Tuesday, August 5, 2008 1 comments ++[ CLICK TO COMMENT ]++

Evercore July Shareholder Letter

Thanks to gurufocus message board poster, vgm, for mentioning Evercore's views regarding the bond insurers. For those not familiar, Evercore Asset Management was one of the investors who asked Ambac not to dilute shareholders early in the year. It was a position I completely agreed with and, unfortunately for me, Ambac still went ahead and raised capital at highly dilute prices. That move by Ambac basically wiped out 2/3 of my investment in Ambac. Management gambled and failed but that's the past.

Evercore released a letter in July discussing their views. Their view still hasn't changed much.

(source: Update of Ambac and MBIA, July 3 2008. Evercore Asset Management)

When we purchased Ambac and MBIA, our research led us to believe that there were two primary ways in which our investments could lose value: either the actual losses sustained on insuring products backed by mortgages would exceed the companies resources or, in an attempt to shore up their claims paying resources and maintain their AAA rating, the companies would raise capital in a way that was dilutive to existing shareholders.

Unfortunately for a lot of shareholders, the latter has occurred. To make matters worse, the capital raise was completely unnecessary given that Ambac got downgraded anyway and the rating agencies are using a new system where having capital above their requirements don't matter.

On the question of ultimate real losses (as opposed to “mark to market” losses which may or may not become real), we actually feel better about the outlook than we did a few months ago. Early on, we developed estimates of losses in the range of $4‐$5 billion for each company. We remain comfortable with those estimates, about half of which have been realized to date.

That's in the ballpark of what the rating agencies are projecting. The market, for what it's worth, is projecting around $12+ billion in losses.

More importantly, there is little to indicate, at least thus far, that the losses are spreading to other parts of the portfolio. Not to commercial real estate, not to auto loans, not to student loans, and not to credit cards. Of particular interest, while this crisis has come to be known as the “subprime mess,” the true subprime portfolios at both companies are performing particularly well; losses on these books will ultimately be measured in the hundreds of millions, not billions, of dollars.

One of the big uncertainties is whether the situation will get out of control for non-mortgage ABS such as student loans and auto loans (these two are Ambac's big exposures outside RMBS and muni bonds.) So far nothing to indicae any problems. GM and Ford have recently indicated that they are seeing deterioration in leases and auto financing. Ambac hasn't been engaged in auto secrutizations, or any other structured finance insurance, for almost an year. So their exposure is from several years back and, unlike real estate, autos are priced with depreciation taken into account. Haven't heard anything on the student loan front, other than some lack of availability (makes sense now that monolines aren't participating and investors are wary of any risk.)

Rather, what we are saying is that losses of this magnitude are manageable and will leave the equity holder with adjusted book values of approximately $23 per share in the case of ABK and $40 per share in the case of MBI. Put another way, implicit in the current stock prices are additional pretax losses of $13.0 billion for ABK and $15.5 billion for MBI; we just don’t see that as being at all likely.

These are all adjusted book values so if you want to be conservative, you should go with book value (adjusted book value takes into account things like future premiums and stuff like that.) The massive shareholder dilution pretty much means that my investment will be loss (unless I average down). The question is how much the loss will be. One also needs to keep in mind that it can take years for any value to be returned to shareholders. So it's definitely a long-term investment.

Evercore speculates on three reasons that may be driving down the share price:

If we’re even close to right about all of the above, it’s fair to ask why the stocks are performing so poorly. We see at least three broad reasons:

First, both companies have lost their AAA ratings, despite the fact that the ratings agencies themselves acknowledge that both companies exceed the AAA minimum capital requirements...

Second, the bears (primarily hedge funds with bearish positions of one kind or another) continue to attack the companies relentlessly. Most recently, they have argued that the downgrades would trigger a liquidity crisis within the company’s asset management businesses as a result of collateral posting requirements and account terminations triggered by the new ratings...

Third, and perhaps most importantly, these companies are caught in the crosswinds of the banks, brokers and others trying to hedge the mortgage exposures they carry on their own balance sheets. To do that, these institutions have entered into trades which effectively make bearish bets against anything that might be tied to the housing downturn, either through short sales of the equities or through the purchase of Credit Default Swap protection. While this has impacted many financial firms, nowhere has the impact been greater than in the case of the monoline insurers, where CDS protection is seen as a direct hedge against the wrap ABK and MBI have provided on many of the bonds these brokerage firms hold.

The last point is the strongest argument in my opinion. Just like how the ABX index has been heavily shorted as a hedge, the monolines are the ideal entity to short if you want to hedge your mortgage exposure. In addition, the monolines are also the perfect short for a chaos trade (i.e. expectation of huge, but low-probability, disaster). If you are hedging a credit bust, the monolines are the best ones to short because they insure credit risk.

Check out the full letter if you are interested in the monoline case...

Ambac earnings are out tomorrow (August 6th)... expect some fireworks...


1 Response to Evercore July Shareholder Letter

August 29, 2008 at 11:22 PM

They are starting to look not so dumb...

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