Wednesday, February 20, 2008

Ambac: Breaking up is hard to do (but still your best choice)

Let's pretend you are the CEO of Ambac. I know, not an enviable job right now. Let's say for the sake of argument, that you really believe in your portfolio. Even though its obvious mortgage defaults will be considerably higher than originally projected, you believe your firm has done great credit work and negotiated the right subordination, and so your losses will be minimal. In other words, let's assume that you actually believe the kinds of things that real-life Ambac CEO Michael Callen has been publicly claiming.

Your problem is that the world at large just thinks your are in denial. That losses in sub prime securities, especially CDO-squareds, are going to suffer severe losses. There is tremendous pressure on Moody's and S&P to downgrade you. As it is, you are completely shut out from writing new municipal insurance business. Once you lose your AAA/Aaa rating, you will more or less be permanently barred from the muni market. There really won't be much hope of reviving your business from there, and you'll be forced into run-off.

This puts you in a difficult position. You believe you have a strong portfolio, but the market doesn't. Unlike other companies, you can't afford to simply tell the market to wait and see. You can't let time prove your point. You have to figure out a way to maintain that rating at all costs, and if something doesn't change right here and now, you will indeed lose that rating.

You are left with only one choice. Separate your good bank from your bad bank. In fact, the Wall Street Journal is reporting Ambac is in talks to do just that. You see, no one is questioning the viability of your muni insurance business. You'll be able to maintain your AAA/Aaa rating on muni insurance if it stands alone. That's your good bank. Then you can work on rebuilding trust with municipal issuers and investors, which will be a challenge. But armed with a AAA/Aaa rating, there is hope. With any other rating, its over.

Of course, that leaves your structured finance business, which is the bad bank. But if Ambac's management really and truly believes that the structured finance stuff was well-underwritten, then they should be comfortable creating a second insurance company which owns only the structured policies. If indeed this portfolio performs reasonably going forward, then the second insurance company will produce strong cash flow. Those structured finance policies require periodic payments to Ambac, so if the "bad bank" performs the way Ambac says it will, then the cash flow return should be attractive.

The challenges of making the split are numerous. There will likely be lawsuits by structured finance holders who logically want to keep the stronger muni business around to support their policies. So we'll see how it plays out. Since government regulators seem keen on providing aide to the muni market pronto, Ambac may get some legal cover if they manage to push this plan forward.

If they don't, then a New York imposed plan seems inevitable. I think its time for Ambac (and MBIA) shareholders to start thinking about how to make the best of a bad situation.

16 comments:

Erich Riesenberg said...

I am curious why the so-called monolines did not stay monoline. Why doesn't the holding company have more than one insurer, one for municipals, one for housing backed securities, and so on. It seems logical, and would prevent the bad from dragging down the good, and in good times it wouldn't have caused any worry, among the asset backed investors for instance, because there was not worry about default.

I realize this is in retrospect, I am curious if there was any reason other than short sightedness that this did not occur. Regular insurance companies have numerous subsidiaries.

cak said...

Ambac will still need to raise capital.

Perhaps not a true precedent, but some knowledgeable folks have pointed out the brilliant resurrection of Mellon Bank via a good bank/bad bank restructuring 20 years ago. Ironically, the major financier was Warburg Pincus who made a ton of money on their "speculation".

Another side note - one of the major rebuilders of Mellon was Anthony Terraciano, just recently appointed to head Sallie Mae.

Accrued Interest said...

Erich: I think it was mostly about moving into an area where the margins were a little better. But it is worth noting that the ratings agencies encouraged all the monolines to "diversify" their business lines. Depfa wanted to get into the muni business several years ago and were told they wouldn't get a AAA rating if all they insured were munis. Not diversified enough.

CAK: I'm reading that Ambac is going to sell equity to existing shareholders. Anyway, according to Spitzer's "3-5 days" comment should be the end of this week.

