Does Anyone Even Know What an AAA Rating is?
I'm not trying to be arrogant but this post is going to sound like I am. Does anyone even know what a AAA rating for a company is? How many know the difference between a debt rating and a financial strength rating?
Unfortunately, it seems like a lot of the monoline bears don't seem to grasp the difference between a debt rating and a financial strength rating. The latest ones to mistakingly mix the two are monolines bears like Doug Kass (read his article here) and Mike Shedlock (erroneous Pfizer comparison here) (I actually think one should read their sites for sometimes insightful off-the-wall bearish views and I think both of these guys know more about investing than me--but not on this point :) ).
The holding company debt of Ambac and MBIA were never rated AAA. Even during the glory days a few years back, neither of these entities were rated AAA as far as I know. Instead, what is rated AAA is the financial strength of their insurance subsidiaries. What is the difference? Let's look at what S&P says...
The debt rating of a company refers to the ability of a company to pay its debtholders; the financial strength rating refers to the ability to pay an insurance claim. A financial strength rating is totally different. For instance, an insurance company has to hold statutory capital and its first obligation is towards its policyholders--not shareholders or debtholders! Even if I weren't biased in favour of the bond insurers, I would be more confident buying a policy from an insurance company rated AAA than to invest in debt from a company rated AAA. In fact, you might even be better off buying insurance from a BBB-rated company than investing in debt from a company rated AA.
Having said that, one can argue that the monolines don't deserve AAA or even AA. You can argue that but that's not what those I mentioned above are making. They are actually (mistakingly) comparing financial strength rating against a corporate debt rating. As it stands, the rating agencies feel confident in their ability to assign ratings (Accrued Interest has a good post on the fact that the agencies are stress-testing under extreme scenarios).
Another misleading statement made by some is to point out share price performance. Well, again, it needs to be pointed out that debt rating refers to the probability of defaulting on corporate debt (or the inability of an insurer to pay its claims in the case of financial strength ratings). Share price performance is typically not considered when evaluating credit (there are many exceptions but I'm speaking in general). The fact that the market price of a share is declining doesn't necessarily mean that the credit quality is declining.
If you can't see why share price movement should have little impact on credit quality, consider the converse case. Namely, imagine a stock price that is appreciating. The fact that a stock price is going up doesn't mean that a bond is better all of a sudden, does it? A lot of companies with very poor cash flow have stock prices that appreciate but would you, as a bondholder, get more comfortable without additional cash flow to speak of?
Now, some people argue that CDS (credit default swap) is indicative of credit risk. In theory I supposed it is. But I am not sure if is in practice. I know very little about derivatives like CDS so I don't have a strong opinion, but I am skeptical of them. My skepticism is due to the fact that they seem to be an illiquid, opaque, market. In any case, during stressful times, markets misprice assets and I believe that the monoline CDS may be too pessimistic (we won't know if I'm right for at least an year; for what it's worth, I remember buying exchange-traded GM bonds a few years ago when they were priced as if GM was facing imminent bankruptcy. Needless to say, GM never went bankrupt and its bonds are now trading much closer to par).
(Just for the sake for completeness, government bonds are also evaluted on a different scale from corporations. So, if you are investing in a country rated A, that's not the same thing as a corporate debt rated A. )
Unfortunately, it seems like a lot of the monoline bears don't seem to grasp the difference between a debt rating and a financial strength rating. The latest ones to mistakingly mix the two are monolines bears like Doug Kass (read his article here) and Mike Shedlock (erroneous Pfizer comparison here) (I actually think one should read their sites for sometimes insightful off-the-wall bearish views and I think both of these guys know more about investing than me--but not on this point :) ).
The holding company debt of Ambac and MBIA were never rated AAA. Even during the glory days a few years back, neither of these entities were rated AAA as far as I know. Instead, what is rated AAA is the financial strength of their insurance subsidiaries. What is the difference? Let's look at what S&P says...
ISSUE CREDIT RATING DEFINITIONS
A Standard & Poor's issue credit rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program (including ratings on medium-term note programs and commercial paper programs)...
The opinion evaluates the obligor's capacity and willingness to meet its financial commitments as they come due, and may assess terms, such as collateral security and subordination, which could affect ultimate payment in the event of default.
INSURER FINANCIAL STRENGTH RATING DEFINITIONS
A Standard & Poor's insurer financial strength rating is a current opinion of the financial security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms...
Insurer financial strength ratings do not refer to an organization's ability to meet nonpolicy (i.e. debt) obligations.
The debt rating of a company refers to the ability of a company to pay its debtholders; the financial strength rating refers to the ability to pay an insurance claim. A financial strength rating is totally different. For instance, an insurance company has to hold statutory capital and its first obligation is towards its policyholders--not shareholders or debtholders! Even if I weren't biased in favour of the bond insurers, I would be more confident buying a policy from an insurance company rated AAA than to invest in debt from a company rated AAA. In fact, you might even be better off buying insurance from a BBB-rated company than investing in debt from a company rated AA.
Having said that, one can argue that the monolines don't deserve AAA or even AA. You can argue that but that's not what those I mentioned above are making. They are actually (mistakingly) comparing financial strength rating against a corporate debt rating. As it stands, the rating agencies feel confident in their ability to assign ratings (Accrued Interest has a good post on the fact that the agencies are stress-testing under extreme scenarios).
Another misleading statement made by some is to point out share price performance. Well, again, it needs to be pointed out that debt rating refers to the probability of defaulting on corporate debt (or the inability of an insurer to pay its claims in the case of financial strength ratings). Share price performance is typically not considered when evaluating credit (there are many exceptions but I'm speaking in general). The fact that the market price of a share is declining doesn't necessarily mean that the credit quality is declining.
