Friday, February 29, 2008 2 comments

Ambac Lowers Dividend and Goes Easy on Structured Products

Bond insurers have somehow managed to transform a breathtakingly dull corner of the financio-sphere into an action-packed, thrill-a-minute spectacle filled with dire peril, a torrent of rating-agency press releases, and eager entreaties from big-name billionaires.


BusinessWeek captures what I have said previously. I hope those sitting on the sidelines are enjoying the show. A day doesn't go by without some potentially market-moving news emerging from one of the monolines. After the market closed, Ambac indicated that it is lowering the quarterly dividend to $0.01. It also indicated that it will not write structured finance insurance for 6 months. Supposedly this frees up $600 million. They are also discontinuing some areas that aren't expected to perform well.


Decoupling Theory Weakening

I have never been one to accept the decoupling theory. In case you are not familiar, this is the theory that postulates that emerging markets do not depend on the US economy anymore. The thinking is that one can avoid market corrections by investing in foreign countries.

The first few months of this year has put that theory to test and it hasn't held up well so far. Plotted below are the US$ year-to-date returns for some key countries (using Dow Jones indexes).

As things stand at the end of February, USA had a return of -9.2% versus -7.8% for the world (including USA). Most of the countries are posting negative returns. Canada is holding up well due to strong commodity prices but my guess is that it will fall when the US economic slowdown is certain and the effects of the 'Subprime Virus' works its way throughout the world. Japan--a market closely watched by me--is holding up well due to strengthening of the Yen.

Historically all the world's stock markets have been influenced by each other (except for small and/or obscure, undeveloped, countries). I think when all is said and done, the world will be no different now than it has been for the last century. Decoupling theory seems premature...


Ambac Deal Hits A Wall

UPDATE: Ross says his investment in AGO does not preclude him from putting money into one of the other monolines through AGO. In plain English this means that AGO may entertain the thought of offering reinsurance to others (obviously at better rates than Buffet's ridiculous offer). Since Ambac is pursuing a very large capital injection I don't think they will consider reinsurance for the time being (however, given that the structure of the deal is constantly changing, anything can happen).

I hate to be posting a lot of unsubstantiated speculations but Ambac is a big, critical, holding for me so I'm following it closely. The latest rumour from CNBC is that the Ambac deal being put together by a consortium of banks, private equity, and other interests, has hit a wall.

The snag was hit Wednesday, when raters said they wanted to see more capital injected in the bond insurer if it is to get a triple-A rating, after the consortium of banks had agreed to come up with $2.5 billion in capital.

The interesting thing is that the shortage of capital seems to be due to the 'split'. The proponents are going to go back to the original plan of keeping the company together:

The consortium will now come up with another structure, which keeps the two together, which could mean that they would need even less capital to keep their triple-A rating, sources close to the deal said.

My guess is that the rating agencies are demanding a high amount of capital for the structured product side during a split. My feeling is that the structured side probably has enough capital (with the $3billion plan) for an AA- rating but the consortium may be pushing to keep that side at AAA (or very close to it).

In other news, Wilbur Ross has decided to invest in Assured Guaranty. This is surprising to me since AGO isn't really facing any problems and can easily raise capital from public sources. Investing in AGO doesn't involve much risk and I wouldn't really consider it a distress situation. If I recall, they didn't write any subprime mortgage insurance since 2004 and the stock is only down around 30% from its 52wk high (vs around 15% for S&P 500).

MBIA also mentioned that further writedowns in January are likely and that they didn't write much new business in January. None of this is really a surprise to me. Ambac and MBIA market share was basically close to zero in January. The additional writedowns are to be expected but the important thing to me is whether they are smaller than before. MBIA has exposure to commercial real estate (Ambac doesn't) and we have seen some deterioration on that front as well.

Wednesday, February 27, 2008 6 comments

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...


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.


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. )

Monday, February 25, 2008 0 comments

S&P February 25, 2008 Stress Test and Ratings Action

Well, I never thought that the monolines, who, even during their best days, are not even one-tenth the size of a decent bank, would have the power to rally the world markets as much as they did. The rallies in the last two days have been massive; but this also makes me concerned that there could be a big sell-off if positive news don't emerge. In any case, the cause of the rally today was favourable action towards MBIA and Ambac from the ratings agency S&P.

S&P carried out a new stress test and took the following ratings action (you can get their detailed report from their website):

  1. FGIC: Rating cut from AA to A; credit watch with developing implications
  2. XL: Rating cut from AAA to A-; credit watch negative
  3. CIFG: AAA affirmed (negative outlook)
  4. MBIA: AAA affirmed (negative outlook); removed from credit watch
  5. ABK: AAA affirmed; credit watch negative

(Assured Guaranty, FSA, Radian, and SCA were not reviewed for various reasons)

Nothing surprising in my eyes so there isn't much to say with respect to the actions. I should note that S&P's model has always seemed to post lower loss estimates for Ambac and MBIA than Fitch and Moody's. So I never really felt that it was a big hurdle to pass the S&P test. The real issue is with Fitch, who is very tough, and Moody's, who is supposedly the most respected rating agency. Recall that the whole present episode in the monoline theater was started with Moody's threatening to downgrade. I think it is more important to see what Fitch and Moody's say.

I haven't looked in detail to see what assumptions were changed in this stress test versus the prior ones. Compared to the December test, the monolines are taking much bigger losses.

(source: Detailed Results Of Subprime Stress Test Of Financial Guarantors, Standard & Poors, February 25, 2008)

Ambac is short by $400 million here, while MBIA is adequately capitalized, and FGIC is short by $2 billion. If Ambac raises close to $3 billion, that should be more than enough to satisfy S&P.

What should shareholders make of these stress tests? It's difficult to say. Clearly the rating agencies have a bigger credibility problem than the monolines. But one would assume that they will get a handle on the situation and start modelling things properly at some point. After all, they have some of the best, highly educated and well-paid analysts working for them. If the present rating agency modelling turns out to be correct, it's actually good news for shareholders. On the surface, it looks like there are huge losses that will occur. But remember that these are stress tests. Some of the assumptions likely won't materialize unless we get another Great Depression.

On another note, MBIA cut its dividend completely and is saying mark-to-market losses will likely be high in the first quarter. The weak first quarter is a dissapointment but the real question is actual losses. Ambac should also cut the dividend since it isn't helping anyone. Yes, you will lose some dividend-oriented index funds that blindly buys high yielding stocks but getting rid of the dividend may provide some ammunition against Bill Ackman and others who claim the holding company is draining reserves.

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Saturday, February 23, 2008 4 comments

Ambac's Final Few Moves

Sticking with the chess analogy I had been using for months, it looks like Ambac will make its final few moves soon. After the strategy being discussed below is executed, it will come down to waiting and seeing how subprime mortgage losses and recoveries. If things deteriorate much further, the company is done for (from a shareholder point of view). Sadly for me, I was investing with the view that Ambac would have raised around $1.5 billion a few months ago. Management made a huge mistake and we are now raising greater amount in worse market conditions. Anyway, we just have to play with what we have (it's a good lesson for investors I guess).

The Plan

Originally reported by CNBC, bankers are close to finalizing the capital injection plan for Ambac. If rating agencies approve the plan, it will supposedly be unveiled Monday or Tuesday:

Under Ambac’s plan, one part of the company would guarantee relatively safe municipal bonds, while the other would insure more complex securities backed by mortgages and other debt.

The company also hopes to raise $2.5 billion through a rights offering to its existing shareholders; the sale will be backed by banks. Ambac also plans to raise roughly $500 million in new debt, according to the person who has seen the plan, who was not authorized to talk about it.

The banks, which include Citigroup and UBS, delivered a draft of the plan to Ambac and credit ratings agencies on Friday, and the company is expected to give its formal consent soon. Officials involved in drafting the plan hope the two new subsidiaries will both receive triple-A ratings, though the firm backing mortgage-related bonds could be rated slightly lower.

There are essentially two stages involved. One is to raise $3 billion. The other is to split the companies. I suspect the expectation is to keep the muni bond business rated AAA, while the structured product business is kept AA or higher.

