Saturday, March 8, 2008 2 comments ++[ CLICK TO COMMENT ]++

Ambac's Swan Song...plus MBIA Thoughts

Well, Ambac just gave away 2/3 of its company. Last week was probably the worst feeling for me as an investor. It's one thing to take investment losses because of poor business decisions or market price fluctuations. But it's another when management does something that one feels is not sufficient. Ambac, one of my biggest holdings, just gave away 2/3 of the company with a huge stock issuance at a very low stock price.

Ambac completed its $1.5 billion capital raising plan outlined earlier this week. The deal is horrendous for shareholders but it satisfies Moody's and S&P--for now.

Ambac Financial Group, Inc. today announced that it has priced its $1.155 billion public offering of 171,111,111 shares of common stock...at $6.75 per share and has granted the underwriters a 30-day option to purchase up to an additional 25,666,667 shares of common stock to cover over-allotments, if any.

In addition, Ambac announced that it has concurrently priced its $250 million public offering of 5 million equity units, with a stated amount of $50 per unit. The equity units carry a total distribution rate of 9.5%. The threshold appreciation price of the equity units is $7.97 which represents a premium of approximately 18% over the concurrent public offering price of Ambac’s common stock of $6.75 per share. Ambac has granted the underwriters a 13-day option to purchase up to an additional 750,000 equity units to cover over-allotments, if any.

Ambac also placed 14,074,074 shares of common stock in a private placement for $95 million with two financial institutions.


If anyone needs an example of terrible executive management of a business, this provides a good example. The original plan was scrapped, and led to losing its AAA rating from Fitch, because the share price of $5 was too low. Now, after months working with bankers, they end up raising money at $6.75. Is this why you pay bankers hundreads of thousands per year for?

The big problem I see with the current strategy is the half-hearted nature of it. They either should have gone into run-off or raised far more capital at better rates. If you are going to dilute shareholders, why not attempt to raise a lot more money. Given the massive dilution, 10% or 20% less doesn't mean much.

Ambac's main bankers, who I believe are Credit Suisse, who is also the lead underwriter to the current share issuance, should also be fired! They may well have ended up issuing shares near multi-decade lows. I also don't know why Ambac didn't do a rights offering where existing shareholders would have at least got something for giving away their company. I feel like Ambac, led by Michael Callen, is essentially lying by saying that a public offering benefits shareholders when in fact it doesn't do much. Credit Suisse is also supposedly the bank that leaked the detailed security information to Bill Ackman for his open-source model so I don't know why Ambac still keeps them. I think Bill Ackman dislcosing the information is good, but when it comes from confidential bankers it raises a lot of questions in my eyes.

Impact of Dilution

Pre-dilution
shares outstanding: 101,550,000
book value: $2,275,735,500
book value per share: $22.41

Post-dilution
capital injection @ $6.75/share: $1,249,999,999
shares outstanding: 286,735,185 (101,550,000+171,111,111+14,074,074)
new book value: $3,525,735,499
new book value per share: $12.30

For those that did not participate in the offering, we are looking at a company that is worth around $12/share (if you assume mark-to-market losses are real). Adjusted book value is slightly higher but that is a long-term value that cannot be unlocked within 10 years in my opinion.

This pretty much takes away one possibility that existed for existing shareholders: run-off. Run-off, which is basically liquidation/bankruptcy for an insurance company, would have yielded a much higher return for existing shareholders. I assume that either management is looking out for itself and/oor is incompetent; or was forced into this move by the New York state regulator. I think the latter is probably the reason. Eliot Spitzer came out with guns blazing and, although they really can't do anything unless Ambac defaulted on its claims, scared management into diluting shareholders.

The only way 'old' shareholders will see a positive return now is if mark-to-market losses reverse. I think the marks are not real and will reverse but it is hard to say when or by how much. Otherwise, the stock is worth $12 if you assume price-to-book-value should be 1.

Looming Conflict of Interest

There is a potentially big problem for existing shareholders with Ambac's plan. I will note that what I'm about to say here is speculation on my part--for the time being. We don't really know who purchased the new shares in Ambac. There is speculation ranging from investment funds (like Legg Mason) to private equity (Cerberus) to the banks that bought insurance. It looks like the private placement, which was very small, went to private equity or hedge funds (likely Cerberus). The vast majority of the shares may have been purchased by banks who bought insurance from Ambac. We don't know for sure.

