Thursday, November 22, 2007

AMBAC: This is not going to work

I have completed a deep dive of AMBAC's insured portfolio. The conclusion: I don't see how they maintain a AAA rating without raising new capital.

The Challenge
First let's consider what AMBAC needs to do to retain a AAA rating. All three of the major ratings agencies have a similar methodology for bond insurers. They need to survive a Great Depression-type scenario. The agencies then estimate how much capital an insurer would need to survive such a scenario. As long as the agencies has capital above this minimum, they get their rating.

Currently AMBAC has between $1.1 billion and $1.9 billion in "excess" capital over what's needed to retain a AAA/Aaa rating, depending on the agency.

What Matters
The ratings agencies have said that mark-to-market losses are "not predictive of future claims" and therefore not a focus of their analysis. I understand where they're coming from, I wrote about a similar idea in AI's recent discussion of Freddie Mac. I'm not sure that alternative methods are likely to come up with more predictive results, but I'm not the one who gets to make up the ratings.

So right or wrong, the ratings agencies are going to focus on a forecast of credit losses when deciding capital adequacy.

Nature of ABS/CDO Insurance
Insurance policies written on ABS and CDOs are in the form of "pay as you go" CDS. What that means is that in the event of a default, AMBAC would only be responsible for paying any interest shortfall and ultimately, any principal shortfall.

So for example, say AMBAC insured a senior, AAA-rated subprime RMBS tranche. Let's say that losses in the pool are such that the junior tranches get wiped out, but the senior tranche only suffers a 20bps/year interest shortfall. AMBAC would only be responsible for paying that 20bps. And those payments would occur over time. This is in contrast to typical CDS contracts, where the seller of protection must buy the reference item from the buyer of protection upon default.

This allows an insurer to absorb credit losses over time. Even if, say, a $1 billion ABS tranche were to suffer a 100% interest shortfall, AMBAC would only pay out annually the interest that went unpaid, probably something like 6%, or $60 million.

Note that this is a good reason why mark-to-market losses aren't everything for bond insurers. Given a default event, the insurer might write down their position entirely, but pay out the claim over an extended period of time. So in terms of capital adequacy, the insurer might be able to earn enough premiums over time to offset losses.

How Bad Will Subprime Defaults Be?
In order to make loss calculations, I needed to estimate what percentage of subprime loans will be foreclosed upon. I think in the 2006 and 2007 vintage, 25% is a good starting point. That is about the percentage of stated income loans underwritten during this period. Of course, not 100% of the liar loans will default, but you got to think the overwhelming majority will.

For 2004 and earlier, I assumed foreclosures would be around 9%, which is the highest level we hit during the 2001 recession. Given that job growth is still positive, I think that's a conservative figure. For 2005, I assumed around 15% defaults.

Recovery should be lower than historical average as well, due to weak home price appreciation. Older deals, like 2003 and earlier might recover at normal levels, but then again, anyone with strong HPA probably will be able to refi or at least work out a loan mod. The overwhelming majority of losses will come from the 2006 and 2007 vintage.

How Much In Losses?
Regardless, I think the way to attack AMBAC's capital adequacy is to consider how much in principal losses their ABS and CDO portfolios are likely to eventually suffer. I believe that if this amount is in excess of the $1.1-1.9 billion figure used by the ratings agencies, then eventually AMBAC would be forced to raise captial in order to retain their rating.

AMBAC's biggest problems will be in their CDO portfolio. I estimate they will suffer $4 billion in losses from their CDO portfolio. This will be almost all in the ABS CDO and CDO of CDO portfolios, which will suffer from the structured squared problem. Losses in other types of CDOs would seem to be within typical historical levels.

Losses in direct RMBS positions look to be in the $2 billion area. Many of their positions will probably suffer no losses at all, as AMBAC usually has significant subordination. But most look like they will suffer some losses.

How Much in Capital?
So how much in capital would they need to retain their rating? Probably at least $2 billion. They have about $1 billion in either loss provisions or mark-to-market losses they've already realized. They should have earnings of around $800 million/year. If we figure that the $6 billion in losses is spread over 3 years, that's about $3.5 billion in internally generated capital. Plus they have about $1 billion in "excess capital" over what they need to retain their rating. That leaves us $1.5 billion short.

You'd assume that AMBAC would want to raise more capital than the bare minimum, so I'm figuring $2-3 billion.