Capital Injection

Ambac's proposal seems to entail a $2.5 billion rights offering, along with $500 million in debt. Needless to say, this is going to involve massive dilution for shareholders but it will keep the muni bond business functioning. We don't know the details yet but let me speculate on a possibility.

shares outstanding: $101,550,000
market capitalization: $1,087,600,500
book value: $2,275,735,500
book value per share: $22.41

capital injection @ $7.50/share: $2,500,000,000
shares outstanding: 333,333,333
new book value: $4,775,735,500
new book value per share: $14.33

In the example, I'm picking a case where they offer shares at $7.50 (a 25% discount). I'm not sure if that is too small of a discount (yes, the discount may need to be bigger :( ) but it seems somewhat reasonable. In that case, book value per share will drop to $14.33 from $22.41. Given the big discount in the stock price, it's hard to say how the stock price will behave.

This pretty much means that old investors will have a tough time making money unless (i) they participate in the offering in order to avoid dilution, or (ii) mark-to-market book value losses reverse in the future. The adjusted book value slightly higher but that still won't be enough overcome the dilutive effects.

Anyway, let's wait and see the terms before making a decision.

Splitting Insurance Companies

Splitting an insurance company can mean a lot of different things. For instance, if you split with one subsidiary reinsuring another, that's totally different from if a split results in diverse units with different ratings. As far as I know, it hasn't been executed by monoline insurers before. However, it has been pursued by other types of insurers such as P&C (property & casulty). I think the monoline split will be similar to the p&c splits of the past.

There were two big splits in the 90's in the p&c insurance sector. If one is interested, they should look up ITT Hartford's reorganization in 1992, and the Cigna split in 1996. The Cigna split, as you will see below, is somewhat similar to what the monolines are trying to carry out right now.

You can search for articles such as More Cigna Splits Unlikely, Raters Say (National Underwriter: Property & Casulty Risk & Benefits Management, July 22, 1996. vol 100 Issue 30, p7) at your library. Now that The New York Times has free access to its archives, I was able to dig up a couple of articles on the Cigna split.

Cigna was a property & casulty insurer who ran into big problems in the mid 1990's due to potential asbestos and tainted soil liabilities. It tried to split in order to contain the problems in one unit.

The Cigna plan calls for the creation of one group of weaker, inactive subsidiaries that would not sell new property and liability policies but would pay claims as they arose on old policies. The active, stronger company would issue new policies and would benefit, Cigna officials say, because it would have higher financial ratings once it was separated from the inactive unit...

Unlike other corporations, whose first loyalty is to their owners, or shareholders, insurance companies have long been regulated under the philosophy that their primary obligation is to policyholders.

(source: Market Place; Who would win in a split-up at Cigna? It depends who is asked. By MICHAEL QUINT. Published: December 8, 1995. The New York Times)

Unlike Ambac, Cigna was a bigger company with a stronger balance sheet so this split was accompanied with some support from the company:

To win approval from state regulators, Cigna agreed last week to cover losses in excess of $800 million at the unit with the largest claims, up from $500 million previously.

In addition, Cigna said that by 2001 it would add $500 million in new capital and financial support to the unit holding its discontinued asbestos and environmental businesses. In last year's third quarter, the company added $1.2 billion before taxes to its reserves to pay asbestos and pollution cleanup claims.

Cigna's decision to divide the businesses was done to allow the more profitable unit to win higher ratings on its ability to pay claims. That would allow it to sell policies to companies that only buy from high-rated insurers.

(source: Cigna's Plan To Split Units Is Approved By KENNETH N. GILPIN. Published: February 13, 1996. The New York Times)

To sum up, Cigna seperated its asbestos and environmental clean-up liabilities from the rest of its business. The former unit was put into run-off right away. The main reason behind this strategy was to get a higher rating for its well-performing business. What the monolines are attempting to do now is the same thing! They are trying to keep a higher rating for the muni bond business, while the structured product business tries to survive with an indepedent rating.

For all this to work, the regulators need to approve it and the rating agencies need to assign independent ratings. My impression from reading some articles related to the Cigna split is that the rating agencies will give independent ratings if there isn't a strong bond between the units. Ambac's corporate structure is as follows:

(source: Ambac Assurance Corp. Credit Analysis - June 2007, Fitch Ratings)

In the monoline case, without knowing any details or being a lawyer, I think the split shouldn't be too hard. The structured products are radically different from the muni bond insurance products so a split shouldn't be hard from an organizational point of view (i.e. should be easy to split the employees, collected premiums, loss reserves, etc). However, from a legal point of view, a split is likely complicated. Ambac will have to ensure that the claims-paying ability of the structured product insurance is still relatively the same as before the split. The buyers of the structured product insurance have a right to be certain that their claims will be paid.

So to sum up, next week will be big. I'll have a big decision on what to do with a rights offering...

(Non-Investment note: I changed the layout of this blog slightly. Hopefully it'll help rather than hurt the navigability. I replaced the text labels with a cloud add-on courtesy phydeaux3. If anyone has any suggestions to improve the blog let me know please. Thanks for the cool free add-on phydeaux3.)

Thursday, February 21, 2008 5 comments

Good Recap of the Monoline Situation by The Economist

(all quotes from Splitting headaches, Feb 21 2008, The Economist)

(source: The Economist; Illustration by Satoshi Kambayashi)

"We were not designed or structured to be the most important company in the entire financial system. -- Jay Brown, MBIA CEO"

So starts off the article titled Splitting Headaches from The Economist (February 21, 2008). That quote is from Jay Brown--the executive that ran MBIA during the early 2000's. He also happens to be the nemesis of Bill Ackman (Ackman's prior hedge fund likely collapsed upon investor withdrawl due to the SEC investigation initiated by MBIA--although he had other problems as well). The quote pretty much sums up the present situation in the monoline world. The monolines as I like to call them are commonly called bond insurers in the press. Companies a fraction the size of a large international bank have ended up playing a crucial role in the financial world.

With rating agencies preparing to downgrade them to levels that could destroy their business, and regulators pushing for bail-outs or break-ups, the monolines' moment of truth has arrived. For anyone linked to the $2.4 trillion of securities they have guaranteed, it is nail-biting stuff.

If you are a shareholder, it's beyond nail-biting (CAK may have some metaphors to describe the emotional toll of owning shares in these forsaken creatures :) ). I have followed quite a few companies in distress situations but the monolines are something. They literally move up and down 2% every day, with 10% moves on rumours happening on a weekly basis--and this has been going on for almost 3 months now.

The life of the monolines have taken many twists and turns, with so many vested interests trying to help and hurt them, that it is on par with a Shakespearan play. Unlike a play, though, the end can pop up any minute; or the end may be in 10 years (when we are certain of subprime mortgage losses and recoveries). Like all plays this too shall end... For once (I generally don't like films with Hollywood endings), I seek a happy ending to this tale.

Though no agreement had been reached as The Economist went to press, the industry had begun to embrace radical change. FGIC, the fourth-largest monoline, filed an application to split itself in two. Ambac, the second-largest, began work on plans to raise $2 billion in capital as a possible prelude to a break-up. And the rehiring of Mr Brown was seen as a sign that MBIA, too, is thinking the unthinkable.

I have generally looked upon a break-up of the monolines with some suspicion. The legal liability from the structured product insurance buyers can be massive. However, like MBIA--which was against a split early on--I have come around to the thinking that a split can work. If the state provides legal cover and if enough claims-paying ability rests with the structured products, I think a split is quite attractive.

Some see this as a negotiating ploy. The monolines know that, by threatening to break apart, they may force Wall Street banks to stump up the cash to keep them whole.

I also used to wonder if this whole split idea was a bluff. Right now, though, I'm of the opinion that it can work as long as the insurance regulator approves of it and the structured product insurance buyers think it is the best possible plan.

Calculating the banks' potential monoline-related losses is more art than science, and estimates range from $7 billion to ten times that. A new report by Moody's puts the CDS exposure alone at $120 billion for a group of 20 large banks. In the event of monoline downgrades, the banks may have to raise their counterparty reserves by a combined $7 billion-10 billion, reckons the rating agency, rising to $20 billion-30 billion if the value of hedged securities falls far. Spread around perhaps two dozen lenders, that number, though big, does not look terrifying.

