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December 06, 2007

Monolines Swoon, CDOs Go Boom and I really wonder why the ratings agencies are given any credibility
by Reggie Middleton

Warning: this is an opinionated blog article that may offend those employed by large rating's agencies or monoline insurers. Recommend reading as a backgrounder:

1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton.
2. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap
3. Follow up to the Ambac Analysis

From Bloomberg news:

MBIA Inc. fell the most in more than 20 years in New York trading after Moody's Investors Service said the biggest bond insurer is "somewhat likely" to face a shortage of capital that threatens its AAA credit rating.

A review of MBIA and six other AAA rated guarantors will be completed within two weeks, Moody's said in a statement today. Moody's revised its assessment from last month that MBIA was unlikely to need more capital after additional scrutiny of the Armonk, New York-based bond insurer's mortgage-backed securities portfolio.

"The guarantor is at greater risk of exhibiting a capital shortfall than previously communicated, (about a week and a half ago - my, aren't we fickle with our opinions) New York-based Moody's said. "We now consider this somewhat likely."

From Standard & Poors:

Standard & Poor's Ratings Services today lowered its ratings to 'D' on the senior swap and the class A, B-1, B-2, C, D, and E notes issued by Adams Square Funding I Ltd. The downgrades follow notice from the trustee that the portfolio collateral has been liquidated and the credit default swaps for the transaction terminated.

The issuance amount of the downgraded collateralized debt obligation (CDO) notes is $487.25 million.

According to the notice from the trustee, the sale proceeds from the liquidation of the cash assets, along with the proceeds in the collateral principal collection account, super-senior reserve account, credit default swap (CDS) reserve account, and other sources, were not adequate to cover the required termination payments to the CDS counterparty. As a result, the CDO had to draw the balance from the super-senior swap counterparty. Based on the notice we received, the trustee anticipates that proceeds will not be sufficient to cover the funded portion of the super-senior swap in full and that no proceeds will be available for distribution to the class A, B, C, D, or E notes.

Today's rating actions reflect the impact of the liquidation of the collateral at depressed prices. Therefore, these rating actions are more severe than would be justified had liquidation not been ordered, in which case our rating actions would have been based on the credit deterioration of the underlying collateral. Across the cash flow assets sold and credit default swaps terminated, we estimate, based on the values reported by the trustee, that the collateral in Adams Square Funding I Ltd. yielded, on average, the equivalent of a market value of less than 25% of par value.

Mind you, Ambac's insured portfolio is 32% of this stuff. Are there anymore debates to be had regarding 50% or more recovery values?

Last quarter, Ambac increased its structured product loss reserve by about $75 million. Would that even be enough to cover the one loss above??? They have $29 billion of CDO exposure backed heavily by Subprime RMBS and ABS CDO Mezzanine that is more than likely to - no, let's make that, definitely result in significantly higher losses for the company. Remember, I feel that public finance will not be the cash cow it use to be and may even develop notable losses due to the bidding up of budgets on bubble revenue that is no longer available.

And what's up with S&P??? Their ratings go from AAA to D in one downgrade. You buy AAA rated paper, rated the same as paper with the full faith and backing of the richest government in the world, then suddenly you are told you won't get your money back! I might as well jump on Moody's ass as well. They change their tune on MBIA and the monolines (sounds like a music group akin to the Monkeys, or the Beetles) every other week. Everybody makes mistakes, especially me. But this is not a mistake. This stuff was not hard to see coming. Hell, all you had to do was read this blog. I query... Why, oh why, are investors heeding the reports of the ratings agencies? How many times must you get hit in the face before you put your hands up? I am not one for litigation (actually I hate and despise it, to put it lightly), but this stuff really, really begs the question.

The CDO story links into the article about from the good doctor and leads into my next set of concentrated shorts as well. I am looking into overpaying with stupidly low cap rates (commercial real estate gurus) and guys who have mounds of credit risk exposure to other guys who couldn't pay up if their lives depended on it. I will release the research to the free portion of the blog once I get my shorts in order - roughly a week or two.

Now, back to Ambac and our regularly scheduled programming...

High reserve estimates in mortgage backed home equity

Ambac has steadily increased its reserve estimate on the mortgage backed and home equity portfolio as the US subprime mortgage market crisis began to have its implications on the financial guarantor industry. Ambac having a significant exposure of $8.8 billion in direct subprime RMBS and the $29 bn in the CDOs is likely to witness a rise in claims owing to rise in default in mortgage market. Ambac is increasing its reserve estimates to be able to settle the claims in future, but the important point is will it be sufficient? Ambac has a loss expense reserve of $279 million and unearned premiums of $3.1 billion. If the default rates continue to worsen, resulting in increased number of foreclosures it would result in higher losses for Ambac. This carries a distinctly very high probability.

Loss ratio will worsen as claims rise

Going forward we expect the company's loss ratio to worsen as the company witnesses rises in the loss expenses. We believe the amount of losses from the direct RMBS, structured finance and consumer finance portfolio will wipe out the company's entire equity.

Deterioration in net claims paid ratio

The secret of success of all the monoliners has been the low net claims paid ratio, Ambac in its recent presentation said its net claims paid ratio has been 4.3% since its IPO in 1991. Ambac's net claims paid ratio has been in the range of 10-12% in the last two years, while in 9M 07 it has been significantly lower, actually negative. Going forward, the net claims paid ratio is expected to worsen and anticipated to reach all time high levels of 35% in 2008. Recovery on CDOs losses can be expected to approach zero.