Dave M. said...

erich, I think that AI has previously said that Radian has always been a split company, which has been a good thing for them lately. Right, AI?

On another note..a question for AI..if a muni bond is changed to a prerefunded status, then the insurance aspect is immaterial, is it not? Thanks.

Sivaram Velauthapillai said...

From a shareholder point of view, retaining AAA is not the only choice. A run-off is a perfect alternative to maximize shareholder value (especially if you are a shareholder like me who thinks the actual value is much higher than what the market is pricing).

Ambac management is pursuing a strategy of maintaing the AAA rating (in order to keep their core muni bond business as a going concern). I personally am ok with that strategy (but depending on the costs of pursuing a AAA rating, run-off is a perfectly viable alternative for shareholders (not sure what the govt or others think though)).

I think if the state provides some legal cover--and I think are (otherwise the monolines wouldn't consider a volunatary split due to the enormous amount of potential legal liability)--then the so-called split solution is attractive. As Cak mentions above, Ambac probably still needs to raise a few billion (kind of hard to do when the market cap is only around $1b and book value is $2b).

If the split leaves most of the capital with the structured product side, while injecting some additional capital to the muni side (cost of raising capital for the muni side will be lower), then it may placate the structured product insurance buyers. They won't really see the claims-paying ability go down much and may not mount much of a legal challenge. What does not make sense is if most of the capital is given to the muni bond side, depleting the claims-paying ability of the structured product side (I suspect everyone is trying to avoid that).

The difficulty, of course, is that the market cap is very low (AGO has a larger market cap than MBI or ABK right now!) and no one would be willing to capitalize anything to do with the structured product side. The world has dealt with tougher problems before so let`s see what comes of this...

Sivaram Velauthapillai said...

There is nothing wrong with insuring structured products per se. I think they are the future and although the monolines may or may not surve (and shareholders like me may face big losses), it doesn`t mean that you can`t insure that stuff.

The problem is that the monolines mispriced the risk. Also, note that nearly all the problems are confined to SUBPRIME mortgage products. Monolines insure credit card debt, auto loans, student loans, and so on, and there hasn`t been any big problems there (with the slowing economy, we`ll see how that does though).

What I call the Subprime Virus is not anything specific to the monolines. Banks, hedge funds, and private investors, misunderstood the risk as well. Maybe it`s greed; maybe it`s the lack of long-term data; maybe it`s change in borrower behaviour; whatever it is, I suspect that you`ll see insurance on ABS in the future...

Anonymous said...

Run-off has two bad side effects, approximately 750-1,000 people their jobs (in NY no less) and each company is severly downgraded. Both are bad PR for Spitzer and Dinallo, and costs ABK management their jobs. I bet NY politicians are keen for split insureres for those 2 reasons, and management will see the light.

Btw, the best argument to counter this is that munis dont need insurance and that "cost" could/should be avoided by forcing current monolines out of business, leaving them in run-off mode. I see this is a political football rather than the invisible hand at work.

Anonymous said...

Anonymous add-on...
Btw, I dont believe the run-off agrement is a good one or would work, only a suggestion. Even ackman isnt making the run-off argument anymore, his proposal emphasizes that people keep their jobs. I think the only obstacle is getting banks as c/p to acquisce. Otherwise, launch a hostile bid for the equity, can the management/employees and declare run-off...

Back to asking what happens to the ABK/MBI cds players now upon a split now...

Accrued Interest said...

Dave M. That is my understanding about Radian. They have a separate mortgage insurance and bond insurance business, which are both owned by a single parent company. Radian insured munis are rated higher than FGIC right now. Boggles the mind.

Technically, if a muni is prerefunded, the issuer has to pay for a new rating if they want one. Bloomberg users may sometimes see a bond with a #AAA rating, with the # meaning that S&P has looked at the pre-refunding docs. So if the issuer does not pay for the rating change, then the bond would get downgraded along with the insurer.

