornly bullish view, but I just don't see the Ambac problems everyone is talking about. Ambac can go to zero but I don't know how one can say that for sure right now.

Concern About Government Intervention

One of the risks for shareholders is that the insurance regulators may seize control of the insurance company from the holding company. Bill Ackman, and others, have been attempting to get the regulator to do this for a few years now but I don't see this happening any time soon. Ambac will either have to default on its obligations or it has to be fairly certain that losses are far greater than the claims paying ability. So far neither of that has happened. Of course, anything can happen when the government is involved but I'm comfortable with what is happening. The insurance regulators seem to be on good terms with the monolines (at least Wisconsin and New York seem to be) so I see low risk of any adverse action from them.

Splitting Muni Bonds from Structured Products

Although Ambac and others have fairly separate muni bond insurance and structured product operations, I highly doubt that they can be split up easily. Something like that may happen if and only if the government seizes the company from the holding company. Until then, it is unlikely. The parent company won't let that happen since the rating agencies and customers perceive the claims paying ability as that of the total entity. For example, when Ambac says it has something like $16 billion in claims paying ability, that should technically be for both the muni bonds and the structured products. You can't just allocate all of the capital to the muni bond; or even split it evenly between the two.

Capital Injection

I still feel that using reinsurance on the muni bonds is still Ambac's best bet right now. That alone won't be enough but that should be used along with other means. I have no idea how costly that would be right now but if we go with something similar to the Assured Guaranty deal ($25billion ceded for $250million in capital), Ambac may have to cede $50 billion to $100 billion of muni bonds. This is basically selling the crown jewels but at some point the jewels are less important than maintaining the kingdom. The problem is that I'm not sure who will be willing to provide that much reinsurance at a reasonable cost. Maybe if those private equity investors and vultures set up reinsurance operations instead of bond insurance firms.

Am I Just Being Too Stubborn--and Wrong?

I still don't see big losses for the monolines. I keep thinking about where my thinking is wrong; I just don't see it. Let's revisit this issue (refer to Ambac's CDO document for reference; all charts and tables are from that document). Ambac has other exposures but I think we should just look at CDOs and CDO-squareds, since that is where the problems are.

The above charts break down the CDO exposure. The BBB and BIG exposures only amount to around $4.3 billion. Even if they were written down to zero (there should be some positive recoveries) you are looking at $4.3 in billion losses. How about the highly rated segments?

I am still maintaining my faith (to a large degree) in Ambac's internal ratings. As long as Ambac is still rating securities as A or higher, I think I am comfortable with them. Yes, they can--and some will--get downgraded but my thinking is that most of the bad events have already started unfolding. The following shows the securities that I feel are a big threat:

I highlighted some items that are worth noting. The big question marks are the CDO-squareds, which in total amount to $2.5 billion, and McKinley Funding III, which totals around $1.2 billion.

The CDO-squareds are going to be close to a total loss. The actual performance will come down to recoveries I think. The CDO-squareds have high attachment points but they are almost entirely mezzanine CDOs (as underlying collateral) so the picture is not so bright here.

The McKinley Funding III security is pretty big and is a concern. Analysts asked about this in the conference call and, well, all we can do is wait and see.

There are a whole hoard of others who have been deteriorating and are now rated around A. These will determine the future of the company. The reason I am still reasonably bullish is because until these drop into the BBB (or below) area, I just don't know how someone can say there are going to be massive losses.

The other thing to note is that the Markit ABX Home Equity indices are stabilizing--or at least it seems that way. The ABX indices likely indicate a worse picture than what the monolines are exposed to (since monolines should have some skill in picking lower risk over higher risk--that's what insurance companies do; and have higher attachment points). Nevertheless, we can look at it as a market pricing indicator.

Here are some Markit ABX index charts. I just picked a few from 2006 and 2007 to gauge the situation.

It's hard to say for sure but the 2006 stuff looks to be stabilizing, while the 2007 indices are still showing weakness. The BBB-rated indices, especially from 2007, shows massive losses. It remains to be seen what transpires over the next few months. There are some economic stimulus being directed at citizens that may lower the subprime default rates (eg. tax rebate, interest rate cuts). We just need to wait and see what happens with the economy.

Decision for Shareholders

If someone purchased one of the weak monolines recently, they have to make a decision on whether to sell and take a loss, or to hold. Some can also try hedging by buying puts but I don't know much about options and don't know how expensive they are. I entered late so I feel less of a panic and am willing to hold for the time being. My view has always been to wait for a few months and see how the subprime default situation unfolds. The big surprise to me was the fact that Ambac didn't raise the $1.5 billion I was expecting.

I hate to say it, but if the monolines recover, Neanderthal may have sold almost right at the bottom around $5 (actual bottom was around $4.50 I think). If one is to exit the position now, it should be based on the belief that things are going to deterioriate; don't do it just because it is getting scary. The fact that Bill Ackman will be releasing a new report should not influence your view much. He is an activist investor and will do things like that. If one is concerned, they can also come up with a hard limit and set a stop-loss order and forget about it. The stock has a possibility of gapping down but that's a risk you take.

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