Could They Raise It?
Whether they can raise this kind of capital or not is difficult to see. It will be a question of whether a well-capitalized partner sees long-term value in their lucrative municipal insurance franchise in excess of the losses expected in ABS. I don't doubt that many potential partners would be interested in the municipal business. Munis never default, so writing insurance on them is like printing money. Berkshire Hathaway has expressed interest in the muni insurance business. I'm sure that if Berkshire put, say, $1 billion into AMBAC, then AMBAC could subsequently do a couple preferred offerings. They'd be expensive, but with Warren Buffett already on board, I think they could get it sold.

On the other hand, stronger players in the municipal insurance business may also be looking for capital, most notably MBIA. Even assuming someone like Buffett would consider investing in a bond insurer, maybe he'd prefer MBIA, who has less ABS exposure as a percentage of total par insured. We'll see.

Timing of a Downgrade
Since the ratings agencies are focused on expected losses, it may be that AMBAC and others have a fair amount of time to find more capital. This might allow stronger players (MBIA) to wait for a better market and do a simple preferred offering. Weaker players will likely be forced to raise capital privately. FGIC is particularly in trouble, as their primary owners are two private equity firms and PMI Group. The latter is obviously unable to provide capital at the moment, and the private equity firms (Cypress and Blackstone) don't want to be in a "good money after bad" position.

Consequences of a Downgrade
A downgrade of any of the big 4 insurers (MBIA, FSA, FGIC, and AMBAC) would send chills through the municipal bond market. The result might hurt all of them, even the one not downgraded. Muni buyers may permanently devalue insurance, causing more deals to come uninsured.

As for the downgraded firm, I suspect they'd wind up running off their existing policies, rather than trying to remain a going concern. Perhaps they'd sell to another insurer at a steep discount to book value. Once downgraded, even to just AA, their business model would be destroyed. Ironically, Radian would be in a much better position if downgraded, as their business model was never predicated on any particular rating.

Why Didn't You Say So Before?
Admittedly, I've been more sanguine about the muni insurers until now. My mistake was being overly focused on survival, as opposed to just maintaining the rating. AMBAC would be able to survive the $6 billion in losses if they occurring over time. But I don't think they will keep the AAA-rating without help.

How to Play a Downgrade?
This is a tough call. Going long CDS is a tough call. First, its awfully expensive, as CDS spreads are extremely wide. Second, AMBAC could get a capital infusion or do a distressed merger, and the CDS wind up not paying off.

Its also possible that AMBAC themselves did better than average credit work. In other words, that their insured deals wind up performing better than the average RMBS and/or CDO deal. If in the CDO world, their deals do only 5% better, losses would drop considerably.

Short the stock seems like a better play, but the stock is already trading at less than half of nominal book value. Still, the headlines are likely to remain bad, and any capital infusion is likely to be dilutive. I'd at least avoid the stock.

Disclosure: No positions in any bond insurer, although I own many insured municipal bonds.


Sivaram V said...

Thanks for the analysis. I appreciate the work you put into this... posting on a holiday as well :)

Your conclusion doesn't surprise me. CIFG just had some capital injection and Ambac, being the one with the largest CDO exposure, would be in a tougher situation.

I think the most valuable contribution from your analysis is putting a figure on the potential loss. No one really says how much losses can be expected and you provide a starting ground for my decision.

Anonymous said...

Firstly, nice blog. This a great glimpse at the bowels of our financial system. The bonds you write about have caused havoc in all asset classes that will not go away until a market can be re-established.

As easy as the examples are laid out, my head swims in alphabet soup(especially since the summer). What in your (or reader's) estimation is the bond class that has fallen most in value relative to it's quality?

My final comment\question is this: I am reading an hearing that there is no market in MBS's: That they are difficult to price and so-forth. Aren't these bonds just real estate at the end? Why (in my ignorance)not just buy these MBS' at .20-.40 cents to the dollar and then sell the real-estate at 30-40% discount? Where is the spread?

Accrued Interest said...

Sivram: Thanks. I was working on the post when the CIFG news hit, and I agree that it reinforces my conclusion.

Anon: The problem is that the bonds being priced at 20c are subordinated. Often their claim on the assets isn't 2nd but 3rd or 4th. So if the real estate has declined in value by even 10%, there probably isn't anything left for the subordinated holders.

See my post "How a CDO Works" for more on this.

Anonymous said...