One thing I don't get is how almost everyone assumes that the structured product insurance buyers were the banks. How about hedge funds, investment funds, and others who bought the insurance? In any case, the whole loss argument, as pointed out in the article, is a guessing game with huge error tolerance. Needless to say, guessing a large number puts you in newspaper headlines so it is in every media-seeking person to publish a big number. Given that everything is a guess, no one can refute it rationally.

The regulator and governor are shedding no tears over lenders' losses. Their primary concern is the $2.6 trillion, tax-exempt municipal-bond market, used by cities, universities and the like to raise long-term funds, much of it from individuals. Were the monolines to lose their top-notch ratings, they fear, many issuers could struggle to meet higher funding costs.

I don't agree with the article here. I don't think the regulator will value muni bonds over structured products. Eric Dinnollo has repeatedly tried to maintain a neutral stance. The people who are biased towards one side or other are politicians (like Elliot Spitzer, the New York Governor), shorts, or those with vested interests (eg. citizens who don't want to pay the higher premiums being charged by Berkshire Hathaway Assurance or others untainted by the present problems).

There are definitely issues in the municipal bond arena...

Municipal borrowers are already being affected by the lack of confidence in the insurers. Overall issuance was 38% lower in January than the year before—though other factors, such as the economic slowdown, were also to blame.

Worse, two little-noticed but important bits of the market have imploded this month, and there are fears for a third, known as closed-end municipal-bond funds. In the first, vehicles sponsored by banks raise short-term money by issuing “tender option bonds” (TOBs), then use it to invest in longer-term municipal bonds and the like. Buyers have fled these programmes, in part because of worries over muni-bond insurance. The banks behind TOBs are having to buy up the unsold bonds, further straining their balance sheets—though losses should be manageable as the bonds are high-quality.

Problems in “auction-rate” securities are causing even more alarm. In this $330 billion market, long-term bonds are, in effect, transformed into short-term ones by having the interest rate reset in auctions every week or month. The allure for issuers, including hundreds of municipal bodies, is lower interest rates than typical long-term bonds, and the ease of paying down debt if they build up a surplus, by simply taking part in the auction themselves...

This month, however, dozens of auctions have failed as investors have questioned the quality of the assets on offer. Tens of billions of dollars of bonds went unsold last week...

Auction-rate bonds may never recover. That would not be catastrophic. They are extra gears, engineered by over-achieving bankers, rather than essential market cogs.

I don't have much knowledge of auction-rate securities but I suspect this is probably the beginning of the end of them.

The more pressing question is whether the government should intervene in any other way than encouraging talks. There are grounds for scepticism. As painful as the disruption in municipal markets is, it looks temporary. Rates fell this week, and high-quality issuers were able to raise finance in municipal-bond markets.

Moreover, there is no supply crisis in the monoline business: Warren Buffett has entered the market (even offering to take on rivals' municipal businesses) and some less-troubled monolines, such as FSA, are grabbing market share. The monolines' woes are already largely priced in. There is scant evidence that leaving their fate to market forces, though it may be painful, would bring down Wall Street banks. If the banks see the danger growing, they will have even more incentive to find the money to help.

On top of which, a state-mandated break-up could trigger a wave of lawsuits, further eroding trust in the system. Eager as they are to be seen doing the right thing, Messrs Dinallo and Spitzer should wait to see graver danger than this before they meddle in private contracts.

Speaking as a shareholder, I don't want the government to intervene. They should simply provide guidance but forcing things one way or another can have unintended consequences.

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Bond Insurer Split Likely Outcome; Ambac's Mortgage Exposure by Issuer

Given MBIA's recent strategy of withdrawing from the bond insurer trade association, Association of Financial Guaranty Insurers, it looks like the big three (MBIA, Ambac, and FGIC) are going to split their muni bond business from the structured product business. Here is what MBIA had to say:

Jay Brown, Chairman and Chief Executive Officer of MBIA said, "It has become clear that MBIA and the other members of AFGI no longer share a common vision for the industry. For one thing, we believe that the industry must over time separate its business of insuring municipal bonds from the often riskier business of guaranteeing other types of securities, such as those linked to mortgages. Additionally, we disagree with AFGI's positions on the appropriateness of monoline financial guarantors insuring credit default swaps and the ability of U.S. financial guarantors to reinsure U.S. domestic financial guarantee insurance transactions with foreign affiliates without paying U.S. corporate tax rates."

When one of the founding members and the largest company in the industry leaves, it's pretty much the end of that trade group. If you recall, Ambac and FGIC already indicated that they are considering a split of some sort. So MBIA joins the rest (assuming I'm reading the CEO's message correctly). (It's interesting that MBIA brought back the original CEO who battled Bill Ackman all these years).

The real question is what the nature of a split will entail. As I have speculated before, if they get cover from the government, and if they re-capitalize and/or leave a big chunk of the capital with the structured product side, it may work out.

Ambac's Mortgage Originators

After running across this article by Tom Brown, I took a look at Ambac's mortgage and home equity exposure by originators. Tom Brown refers to a Moody's ranking of originators by underwriting quality and I am using that information in the table below. I am also not familiar with the mortgage lending universe so I am not sure if there are subsidiaries that I'm not marking with the proper colour. Only the lower rated assets (BBB+ or lower according to Ambac internal rating) are shown since those are the mostly likely to post losses. However, I should note--and this is important--what likely matters is ratings migration. If something was originally rated BBB then it is likely that Ambac wrote in more protection (or charged more) to compensate for the risk. The huge losses, in contrast, will come from those originally rated AAA but are now in the BBB segment.

I only have access to the publicly listed information on the website so, unfortunately, this excludes the CDOs and CDO-Squareds, which is where the real problems are (someone working in the industry may be able to use Bloomberg or some other service to look into the CDOs but I don't have access).

The table shows that most of Ambac's originators lie in the middle of the pack (or are unknown). Ambac has low exposure to most of the companies with good mortgage underwriting standards.

Ambac's problems are with CDOs and CDO-squareds more so than with RMBS so this information is simply another additional point to consider. The company where direct RMBS matters is MBIA (but I believe MBIA didn't publish this information).

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Wednesday, February 20, 2008 1 comments

Historical Japanese Urban Land Prices and a note on Suruga

I have been researching Japanese stocks and started looking at real estate more deeply. Japanese real estate stocks and REITs had a big run-up in 2005 (mostly on foreign investor demand) but have come tumbling down in the last year.

Suruga Corporation

I have Suruga Corporation (TSE: 1880) on my watchlist and have been reading up on it. It's a small company so their website only has basic information in English (as a sidenote, for a tech-savvy society, Japan is weak when it comes to the Internet). Suruga's main business is real estate construction.

A company trading 20% below book, with a P/E around 5, and an ROE of around 15% should make me jump at the opportunity but it doesn't. The problem I have is that due to my inexperience I don't know how to judge cyclical companies. I'm not sure if this low P/E is an earnings peak or not. The fact that the stock has sold off and is near multi-year lows makes me think the P/E is not a cyclical peak but I don't understand real estate very well. I like Suruga because of its attractive ROE (for a Japanese company) but that is due to leverage. Suruga, although having good interest coverage and no immediate risk, is leveraged at around debt/equity ratio of 1.

Historical Japanese Urban Land Prices

With Suruga near the forefront of my research, I've been looking into Japanese real estate. I'll be posting as I collect information but let's start off with land prices.

Japan, as you may know, probably had the largest real estate bubble in the last 50 years (for a developed country). As you will see in the first chart below, the bubble was primarily a commercial real estate bubble. In contrast, what USA is going through now is a residential real estate bubble.

A huge chunk of the value of a property is the land. Looking at land prices should give us some idea of the present landscape. As a side note, if the Japanese consumer is to recover, real estate may play a big role in that. Rising real estate prices will boost consumer confidence and allow an expansion of the consumer balance sheet.

The above chart is urban land prices from 1964 to 1997 from the Japan Statistics Bureau. I simply picked urban land prices because I ran across the data (I suspect rural will show a similar pattern). The graph plots an index with a value of 100 in the year 2000. One thing I am not sure is whether this is adjusted for inflation (I suspect it is but need to confirm).

As you can tell easily from the chart, Japan had a huge commercial real estate bubble. It, along with the stock market, has been in a massive crash for more than a decade. The crash has been so bad that prices are back to what they were in the early 70's!!!

