Ambac Does It Again

By: Reggie Middleton | Wed, Apr 23, 2008
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I apologize if I seem defensive or full of myself, but often when I strike out with a contrarian opinion, I get a lot of negative feedback. It often causes me to view things defensively. Case in point - Ambac. When I first released my analysis on this company, quoting:

Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion equity base

I came to this conclusion after a detailed analysis of Ambac's portfolio (at least what Ambac has made public, which was sufficient) covering exposure in the Structured Finance, Sub-prime RMBS and the Consumer Finance business. Ambac's management was forthcoming enough to publish a portion of their insured portfolio which allowed me to review each structure.

I am short Ambac and MBIA (for whom I have also released research), so be aware of my position as I present this opinion. I profit not necessarily from whether ABK can continue as an ongoing concern (which is in doubt and wouldn't hurt my shorts to say the least), nor from an infusion of capital (whether it be debt or equity, either of which would be a poor investment from my perspective) but from the significant decline in value of the existing shares in which I have taken a bearish position. To determine my short position, I calculated relative nominal book valuations, actual economic book valuations and produced standard financial forecasts. Of interest is the loss tail analysis wherein I have estimated the present value of the future losses.

Stating this company would suffer $8 billion of losses and was effectively insolvent was met with derision, skepticism and other adjectives which I won't mention. Even the reader rating system showed a poor reception (I am aware that my writing style irks some, but hey - that's who I am). I recieved a lot of requests for substantiation of my assumptions, hence I released more info (remember, this is not a paid service and I am not an analyst - I am a private investor). I first took a bearish position on Ambac and MBIA in the $60 to $80 range. I published the research while they were in the mid $20 to $40 dollar range. Well, they are $5 and $11 respectively, and I expect them to fall further and eventually go out of business. It appears to me that Ambac is still effectively insolvent after their latest press release which shows a very big loss on operating earnings as well as the massive loss in net earnings which includes the mark to market controversial writedowns. If you read through the insurance section of the blog, you will see that I have written extensively on this top and these companies. Thier entire business model is moot. They are trying to underprice the market on risk, and no arbitrage trade works consistently forever since even if there was an inconsistency in pricing that these companies found, it would be compensated for over time by the market. Basically, there is no free lunch.

Interestingly enough, the Bear Stearns analysis recieved some derision in the other places it was published as well. I wonder... I believe that there are several other well known financial services companies that are effectively insolvent and will meet an ignominious end. Many of the negative comments I recieved stemmed from two major camps:

  1. The first was the "Our business is to complex and complicated for you, and outsider, to understand".
  2. The other camp was the "Look at all of these big, smart name brand investors who invested contrary to your opinion. You have no idea what you are talking about because we've never even heard of you"

Well, my responses to these were:

  1. If the business model is too complex for the average financial guy to understand, its probably too complex period. In addition, I did understand it - it was just a bad business model.
  2. I actually dedicated an entire post to the name brand thing. Big hedge funds, billionaire investors, and well known private equity funds have all contributed to my trading profits thanks to their buying into the companies that I have shorted, driving the price way above what it should be and allowing me to profitably short some more. See the post for those who are hooked on name brand investors.

I can go on, after all the folly of this company being rated AAA by 2 of the 3 major ratings agenies is a joke (see my cartoons), then their is the systemic CDS risk they pose to the rest of the financial system. These guys are going to cause a CDS domino effect that nobody is going to want to see. Even those short the CDS will not get paid when the other side of the deal can't pay up. How do we know who can pay up and who can't? We don't know because of the non-existent credit risk management that is in place. I urge you to revisit who's holding the $119 billion bag? Then there is the issue of nobody wanting to do business with these companies in the first place, forcing this "AAA" rated company into runoff. Honestly, read through this earnings announcement and consider that Moody's and S&P just reaffirmed its AAA status!

Well, let's see how Ambac has done this past quarter:

From Bloomberg:

Ambac Financial Group Inc., the bond insurer that lost 93 percent of its stock market value in the past year, posted a wider loss than analysts estimated after $3.1 billion in charges for subprime-mortgage securities.

