Wednesday, June 4, 2008 13 comments ++[ CLICK TO COMMENT ]++

Moody's Likely to Cut MBIA and Ambac Ratings

Moody's says that it may cut MBIA and Ambac ratings:

Moody's Investors Service on Wednesday said it is likely to cut the top ratings of the bond insurance arms of MBIA Inc and Ambac Financial Corp, on concerns about mortgage-related losses and limited new business prospects...

The ratings on MBIA Insurance Corp and Ambac Assurance Corp are likely to be cut to the "Aa" level, which would be one to three notches lower than its current "Aaa" rating, though a drop to the "A" area is also possible, Moody's said.

It cited growing concerns that losses from residential mortgage-backed debt will be higher than expected and significantly constrained prospects for new business as reasons for the action.

MBIA and Ambac are also hampered from raising new capital, as their market capitalization has plunged and their cost of accessing the debt markets is very high, Moody's said.


It's a surprise to me but given how the rating agencies keep changing their mind, nothing coming out of them is truly surprising anymore. The market probably priced in a possibility of ratings cut given how the share prices of MBIA and Ambac are only down around 10% to 20%.

We won't know until Moody's releases their full analysis but it'll be interesting to see what has changed in the last few weeks to make them abruptly revise their opinion (they affirmed the opinion just a few months ago). Ambac and MBIA posted large HELOC and CES mark-to-market losses but, if I recall, Moody's simulated big losses in those assets before. Commercial real estate is another area that may have weakened recently (Ambac has no exposure here but MBIA does). The rating agencies have confidential information from the financial guarantors, as well as information from thousands of other credit instruments they rate, so they may be detecting something that is not obvious. The rating agencies also use subjective opinions of future business potential so that can also play a role (but business is actually stronger now than 6 months ago so that probably isn't the reason).

Well, Ambac management gambled by diluting the shareholders in order to maintain their rating, and it seems to have totally backfired. If Ambac and MBIA get downgraded, they will likely end up in a run-off state. They may be able to write insurance on structured products (especially lower quality stuff rated BBB or lower). Their municipal bond writing days will be pretty much over.

MBIA, run by Jay Brown, clearly doesn't like the Moody's decision and isn't planning to move the money raised a few months ago to the insurance subsidiary:

MBIA Inc. on Wednesday said it disagreed with Moody's decision to place the company's rating on review for downgrade and pointed out that there has been no adverse material changes in the environment. "We are surprised by both the timing and direction of this action and can only conclude that the requirements for a Triple-A rating continue to change," said Jay Brown, chairman and CEO of MBIA, in a statement. The mortgage insurer also said it will not funnel $900 million of cash held at the holding company to MBIA Insurance Corp. as it originally planned to since it was aimed at supporting its triple-A ratings.


MBIA is doing the right thing by holding on to the cash from the recent capital infusion. Unfortunately, Ambac seems to have moved the money to its insurance operation (I'm not entirely sure). The whole reason for the capital injection was to keep the AAA ratings and now that those ratings seem to be gone, there is no need for that money. Once you move it to the insurance subsidiary you have little control over it since insurance companies are heavily regulated and shareholder rights come behind others (this is not the case in a conventional corporation). Once the government gets its hand on it, you won't see any of it.

As I indiciated when the crisis started to get out of control early this year, Ambac should just go into run-off. That's the best situation for shareholders. I didn't like the capital raise plan but it was a management decision. If Ambac does get downgraded, it should go into run-off (unless they can somehow write insurance for structured products). They should try to sell off their assets to anyone that might want them, or just shut down everything and go into run-off. That's still the strategy that maximizes shareholder wealth (assuming you don't have AAA rating). However, I suspect management will not want to do anything like that (agency cost conflict). Management also signed on to (with shareholder approval) some massive golden parachutes and accelerated bonuses in order to retain employees so the cost is going to be high even if you go into run-off.