If banks (who also purchased insurance from Ambac) do end up being the biggest buyers of shares, it is extremely detrimental to existing shareholders. It's one thing if they had provided a line of credit, bought debt, or even invested in the surplus notes. But it's another when they buy shares and end up with ownership. Since around 66% of the company was given away, it is quite possible that the banks, who are also buyers of insurance, now own the majority of the firm. There are two problems I see with banks owning Ambac.

The first problem is that banks, who bought insurance, tend to be conservative and may have working relationships with Ambac. One of the problems in Japan in the 90's was the keiretsu cross-shareholdings. Banks in Japan held large cross-ownership positions in many Japanese companies. This seemeed good when times were good, with the banks lending money, financing projects, and so forth. But some argue it was a disaster when Japan went into its long decline. The banks cared more about the companies paying them back than about improving the company. Many companies avoided taking on more risk, or trying to innovate, or change the corporate culture. This ended up creating, what I would call, zombie-like corporations that were big and powerful but didn't change with the times.

If banks take majority ownership of Ambac, I can see Ambac turning into a zombie. Instead of being innovative and trying to win business, the banks will want to simply maintain the status quo and avoid risk. In other words, the banks would want to get paid first as insurance buyers rather than as shareholders. In essence, you end up with a situation where a company is almost run by its debtholders rather than the shareholders. This was the case in Japan. According to some, one reason Japanese companies don't take on more debt is because the banks who have cross-shareholder ownership don't like it (it makes sense: the banks, who were taking huge writedowns elsewhere due to bad loans, were the creditors so it's bad to take on more debt; whereas shareholders will be in favour of a reasonable increase in debt).

The second problem is that banks may simply end up perpetually diluting shareholders forever! A "normal" shareholder will never let this happen since you are losing the value of whatever you own. However the banks have an economic interest in doing so. As Bill Ackman and others have pointed out, structured finance insurance buyers, particularly the banks, get a "ratings arbitrage" through the insurance companies. That is, the banks have higher capital requirements than insurance companies like Ambac. It is far more expensive for a bank to write down assets than it is for a monoline. Given that Ambac's shareholders don't care about ratings (except for the ability to write new business), whereas the bank insurance buyers do care, you can see the conflict.

For example, let's say Ambac is unable to write new business due to its business being permanently damaged. In such a case, a "normal" shareholder will want to go into run-off (i.e. liquidation). If the business can't generate new business, you liquidate the business or sell it off. It's as simple as that. However, a bank, who is an insurance buyer, will not want to do that. They would want to keep AA- (or higher) rating, or else they will have to take mark-to-market charges on their books. I can easily see the bank continuously diluting shareholders in order to keep high ratings, even if those ratings don't help generate business.

I don't know if management did this on purpose (to give up ownership to the banks) or if they were just too incompetent to see the potential problem here. I hate to say it but it wouldn't surprise me if Michael Callen, being close with Citigroup (the owner of Ambac in the 80's), decided to take it back under the wings of the banks. Warren Buffett always says that management is important because if they don't act in your interest, you are screwed. This is doubly so for OPMI (outside passive minority investors) like everyone reading this blog. I hope I am wrong with my distrustful view of Ambac's management but I really wonder why they didn't use debt-like instruments (surplus notes, debt, loans, etc) instead of giving away ownership via shares. I mean, even preferred shares would have been a whole lot better!

I will repeat that this is all pure speculation on my part. It may very well be that most of the shares were bought by existing shareholders, private equity, or mutual funds. The problem I mentioned above doesn't apply if these are the new majority owners. The best thing is if we can keep insurance buyers from taking ownership of Ambac.

Final Thought

The dissapointing thing to me are twofold. First of all, it turns theoretical losses into real losses. I never felt the share price really indicates anything but when you dilute your book value, that is a fundamental loss. Secondly, I feel it is a weak plan even a dumb guy like me could have come up with. Ambac initially decided not to raise capital because the price of $5 was too low. Well, now they end up issuing shares at $6.75, which is almost the same as before.