Siviram: I am thinking of writing a post about how not everything in the SF world is crap. In fact, most of it is pretty good from a cash flow perspective. The problem is that the bad stuff is so bad that it really might overwhelm all the good stuff.

RowdyRoddyPiper said...

I have no idea if this good bank / bad bank solution is fair, viable legal or works. I guess it's no more unfair to SF policy holders/CDS counterparties than the initial decision for the monolines to enter these arenas was to existing muni policy holders. If they were really thinking they might not split by product lines but by expected losses. I mean there are plenty of marginal muni credits right? Orange County is about due for another spin of the wheel and please don't tell me for a minute there aren't some municipal treasurers that lost the grocery money on ABS.

PNL4LYFE said...

It will be interesting to see what, if anything, comes from Ackman's proposal. The short version is that the muni and structured business would be split so that the muni business is considered 'safe' again. The muni business could then pay dividends to the structured business to help it pay claims (but NOT at the expense of the muni entity's rating). Any excess left at the structured entity could then be paid to the holding company as dividends.

If the rhetoric from MBI/ABK management is correct, all policyholders and shareholders will be protected. The muni entity will remain AAA, they will be able to write new business, and the debacle in the muni secondary market should fade. The structured policyholders will still have access to excess capital from the muni business. Sure, they may not be able to write new structured business, but let's face it: this market does not exist anymore (at least for now). If they were 'smart' in their structured underwriting, shareholders will get whatever is left.

In reality, I don't think that's what will happen; if it does, management will fight it tooth and nail. The only reason they would object is because they know the structured business is nuclear waste and that no value will be left to pass through to shareholders.

Anonymous said...

Off topic, sort of...
How does this whole debacle affect the average man? Two projects in my area are to be funded by muni bonds. One is a proton therapy facily (150 mil) that will sell ~ $95 mil in (I assume) revenue bonds and get the rest in gov $. Can the $90 mil be sold in this market? If so how and to whom and at what %? The second in a minor league baseball stadium that needs $10.5 mil in rev bonds...same questions. Where do I look to see if the bonds are offered?

Christopher Wheeler said...

As I see it, the problems in structured finance are mostly with the CDO products based on mortgages. Those problems are caused by a two piece chain of causation, with the first problem cascading into the second.

1. The risk assigned by the ratings agencies was based on the assumption that the collateral would not decline in value ("Real estate always goes up"). No one seems to have asked the question of who would buy a house for 8 times their annual income. With the asset bubble deflating, the collateral is only worth 60-70% of the loan value.

2. That leads into the second problem, which is that the SF vehicles are so complicated that no one can get their hands around which tranches are actually going into default. With the modeling assumptions proven false (and on the down side), everyone knows that somebody is going to be hosed, but nobody knows who. This uncertainty is what is pounding the monolines.

Now here in flyover country where I live, 99.9% of the people think monoline is what you catch bass with, but about 10% know what a municipal bond is. Those people will be pushing to protect the munis, so there will be political pressure building to split the insurers so that business as usual can continue on the municipal side.

Accrued Interest said...

Anon:

As far as whether the projects you mention can get done... The muni market in general is doing pretty well. So new bonds with good ratings don't have a problem coming to market. In fact, long-term new issue municipal yields are right at their all-time lows.

There are problems in secondary market trading of FGIC insured bonds especially with no underlying rating. AMBAC and MBIA less so, but its still a problem.

Anonymous said...

RowdyRoddyPiper,

As reported in various places, the city of Vallejo, California is on the brink of declaring bankruptcy (apparently through longstanding mismanagement rather than any recent bad investment decision). The current turmoil in the muni markets can't be helping it, or any other cities that might find themselves pushed to the edge in the new environment.

Just imagine if the "safe" muni side turned out not to be... if defaults in this area unexpectedly turn out to be correlated, just like subprime turned out to be.

Mable said...

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