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13 Response to Moody's Likely to Cut MBIA and Ambac Ratings

contrariandutch
June 4, 2008 at 3:51 PM

Well, just when you thought you were near the bottom the abyss opens beneath you...

As Martin Whitman suggested might happen in his Q1 shareholder letter rating agency capriciousness is proving a serious problem.

I don't agree though that runoff is the best solution. As Radian Group has demonstrated there is decent demand for AA (Ambac's likely rating after downgrade) insurance and insurance rates are probably going to be very good at least for a couple of years. Also, if the damage ultimately turns out to be rather limited, a AAA could be had again.

For now, I will just have to suffer the psychological pain of sitting on a substantial loss I guess.

June 4, 2008 at 4:34 PM

Just when things were looking slightly better (some new business, some stabilization in the credit market, etc), it turns for the worse...

At least your price is nowhwere near my high price ($25ish) or even higher (those who owned the company for many years). I remember someone saying that these financial stocks may end up being like tech stocks back in 2000. Just because something dropped 70% doesn't mean it won't drop another 70%.

The book value is still higher than your price (I'm guessing on your price) so you should be ok. Your biggest enemy is management. They may destroy shareholder wealth in order to preserve their salaries and bonuses. It already happened once when they diluted the shareholders (although I wasn't totally against it) and there is nothing to stop them from looting or wasting more of what is left.

I don't see what they can do without a run-off scenario. A huge chunk of the company writes muni bond insurance, which pretty much requires AAA. What are all those highly-paid employees going to do? Ambac's latest press release says something about those resources benig moved to the Connie-Lee unit but you still need a AAA (unless they can capitalize Connie-Lee as a separate AAA unit--given that stories of private equity and hedge funds were thinking of creating AAA-rated units, Ambac can do that as well if its unit is totally seperate. But they don't have enough capital and the regulators won't let them move it anywhere).


Ambac has some hope with AA but it won't be easy. First of all, the way the rating agencies are going, there is nothing to stop them from downgrading them again. Chance of Ambac going to junk (lower than BBB) is pretty low right now, but what's to say it won't be cut to A- in a few months? I don't know if it's worth taking the risk on building a business when it can fall apart the next time the rating agencies do something. Recall that Fitch basically implied that no amount of capital will be enough for a AAA rating. Partly that's due to their incompetence in rating structured products but partly it shows that the rating agencies may never get a handle on anyting.

As for Radian, it has built its whole business on a AA rating. Ambac and MBIA never did and it won't be easy for them to do so. Furthermore, Radian is a mortgage insurer whereas Ambac and MBIA are primarily municipal bond insurers.

I agree with your thinking if your strategy is to concentrate on non-municipal stuff. In that case, you would still have to put the muni bond business in a run-off of some sort. There is room to write insurance for structured products with a AA or even A rating. Most of teh credit enhancement is for BBB-rated products (eg. practically all of Ambac's auto loans were originally BBB-rated). But the rating agencies may not allow you to write without more capital (or else you end up with potentially even lower ratings). Competition may also be a bit tough given that you will be competing against CDS contracts written by unregulated hedge funds (the big advantage insuers have over these guys is confidence that arises from insurers being forced to hold capital, but Ambac and MBIA don't have much confidence from anyone right now).

Even if Ambac goes into run-off, it doesn't have to be permanent. Unlike liquidation in other businesses, a run-off will still permit the company to start writing in the future if it wanted to. So it's not a total shutdown. However, you will lose your employees and any talent you had. If the Yahoo Finance numbers are correct, Ambac and MBIA have less than 500 employees so a run-off isn't quite the same as a "typical" company shutting down and laying off 5000 people.

June 4, 2008 at 4:41 PM

MBIA may accelerate its break-up... One of the advantages MBIA has is that it didn't deploy its $900m that it raised.