Essentially all this means that this is the last move as far as existing shareholders are concerned. Even if Ambac survives in the future, any additional dilution will likely be lethal to the existing shareholders. Furthermore, the new owners are not necessarily the same as the old ones and they may have different interests.



Bizarre Ambac Stock Price Movement

As I have remarked before, a day doesn't go without some excitement of one sort or another in the monoline world. There was some bizarre stock price movement in Ambac shares on Friday.


(source: finance.yahoo.com)


There was a huge block trade at the end of the day on Friday that caused the shares to jump. The price is down after-hours so I'm not sure if this is a data error or not.

If this was a real trade, I wonder if it is the underwriters (or some affiliated party) covering their hedge (short) position. Since no one backstopped the Ambac offer (although there was unofficial support supposedly), the underwriters may have hedged their position by shorting the stock. It also would have been in the interest of the underwriters to drive the stock price down as much as possible, then participate in the offer and then cover their position.

If you get a sense of disgruntlment with management, you can see why. How can you price your offering without any backstop and then possibly allow the involved parties to short the stock? The line between hedging and picking up shares cheap gets very blurred when management and Ambac's banker advisors sign these deals. I'm not even a well-paid banker or one with financial expertise and even I can see how ridiculous this plan was. To see a more professional and competent capital funding plan, look at MBIA. MBIA's offer was backstopped and it was at a fixed price which was nowhere near a stock price low.



Now for some action from Ambac's rival...MBIA...


Well, You Have to Hand it to Jay Brown

He sells off his exotic car collection and invests his money in MBIA. He postpones retirement and decides to take one of the toughest chief executive jobs out there. And he decides to complete the cycle that he started, when he led to MBIA into the structured product insurance business. He also caps his career by confronting his old nemesis that he defeated in the past, Bill Ackman of Pershing Square. The guy I'm talking about is, of course, Jay Brown, the CEO of MBIA.

He certainly has his critics, especially since MBIA pursued the structured product business under his watch in the early 2000's. But, boy, talk about coming out with guns blazing. He certainly doesn't mind confrontations. There were three confrontations that he initiated: (i) against Bill Ackman, (ii) against tax-sheltered insurers, (iii) against Fitch ratings agency.

Battle Against Ackman

The battle against Ackman is well known. Brown was possibly the person that placed the final straw broke the camel's back with Bill Ackman's prior hedge fund. Although Ackman had other issues with some real-estate deal gone bad, his investors probably pulled out their funds after SEC initiated an investigation due to MBIA's prodding. Ackman didn't do anything wrong and the SEC stopped its investigation but that was too late. Ironically, MBIA restated earnings and had to pay a fine (so Ackman was right) but it came out ahead. A similar thing may happen now. It is quite possible that MBIA may take big losses, though not as bad as Ackman's estimates, but Ackman may have to leave the battlefield. MBIA can survive much longer than Ackman can and I suspect that he will unwind his short positions long before MBIA ever goes bankrupt.

Attack on Taxes?

I wondered what the hell he was doing when he started talking about the tax benefits of off-shore insurers. Now I see what his tactic was--it's quite smart. It has less to do with taxes than deflecting the problems and attacking your main competitor.

The biggest threat to MBIA is not Ambac. We know that. Contrary to popular opinion, neither is it Berkshire Hathaway Assurance Corporation (BHAC). Berkshire charges too much and Buffett isn't doing anything special to help the crisis. He mostly seems to charge a lot and write insurance on top of the existing monoline insurance which doesn't really do much for the insurance buyers. This is one reason muni bond yields are exceptionally high, and structured product issuance has completely dried up (BHAC plans to write zero insurance for structured products). This is very lucrative for BHAC but you are not going to gain market share doing that. I suspect that BHAC will also withdraw from the industry when premiums decline in a few years. We can also rule out FGIC and SCA, whom likely won't retain their AAA rating. So, now does it seem obvious who the biggest competitor to MBIA is? It's Assured Guaranty (AGO).

Assuming MBIA survives ad regains some credibility with potential customers, Jay Brown correctly perceives the big battle with Assured Guaranty in the future. Although AGO is small, it can tap capital from Wilbur Ross and hence can become a formidable opponent. I'm not sure how long it takes to build up an operation anywhere near the size of MBIA (probably takes 2 to 5 years) but AGO will be trying to seize the opportunity.

