Thursday, June 5, 2008 0 comments ++[ CLICK TO COMMENT ]++

S&P Cuts Ambac and MBIA to AA... What Next?

S&P announced that it is cutting Ambac and MBIA to AA. The parent holding companies were cut to A and A- from AA and AA- for Ambac and MBIA, respectively.

Standard & Poor's Rating Services today lowered its financial strength ratings on Ambac Assurance Corp. and MBIA Insurance Corp. to 'AA' from 'AAA' and placed the ratings on CreditWatch with negative implications.

The ratings on the holding companies, Ambac Financial Group and MBIA Inc., have also been lowered to 'A' and 'A-' from 'AA' and 'AA-', respectively, and placed on CreditWatch with negative implications. The rating actions on the companies reflect our belief that these entities will face diminished public finance and structured finance new business flow and declining financial flexibility. In addition, we believe continuing deterioration in key areas of the U.S. residential mortgage sector
and related CDO structures will place increasing pressure on capital adequacy. The 'AA' financial strength ratings of these companies are supported by currently sound claims paying ability and liquidity levels in our opinion.

Not much of a surprise to anyone following the situation. Kind of interesting how S&P beat Moody's to be the second to downgrade even though Moody's announced its review first. They were literally waiting to see if the other would downgrade first.

Both companies seem to be way above AA requirements so chance of further cuts are unlikely for a few months (or until the rating agencies feel like changing their models again :( ). However, MBIA will be under slightly greater threat due to its CMBS exposure (commercial mortgages).

An average company that is rated A or A-, or an insurer rated AA and AA-, would be more than happy with that rating but it's not good enough for bond insurers. For example, my other insurer (a reinsurer actually), Montpelier Re, is only rated BBB and would be happy with anything containing the first letter of the alphabet. For those not familiar, the core business of bond insurers is something called credit enhancement. That's basically the tactic of lowering debt costs by using a higher rated bond insurer to back the bond. The lower the rating, the less likely a bond insurer can attract business. It's not too difficult to get a AAA rating if you have adequate capital. Berkshire entered the market a few months ago without doing much and Macquarie bank, out of Australia, is almost ready to launch a AAA-rated bond insurer (what is difficult, though, is developing a reputation or developing models and skills to value risk). Furthermore, muni bond insurance, which used to be the core business at most monoline insurers, involves raising already high ratings (often A or higher) to AAA so that's almost impossible without a AAA rating.

Utter Failure of Management Strategy

Well, Ambac management rolled the dice twice and fucked up both times. First time by underwriting risky mortgages (before my time). Second time, after I invested, when they heavily diluted shareholders in order to reain the AAA rating against the wishes of many shareholders including me. The message from long-term shareholder, Evercore Asset Management, which I agreed with, fell on deaf ears and management just wasted anywhere from $1 billion to $8 billion with their failed strategy (high estimate is the cost of forgone capital gain if there is a recovery). It's always dissapointing when highly compensated executives destroy billions in a short amount of time (a working class person like me would never lose that much money and would be fired if I did that).

Anyway, it's a strategic mistake--albeit a very large one--and it's understandable when it comes to investing. Even good intentions can end up backfiring (consider Eddie Lampert, who is considered a top-notch capital allocator, spending billions buying Sears stock at $150+. He wasted billions and it didn't improve the business, lowered employee morale, and ended up looking amateurish given that the stock is currently below $100. That's all in hindsight and my point is not to say that I'm better than Lampert but that strategic actions can fail). I just hope that management doesn't do something stupid right now. One of the dumbest things management can do is to reverse-split the stock (if prices drops) or sell off good assets at depressed prices.

Now that Ambac's destiny is not tied to rating agency actions, government regulator threats (particularly from Elliot Spitzer, before he left the scene), or investment bank pressure, it's all down to fundamentals. I suspect all the monolines, including Ambac and MBIA, won't make the front page news for a while.

I think the stock price may decline further but a lot of negative news is being priced in. I know I said that when the price was $25 but, quite frankly, the mortgage losses haven't deteriorated as much as the stock price indicates. Yes, stocks are forward-looking and they are projecting life-time losses but even that looks questionable.

The Future

I'm not an expert on insurance but I am a shareholder and probably care about the company more than most people out there, including management. This is doubly so given that I run a concentrated portfolio and have a huge chunk of my net worth (however small) invested in it. I think there are many strategies Ambac can pursue. The downgrade actually removes pressure to do anything in a rashful manner. So Ambac can sit and think things through. It also opens up several avenues that weren't available before. When they had to maintain the AAA rating, they didn't have much of a capital cushion to do anything. With AA, they have a big cushion and they can contemplate various activities.

Their strategies include selling their muni bond business. They can't sell their obligations but they can contemplate selling their technology, employee skills, risk models, and so forth. If that doesn't happen, they should shut it down. Ironically, the structured product side is what caused all the problems, but the employees on the muni bond side, who really didn't do anything wrong, may be the ones to lose all their jobs!

Another possibility is to rise from the ashes as a reinsurer. Reinsurance is much easier and you can probably do it easily with AA rating.

The "split" option is still something to consider. MBIA seems to be pursuing it vigorously and others who are downgraded much further below AA were purusing it a few months ago (heard no word recently on how that's going).

Another wild option is to start a new bond insurer. As I mentioned above, it doesnt' require much as long as you have the capital (Ambac and MBIA need more capital if they go this route). The regulators will be unhappy with it but they may not be able to do anything to quash the idea (if they do, I think it should be easy to win in a court of law--why can Macquarie with private equity (zero experience in insurance) start a bond insurer and Ambac can't?). So far, their press release from today says that they were contemplating starting a "new" AAA-rated bond insurer using their Connie Lee subsidiary (this is in run-off right now).

Prior to the rating agency announcements this week, Ambac had been accelerating its efforts to launch a new AAA-rated financial guarantor utilizing Connie Lee, a fully-licensed financial guarantee subsidiary of Ambac Assurance Corporation. Connie Lee would be recapitalized with surplus capital from Ambac Assurance and, potentially, from one or more third parties. Ambac Assurance currently has substantial excess capital available under both Moody’s and S&P’s capital models.

Michael Callen, Chairman and CEO of Ambac, commented, “We believe there would be strong demand for a stable AAA financial guarantor focused solely on guaranteeing the obligations of both municipal and global public finance. We also believe that, based on its proposed capitalization and business plan, the new Connie Lee will receive regulatory approval and will attract stable AAA ratings. Ambac remains committed to working closely with S&P and other rating agencies not only to further explain the details of our insured portfolio and the results of our active portfolio remediation efforts, but also to explore all strategic options available to us.”

I'm not sure if that plan was feasible without a downgrade or irrespective of the downgrade. I have a bad feeling about this plan--at least for the time being. It requires capital injection and we know how that turned out last time right? Management has a strong incentive to keep their jobs even if it doesn't help shareholders. It's not a bad idea but the details will be important.

Let's see if management earns their salaries. Executives are really paid for situations like now. At other times I feel that they just coast off the workers below them...

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