The first-quarter net loss was $1.66 billion, or $11.69 a share, New York-based Ambac said today in a statement. The company's operating loss of $6.93 a share was more than three times the $1.82 estimated by six analysts surveyed by Bloomberg.

Ambac fell as much as 22 percent in early New York Stock Exchange trading as new business slumped 87 percent after states and municipalities shunned its insurance and the market for mortgage securities dried up. Ambac, the second-largest bond insurer, increased by more than half its estimate of the claims it will need to pay on home-loan debt by $2 billion.

This "could send a negative ripple effect through the market," said Wayne Schmidt, senior portfolio manager at AXA Investment Management in Minneapolis, which has about $14 billion in assets under management. "It sends a message that we're not out of the woods yet."

Ambac fell to as low as $4.70 in early trading after closing at $6.03 yesterday. Armonk, New York-based MBIA Inc., the world's largest bond insurer, was down about 10 percent.

"The housing market crisis continues to disrupt the global credit markets and our credit derivatives and direct mortgage portfolios were severely impacted once again," Ambac interim Chief Executive Officer Michael Callen said in the statement.

Damaged Franchise

Ambac staved off the loss of its AAA rating at Moody's Investors Service and Standard & Poor's by raising $1.5 billion in a March stock sale. Ambac last year placed its AAA stamp on $524 billion of securities it insurers, its main business.

Fitch Ratings cut Ambac Assurance Corp. to AA in January. All three companies have negative outlooks on the ratings.

"Ambac's franchise has been damaged by recent ratings pressure and negative publicity," Barclay's Capital analyst Seth Glasser wrote in a research report this week.

The $1.5 billion sale of stock and convertible units nearly tripled Ambac's outstanding common shares to 285 million. The company this week said it's seeking shareholder approval to increase authorized shares to 650 million from 350 million.

"While we realize that these are disappointing credit results, we continue to believe that the capital raise and strategic business actions taken during the quarter will enable us to get beyond this credit market," Callen said today.

Market Slump, Writedowns

The company posted net income of $213.3 million, or $2.04 a share, in the first quarter of 2007, just before the subprime- mortgage market began its collapse.

The housing and credit market slump that ensued since has pushed Ambac to three straight net losses after more than a decade of quarterly profits. The bond insurer posted a record loss in the fourth quarter of $3.3 billion, or $31.85 a share, largely on writedowns of $5.2 billion related to collateralized debt obligation guarantees.

Credit-default swaps that protect against the risk Ambac won't be able to make good on its guarantees rose the most in two weeks. The contracts, which rise as investor confidence deteriorates, climbed 58 basis points to 761 basis points, according to CMA Datavision. They've more than doubled this year.

Municipal Backlash

Ambac, which pioneered municipal bond insurance in 1971, was hobbled by its expansion into CDOs, which package pools of debt, including mortgage-backed securities, and slice them into pieces with varying ratings.

As defaults on subprime mortgages climbed, the credit ratings of CDOs collapsed, requiring Ambac and other guarantors to hold more capital against their guarantees on the securities.

Ambac insured just 1 percent of municipal bonds sold during the first quarter while its smaller competitor Financial Security Assurance Inc., a unit of Dexia SA of Brussels and Paris, took 65 percent of the market, according to Thomson Financial data. FSA has a stable outlook on its AAA ratings from all three major credit rating companies.

City and state officials also have begun to question the value of bond insurance. California Treasurer Bill Lockyer is circulating a petition to require credit rating companies to change how they assess municipalities. The current rating system exaggerates the risk cities and states will default, creating artificial demand for bond insurance, Lockyer said.

At hearings in Washington earlier this year, U.S. Representative Barney Frank, a Massachusetts Democrat, told Moody's it had a month to change the way it rates municipal bonds or face legislative intervention.

 


 

Reggie Middleton

Author: Reggie Middleton

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