If you can't see why share price movement should have little impact on credit quality, consider the converse case. Namely, imagine a stock price that is appreciating. The fact that a stock price is going up doesn't mean that a bond is better all of a sudden, does it? A lot of companies with very poor cash flow have stock prices that appreciate but would you, as a bondholder, get more comfortable without additional cash flow to speak of?
Now, some people argue that CDS (credit default swap) is indicative of credit risk. In theory I supposed it is. But I am not sure if is in practice. I know very little about derivatives like CDS so I don't have a strong opinion, but I am skeptical of them. My skepticism is due to the fact that they seem to be an illiquid, opaque, market. In any case, during stressful times, markets misprice assets and I believe that the monoline CDS may be too pessimistic (we won't know if I'm right for at least an year; for what it's worth, I remember buying exchange-traded GM bonds a few years ago when they were priced as if GM was facing imminent bankruptcy. Needless to say, GM never went bankrupt and its bonds are now trading much closer to par).
(Just for the sake for completeness, government bonds are also evaluted on a different scale from corporations. So, if you are investing in a country rated A, that's not the same thing as a corporate debt rated A. )
Yes, the PFE comparison and Kass' article were both annoying. I was surprised to actually see one of the top/smartest posters on the MBI board buying into the fluff.
ReplyDeleteRumors now floating that Cerberus may want a piece of ABK. You may recall me mentioning here about that board member who resigned mid January being an employee of Cerberus - quite a coincidence...
"W. Grant Gregory resigned from the Board of Directors of Ambac in order to concentrate on his professional responsibilities as the President of Cerberus Operations and Advisory Company..."
BTW, the board seat is still vacant.
I'm still thinking Wilbur Ross will step in as well, and probably announce this weekend.
So things are moving along, but the numbers coming out of the housing sector, Fannie Mae, etc. continue to be absolutely abysmal. Still pretty scary, from a general eco point of view.
There have been so many rumours that it'll be interesting to see how it all works in the end. Unfortunately, there will be big dilution for existing shareholders.
ReplyDeleteHaving some private equity investors is far better than having the banks. I can see some conflict of interest with banks taking a big stake. If banks take a sizeable ownership, they won't necessarily act in the interest of other shareholders. The banks' main concern will be to ensure that any of their potential claims will be paid. Private equity, in contrast, will act like public equity. Furthermore, as you have pointed out before, private equity will provide expertise that is rare. Depending on the firm, they are good in taking positions in distress cases.
(But I will note that PE has had a rough time with some of their recent buyouts of GMAC/etc so their skill in analyzing debt needs to be questioned somewhat.)
As for the housing situation, I concur. The situation has been very bad. But as far as I'm concerned, what matters is not necessarily how bad the situation is; instead, what matters is what the market has priced in. When I invested in Ambac, it was as a distress case so what matters is what is already cooked into the company outlook. I remember David Dreman saying in his book that, at some point, negative news hardly has any impact on beaten-down stocks while positive news has a big positve impact (he wouldn't touch situations like this but the observation applies). If I'm not mistaken, Fannie Mae actually ended the day positive (or flat). Similarly, a lot of housing-related retailers have been posting horrible numbers but I think Home Depot actually ended the day positve a few days ago (when they announced their big negative outlook for 2008).
The dissapointing thing for me is management incompetence in not raising capital at higher prices. This is a truly tragic mistake! Existing shareholders are going to be fleeced. There is still some room (adjusted book value is higher; actual claims unknown; competitors (FGIC/FSA/etcA) getting shut out of muni bonds due them losing AAA--likely permanently)... Ambac may end up saving the world but the shareholders may not make it safely...
If a rights offering is served up to shareholders I'm hoping a possible arb card can be played. I pulled one off last year, albeit it was so ridiculously obvious that it scared me and I only made a few bucks out of it -
ReplyDeleteRevlon - 1 right to buy 1 share at $1.05. With one week till expiration, the rights were trading at .07 and the stock was at 1.27. Bought the rights at .07, exercised @ 1.05, then immediately sold the stock at 1.31, for a 19 cent gain, about 16%. It was one of those weird situations that, upon doing the calculations, I assumed something had to be wrong., hence my small risk on the play. It was shareholders dumping 100 mill rights on the market to no one interested in buying the underlying stock. Their loss, my gain.
It was easy with REV because exercise px was fixed whereas most are avg px over a pre-determined time frame. We'll see.
I have to correct myself due to my perpetually overly optimistic demeamor. LOL.
ReplyDeleteThe Revlong rights were (I believe) 3 rts to buy a share. The return was more like 4%. Revisionist history!
LOL... when I first read that, I was like... 'hmm... 16% is a small gain for him?' ;)
ReplyDeleteI was following Revlon as a potential investmetn opportunity before... gave up on it when I felt that there was a conflict of interest in Perlman having a huge debt ownership (Revlon was paying a lot in interest for the bonds so Perlman, even though he owned a huge chunk of the equity, seemed to have little interest in turning things around)...
I think if you short the stock then there might be a true risk arbitrage play there. Given that Ambac is fairly well-known company I think any opportunities will be slim unless you take a one-way bet.
If I had more money I would subscribe to the rights offering. Since I don't have much free capital, I'll likely have to get rid of the right. I'm not sure how taxes are handled for that situation...
Lordy. The market is so bad it even has Wilbur Ross going conservative -
ReplyDeletehe's putting money in AGO. Too funny.