An interesting aside is that Japan had been going through a massive deflation and land prices kept falling along with it. I see some people arguing that real estate maintains value during a deflation but that hasn't been the case here (I believe US real estate also collapsed during the Great Depression--another deflationary episode). The only safe things during a deflation are cash and bonds (that don't default).

Let's look at the year-over-year change in urban land prices:

This chart plots the year-over-year change in overall average urban land price. Note that the labels for the year are staggered a bit to the left (the chart ends in 2007). This chart literally shows the history of modern Japan.

As is generally the case with any asset, the price appreciation in the early stages tends to be really high. In this case, Japanese land prices went up more in the late 60's and early 70's than during the bubble years in the 80's. In the earlier stage, the index went from around 10 to about 60, for a 6x move; whereas it only went from 60 to 150 during the boom years, for a 2.5x appreciation. Japan Inc. made the frontpages in the 80's but the country's key prosperous period was earlier. It pays to be early to the party--you can have the appetizers for yourself ;)

The prices hit a peak in 1991 and it has been falling ever since. It has been a disaster for anyone who bought anywhere the top. In fact anyone who bought since 1982 or thereabouts is underwater (of course, if the land were put to productive use, the yield on that (eg. rent) should compensate some of the loss). There have been some false recoveries along the way, burning anyone who ventured into real estate (this has been the case with stock market investors as well, with many getting burned on Japan over the years).

The decline has been slowing lately, and looks like it is about to turn positive. The question for real estate investors is whether there will price appreciation in 2008 (I should note that some other real-estate-related measures had prices turning positive for the first time in 2007). I want to do more research on valuations (Japan is still expensive relative to many other developed countries--although land is scarce there) before I form a strong opinion but if I had to guess right now, I would say that prices will appreciate within a few years. However, there are some risks in Japan.

One of the immediate risks is that Japan is heavily leveraged to exports, and with the US economy slowing down, any weakness in China may send Japan into a recession. My understanding is that Japan fell down after the Asian Flu back in 1997 so a similar risk is a threat.

So will prices rise for sure? The answer is tougher than for many other countries. One of the longer-term problems with Japan is that they have an aging population. Their population will start to contract sharply so housing and land demand will decline. So prices don't necessarily have to rise. However, given the steep drop and present valuation resembling the 70's, I think prices will start to rise. The question is when.

Next on my list are real estate prices (as opposed to land) and stock prices of companies engaged in the industry.

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Bond Insurer Random Thoughts

Well, I don't really have anything insightful to say about what is happening in the monoline world. There are too many uncertainties, and too many competing plans floating around. I'll present some bearish and bullish articles I ran across...

Accrued Interest has a blog entry pointing out that a split is perhaps the best for Ambac. The author pretty much sums up the present predicament for the AAA-rated mononlines. I made a lengthy pos in the comments area so check that out if you are interested in my thinking. The way I look at it, a run-off is still a possibility for shareholders if the cost of maintaining a AAA rating is too high. But I am not sure if the government, shorts, or other parties are going to like that. I would be supportive of a split if (i) the government provides cover for any lawsuits from structured products insurance buyers, (ii) capital infusion doesn't cost "too much", and (iii) present shareholders get a piece of the muni bond business (if the split involves "spinning off" the muni bond business in some manner and leaving the structured product side for present shareholders, it would be very bad for shareholders--I am confident that management won't contemplate such a scenario).

Bill Ackman is supposedly presenting a "new" plan to save the monolines. I haven't looked at the details of his "new" plan but it sounds pretty much like his old plan. To recap, his main strategy has been to cut off dividend payments to the holding company in order to bankrupt it. He supposedly has a huge position in CDS on Ambac and MBIA bonds (along with short positions in stock, and ownership in put options). I suspect his CDS contract is too big and too illiquid to unwind so he has to constantly call for a bankruptcy of the holding companies. Fortunately, the New York bond insurance regulator shot down the plan. Nevertheless it's dissapointing to see that the media is giving such credence to his ideas. I can't think of too many cases where a short-seller has come to represent the interests of the industry and its customers.

Here is an article from Matt Koppenheffer writing for The Motley Fool and presenting his view that the stock price charts for Ambac and MBIA look like the point where Wile E. Coyote falls off the cliff. Apart from the over-used cliche, he goes on to reference an old post from 2002 predicting some of the problems that the monolines are running into now, and mentions that someone who shorted the stock back then (2002) would have made 70%. Sounds like a big number but over a period of 5 years, that's only around 11% annualized if I'm doing my numbers right. Given the risk with shorting and the need to pay dividends, I'm not so sure that is worth. Having said that, note that short-sellers like Bill Ackman use CDS contracts (Ackman also uses CDS on the long side eg. BGP). I suspect this is to avoid the downside of shorting a stock directly (of course, the CDS market has its own set of issues such as illiquidity and the inability to exit a position unless the company defaults).

Reuters summarizes the legal risk of splitting in this article. Pretty basic article but sort of touches on the unknown issues.

We touched on the issue of whether the bond insurance industry makes sense in the past before the current meltdown, but here is Portfolio magazine questioning the validity of bond insurance (they actually call it a racket). As I have remarked before, if bond insurance makes no sense why was anyone buying it for decades? The fact of the matter is that bond insurance improves efficiency in the underlying market. Just like how house insurance avoids the need for you to precisely calculate the risk of losses for a house you buy and then make a huge bet, bond insurance commoditizes the market and lowers the cost. Also claiming that the bond insurers charge too much and have a high profit margin misses the fact that the insurers have to keep large capital on hand (depressing returns). In fact, if someone thought the bond insurance was a racket then wait until they see the costs of bond issuance go up significantly if the insurers fall.

If there is anything positive in the monoline world (not for me but for others :) ), well, it's the fact that the monolines have been a daytrader's dream. The stocks consistently have daily moves of 1% to 5% one way or another. Astute traders are making a killing I'm sure.

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Tuesday, February 19, 2008 5 comments

MBIA: CEO Shuffle; Ambac: Trying to Raise $2 Billion

UPDATE: Added to link to Tom Brown's rebuttal of the bears...

MBIA Replaces CEO

I never really understand the goings and comings of MBIA. The latest event is the CEO shuffle:

Bond insurer MBIA Inc said Tuesday that former Chairman and CEO Joseph Brown was returning to replace current CEO Gary Dunton as the company, beset by mortgage-related losses, scrambles to maintain a top credit rating...

Between 1999 and 2004, Brown ran MBIA and its main unit, MBIA Insurance Corp. He joined the firm as a director in 1986 and retired last May.

Well, it's hard to say what is positive news and what is negative these days. I am guessing that this is good news given that the CEO ran the company before and was with the company as recently as early last year. I am guessing that Warburg Pincus and other key shareholders likely pushed for the change (there was little else that happened to warrant a shuffle).

Ambac Trying to Raise Capital

Ambac is trying to raise around $2 billion via a rights offering. It's premature to say anything concrete until we get the details on the cost and the amount. A lot depends on how much capital is required by the rating agencies. No word on what the agencies are requesting.

It also looks like both Ambac and MBIA are trying to split their muni bond business from the structured product business. I personally am not favourable to this idea. It involves too many complexities, increases legal liabilities, and can result in shareholders being pushed aside. I think the government needs to provide cover and absorb any lawsuits for any of this to make sense.

Tom Brown has a good write-up of the situation. He is bullish so we both share the same wavelength on many thoughts...

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Sunday, February 17, 2008 12 comments

Bill Miller 4Q 2007 Commentary

Bill Miller published the 4th quarter commentary and it is always an interesting read. He is having a tough couple of years and he says it is somewhat similar to 1989 and 1990. Here are some excerpts...

Are we in 1990?

The past two years are a lot like 1989 and
1990, and I think there is a reasonable probability
the next few years will look like what followed
those years.

The late 1980s saw a merger boom similar to what
we have experienced the past few years and a
housing boom as well. In 1989, though, the merger
boom came to a halt with the failure of the buyout
of United Airlines to be completed. The buyout
boom had been fueled by financial innovation.
Then it was so-called junk bonds..Now it is subprime loans
repackaged into structured financial products...