ContrarianDutch, what are your thoughts on the break-up idea? Ambac looked at it and it went nowhere before but that was likely because they were trying to keep a AAA rating. If your rating is lower, capital requirements should be lower for a break-up. Unfortunately, Ambac may not have this option if its capital is deployed...

contrariandutch
June 4, 2008 at 5:57 PM

You are right that my price is better then yours, I got in at $3 so that is almost certainly below book value, which is about $4 if the marks to market turn into real losses. Adjusted book is probably $10-12 even if the marks to market turn into real losses. So yes, I am still confident I should get out okay. Even so, losing 15% in one day on a really big position is a bit stomach churning. Perhaps what I am most annoyed about is that I could have gotten so much better a price with a little more faith in our bearish friends. But that's 20/20 hindsight speaking.

Suffering stomach churning losses occasionally comes with the territory when following a dedicated contrarian/value strategy. When the market turns on a stock there is no telling how ridiculously undervalued it can get. The opposite is also true. Many a bear has been splattered all over Wall Street trying to short a stock with no intrinsic value as it rocketed towards the moon. They always come down in the end, but calling a top on a speculative bubble is not for the faint-hearted.

I think there is a crucial difference between the tech bubble and the bond insures bust. The bond insurers have cash flow an capital and lots of it, the uncertainty is in possible losses on their insurance book. The wilder tech plays had no cash flow, no capital, just a business model and sometimes not even that.

I think splitting is a goos idea as the muni business is currently getting dragged down by the RMBS debacle. Splitting into two entities under a common holding company would prevent that in future. If MBIA get's downgraded I would fully support them using the $900 million they have to bankroll a fresh muni insurance unit. The existing muni business could get transferred. Either on the sayso of the regulators or in due time as the damage from the RMBS blowout becomes clear and it becomes possible to set the right amount of capital to cover for the losses and move additional capital in the muni unit without endangering the structured credit unit. In fact, I think Ambac would do well to try to get the regulators to enable them to split. Ambac can only do it with regulatory help as they don't have the cash to bankroll a fresh muni unit and have to pull capital out of the undivided business to the potential detriment of stuctured credit policy holders.

For shareholders splitting would probably great as I suspect the stand alone muni unit would immediately be worth much more then the combined businees is valued at now. It might even be a good idea to float a couple of shares in the muni subsidiary on a public market to make it's value apparent to the mark to market fanatics.

I actually think even a AA rated insurer could do well. Radian has build a substantial bond insurance book mainly on synthetic CDO's but they also take the weaker muni's. After downgrade Ambac and MBIA would go from weak AAA's to strong AA's and there is a market for that. Hedge funds have a problem in that they have to post collateral when a trade goes against them. Before this is over the street will be littered with the wreckage of hedgies who couldb't post collateral(remember Carlyle Capital? didn't lose a dime but blew up on margin calls). If staff become redundant, fire 'em. It's the US after all. As for a downgrade way below AA, the rating agencies would have a lot to explain (and S&P in fact seems to stick to the AAA verdict still) and if it turns out Ambac and MBIA sail through with little damage except for that inflicted by what will then be shown to be unwarranted downgrades they become sitting ducks for the mother of all class action lawsuits (could happen anyway if the very costly capital raises are ultimately found to have been entirely superfluous).

Going into runoff indeed does not stop you from resuming business later. However, with just skeleton staff, your underwriting expertise gone and your name sinking into oblivion it's going to be tough. I think it would be better to soldier on with a AA and focus on structured credit and weak muni's and try to get the AAA back later.

Note that I think the structured credit business actually looks very promising. It is likely to resume it's steady expansion once the current trouble blows over and prices for even AA wraps should be good in a nervouw market.

In fact in retrospect (again with the 20/20 hindsight, if only I could be half as good at seeing the future...) Ambac should have forgotten about raising capital given the terrible price of it's shares and just take the downgrade on the chin. Sure, costs them muni business but they are not writing much of that anyway and the downgrade may still come. Management really dropped the ball on that.