Very interesting work, and I've been waiting for your conclusions ever since I read about your project. Thank you for carrying through this exercise and writing it up.

Here is an aspect that I have never seen critically discussed. Ambac and MBIA not only sell insurance, but they also act something like banks for some of the note emitters. The note emitters invest their proceeds with Ambac or MBIA, and these monoline insurers promise to pay this money back with guaranteed interest. These are called "investment agreements" in Ambac's and MBIA's SEC filings. I believe that these are also called GICs (General Investment Contracts). The insurers try to make money on the spread, between what they pay out and the return on their investments. The investments they hold for this purpose are significantly larger than the investments held for paying eventual insurance claims. Ambac reports $19 billion in this "financial service" portfolio, compared to $10.4 billion in its financial guarantee portfolio.

And what did they invest in? Ambac invested a sizeable chunk in ... mortgage-backed securities (no other precision in its SEC filings, except that only a small part of the ABS is agency stuff). Ambac reports $4.7 billion in mortgage-backed securities and $2.2 billion in asset-backed securities. Only $0.4 billion of this is agency-backed. A 10% haircut of the non-agency mortgage-backed stuff would knock off nearly a third of Ambac's capital cushion.

And what would happen if the "depositors" start worrying the safety of their deposits and begin asking for their money now? Ambac's filings don't give much detail there, although they say that the depositors get their money only after certain unspecified events.

A downgrade of a major monoline insurer, or simply fear of such downgrade, could have something of a domino effect. That is because part of the guarantee portfolio consists of bonds insured by other insurers. This seems somewhat shortsighted, since liquidation of these bonds would most likely occur in a context of strain on the insurers.

Did you look at Moody's and Fitch's latest "pre-reports" of their latest stress tests? If so, what do you think about their work? (They are available on the insurers web sites.) Fitch used its "Matrix" model, lowered the ratings on subprime RMBS and ABS-CDO's (up to 4 notches for CDOs), and assumed recovery rates appropriate for the new ratings. This seems pretty simplistic to me -- after all, a CDO tranche insured by SCA was just downgraded from AAA to CCC-. Moody's carried out Monte Carlo calculations using information from the monolines and various assumptions. This seems more ambitious than Fitch's approach, but the assumptions are probably important: "Guarantors have not uniformly tracked -- in detail -- the composition of cascading CDO assets held within the CDOs that they insure." Moreover, this calculation only included losses due to CDOs, unlike Fitch who assumed downgrades of insured RMBS tranches too. Moody's assumed 10% maximum subprime RMBS loss which led them to conclude that all the RMBS exposure looks safe (while admitting that losses could appear if "subprime expected losses" were to rise to 12% or 14%).

Have you seen the Nov 2 report by Morgan Stanley analyst Ken A. Zerbe, entitled “On the Knife’s Edge: Can the Financial Guaranty Industry Survive?” This report seems to have had a large effect. I don't have access to such reports, but I have read the conclusion: "We had thought that the market was excessively discounting the risk of loss in the financial guarantors, but we misjudged the speed and breadth of the deterioration in the credit markets. We acknowledge that our prior call on the industry and the ABK stock was simply wrong, with several new data points now leading us to take a more cautious view of the group. ... We now believe the guarantors, particularly Ambac, could be forced to raise equity as losses mount in order to protect its AAA rating."

I have been short some of these insurers for several months, particularly SCA, Ambak and FGIC (via a short on PMI).


F-Trader said...

Nice job.

Anonymous said...

Love the post. Any more details on the loss estimations? How do you go about estimating losses for CDO^2?

Anonymous said...

Munis never default

haha... famous last words.

Anonymous said...

I believe that these are also called GICs (General Investment Contracts).