By 1990, housing was in freefall, the savings and
loans were going bankrupt (as the mortgage companies
did in 2007), financial stocks were collapsing,
oil prices were soaring in 1990 due to a war in
the Middle East, the economy tipped over into
recession, and the government had to create the
Resolution Trust Corporation to stop the hemorrhaging
in the real estate finance markets. Eerily
similar to today, the situation began to stabilize
when Citibank got financing from investors from
the Middle East.

He seems to think the current period is similar to the 1990 period. That thought has also run through my mind but given the unprecedented run-up in house prices, I'm not sure how likely the the future will resemble anything like the early 90's. The housing recovery may take a lot longer than in 1990 and this can hurt financial and real-estate stocks for much longer. But the argument in favour of a quick recovery is the fact that the correction in real-estate-related assets have been very steep.

I think the market is in for a period of what the Greeks
refer to as enantiodromia, the tendency of things to
swing to the other side. This is not a forecast, but rather
a reflection on valuation.

All of the poorest performing parts of the market,
housing, financials, and the consumer sector—with the
exception of consumer staples—are at valuation levels
last seen in late 1990 and early 1991, an exceptionally
propitious time to have bought them. The rest of the
market is not expensive, but valuations cannot compare
to those in these depressed sectors.

Bonds, on the other hand, specifically government
bonds...are very
expensive...The 10-year Treasury trades at almost 30x
earnings, compared to about 14 times for the S&P 500.
The two-year Treasury yields under 2%, and is thus
valued at over 50x earnings!...

Even more compelling are
financials, where you can get dividend yields about double
that of Treasuries, which only adds to their allure, with
them trading at price-to-book value ratios last seen at the
last big bottom in financials.

I share Bill Miller's view that US stocks are neither expensive nor cheap, and the beaten-down sectors like financials and consumer discretionary (especially anything to do with real estate) seem to have low valuations. The big risk for investors (especially foreign ones) is the potential for further US$ decline.

I tend to go for risky stuff (maybe I should change this strategy) but one can find relatively cheap stuff in the struggling sectors. There are companies that can easily go bankrupt; and there are others who are unlikely to go bankrupt. For example, some financial industries like bond insurers (eg. ABK, MBI) and mortgage lenders (eg. CFC) are risky, but large money center banks (eg. BAC, C) or investment banks (eg. MER) are safer. Similarly, homebuilders (eg. PHM) are risky but building material suppliers (eg. USG) are safer. Some of the established retailers like Home Depot and Sears may battle their way through any economic problems but the smaller, niche, players are risky. I'm not recommending any of these (simply giving some examples) and none of this means that you won't lose money one way or another. However it does mean that buying an established financial company with a decent dividend yield and long-term history seems attractive.

I think enantiodromia has already begun. What took us
into this malaise will be what takes us out. Housing stocks
peaked in the summer of 2005 and were the first group to
start down. Now housing stocks are one of the few areas
in the market that are up for the year. They were among
the best performing groups in 1991, and could repeat that
this year. Financials appear to have bottomed, and the
consumer space will get relief from lower interest rates.
Oil prices have come down, and oil and oil service stocks
are underperforming in the early going.

Clearly a bullish comment on the beaten-down sectors. I'm not sure if this is a bit too early...

Investors seem to be obsessed just now over the question
of whether we will go into recession or not, a particularly
pointless inquiry. The stocks that perform poorly entering
a recession are already trading at recession levels. If
we go into recession, we will come out of it. In any case,
we have had only two recessions in the past 25 years, and
they totaled 17 months. As long-term investors, we position
portfolios for the 95% of the time the economy is
growing, not the unforecastable 5% when it is not.

I believe equity valuations in general are attractive now,
and I believe they are compelling in those areas of the
market that have performed poorly over the past few
years. Traders and those with short attention spans may
still be fearful, but long-term investors should be well
rewarded by taking advantage of the opportunities in
today’s stock market.

Needless to say, doing anything now is definitely a big call and could make the difference between a disaster or huge success. Even if you are a long-term or medium-term investor, housing is scary because the run-up in prices and the demand was unprecedented in modern US history. The fact anything heavily tied to housing is cyclical multiplies the damage from a mistake.

On Potential Countrywide Financial Takeover

Legg Mason Capital Management (LMCM) is the largest
shareholder of Countrywide Financial (CFC), holding
about 11.8% of the company’s shares outstanding as of
December 31, 2007.

We were quite surprised by the decision to sell the
company at close to a seven-year low in the stock price,
and agreeing to a bid that amounts to only 30% of book
value and under 3x consensus earnings for 2009
. What
makes the decision puzzling is that the company was seeing
solid deposit growth, has no apparent capital
problems, was not forced by the regulators to seek a
merger partner, and is in sufficiently sound condition to
have declared its regular quarterly dividend at the end of
January. Subsequent to the decision to sell, the Federal
Reserve cut interest rates sharply. The reduction in rates
is quite beneficial to CFC by reducing its costs of deposits,
and by setting off a wave of refinancings that should
significantly increase its loan production.

I was surprised with the Countrywide decision as well. No doubt mortgage lenders have run into massive problems, with many declaring bankruptcy. However, except for some wild, unsubtantiated, rumours of imminent bankruptcy, CFC seemed to be strong enough to survive the downturn. I don't have a position in CFC and haven't followed it closely enough, but the deal looked to me as if insiders were looking for an exit strategy more than anything. Whatever the case may be, it is up to the shareholders to accept or reject the deal. It looks like Bill Miller is adding to his position:

We petitioned the Office of Thrift Supervision for
permission to increase our holdings in CFC to up to 25%
of the shares outstanding. That permission was granted
on January 18, and we (LMCM) have increased our holdings
to about 86 million shares, representing 14.9% of the
company’s shares outstanding...

We have asked CFC’s Board to eliminate the poison pill
(or at the least provide us with an exemption from it) as it
plainly is unnecessary since the company has already
agreed to be acquired by BAC. Eliminating it would
allow us to acquire additional shares, should we decide to
do so.

We have asked other companies to allow us to exceed pill
thresholds, and those requests have been routinely
granted, as we are long-term patient shareholders, not
activists or acquirers. We fully expect CFC’s Board to do
the same.

Bill Miller views the takeover as offering CFC shareholders a put option on their company:

It is important to understand that CFC’s Board has effectively
negotiated a put option contract with BAC. Shareholders
now have the right to put the company to BAC
for 0.1822 shares of that company. They may elect not to
do so, in which case the company will remain independent.

Given the turmoil in the mortgage and credit markets, and
the failure of hundreds of mortgage originators, some of
whom were public, this provides protection to CFC
owners from a worst-case outcome should the housing,
mortgage, and economic situation worsen dramatically.
On the other hand, should the actions of the Federal
Reserve and the economic stimulus package lead to a
gradually improving situation, CFC owners can turn down
the deal, should they believe that is in their best interests.

I don't think Bill Miller is hedging his position (i.e. not shorting BAC stock as risk arbitrage players would) so this is basically a bullish bet on housing. I suspect Miller will be happy to own BAC shares if CFC accepts the buyout so this looks attractive to him.

On Potential Yahoo! Takeover

LMCM is YHOO’s second-largest shareholder,
owning over 80 million shares. Subsequent to the
deal being announced, we have met with Steve Ballmer,
MSFT’s CEO, and spoken with Jerry Yang, CEO of

That said, we think it will be hard for
YHOO to come up with alternatives that deliver more
value than MSFT will ultimately be willing to pay.

I don't follow these companies well enough to have a strong opinion. My feeling is that Yahoo is struggling but it has a strong brand and display advertising. Their problem is that they are having a hard time monetizing their strong brand. To make matters worse, Yahoo is good at display advertising but what is popular with customers is context-sensitive text advertising. The problem with these tech companies is that even though they have huge barriers to entry (online mass advertising is locked up between the three, Google, Yahoo, and MSN), their valuations are high. Yahoo's TTM and forward P/Es are 63 and 54, respectively (growth companies should technically not have depressed earnings). It's awefully hard to satisfy the required growth rates for such high valuations even if you are one of the top 3.

It has been reported that MSFT has been
discussing a combination with YHOO for well over a
year, and that it had been prepared to pay over $40 per
share previously. We have no way of knowing whether
those reports are accurate or not.

Our own valuation work puts the value of YHOO in the
range of those reported numbers, though, and we think
MSFT will need to enhance its offer if it wants to
complete a deal. YHOO shares were recently trading at a
four-year low, and the stock averaged above the current
offer price for all of 2004.