I do not think management was thinking about their own pay when raising the extra capital. Even in runoff Ambac will be around for decades as it's contracts slowly unwind and it wold be paying it's staff all that time. Most likely Ambac management are a bunch of absolute computernerds who were clueless on the psychological aspects of the financial markets just when that psychology focused intensely on their company. I can just here them thinking "our models show $1.3 billion losses tops and we can pay ten times as much, what are all those slavering idiots going on about???". Of course nervous rating agencies then pretty much told them " raise capital or lose the AAA" and they didn't think they had a choice.

contrariandutch
June 4, 2008 at 6:20 PM

There is a good article on bankstocks.com arhuing why RMBS losses may not be nearly as bad as many observers believe.

June 4, 2008 at 8:10 PM

Thanks for the lengthy post ContrarianDutch. I appreciate you taking the time to elaborate on your thoughts. Some responses...

TIMING

It's too bad your timing was off but that's the nature of investing--and I'm sure you know more about it than a newbie like me. When I invested in Ambac, the stock plunged 70% within 3 days! It was a totally weird feeling for me. Not exactly sad or displeased, but rather bewildered. I was following Ambac for months, and thought the 60% (or whatever) decline over the last year meant most of the pesssimism was priced in. Boy, was I wrong. Benjamin Graham said to buy stocks 50% to 75% of book value and Ambac was something like 60% (I think). Unfortunately there has been so much write-down that it is still 50% of book value (meaning the value dropped significantly). To make matters worse, I took a concentrated position with a huge chunk of my portfolio (only saving grace is that I don't have much money and I'm somewhat young). Oh well.

The good thing, though, is that most of the losses are mark-to-market losses. These losses can turn out to be real losses but it is not certain. In contrast, if you were investing in an industrial company or a retailer or whatever, and if the book value dropped 70% then there is little chance of getting that back (except with a highly optimistic case of strong profits in the future). All Ambac, MBIA, FGIC, et al, need is for mortgage losses to be reasonable and for the marks to reverse.

SPLIT

The split won't be quite a clean split where the bad portion can be ignored. It will be difficult to get the regulator to agree but I wrote a post a few months ago speculating that it may be possible. It happened in property & casulty insurance before but hasn't happened in the bond insurance world as far as I know. MBIA seems to be pursuing a split idea (even before the current action) so it may happen. As you pointed out, MBIA has $900million whereas Ambac, due to management incompetence or rating agency misguidance, doesn't.

Anyway, it'll be interesting to see what happens. FGIC, a monoline that was downgraded deeper a few months ago, was supposedly pursuing a split. I haven't heard any stories lately but they were much further ahead than Ambac or MBIA ever were.

ONLY COMPETITIVE ADVANTAGE

I remember saying this when Berkshire Hathaway Assurance entered the market (or maybe it was when Wilbur Ross capitalized Assured Guaranty): the key competitive advantage that MBIA and Ambac have now is structured products. Contrary to many out there, I actually think that is the future (things like credit card loans, auto loans, student loans, etc are in their infancy in many emerging markets). Ambac and MBIA also have expertise in that area that other monolines and CDS-writing hedge funds/investment banks/pension funds don't have. I'm not even sure if any more than 10 or 20 institutions can price ABS of auto loans (for example). On top of that, the AAA-rated monolines (Berkshire Hathaway Assurance, Assured Guaranty, FSA) likely won't ramp up structured product insurance given the uncertainty due to the mortgage products.

I agree with you that hedge funds and investment funds writing CDS contracts are no substitute for insurance contracts in the long run. Similar to your thinking, I think we'll start seeing some big implosions soon. The unregulated parties writing CDS are going to be no different than fly-by-the-night merchants. However, right now, the market loves these unregulated parties writing CDS in an insurance-like manner without holding any capital.

MANAGEMENT

I'm not as confident in Ambac management as you are, after seeing them give away 2/3 of Ambac at depressed valuations through some highly questionable share offering. The share offering wasn't even backstopped by any banks that were discussing with them and I don't think anyone participating in the offering were made to sign contracts preventing them from shorting the stock (shorting the stock while participating in an offering is a hedging strategy but it can drive down the price). The worst thing is, I don't know who owns Ambac right now. Given that more than 50% of the company was diluted, it's not clear who ended up buying the offering. Anyway, that's the past.