People with their retirement in funds such as the TRowePrice Stable Value fund aren't going to be happy if those things start blowing up.
The Stable Value Common Trust Fund Trust Fact Sheet
Sponsored by T. Rowe Price Trust Company
The T. Rowe Price Stable Value Common Trust Fund (“trust”) has been selected by your employer as an investment option for
your retirement savings plan. The trust seeks to provide you with maximum current income while maintaining stability of
principal. The trust cannot guarantee that it will achieve its investment objective.
What Are GICs, BICs, and SICs?
The trust will invest primarily in GICs, BICs, and SICs. GICs, BICs, and SICs are types of investment contracts that are
designed to provide principal stability and a competitive yield. GICs are also known as guaranteed investment contracts and are
issued by insurance companies, while BICs are known as bank investment contracts and are issued by banks (insurance
companies and banks are “issuers”). In a GIC or BIC, the contract holder places funds on deposit with the issuer and the issuer
promises to repay the contract holder’s deposit, plus interest, in accordance with the terms of the contract. The ability of the
GIC or BIC issuer to meet its contract obligation to repay the deposit (principal), plus interest, is dependent upon the issuer’s
financial strength.
SICs, or synthetic investment contracts, are similar to GICs and BICs. They can be issued by banks, insurance companies, and
other issuers, and they are designed to provide a stable asset value. However, unlike GICs and BICs, SICs are directly supported
by high-quality fixed-income securities, and the purchaser takes the credit risk of these underlying securities. While payment
under a traditional GIC or BIC is solely dependent on the financial strength of the issuer, SIC contract holders are able to rely in
part on the SIC issuer and in part on the supporting securities for credit protection, thereby providing added diversification and
stability. The trust’s total investment in all SICs will generally not exceed 75% of the trust’s total value at the time of purchase.
GICs, BICs, and SICs are considered to be illiquid investments and may be subject to substantial penalties if terminated prior to

Accrued Interest said...

Well, all I can say about GICS is that its a common insurance product, not just from the monoline insurers. I'd say that if a given insurance company went down, the GICS they had out there would cause problems, but it would be manageable. Now, if several insurers went down, that'd be a bigger problem.

Accrued Interest said...

I pretty much assumed the CDO^2 would lose 80-90% of value. Those things are toast. Maybe older vintages will do better. But 2006-2007 are toast.

Walt French said...

My thanks, too, for the post. But a question.

If insuring munis is so fall-off-a-log easy, why would Berkeshire, which knows a thing or two about insurance, buy damaged goods when it could open a storefront tomorrow and not have to worry about landmines in somebody else's book of business?

Likewise, if you were a lender, wouldn't you rather see Berkshire as the insurer than some maybe-can't-survive other firm?

"Inquiring Minds Want to Know!" ®

Accrued Interest said...


Yeah I agree. It might get to the point where buying into FGIC or AMBAC's existing franchise is so damned cheap that BRK can buy in cheaper than doing a start up.

I'd think if BRK wanted to invest in a muni insurer, and all else was held equal, they'd do MBIA. But investing in FGIC or AMBAC might actually be that much cheaper. We'll see.

Anonymous said...

Hi Accrued Interest,

Thanks for your analysis.

You say:
"they will suffer $4 billion in losses from their CDO portfolio"
"Losses in direct RMBS positions look to be in the $2 billion area."

Can you explain how you arrive at these numbers?

I've also tried to assess myself how much they might have to pay out and have a hard time exceeding $1B, which would imply this company is going to be okay.
This kind of assessment is very difficult, since as outsiders we don't know the details of their exposure. So, it's hard to second guess the company and the credit agencies, who all still maintain AAA.

Since the stock price is very far below book value, it seems to me you need to fear a recession of epic proportion to still rate this company a sell.

Lastly, it seems to me they have a lot of ways to raise capital. Here are 3 easy ways:
1. let their book run off a bit freeing up capital
2. divert some exposure in their book from transactions that require a lot of capital coverage to transactions that require less.
3. get reinsurance on some 'safe' portion of their book.

What do you think?

Thanks, and keep up the good postings.

Anonymous said...

I think an interesting option to look at in the monoline credit insurance area is AGO. The firm has always been at a disadvantage compared to larger rivals such as MBIA and Ambac, but looks to me like they are primed to now benefit substantially now from competitors weakness.

AGO intentionally avoided subprime backed CDOs over the past three years and is clearly being rewarded by the market as a result compared to competitors - but its still cheap trading around its book value. I don't know what its debt trades at. Anyway, if anyone has any thoughts, I'd love to hear them (especially AI's).

Full disclosure: I've already bought a very small amount of AGO shares.

Unknown said...

