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January 15, 2008

Ambac Now Has a Municipal Bond Issue to Worry About - Im not going to say I told you so
by Reggie Middleton

I'll make this one quick and clean. From the blog post dated Thursday, 29 November 2007 - Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion in Equity!:

"The calculations in this analysis are only estimated losses in 4 insured categories (of many, they are enough to generate significant losses). I am expecting higher losses in Public Finance as well due to the loss of property tax revenues (lower tax base) and income tax revenues led by housing value declines and loss of corporate revenue and jobs, respectively. Many municipalities created huge budgets during bubble times (like everyone else) and failed to prepare for the bubble to burst. Now unfunded services run rampant. The shortfall will have to be covered somewhere, and default on debt service is not out of the question.

In the base case scenario created, we expect the company to report losses to the tune of $8 billion+ in its Structured Finance, Subprime RMBS and the Consumer Finance portfolio. This loss will wipe out the company's remaining equity and it will need to raise an additional $2 billion in order to function as an ongoing concern. Moreover, we think the company will need to reinsure a higher percentage of its portfolio in order to transfer risk and free up capital."

The ironic thing is that this particular post encompassed an awful lot of research and calculation, but was derided by many as being too tabloidal and not credible - despite the fact that this post and the three that followed it on Ambac contained more data and analysis (over 80 pages worth) than any Ambac commentary I have seen freely offered on the web to date, save Ackman's Pershing presentation. Two things of note here: 1) the majority are usually overly optimistic at the onset of a bursting bubble, and 2) nothing takes the place of good 'ole fashion, thorough fundamental analysis. It appears the post is rather prescient in light of the following.

From Bloomberg.com:

Wells Fargo & Co. put out a little notice dated Jan. 2 in its role as trustee on a bond issue sold in 2000 by the director of the state of Nevada, Department of Business and Industry.

"The Bonds are scheduled to pay principal and interest in the aggregate amount of $19,013,846.88 on January 1, 2008," says the Notice, which continues: "However, amounts available in the 1st Tier Debt Service Fund and the 2nd Tier Debt Service Fund are insufficient to pay all amounts of principal and interest coming due on that day."

The trustee goes on to report that, in order to make the Jan. 1 debt service payment, it dipped into the debt service reserve funds, taking $1,620,907.02 from the First Tier fund and $762,896.30 from the Second Tier fund.

Withdrawing money from the reserve funds is never a good sign; depending upon how the issuer defines "default" in its documents, it may even signify a so-called event of default. Not to worry, bondholders -- even if the trustee draws down all of the reserve funds -- the First Tier bonds are insured!

By Ambac Financial Group Inc.

"Will there be an Ambac if or when this particular municipal bond issue taps out? Investors have to hope so...

Perhaps I should mention that the issuer of those bonds guaranteed by Ambac back in 2000 was the "Director of the State of Nevada, Department of Business and Industry," but the state has no obligation to repay them. No, the $451 million in First Tier bonds helped build and are secured by the Las Vegas Monorail...

And, hey, let's face it, Las Vegas! Who ever lost money in Las Vegas, right?..

The high-yield muni market came crashing down just a couple of weeks after the monorail bonds were sold, when Heartland Advisors of Milwaukee told investors that it had decided to cut the value of its High-Yield Municipal Bond Fund by 70 percent, and its High Yield Short Duration Muni Fund by 55 percent...

An internal pricing committee had found that it was almost impossible to determine what a lot of the bonds in the funds were worth. Sound familiar? I'm not sure the high-yield muni market has ever come back.

And when will that be? The First Tier fund began life with almost $21 million, the Second Tier with a little more than $14 million. In lowering the credit rating on the bonds last July 10, to CC from CCC, Fitch Ratings said it expected "internal liquidity" to last "for, at best, three years."

I suspect a taxpayer bailout long before that occurs, but you never know. Ambac, if there is one, may yet be called upon to make those debt service payments."

Of course, after the November blog post, Ambac had to go for additional reinsurance, and of course I didn't like how it went down. See Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibilty They May Have Had Left:

"Ambac buys reinsurance from Assured Guarantee, a company in the same business as Ambac taking very similar losses, and it gets to retain its AAA rating??? Doesn't anyone see concentration risk and an uncomfortable amount of correlation here, or is it just me?

Assured Guaranty reported a net loss of $115.0 million, or $1.70 per diluted share, for the quarter ended September 30, 2007 compared to net income of $37.9 million, or $0.51 per diluted share, for the third quarter of 2006. The decline in net income was primarily due to an after-tax unrealized mark-to-market loss on derivatives (hey, isn't that what Ambac and MBIA said as well?) that was announced by the Company on October 22, 2007 of $162.9 million, or $2.40 per diluted share, on financial guaranties written in credit default swap ("CDS") contract form. As of November 30th (38 days later), it reported that it has after tax mark to market losses of $220 million. They are averaging one and a half million dollars per day in value loss, with this rate bound to accelerate in the very near future (they only had $1.6 million in 9/06 - that's a 200x increase). The macro conditions that brought upon the CDS (paper) loss are getting much worse, not better as the trend clearly indicates. About 70% of the unrealized CDS loss stems from RMBS and CMBS swaps. Well, you know how I feel about the residential market. Here is how I feel about the commercial market. Things are about to get much worse. Despite all of this, AGO now accepts $29 billion of additional ceded risk from one of the most dangerous monoline portfolios in the business. I am appalled!

I hear a lot of people crooning about this being only paper losses, and not actual claims until payment is defaulted or missed or principal is actually and materially impaired before maturity. Well, it is happening now, and in droves. AGO's management laments on how they have minimal exposure and losses to direct subprime liabilities, which appears to be true with a casual glance at their reporting, but the devil is again, in the details. Aside from 75% of AGO's mortgage portfolio being in the most toxic vintages of 2006 and 2007 (which most likely will lead to problems down the line), they have a strong correlation in product mix with Ambac, the company they just reinsured $29 billion of exposure. Ambac's loss exposure is stemming primarily from their structure product and consumer finance guarantees, not their residential mortgages, per se. Structured finance in particular is what got them in trouble. There is no real loss history on this stuff, because it is brand new and the losses that are being witnessed now are tremendous. Well, hazard a guess as to where the majority of Assured's earned premium comes from? That's right, structured finance. As of 9/30/07, it was 58%. Now, with the acquisition of Ambac's risk, and of course depending on exactly what it was that was actually reinsured (we don't really know yet, do we?) it will/can definitely shoot upwards, significantly upwards. No matter which way you look at it, there is a VERY high concentration of risk, especially in an area with no real discernible loss history and the only real discernible losses being significant. Compare and contrast to the actuarial loss histories used in life, vanilla P&C, and health lines - we're talking multiples of decades (like 50 - 60 years+), not just a few years as in CDOs. That is REAL insurance. This new fangled, financially (not so)engineered, structured product guarantee business is gambling with shareholders capital, pure and simple - slot machines - Vegas style!"

Speaking of "Vegas style", isn't that where the allegedely low risk/no loss muni bond insurance book is at risk of taking a haircut. The prophetic pun intended, of course.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
718-344-5953
http://boombustblog.com/

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