I feel like Bill Miller is a bit too optimistic here. Yes, Microsoft is being opportunistic by offering a price off the 52 week low. But Yahoo doesn't seem to have anything going for it. I also don't think Microsoft needs this deal as much as some make it out to be. There are major integration risks if Microsoft buys Yahoo. Unlike prior purchases, Yahoo is massive and there is room for big culture conflicts, not to mention issues with technology integration issues. Lastly, with such a high valuation being placed on Yahoo by the market, I'm not sure how easy it will be for Microsoft to satisfy market expectations in the future.

Saturday, February 16, 2008 0 comments

Added to Watch List: Sears Holdings (SHLD)

I don't consider myself as a pure value investor but if one was inclined towards value investing and was to blindly invest in a company, I can't think of too many better candidates than Sears Holdings (SHLD). It's amazing to see so many superstar value investors take a position in Sears (note: the list may have changed since then so we don't know the exact holdings). The list includes Martin Whitman, Jean-Marie Eveilard, Bruce Berkowitz, Mohnish Pabri, and...uh... Bill Ackman. For once, I'm on the same wavelength as Ackman ;)

I don't invest blindly based on others (not only do you not have the same risk profile and investing time horizon, but you will also learn nothing (I'm trying to learn on my own :) )). But Sears is starting to look attractive on its own. If you are looking for something with a lower risk profile and don't ever want to hear the word subprime ever again :) Sears may be worth considering.

Current Numbers

Here is how Sears stacks up right now:

Market cap: $13.6 billion
TTM P/E: 12.2
Forward P/E: 23.8
P/Book: 1.26
P/Sales: 0.26

ROE: 10.9
Debt/Equity: 0.41

The stock is down around 50% in the last year, and is basically trading at the 2005 price. The most attractive thing about SHLD is its low price-to-book-value. It is only trading around 25% above its book value, and if the stock drops closer to book value, it can be highly attractive IMO. You won't find many big-name retailers trading at P/B of around 1.25.

What Went Wrong

Sears stock is getting clobbered--down over 50% in an year--and most of it is attributed to poor management. In fact, Herb Greenberg awarded the worst CEO of 2007 to Eddie Lampert of Sears. I'm not so sure. If you look at its competitors like JC Penney, Macy's, and so forth, all of them have followed a similar pattern. All the retailers are selling off due to a slowing economy. The real test is what happens over the next couple of quarters when the economy actually slows down and the good performers will be seperated from the poor ones.

I haven't been following Sears closely but did pay some attention to it over time. There was, what I feel, a lot of speculation in the stock over the last few years. A lot of it centers on two theories.

The first theory was that Sears has severely undervalued real estate holdings. This is illustrated clearly in this October 2007 Barron's article. According to Bill Ackman's Pershing Square calculations, Sears' enterprise value per square feet is only $33 versus $100 to $600 for competitors. This may very well be true but I don't value it that much due to the potential for a commercial real estate collapse. Commercial real estate may be entering a correction and it will be awefully tough for Sears to unlock that value any time soon. It probably also isn't easy to unload your real estate while other retailers are cutting back due to a looming slowdown in the economy. I think the real estate story has merit but it can take a long time to unlock the value.

The other theory that propelled the stock was when so-called value investors loaded up on SHLD on the expectation that (i) Eddie Lampert will be the next Warren Buffett (BusinessWeek cover may be a curse like the Sports Illustrated cover ;) ), and (ii) Sears' cash flow will end up being used to finance other investments (a la Berkshire Hathaway, the original textile mill, and Buffett's investments in Geico/etc)... Well, I would run away from the first thought. I have a lot of respect for Eddie Lampert (read below) but no one knows who is going to be the next Warren Buffett--assuming there will be a better investor. This is like how everyone thinks the next big superstar in the NBA is the next Michael Jordan. Well, people have been saying that about Jordan for years; and people will be saying the same thing about Buffett for years if not decades... I also wouldn't put much faith on the second strategy panning out well. Eddie Lampert supposedly has other private holding companies so how can you be sure SHLD will be his main vehicle? Furthermore, nothing Eddie Lampert has done indicates to me that he wants to wind down Sears and use the cash flow elsewhere. If anything, he is committed to Sears as a retail operation.

Why Sears is Worth Considering

So, it is not only growth investors who trip over themselves on some hot idea; value investors can be quite speculative as well. I think all the froth related to the points cited above is out of the stock now, and the valuation looks reasonable right now. As I mentioned above, if the price drops to book value, this could be a real steal. The real estate is already undervalued (although it's hard to unlock that value) so the stated book value is likely quite conservative.

I don't know much about Eddie Lampert but I have a lot of respect for him. Ever since I read about him being kidnapped at gunpoint, only to recover and make a great deal, I gained a lot of respect for him and have been watching his moves at Sears. Some say he is one of the best capital allocators out there. The example I remember was someone saying that he somehow managed to buy back stock near the lows again and again (in contrast, most executives don't know what the hell they are doing and sometimes end up buying back stock at highs). Eddie Lampert is also a through-and-through value investor in trying to minimize costs down. Unlike Buffett, however, he is a control investor who actually studies the business and involves himself in the day-to-day operations.

I haven't looked into Sears deeply so I won't comment on its future (I'm not into shopping but its brand is unspectacular from what I gather--I'm in Canada though, where Sears actually is doing OK compared to the US). I am attracted to the stock due to its low valuation more than anything to do with its brands or corporate strategy. I've been looking for a retailer (this is the other big industry that is selling off these days) and SHLD is one of the most attractive out there. I still need to do some homework (SHLD probably has one of the worst investor relations website on the planet. There isn't even an e-mail contact to request investor kit or any docs. Even Japanese companies have better English websites :( I guess SHLD is run like a hedge fund with minimal info)...

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Splitting Bond Insurers: The FGIC Case

The biggest news in the monoline world right now is the notion of splitting the muni bond business from the structured product business. I'm sure that everyone, especially anxious shareholders, have been contemplating this scenario. I personally think Ambac is unlikely to seperate the muni bond business from the structured product business (but I can be wrong). The government would have to force the situation or at least provide some compensation (to the structured product insurance buyers).

In general, I think the splitting strategy is quite dumb and simplistic. I don't really know how one can discriminate against those that bought insurance on the structured products. One should also remember that structured products are not subprime residential real estate assets alone; they also include ABS of credit card loans, student loans, auto loans, commercial real estate, and so forth. There is going to be all sort of collateral damage to the educational institutions, auto retailers, and others, who benefit from secrutizing their debt.

I think we can be certain that the structured product side will go into run-off (liquidation/bankruptcy) right away so insurance buyers of those products will seek compensation via litigation. The State of New York is willing to step in front and provide cover for the lawsuits but even they may lose in the end.

The FGIC Case

In any case, FGIC, the 3rd biggest monoline and generally considered the weakest of the top 3 (although Fitch downgraded Ambac long before FGIC), is voluntarily pursuing a break-up. I highlight the voluntary element because this implies that the shareholders of FGIC, PMI and Blackstone, have calculated that the break-up maximizes their shareholder value. My guess is that if the monolines don't have to pay out any damages from lawsuits (either the government pays or no one does) then splitting may make sense.

The break-up will set a precedent (AFAIK monolines have never been able to do what is being considered now). Let me pick some insightful thoughts from a Fortune article on the FGIC story.

The plan, which appears to be unprecedented in modern financial history, seeks to separate FGIC's profitable municipal insurance business from its collapsing structured product insurance operations. Details were scarce Friday, but top Wall Street executives said the move was aimed at protecting the steady cash flows from FGIC's muni bond unit from burgeoning defaults and downgrades in the firm's risky and massive structured product portfolio...

FGIC insures about $45 billion of the $425 billion worth of municipal securities on the market. By way of comparison, its structured product portfolio insured about $42.3 billion in investments as of Sept. 30.

It's hard to say anything until some details are worked out. I'm not sure who will be calling the shots in a break-up. Will it be the monolines or will it be the regulator?