We'll see what management does now. Dumbest thing ever will be to raise more capital (they said they are not going to but they said the same thing before and changed their minds)...

The positive out of all this is that the stock is only down around 17%. I'm not downplaying your big loss on a sizeable position but this stock is highly volatile. It's one of the most volatile stocks in the last 6 months on the NYSE. It isn't common for it to move 5% to 10% in one day on seemingly no news. So I'll take a 17% drop on extremely bad news (dropped from S&P 500 as well).

I'm curious to see if S&P cuts them as well or not.

June 4, 2008 at 8:13 PM

Oh one thing I disagree with you on... these companies can't sue the rating agencies. They won't win and I don't think they should (even though I will benefit from a lawsuit win). Rating agencies simply provide OPINION and I think it would be unreasonable to expect anything more. If rating agencies can be sued then you can literally sue any analyst that is wrong. It will seriously curtail freedom of speech. I'm sure your fellow freedom-loving-Dutch friends might agree with me :)

synchro
June 4, 2008 at 11:36 PM

http://accruedint.blogspot.com/2008/06/monolines-let-me-see-you-with-my-own.html

I feel sorry for the MBI/ABK shareholders (see above link on obituary/analysis) -- except those shares held by Martin Whitman and Bill Miller. Those guys should have known better. Their recklessness and lack of risk controls cost their fund investors millions.

For a perspective of how a _true_ value investor or acuurately labeled "contrarian" investor should think and behave, one should read FPA Capital's Robert Roddriguez latest annual report

http://www.fpafunds.com/capitalfund_downloads.asp

Rodriguez is the true value investor you guys should be modeling after.

Marty Whitman took leave of his senses starting last November 2007.

Bill Miller and David Dreman are lost causes.

synchro
(the "anonymous" poster on the Sears thread)

June 5, 2008 at 11:34 AM

Hi Synchro,

I don't mind hearing the dissenting views from bears. I actually had a long post on why you guys are going to have a tough time in the future but it was lost :( Maybe I'll write about it later. The big risk for you guys is that shorting has a higher cost than going long. Your max upside is 100% and you have to wait a long time. For example, is Sears likely to go down 50% or go up 50%? It can pay off but you still have to wait. David Einhorn, for instance, has been short MBIA for 5 years. William Ackman has been short for even longer. The only reason they are not bankrupt is because they were skilled in shorting via CDS. CDS contracts were underpriced over the last few years and it doesn't cost much to hold. In contrast, those shorting via the stock or options probably lost a bundle.

Ambac may go bankrupt and I never claimed to be a successful investor. But I find it kind of sad that you would chop down Whitman and Miller, who have extremely good long-term records, just because of the last couple of years.

I'm not taking anything away from Robert Rodriguez but (i) his history is shorter, and (ii) he made a big chunk of his money with overweight in energy. According to information on his site, 25% of his holdings (capital fund) are in energy. As Miller has pointed out, most of his issues can be summed up with two issues (i) underweight in energy, and (ii) poor performance in financials.

In the long-run, Whitman and Miller have done well. I know you are saying that they have lost all the experience and skill mastered over teh last few decades within the last year, but I beg to disagree.

Rodriguez is a very good investor but I'm not sold on him yet due to his heavy energy holdings. I'm bearish on energy and it's not clear if he is riding the commodities boom or actually has good stockpicking skills. Don't get me wrong: he is still very good but not yet in the category of Whitman or Miller in my eyes. It's just like William Ackman, who has done exceptionally well (i) by shorting monolines, and (ii) financial engineering (eg. McDonald's, Target). Although he is good, it's not clear how good Ackman really is. For instance, if we enter a bear market or credit is tight, financial engineering may go nowhere. Target isn't going to do well just because you sell off the credit card division or whatever.

sc
June 5, 2008 at 2:53 PM

Where do you think the run-off value of ABK/MBI is?

contrariandutch
June 5, 2008 at 3:34 PM

Sivaram,

First of all, I didn't intend to belittle your own Ambac loss or be condescending. If it appeared like that I apologize for my careless wording.