There are a lot of details about Ambac's CDO and direct RMBS portfolio on their web site. (look under "Highlights" on that page). It's clear that the deals labeled 24-28 with the mezz CDO and CDO squared are the most risky. Their par value totals about 2.5 billion. It's important to note that these deals have subordination levels between 30% and 57%, so loss estimates could vary widely with detailed assumptions about defaults and recoverys (e.g. one could imagine that 10% loss on the ultimate underlying portfolio would be no loss for Ambac and 14% could be almost total loss in those CDO squared deals). I disagree with the analysis that if they do need to raise capital then the value is just the franchise name. While it is possible that Ambac needs to raise capital, it is likely even in that event that the estimated runoff of the existing overall portfolio is substantially cash flow positive, so it should provide good collateral for a credit facility even in stress test scenarios.

Disclosure: I have no current position in Ambac, but I regard RAMR, with its 5% RMBS portfolio (maybe 1% subprime) to be very attractive at these levels.

Unknown said...

I forgot to mention above that, based on Ambac's disclosure, 35% of their CDO squared exposure is from the 2006-2007 timeframe. So that amount is less than $1 billion.

Anonymous said...

"muni's never default..."

First, holders of NY city debt in the early 1970s would beg to differ. I don't trade munis, so that is the only case I can think of off the top of my head. I suspect there are others.

Why would anyone bother to get ratings or buy insurance if there was never a default? I would hope Warren Buffet (or anyone) would ask that question before entering the muni insurance business-- the opportunity has been there a long time (and he hasn't grabbed it), so maybe he already asked...

Wall St "analysts" (is this considered an oxymoron yet?) are very fond of saying munis cannot default "because they can always raise taxes". I think people like Hugo Chavez and Fidel Castro might agree-- but more learned people would say its not quite that simple.

Clearly, a city or state could raise taxes by a certain amount without a huge issue-- but its rather absurd to suggest taxes are an endless source of funds.

Higher taxes tend to discourage economic activity and/or encourage more black market / off the books economy. People have the option to move to more fiscally conservative locations.

Obviously, AMBAC's exposure to to mortgage debt is getting all the attention, but their muni exposure shouldn't be considered "risk free". Remember: their mortgage exposure was thought to be risk free 6-12 months ago.

Many cities and states have MASSIVE off balance sheet debts: inadequately funded pensions, and totally unfunded health care obligations being high on the list. Many govt "accounting standards" make Enron look fiscally conservative. In addition to the sometimes discussed "off balance sheet" liabilities, state/local govts face rising social spending (both welfare and health care related) much of which will not be reimbursed by the Federal govt.

Some state/local govts (I am thinking major urban centers in particular) have allowed their infrastructure to literally rot. Roads are covered in potholes and divots; and quite a few are completely clogged with traffic from dawn to dusk. Look up the effect that bad roads have on third world countries -- at best they limit commerce, which is just another way of saying they limit the tax base.

With all the growth of housing and commercial property (aka suburban sprawl), many water, electricity and sewage systems are stretched and in need of expansion.

Somebody is going to reply to me and say "yeah, but those costs are born by the sewage or water authority, not the state"... Authorities are the original off balance sheet entities, long before Enron. Look it up: the NY State Turnpike Authority was created to circumvent voter imposed limits on debt issuance.

Raising taxes "directly" or raising taxes via an off balance sheet "authority" is just window dressing from an economic perspective. Either way, a government entity is taking money away from Joe and Jane Public.

To a certain level, this is "no problem" -- but there are limits before people rebel. Sometimes literally, sometimes by moving away or shifting to a black market economy.

Let's not forget that almost all state/local govts increased their spending in response to the "windfall" property taxes they received during the housing boom. The windfall has proven to be short term, but a lot of the new spending is repeating.

Since states/local govts have so much existing off balance sheet / unreported liability already, a future tax increase is already baked into the cake... future tax increases are already spoken for.

That means if finances become strained, many muni issuers will find they cannot "just raise taxes" -- and muni insurers will find themselves on the hook for a business they thought was just "printing money"

Anonymous said...

I probably should have written that last bit more clearly...

In the last few years, many mortgages were made under the (implicit) assumption that the housing boom would go on forever. They need continuous HPA (house price appreciation) to work. Call it over optimism during a bubble.

Well, that "over optimism" wasn't limited to just mortgages. In many cases, governments saw increased property tax and stamp tax (tax on transferring the property deed) rising with the housing boom -- and they too linearly interpolated this trend indefinitely into the future.

Well, the housing bubble is over Property related taxes are going to be much lower than expected / planned for. A lot of the new spending is perennial and ongoing, but the expected tax revenue has proven over-optimistic.