Many Wall Street traders were befuddled by FGIC's move and the massive losses it could cause investors who bought mortgage-related securities backed by the insurer. If FGIC were to split up, under Wall Street's convention, that would trigger an automatic pricing re-valuation of every bond that the firm had guaranteed. But with the collateral behind many of these bonds trading between no more than 20 to 40 cents on the dollar, billions of dollars worth of securities would be forcibly sold or valued lower, causing massive losses.

If I'm not mistaken, the buyers of insurance--mostly investment banks and hedge funds--have not marked down much for the top 3 monolines, MBIA, Ambac, and FGIC. Unlike the situation with SCA, which never had a AAA rating and hence was always viewed as a riskier smaller player, FGIC-related markdowns will be the biggest seen yet.

Isolating the company's structured product portfolio would, at least in the short term, likely create more problems for FGIC. Thousands of investors in structured products backed by FGIC would likely sue the company over the move...

Traders on Friday also questioned whether FGIC's proposal is legal. Regulators have a duty to protect the municipal bond market, but it's unclear whether they have the right to take such drastic action - or, as one Wall Street executive whose trading desk has exposure to FGIC-insured mortgage-backed securities put it, "carve up a corporation's cash-flows."

One hedge fund executive - who has longstanding profitable bet on the decline in the value of bond insurers' debt - said that the legal documents providing insurance to collateralized debt obligations (CDOs) and other structured products clearly state that they have a primary claim on FGIC's cash flows. "This isn't going to be so easy," said the manager.

I don't think FGIC will entertain this solution unless it was provided cover by the government. The lawsuits won't be handled for many years in my opinion. From a shareholder point of view, the company will be bankrupt or fully recovered by the time any of these lawsuits are finished.

One big question mark is how the rating agencies will look at this strategy. If they don't give a AAA rating, even after handling the capital needs, for the muni bond business, then this plan accomplishes nothing.

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Friday, February 15, 2008 4 comments

Purchase: BCE

I decided to take a risk arbitrage position in BCE (TSX & NYSE: BCE). I was considering PENN but I feel it is better to go with a safer bet with a 10% lower return. As I quoted in a prior post, arbitrage deals work until they don't. I don't want to be the last one holding the bag when it fails.

Derek DeCloet of The Globe & Mail--one of the best business reporters in Canada--pretty much summarizes the situation in his latest article. Just to recap the risks...

The risks clouding this takeover are three: The bondholders could win their lawsuit in Quebec Superior Court; the buyers, led by the Ontario Teachers' Pension Plan, could walk away; or the banks, led by battered Citigroup, could break their agreement to fund the deal.

The way I see it, the bondholders are unlikely to win. I mean, how can you sue a company for taking on more debt when you never bought a bond that stipulated that they cannot do that?

I don't think the buyers will walk away. They seem committed, with the Ontario Teachers Pension Fund already owning a big chunk of BCE. They clearly like the company and think this will work.

The real risk is the bank financing. Since some of the funding is coming from Canadian banks like TD, which are not tainted by the subprime or LBO problems plaughing Wall Street, a failure seems low. Yes, there are US banks involved and the banks had a hard time selling the recent Harrah's deal. But of many of the deals out there, this is the type of deal that is attractive in the present climate. BCE is a leading, solid, telecom that pumps out cash and should weather an economic slowdown or other looming issues.

There is always the possibility of adverse government intervention but this seems like a remote chance given that nothing has been said for months. BCE is also getting beat by cable companies like Rogers, so I can't see much being made about the deal.

(you can get detailed documents from the official site here)

BCE takeover price: C$42.75
Closing Date: 2Q 2008 (likely May 2008)
Current price: C$35

Gain if deal closes: 22%
Loss if deal fails (guess): -11% (C$31)
Probability of success (guess): 75%
Probability of failure (guess): 25%

Expected Return = 0.75*0.22-0.25*0.11= 13.75%

This is a pretty good return if the deal closes by the second quarter. An attractive thing for me is the fact that it is in my local currency. After my returns being shaved off due to a declining US$ in a few of my situations, the currency situation will not impact me this time.

I think the stock price may drop a bit more if the stock market sells off. But who knows what will happen and I don't want to bank on that.

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

I would say 75% chance of going through. The lead takeover party, Teachers Pension Fund, is already a shareholder of BCE and hence likes the company.

(2) How long will your money be tied up?

This deal shows how things often take longer than initially forecast. Original deal was supposed to close in 1Q 2008 but now it looks like late 2Q 2008. Tying up my capital for that long is fine with me.

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

Chance of something better is zero. All interested parties submitted a bid and this company is way too big for some unknown party to show up if the bid fails (however, one of the prior interested parties, like Telus, may make a lower bid.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

There is a big risk with financing. If financing causes the failure of the deal, the stock will likely drop 10% to 15% (my guess). There is a possbility that Telus, a competitor that dropped out of bidding, might bid at a lower price than the current takeover price. In the worst case, I think BCE is the type of company that one can hold given its stable operations that should not be impacted too much during an economic slowdown or recession (its yield of around 4% is pretty stable).

If the Deal Fails...

This is a stock that I may hold if the deal doesn't close. If the deal fails, you are looking at a company with the following stats:

Market Cap (approx): $28 billion
TTM P/E: 12.4
Forward P/E: 15.4
P/B: 2.2
Dividend yield: 4%
Debt/Equity: 0.8
ROE: 15.9%
Industry: Telecom Services

The stock may drop around 10% but it isn't expensive by any means. Valuation is similar to other telecom peers such as AT&T in USA. Also, during an economic slowdown, something like BCE may hold up better than the rest.

Purchase Price: $35.27

(I also purchased BCE for my mom's account. It's actually a pretty good long-term hold for her even if the deal doesn't close.)

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FGIC Splits Muni Bond Business from Their Structured Products

FGIC became the first company to split their business in two; one handling muni bonds and another for structured products. I'm not familiar with FGIC so I don't know what happens to their international operations, if they have any. (Just to clarify, they are in the process of trying to split. This may take a while.)

Dave Merkel of The Aleph Blog thinks the state can't force a split of the business:

...the state insurance commissioners lack authority to favor one class of claimants over another to the degree of setting up a “good bank/bad bank” remedy, where municipalities get preferential treatment ovr other potential claimants... The insureds that would be forced into the “bad bank” would likely not have agreed to the contract had they known that the claims-paying ability of the guarantor would be impaired.

It does seem bizarre that the regulator will favour one party over another but governments aren't necessarily efficient or know the complexities of many problems. Dave also thinks (in a subsequent post) that the state gave FGIC legal room to carry out a seperation (the lawsuits will be directed at the state more so than FGIC in the future).

As an Ambac shareholder, I would be against the split and Dave also thinks that these companies will put up a big fight:

Now this doesn’t mean that New York won’t try to split the guarantors in two; I think they will lose on Ambac because it is Wisconsin-domiciled. With MBIA, they will lose after a longer fight, because they don’t have the authority to affect the creditworthiness of contracts retroactively.

The problem with any battle with the government is that you can go bankrupt (due to lack of funds or loss of faith by customers) even if you win in the end. Legal challenges disproportionately benefit lawyers and can harm shareholders.

Thursday, February 14, 2008 1 comments

Another Weird Day for the Monolines

UPDATE: Just ran across this GaveKal forum post with a good discussion of the monolines and some of the issues that have cropped. I generally respect GaveKal for their off-the-wall thinking.

Well, the day started off with hearings on the state of the bond insurance industry. Most of the prepared testimony made it to the press yesterday so nothing materially significant happened.

Eliot Spitzer started off by saying the monolines should split the municipal bond business and the structured finance products business. What was surprising to me was how he implied that something will happen within a week if the bond insurers can't raise capital on their own. I am not an expert on government regulations but I believe he doesn't have any power to do anything to the insurers. It all comes down to what Eric Dinallo, the New York regulator, does (in the case of Ambac, whose "home" is in Wisconsin, it depends on the Wisconsin regulator as well). The New York regulator seems to suggest something similar to what Spitzer was saying. The unfortunate thing is that some seem to think that the Warren Buffett plan is viable when in fact it is nothing more than looting the good business while the uncertainty over subprime assets remain. Ambac's CEO supposedly called the Buffett offer "virtually laughable".