Second, I am probably not much older then you (didn't you write somewhere you are thirty?)

Third, big losses come with the territory of trying to buy companies dirtcheap. Sometimes they become even cheaper, by a lot... I have seen 50% unrealized losses (but not in one day!) and seen them reverse as well just in the last year. I still don't like it.

Fourth, it may take quite a long time to find out who is ultimately right about Ambac and MBIA. In runoff I think Ambac is worth $10-12 if marks to market turn into real losses. (Book value is about $4/share, there is about $4 billion coming in for the next five years so accounting for costs and NPV of the income stream, I think that adds $6-8).

Fifth, A split will not be clean but currently Assured Guaranty, with a fraction of the muni insurance and some RMBS problems of it's own, is worth more then Ambac and MBIA combined. A split could reveal the value of the muni business currently drowned in RMBS fears. It would also restore the ability to write muni business which is otherwise just not happening (especially not now that S&P has suddenly cut to AA foreclosing any possibility of keeping a AAA on the combined companies).

Sixth, I fully agree there is probably good business in stuctured credit. If anything, prices should be much better in the near future.

Seventh, even in runoff, if marks to market even partially reverse this will be a great investment after all (even at $25/share Abac could be good in the end).

Eight,

Synchro, you really don't know yet how this will turn out (nobody does). As for comparing guru's, I am not especially fond of it, but here goes. According to there respective last annual reports mr. Whitman and mr. Rodriguez (or rather their funds) have remarkably similar performance. Since fund inception FPA (Rodriguez) has returned 16.24% yearly and Third Avenue Value (Whitman) 16.83% a year. Whitman wins on the ten-year term with 12.63% annually against 9.7% for Rodriguez over that period.The five year term is another Whitman win with 22.35% a year against 15.67% a year for Rodriguez. Over the one-year before october 2007, Whitman wins again with a 19.25% return against 11.15% for Rodriguez. Seems to early to write off Whitman. The chart Sivaram links to graphically demonstrates the difference in the last ten years. In all, I would rather have Whitman's returns over any longer reference period so who should I model after? I also would not be comfortable with the kind of large energy related holdings Rodriguez has. Energy has done well for several years now but it's future performance is heavily linked to macro-economic developments that are impossible to predict with a high degree of confidence.

So I guess I will stick with my current approach for now.

June 5, 2008 at 4:59 PM

ContrarianDutch,

Sorry about the misunderstanding. I didn't mean to be rude but was perhaps expressing my dissapointment. I didn't mean to be rude to you by the way... Interesting day for sure. You can see how the stock price has divorced to any reality when the stock rallies 5%, and reverses some of the losses of the prior day, on the day ratings are cut. The stock market had a big up day but it's still interesting to see big rallies...

---------

SC,

I'm not sure what the run-off value is but it is likely higher than the stock price. BUT that depends on a lot of 'if' and 'but'. ContrarianDutch provides some rough guide, which is sort of my thinking as well. Basically it will come down to how badly the mark to market losses will behave...

I think book value is still the best measure to use when evaluating insurers but there is a lot of uncertainty...

Won
June 20, 2008 at 1:30 AM

Moody's downgrades Aaa rating of Ambac, MBIA
By Wallace Witkowski
Last update: 6:13 p.m. EDT June 19, 2008
Comments: 41
SAN FRANCISCO (MarketWatch) -- Moody's Investors Service said late Thursday it cut the Aaa ratings of bond insurers Ambac Inc.-0.04, -1.9%) and MBIA Inc. (MBI:
MBIA Inc
Moody's downgraded Ambac's insurance financial strength rating to Aa3, and MBIA's insurance financial strength rating to A2.

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