Lots of governments like to talk tough about spending cuts, but mostly these cuts are relative to an assumed increase. Instead of 9% increased spending, we "cut" the budget and will only spend 7% more than last year. If you look at government spending over time, it is always increasing-- only the rate of increase changes.

Will municipal workers accept having their pensions slashed by 30% (which supposedly is the average underfunding nationwide)? Can you cut welfare and health care spending by double digits? If you don't fix the roads, businesses can't deliver goods as fast, so they do less business at the margin, and the govt collects less taxes. And of course, all the above things are going to attract voter attention.

On the other hand, defaulting on bonds owned by a bunch of rich people is politically a lot easier to do. The "rich" are small in number (and in votes).

P.S. If living within our means was a viable option, we wouldn't be talking about a mortgage crisis.

Anonymous said...

A Lehman Brothers index comprising U.S. TIPS is up 11.7% since the start of the year and 10.4% in the past 12 months through Nov. 21. By contrast, the Standard & Poor's 500-stock index is nearly flat year-to-date and up 1.2% for the past 12 months through Nov. 21.

Didn't you have a negative article on TIPs about 6 months ago? Yes, I thought so and figured it was a good contrary indicator.

Sivaram V said...

My opinion on a couple of issues discussed here...


I just took a cursory look and it certainly seems safer. The stock price certainly reflects that.

Although they didn't write any CDOs in recent years (very smart move), they have huge exposure to RMBS from the last 2 years. Check out page 2 of this doc:


Anything 2006 and 2007 is risky and most of their RMBS is from that period. Overall it's still safer than Ambac but I'm not sure if it's better than MBIA (MBI has low chance of needing capital but has potential for big losses).

Another point one should consider is that attractiveness of a security depends on PRICE!!! AGO is only down around 20% versus 50% to 70% for MBI and ABK. MBI is trading at around 66% of book value; Ambac at 45%; and AGO at 86%.

Given all the uncertainty and risk in these monolines, I'm not sure I would want to buy anything close to book value (the 14% discount isn't enough IMO). Yes, all these companies traded above book for most of their life, but now they don't. You may never get a P/E expansion back to their earlier levels for years so buying close to book is not attractive in my eyes.

Now, if you think that they can steal market share then it may be attractive. But if you are conservative and go with historical trends then AGO is not cheap.

If I wanted something a bit safer, I would consider MBIA. Having said all that, I think if you pick one that does not go bankrupt or get diluted like crazy, then you will likely outperform the market for years. I don't think it matters which one you pick. I can see all of them--that don't fail--doing well. (these monolines are also not economically sensitive so if the US slows down they'll be ok)



If Ambac needs capital injection, I don't think they will be able to run off the book. The reason is because rating agencies may not give them enough time. They'll probably give them 1 or 2 months and that isn't enough time to increase capital via the existing cash-flow positive deals.

Fitch is supposed to release their opinion soon and I think Ambac may need capital. But the tricky thing for investors sitting on the sidelines is that it's not clear if the stock market is ALREADY discounting that. For instance, the whole sector rallied when CIFG received some capital injection (although this was with holiday trading with low volumes). You would think that the market will sell off these stocks sharply given that dilution is a possibility for almost the whole sector. So it looks like the market is pricing in some dilution.

Anonymous said...

I work at a financial guarantor managing firm capital. While you are correct directionally, I think in the short-term the bigger risk to AMBAC is the likelihood of further downgrades on their CDO portfolios and what the lower rating translates into in their stochastic simulation capital model. Such models tend to be highly penal of substantial downgrades.

Havoc said...

Naive question: Could Ambac raise capital without diluting shareholders through a rights offering? (Why did Countrywide, for example, give away equity to Bank of America rather than to existing shareholders through a rights offering? Is there some downside to a rights offering vs. selling the convertible?)

Accrued Interest said...

Alright every one, sorry for being an absent blogger. I'm going to post a more detailed description of my AMBAC analysis. Here are a couple quick points:

1) AMBAC has $29 billion in ABS CDOs they've insured, including $2.5 billion in CDO ^2. All but $500MM was 2007 vintage.

2) I'm obviously being facetious when I said munis "never" default, but the default history is stunning. Moody's has never rated a general obligation municipal bond which defaulted. Including NYC, which never actually missed any payments to regular bond holders. And including Orange County, which did default on some of its pension obligations, but did eventually pay all interest and principal.

