Wednesday, February 20, 2008 0 comments ++[ CLICK TO COMMENT ]++

Bond Insurer Random Thoughts

Well, I don't really have anything insightful to say about what is happening in the monoline world. There are too many uncertainties, and too many competing plans floating around. I'll present some bearish and bullish articles I ran across...

Accrued Interest has a blog entry pointing out that a split is perhaps the best for Ambac. The author pretty much sums up the present predicament for the AAA-rated mononlines. I made a lengthy pos in the comments area so check that out if you are interested in my thinking. The way I look at it, a run-off is still a possibility for shareholders if the cost of maintaining a AAA rating is too high. But I am not sure if the government, shorts, or other parties are going to like that. I would be supportive of a split if (i) the government provides cover for any lawsuits from structured products insurance buyers, (ii) capital infusion doesn't cost "too much", and (iii) present shareholders get a piece of the muni bond business (if the split involves "spinning off" the muni bond business in some manner and leaving the structured product side for present shareholders, it would be very bad for shareholders--I am confident that management won't contemplate such a scenario).

Bill Ackman is supposedly presenting a "new" plan to save the monolines. I haven't looked at the details of his "new" plan but it sounds pretty much like his old plan. To recap, his main strategy has been to cut off dividend payments to the holding company in order to bankrupt it. He supposedly has a huge position in CDS on Ambac and MBIA bonds (along with short positions in stock, and ownership in put options). I suspect his CDS contract is too big and too illiquid to unwind so he has to constantly call for a bankruptcy of the holding companies. Fortunately, the New York bond insurance regulator shot down the plan. Nevertheless it's dissapointing to see that the media is giving such credence to his ideas. I can't think of too many cases where a short-seller has come to represent the interests of the industry and its customers.

Here is an article from Matt Koppenheffer writing for The Motley Fool and presenting his view that the stock price charts for Ambac and MBIA look like the point where Wile E. Coyote falls off the cliff. Apart from the over-used cliche, he goes on to reference an old post from 2002 predicting some of the problems that the monolines are running into now, and mentions that someone who shorted the stock back then (2002) would have made 70%. Sounds like a big number but over a period of 5 years, that's only around 11% annualized if I'm doing my numbers right. Given the risk with shorting and the need to pay dividends, I'm not so sure that is worth. Having said that, note that short-sellers like Bill Ackman use CDS contracts (Ackman also uses CDS on the long side eg. BGP). I suspect this is to avoid the downside of shorting a stock directly (of course, the CDS market has its own set of issues such as illiquidity and the inability to exit a position unless the company defaults).

Reuters summarizes the legal risk of splitting in this article. Pretty basic article but sort of touches on the unknown issues.

We touched on the issue of whether the bond insurance industry makes sense in the past before the current meltdown, but here is Portfolio magazine questioning the validity of bond insurance (they actually call it a racket). As I have remarked before, if bond insurance makes no sense why was anyone buying it for decades? The fact of the matter is that bond insurance improves efficiency in the underlying market. Just like how house insurance avoids the need for you to precisely calculate the risk of losses for a house you buy and then make a huge bet, bond insurance commoditizes the market and lowers the cost. Also claiming that the bond insurers charge too much and have a high profit margin misses the fact that the insurers have to keep large capital on hand (depressing returns). In fact, if someone thought the bond insurance was a racket then wait until they see the costs of bond issuance go up significantly if the insurers fall.

If there is anything positive in the monoline world (not for me but for others :) ), well, it's the fact that the monolines have been a daytrader's dream. The stocks consistently have daily moves of 1% to 5% one way or another. Astute traders are making a killing I'm sure.

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