Will Ambac be tripping over covenants soon? Creditors may be calling

On July 30, 2007, Ambac Financial Group, Inc., as borrowers, entered into an amended and restated $400 million five year unsecured, committed revolving credit facility with Citibank, N. A., as administrative agent, The Bank of New York and KeyBank, National Association, as co-syndication agents, HSBC Bank USA, N. A. and Wachovia Bank, National Association as co-documentation agents and Citigroup Global Markets Inc. as the sole lead arranger and sole book runner, and certain other financial institutions, as lenders. The Amended and Restated Credit Facility replaces a previously existing $400 million five year unsecured, committed revolving credit facility, which was due to expire on July 28, 2011. The New Credit Facility expires on July 30, 2012...

The Company and/or Ambac Assurance may borrow under the Amended and Restated Credit Facility for general corporate purposes, including the payment of claims. Subject to the terms and conditions thereof, the Company and/or Ambac Assurance may borrow under the Amended and Restated Credit Facility until the final maturity date, which will occur on July 30, 2012...

The Amended and Restated Credit Facility contains customary representations, warranties and covenants for this type of financing, including two financial covenants: (i) maintain as of the end of each fiscal quarter a debt-to-capital ratio, excluding debt consolidated under FIN 46, hybrid securites and credit link notes, of not more than 30%, and (ii) maintain at all times total stockholder's equity equal to or greater than $2.9 billion. The stockholders' equity financial covenant will increase annually, in an amount equal to 15% of the prior fiscal year's net income and 15% of the net proceeds of any future equity issuances. The Amended and Restated Credit Facility also provides for certain events of default with corresponding grace periods, including failure to pay any principal or interest when due, failure to comply with covenants, any material representation or warranty made by the Company or Ambac Assurance proving to be false in any material respect, certain bankruptcy, insolvency or receivership events affecting the Company or Ambac Assurance, defaults relating to other indebtedness, imposition of certain judgments and a change in ownership of the Company and/or Ambac Assurance.

Comment

Ambac's revolving credit facility of $400 million is subject to various financial covenants such as maintenance of a debt to capital ratio of 30% and stock holder's equity of greater than $ 2.9 billion. We anticipate the huge losses that the company could witness owing to its subprime exposure in its portfolio could erode its shareholder's equity. As of 30th September 2007, Ambac has a shareholder's equity of $5.7 billion and a debt/total capital ratio of 19.7%. The amount of losses on Ambac's portfolio continues to be a hotly debated topic, and how much of its equity will be eroded continues to a topic of discussion among the financial pundits. However, our concern relates to the Ambac's ability to maintain any equity in the face of a deluge of rising and increasingly voluminous losses on its structured products portfolio.

Ceded premium to become unanticipated risk?

From 3Q 07- 10Q, page no-56

To minimize exposure to significant losses from reinsurers, Ambac Assurance (i) monitors the financial condition of its reinsurers; (ii) is entitled to receive collateral from its reinsurance counterparties in certain reinsurance contracts; and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. Ambac Assurance held letters of credit and collateral amounting to approximately $379.2 million from its reinsurers as of September 30, 2007. The rating agencies continually review reinsurers providing coverage to the financial guarantee industry. The following table provides ceded par outstanding by financial strength rating of Ambac Assurance's reinsurers, on a Standard and Poor's ("S&P" - see my comments on S&P above) basis:

Comment:

The financial strength of the company's reinsuring Ambac's portfolio can be a cause for concern as the ceded par to the AA rated reinsures have witnessed a significant increase since FY 2006. Moreover, any potential downgrading of the ratings of the reinsurance companies can be devastating for Ambac (and the ratings agencies have been on a mission to regain credibility, lately). The turmoil in the subprime mortgage market resulting in huge claims from various financial institutions could result in huge payout for these reinsurance companies. Their ability to pay the claims to these companies will test their ability to maintain their ratings. Moreover, in case any of the reinsurance companies (reinsuring Ambac's portfolio) fails it would put undue pressure on Ambac ability to manage the huge losses on its portfolio. Ambac having its portfolio reinsured mainly from AA rated reinsurance companies is a potential threat for the company. In the recent presentation, Ambac chief has identified reinsurance as a potential option to offload risk, we believe it would obviously not be on favorable terms for Ambac.

Reggie Middleton
http://boombustblog.com/

Reggie Middleton is the personification of the freethinking maverick--the penultimate nonconformist as it applies to macro strategies, investment, and analysis. He uses his background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation, and financial analysis to pursue, analyze, and capitalize on global macroeconomic opportunities.

Finding most available research lacking, both in quality and quantity, Mr. Middleton assembled his own talented research staff. As forensic research is a lynchpin for his own investing, "to actually put food on the table," he stands behind it as doing what it is supposed to do - illustrate, elucidate and educate.

He does not sell advice or research. He is an entrepreneur who exists outside of mainstream corporate America and Wall Street. This allows him the freedom to do things that many cannot--perform without conflicts of interest and corporate politics. He prides himself on developing some of the highest quality, actionable research available - regardless of price. He welcomes any and all to peruse his blog of freely available analysis, opinion and participatory social media; use his custom tools, download files, interact with the community and make critical comparisons from a results orientated perspective. Reggie believes ideas and implementations are improved and fine-tuned when bounced off of the collective intellect of the many, in lieu of that of the few - in essence, a form of collaborative open source financial analysis.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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