Most of the defaults in municipals occurs with "corporate-like" obligations. In other words, operating companys (either for or not for profit) not governmental entities. So that's hospitals, housing projects, private schools, etc. The history of municipal utilities, public universities, transportation authorities, etc. defaulting is very very very rare.

Anonymous said...

"Most of the defaults in municipals occurs with ... hospitals, housing projects, private schools, etc."

Yes, and that's interesting because there must be municipalities which have gotten out on a limb with shopping centers, housing developments, etc. That's a vector -- in addition to general markets turmoil and tax revenues falling from the housing implosion that's still happening -- for the housing crisis to start upsetting munis. I wouldn't use the "virtually no" default history as a forecast for what's now out there.

Accrued Interest said...

Well Walt, I think there are two things I understand better than almost any blogger out there: munis and CDOs. Most so-called industrual development bonds, which would finance something like a shopping center, hotel, sports arena, etc, are not backed by tax revenue. And if they are, its usually property taxes collected on the project itself. So actual governmental revenue isn't at risk.

Now, property taxes are a real risk. I think there is a slim chance of that actually causing muni investors to lose money. Think back to California. They had big time problems due to reduced capital gains tax collection in 2002. All those Silicon Valley billionaires suddenly had no taxable income! But there was no default. In fact, the state remained investment grade the whole time.

Richie said...

LOL, I think you guys will have fun reading this paper...look at the author. Its available through JSTOR and maybe google scholar. If you're interested but can't get access, let me know and I can get you a PDF.

"The Credit Crunch" by Ben S. Bernanke; Cara S. Lown; Benjamin M. Friedman

Brookings Papers on Economic Activity © 1991

Anonymous said...

AI - I would be very interested to read your analysis on muni default probabilities -- present tense-- if you have any. It is an area I have very little experience / expertise, and I have found GASB regulations to be very frightening (in an Enron sense). I readily admit I have little knowledge about municipal finance-- but every time I read about a swap deal blowing up, its pretty obvious the public finance officials don't understand it either. Jon Corzine, with his Goldman background, allegedly had a lot of trouble understanding some of the swaps NJ municipalities had entered.

Anyway, I know that municipal defaults have been somewhat rare the past 50 years or so -- but I am not sure it is fair to extrapolate that history forward:

Government was much smaller and fiscally conservative before the new deal / World War II. Lots of projects that might be considered public today, like building the Erie Canal, were privately financed until around the new deal or so. Lots of projects, like the Hoover Dam, were depression era "make work" projects. The interstate highway system resulted from Eisenhower seeing the Autobahn and the need to mobilize the U.S. for the cold war.... so in short, a lot of public spending finance is "recent", the last 50 years plus or minus.

During that time, municipalities had the wind at their back. After WW2, the U.S. economy had zero competition for a decade or so (everyone else had been bombed in the war). On top of that, demographics were hugely in public finance's favor.

Obviously no way to predict the next 50yrs, but it seems like a lot of trends will turn against public finance. An aging population generates less income (paying less taxes)-- but needs a lot more health care spending. I already mentioned how lots of infrastructure needs repair / expansion. There are lots of debts (public employee pensions and OPEB) that do not appear "on the books" according to GASB, but they are real. And unlike 50yrs ago, municipalities are starting the next 50yrs from a far far more leveraged position.

I agree that municipal defaults have been historically rare, but I am not sure whether or not that trend can be extrapolated forward. Defaults may or may not rise, but I don't think history is necessarily a good guide.

Unknown said...

accrued interest said:
"1) AMBAC has $29 billion in ABS CDOs they've insured, including $2.5 billion in CDO ^2. All but $500MM was 2007 vintage."

What's most relevant to RMBS concerns is the vintage of the underlying collateral. That's broken out in section B of their disclosure:

Anonymous said...

Today AMBAC showed another graph about vintage of their CDO squared.
It shows peak vintage at Q3 2005.
There is almost no exposure to 2007.
There is little exposure to the second half of 2006.

They also showed a graph showing loss development of 2005 vintage to be just like older years, while 2006 is higher.

Let's look into more detail of the largest exposure: deal 26 with $1.4B of par value.

This deal has 30% subordination below AMBAC. This means 30% of the inner CDOs need to go bust for AMBAC to incur any losses on the outer CDO.

The original vintage of underlying RMBS in this deal is approximately:
2007: 1%
2006 Q3/Q4: 7%
2006 Q1/Q2: 23%
2005 and earlier: 69%

The inner CDOs are 94% AA rated and 6% A rated, while the underlying collateral of those is primarily BBB.