MBIA rebutted Bill Ackman's open-source model and attacked him, all the while Bill Ackman discloses that he has a million shares worth of put options on Ambac and a little less on MBIA. Bill Ackman is going all out and is likely short the stocks, is long Credit Default Swaps, and now seems to have positions in put options as well. Since he runs a hedge fund that doesn't have to disclose much, we don't know if his position has decreased.

The shares of MBIA and Ambac rallied sharply near the end of the day on news that Moody's downgraded FGIC but mentioned that MBIA and Ambac have strong franchise value. Moody's is still reviewing the big two for a possible downgrade within weeks.

However, the biggest news for me was word that Legg Mason Capital Management took a position in Ambac. LMCM for those not familiar is run by value investor Bill Miller (and others). He hasn't been having a good couple of years but I'm a big fan of Bill Miller so this is very good news in my eyes. The only thing is that they likely bought the stock at a much lower price and the position is small for them so it isn't a big bet for them. SEC filing shows that they own around 7 million shares worth about 7% of the company.

(Useless but interesting statistic for the day: For those keeping score, Zimbabwe's inflation hit 66,216%. )

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The State of the Bond Insurance Industry Hearings Today

US Congress is holding a hearing on the bond industry today. We have parties representing different interests including the New York insurance regulator, Federal Reserve, bond issuer, rating agency, bond insurers, and bond insurer shorts. Missing from the hearing are the big Wall Street investment and money center banks, some of whom have big exposure to the insured bonds and structured products. Bond insurance buyers, such as hedge funds, pension funds, and retail investors, are also not represented. So this is all from the "seller/issuer" point of view. The federal government probably can't (and won't) do anything right now but, nevertheless, we can get a sense of where some parties stand. The Federal Reserve likely won't do anything either since insurance is likely outside their mandate.

As an Ambac shareholder, I'm still against any government intervention. We need a private-sector plan. If the government wants to do something, they should direct their efforts at the subprime borrowers who are on the verge of default.

Tuesday, February 12, 2008 13 comments

Warren Buffett Offers $800 Billion of Reinsurance for the Monolines

UPDATE 2: Wilbur Ross says he thinks the Buffett deal makes little sense but will pressure the regulators and banks to act. He is still working on a deal and will have better economics than the Buffett deal. I'm not really sure what the rating agencies think of all this.

UPDATE: Ambac just said it rejected the Buffett offer. Supposedly the company that rejected the offer before (that Buffett was referring to) was someone else (likely MBIA IMO). None of this should be a huge surprise to anyone. Buffett's asking price is steep no doubt. You know the price is too high when Bill Ackman says it's a good deal (LOL). The real question mark in my mind is what happens if the price is lowered. Then things get interesting... I still think if Ambac were to raise capital, reinsurance for some portion of the required capital makes sense.

Nothing surprising but Warren Buffett publicly announced that he is willing to underwrite (through reinsurance) $800 billion worth of municipal bonds. The offer was made to Ambac, MBIA, and FGIC.

Buffett said that under the offer, Berkshire would assume the liability for the bonds in exchange for a payment from the current insurers of 1.5 times the premium they are receiving. Buffett said one firm rejected the offer, and the other two have not responded.

I think MBIA is the one that rejected the offer. It makes little sense for them right now given that they already raised a lot of capital. As I have said before, reinsurance makes sense for Ambac depending on the price. Based on rating agency opinion of the AGO transaction, Ambac would have to give up around $100 billion in muni bonds to secure $1 billion in capital.

The price is very steep: 1.5x premium received. Basically you will not only not make any money on the muni bonds but also lose up to 50% (but unearned premiums are invested in low-risk bonds, the actual loss may be more like 30%). Since muni bonds typically have low premiums, this loss isn't as bad as it seems. Issuing shares or debt is likely more expensive than losing 50% on muni bonds. Depending on details, issuing stock means you are giving up around 20% earnings yield (say a normalized P/E of 5), and around 15% for debt-like instruments.

I'm sure that Berkshire Hathaway isn't the only one offering reinsurance so one should be able to shop around. The other big reinsurers like Munich Re, Swiss Re, along with the small Bermuda-based reinsurers will likely consider reinsuring muni bonds. Some stories are saying that reinsurers are doing poorly because premiums for catastrophes (eg. hurricanes, earthquakes, etc) are down this year so I'm sure many would consider municipal bond reinsurance, which is historically a very low risk activity.

If Ambac is reasonably sure that it can maintain its AAA rating then unloading the muni bonds is a good strategy (if they don't care about AAA, then Ambac doesn't have to do anything since it was around $2 billion over the AA-required capital limit in January (this was for S&P I believe)). The problem is that rating agencies are very flaky these days and one can never be sure what they are thinking. Given the fact that none of them have given a hard target of any sort, reinsurance is a risky proposition.

Without being a financial expert or being privy to confidential information, I would prefer of Ambac reinsures around $100 billion of muni bonds (to generate $1 billion in capital) and does a share rights offering of $500 million to $1 billion. This is assuming we can get a somewhat solid opinion from the rating agencies.

Saturday, February 9, 2008 6 comments

Added to Watch List: Thornburg Mortgage Convertible Preferred

I'm adding Thornburg Mortgage 7.5% Cumulative Convertible Redeemable Preferred Shares Series E (TMA-PRE) to the watch list. Anything to do with residential real estate is very risky so this is not for the faint of heart.

Thornburg mortgage (TMA) is a mortgage loan company (a REIT without physical real estate holdings) concentrating on jumbo adjustable rate mortgages (ARM). In other words, it caters to the upper middle-class and upper class real estate buyers. It essentially makes money on the difference between in the cost of the mortgage and what it charges.

I am attracted to the preferreds because they are convertible and have a decent yield (9%). I'm still trying to figure out what is a good return for me but my current thinking is that anything that yields 10% for the long-term is worth looking at. Stocks have a long-term return of around 10% so a bond that can beat that is worth considering. However bond/preferred coupons don't increase so inflation is a huge risk. To overcome this, I primarily look at convertibles or bonds for the medium term (i.e. 5 years). These preferreds (and bonds in general) are also less tax efficient than common stocks.

Some notes on the series E preferreds (I still have to read the prospectus to confirm this info):

  1. call info: June 19 2012 @ $25 (current preferred price: $19.50)
  2. conversion info: 0.77232 common shares (current break-even conversion price $25.25; current stock price: $13.12)
  3. cumulative
  4. Moodys rating: Caa1; S&P rating: CCC
  5. current yield: 9.64%

There is also the 10% series F which is very similar but I like series E because its price is below the par value and hence is unlikely to be called. If you are ok with the preferred being called and/or want to convert at a lower price, the series F is a better bet.

One risk with ARM is that if rates go up (haven't lately but likely in a few years) defaults may rise. The upper class hasn't been impacted by the slowdown yet (mostly has been hurting subprime mortgage borrowers so far) but it remains to be seen if that will last. Already you are seeing some luxury clothing retailers noticing some weakness so I wonder if homes will also be an issue.

Since this is a REIT, it has historically paid out most of its income to shareholders on a consistent basis. During the housing boom in this decade, it has paid around $2.50 per share in dividends (to common shareholders). I think the likelihood of it paying preferred shareholders in the future is pretty high.

The real big risk is bankruptcy risk. If I were to take a position, I have to do more homework on that front.

Assuming one deduces that bankruptcy is remote, I think this is worth picking up if yield reaches around 12% (but I'm not sure if it's going to hit that number).

Couple of Others

A couple of other somewhat distressed, lower risk, convertibles are the following:

  1. Citigroup Inc., 6.50% Dep Shares Series T Non-cumul Convertible Preferred Stock (C-PRI)
  2. Bank of America, 7.25% Series L Non-Cumulative Convertible Preferred Stock (BAC-PRL)

Both of these were issued in January of this year (these were some of the big capital infusions that made the news a while back). If you think both of these companies will recover from their current subprime-induced problems then it's worth checking out these preferreds. Given their low risk, the yields are not that great (around 6%) so I would wait for them to drop a bit more. One should also evaluate whether it's worth buying the convertibles instead of the the common stock. With Thornburg, I like the convertible preferreds because there is a chance that housing may not recover for many years so I don't mind getting paid to wait (I'm assuming the company doesn't default or go bankrupt). These banks, on the other hand, can easily recover within 2 years (and yield is lower) so the common stock may be more attractive (have to do an analysis).

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