By attacking AGO's tax-haven status, and threating to re-locate to a tax haven, Jay Brown is shifting the wrath of the government onto AGO. In the past none of this mattered (since MBIA and Ambac totally dominated the business on both sides, muni bonds and structured products). But with their weakened state, MBIA likely needs all the help that it can get. All it takes is for a few municipalities, which are by defintion run by politicians, to start favouring American-based insures and you can see what Jay Brown is trying to accomplish. There is also the remote chance the government may lower taxes for the monolines (highly unlikely but you just never know).

Generally, initiating some attack via the time-trusted excuse of 'unfair taxation of tax-havens' doesn't get far. But given that MBIA's status and reputation are near all-time lows, it has the benefit that any down-and-out person has: they lose nothing by trying something drastic. I like Jay Brown's move here.

Likely End of Fitch's Monoline Rating Business

The most drastic move by Jay Brown has been his attack on Fitch ratings. He asked Fitch to withdraw their ratings for MBIA's insurance subsidiaries (full letter he sent along with Fitch's response here). It still wants Fitch to continue issuing debt ratings (so this move is only in regards to the financial strength ratings assigned to insurance companies).

You can get some justification for his thinking behind his move by reading his March 3rd letter to owners. Fitch's models have always been the toughest and, as you may know, it was also the only rating agency to cut Ambac to AA.

What MBIA is doing makes sense but it is a risky move (since the market may perceive it as an attempt to hide losses). MBIA gives the standard excuses which have nothing to do with the real reason for this move. For instance, MBIA says Fitch tripled its fees and it is too expensive. MBIA is paying Fitch $850,000 to rate its insurance subsidiaries but that isn't a big deal (it's still lower than the $2million or $1.65m paid to Moody's and S&P, respectively).

The real reason for the move is that Fitch is not only aggressive with its cuts (it may cut MBIA in the near future), but because Fitch literally says that there is no way to assign a AAA rating to any structured product insurance company. This puts the monoline insurers with exposure to structured products at a huge disadvantage. It is very hard to compete in a business where ratings matter, when new entrants or those without structured product exposure can easily get a AAA rating.

I was always somewhat surprised that Fitch can't put a dollar figure on the amount of capital required to properly insure structured products. The main value-added job of rating agencies is to come up with ability to pay claims and if you can't do that then why are you even in business? Certainly it accomplishes nothing for MBIA, Ambac, and others, to pay Fitch for nothing.

If Ambac also follows through (speaking as a shareholder I hope so, since we don't need to pay an agency to say 'no amount of capital is enough', this is basically the end of Fitch's rating of monoline insurance subsidiaries (note that this is not the same as rating debt). With the (formerly) two largest insurers not paying Fitch, it will be hard-pressed to continue with any credibility. It won't have access to confidential information from MBIA and Ambac, and hence won't be able to do as good a job. It can use public information but that's nothing valuable and the market won't pay them for it. I suspect that others with structured product insurance, like FGIC, CIFG and ACA will also stop paying Fitch in the future.


Epilogue

In chess, the most powerful piece (not counting the King) is the queen. Warburg Pincus brough back Jay Brown and that is the queen here (I realize this isn't as good fit in terms of gender but that's not the point). MBIA is taking huge risks with the queen and basically playing for a win right here. The Fitch move, in particular, could backfire if insurance buyers perceive that as arrogant and hiding a risky business.

I hope Ambac doesn't wither away into a zombie-like state and actually plays to win as well. As the down and out Bill Miller says of his current strategy, "As things fall, you've got to play more and more offense, not defense."

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2 Response to Ambac's Swan Song...plus MBIA Thoughts

Anonymous
March 10, 2008 at 9:21 AM

Fairfax Financail did the same regarding Fitch in 2003. It worked for them. http://fairfax.ca/Assets/Downloads/Press/fpr2004-08-31.pdf

March 10, 2008 at 11:47 AM

Thanks for pointing out the past move by Fairfax...

I don't really care what Fitch does but if Ambac (or others) are paying them for the ratings, then there is nothing wrong with dumping Fitch. It can backfire right now but credibility of the monolines are near all-time lows so there isn't much to lose...

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