So, we have quite a bit of information here.

Next step: figure out the risk that a lot of the inner CDOs will go bust.
Who knows how to do that?

Anonymous said...

News out.."The chief financial officer at Ambac Financial Group Inc on Tuesday said the bond insurer would consider reinsurance transactions to free up capital as investors worry about Ambac's exposure to subprime-related assets.

Ambac CFO Sean Leonard said the company will continue to defend its triple A rating, and added that there's a lot of opportunity for the company to reinsure its transactions. He said about 85 percent of the company's portfolio is non-mortgage related.

Leonard made his remarks at a Bank of America bond insurance conference in New York. Other options Ambac would consider to raise capital include issuing debt or equity, executives said.

Bond insurers face questions on whether they have enough capital to absorb losses on their guarantees against defaults. Ambac executives said the company's excess capital tops $1 billion. ""

Anonymous said...

Berkshire owns General Re I think. Could this latest news be a back door atte mpt for Buffett to enter the bond insurance business?

Buffett's right hand man with the reinsurance brains is Ajit Jain, and he might be getting excited about the carange we are seeing.

Anonymous said...

Interesting post. I really don't like the concept of rating the insurers using one criteria and using mark to non existent market for others. This sets up a situation where you have both regulatory and rating agency arbitrage opportunities. Everything is mark to market (regardless of likely outcomes), but any security with credit enhancement gets booked at par. As a thought experiment, suppose that instead of the super SiV, Citi just set up a bond insurer, capitalized it with a few billion, and insured the super senior AAA stuff -- not their own, mind you, but lots of it which would then stabilize the markets, etc. Obviously this wouldn't fly. But the existing credit insurers are getting grandfathered on this.

These insurers simply aren't AAA. Traditional AAA credits (not synthetics) don't default, or have a highly remote chance of default over a rather lengthy period. However, if they get downgraded, then they are dead, since they have no future revenue.

I am not sure that I agree with your logic about booking losses. It almost sounded like you were saying that they book the losses when they pay out cash. I think they have to accrue their best estimate of ultimate losses based on estimates, models, etc. Maybe they can discount for the time value of money, but it isn't pay as you go.

Therefore the idea that they can count on future earnings instead of raising capital for losses on their current portfolio doesn't really make sense. Unless the rating agencies allow them to make optimistic estimates.

I hadn't even considered GIC exposure. That could bring them down. Disclosure -- I have a couple of puts on mbia, but it was just an emotional investment decision.

Anonymous said...

BK has $8.8B in notional exposure to direct sub prime RMBS. You are assuming they lose $2B. Based on an average subordination of 22%, you would never get to $2B in losses on the ABK layer, given the default rates you are projecting, AND that is assuming they are all of the worst vintage, which they are not, that they are ARMs, which they are not, and that they are from the wors servicers/originators, not again. Will not take a stab on CDO2, because who knows on that one, but if direct losses are much less, whole capital raising will not be necessary

Accrued Interest said...

My $2 billion was for their whole RMBS position, which is $53 billion.

Anonymous said...
This comment has been removed by a blog administrator.
Accrued Interest said...

If you wrote the comment I just deleted, please read this:

Then rethink your comment. You are welcome to repost if you have something of substance to say.

Anonymous said...

Fitch lowers the ABK rating and 24 hours later, the stock rallies when either bailout or buyout rumors develop.SCA is next.. Popped on the 23rd, down 30% today on a Fitch downgrade and will pop 30% plus tomorrow IMO
We just saw this movie...

Now SCA might be a frozen target if the downgrades extend, but they will now run this stock on the buy or bail model...
If the stock does not blow past 5 by Monday, I would be surprised.

Anonymous said...

SCA is getting this type of chatter on other blogs tonight.
To me , they are in the same fragile state as MBI and ABK, but I agree with you. SCA should explode upside
( if you can really use such superlatives to describe a beaten up stock)
MBI and ABK are also going to run as Buffet lead the way on the M&A train.
ABK already up in after hours trading, as is SCA
The bailout appears to be in the wings and if you have investment in this junk, at least you got to see ABK ride up 80% this week, with a probable 100% further upside. SCA should hit 6 bucks by the time it is "saved
The munis are this month's momo plays

You said...

When you are right you are right