Saturday, December 29, 2007

You're wrong Assured Guaranty. You have that power too.

Berkshire Hathaway is starting its own municipal bond insurer, Berkshire Hathaway Assurance Corp. There are three questions. First, what impact will this have on the muni market? Second, what impact will this have on other monoline insurers? And third, what will muni guys call the new insurer? BHAC? (Pronounced like Be Hock? Maybe the old Oracle should have thought about that a bit more).

The answer to the first question is that its great news. See below.

The answer to the second question is that its great news for some and terrible news for others. Remember that it was often speculated that Berkshire could be a source of capital for the likes of AMBAC, MBIA or FGIC. I myself wrote the following in November:

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.

Now Buffet won't be on board, so you can forget all that. Its possible BHAC sells some reinsurance to existing muni bond insurers, but that won't inspire confidence in the overall concern like a direct investment would have. I'd therefore put the odds of an eventual downgrade of FGIC as very high, AMBAC and MBIA as moderate. S&P and Moody's are currently satisfied with both MBIA and AMBAC's capital position, which means that any downgrade of these two is likely 6-12 months away if it happens. I believe both MBIA and AMBAC will need more capital, so the moderate odds of a downgrade is based on the odds of them raising more capital. FGIC on the other hand needs capital pronto and I don't know where its going to come from.

I'm skeptical that any of these three can remain a going concern without a AAA rating. I'd suspect they go into runoff. MBIA stock was down nearly 16% today, AMBAC down nearly 14%.
Meanwhile, Assured Guaranty was also lower today by about 4%. The market is reading the Buffett news all wrong by punishing AGO. See, AGO is kind of like the C3-PO of bond insurance. Not especially better than the next protocol droid, but happened to get stolen by the right Jawas at the right time. Now AGO is right in the middle of saving the entire galaxy from the Evil CDO Empire! I guess Buffett is kind of like Luke in this metaphor? Or maybe Obi Wan? I digress.

AGO has benefited from a ton of free press in the last 6 months. As problems with the larger, more established MBIA, FGIC, and AMBAC became apparent, both the ratings agencies and Street firms starting publishing regular reports on all bond insurers. This thrust little Assured into the mainstream consciousness. Suddenly the "reputation" barrier to entry in the municipal insurance business had been smashed into who knows what.

The only risk AGO stock holders face is the possibility that municipal bond insurance declines as a concept. That bond buyers are no longer willing to pay for extra protection on AA-rated school districts and A-rated sewer systems. The fact is that the history of defaults on these types of credits is slim indeed, which is exactly why the municipal insurance business is so profitable. Classically, muni buyers liked insurance because it prevented them from having to do any credit research. So the question is, will investor laziness trump the fear created by current insurer troubles?

I believe the entry of Buffet's firm solidifies the laziness argument. Now municipal buyers can say that we have three solid insurers without any significant structured finance holdings: FSA, AGO, and now BHAC. That's enough insurers to diversify a portfolio reasonably. We can also dismiss FGIC and whomever else winds up going down as insurers who made bad decisions. Not that insurance is a bad business or a bad concept.

I've been around the muni market long enough to know that these people like the status quo. Even more so that other markets. They want to believe in insurance. They want to keep buying insured bonds without thinking about it. They won't need a lot of convincing that throwing FSA and AGO out with the FGIC bathwater is a bad idea. Its what they want to believe anyway.

So back to AGO stock. Its really the best pure-play muni insurer going. Current its trading around 1.1x book. MBIA and AMBAC had been trading more like 1.3x prior to the credit crunch. But that's not the real reason to own AGO. Assured is going to rapidly rise from also-ran to major player in municipal bond insurance. Municipal issuance is going through a bit of a lull here, but after the new year, we're going to see muni issuance ramp back up. Issuers are going to be looking for insurance, and they ain't going to be calling MBIA. Assured, FSA and Berkshire are going to dominate municipal insurance in 2008. This should allow Assured to grow their book value just as fast as they can get capital to grow it. This will also create improved pricing power, which is the reason Buffett gave for making an entry into the muni market. So you may argue that AGO should trade at a higher multiple of book value than MBI or ABK did in years past.

AGO's stock may be rocky, especially if any of the problem 3 wind up in run-off in 2008. But still, as a long-term investor, I'd be happy to ride that out. AGO has a great model and a great opportunity. In time, they will learn to use this power. And I want to be in on the ride.

Disclosure: I own many insured munis, and am personally long AGO stock.


Anonymous said...

AI once said.."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.""

And also says.."I'm skeptical that any of these three can remain a going concern without a AAA rating.""

I'm confused. Perhaps a great blog entry in the future would be to explain the different business models of these companies.

If FGIC gets downgraded, to what rating would you guess? And why would this really hurt them if say, they go down to AA rating?

Anonymous said...

Hi AI,
I posted once before about AGO saying how their insured subprime RMBS securities were doing, etc. I was just wondering if you were long AGO at the time you responded to my question. I am very (pleasantly) surprised to hear you are long AGO btw.

Sivaram V said...

How dare you insinuate that Buffett is Luke or Obi Wan? Didn't you know that he was an Oracle... green... wise... shrouded in mystery... he's cleary Yoda :) Teaching disciples--in this case the undisciplined bond insurers--the wisdom and courage to defeat the evil forces lurking everywhere ;)

On a serious note...

I think the whole industry is good for those that will survive. I don't know much about AGO but it is the "safest" bond insurer for sure. However, I'm not really sure I agree with some of your conclusions and the potential upside you see in AGO.

I think a lot of it comes down to brand name recognition and insurance underwriting expertise. Does AGO really have the expertise of Ambac or MBIA? I would guess not. Given the issues by Ambac, MBIA, and others, you would question their expertise but the verdict is still out. Until they start posting real losses, it's hard to say.

If AGO actually can write more insurance, why are they giving up their capital to take on reinsurance (from Ambac in the latest example)? Instead of providing reinsurance, they would forgo that and write more insurance for muni bonds instead, wouldn't they? I'm sure the reinsurance deal was attractive to AGO but still...

I'm also not sure if a good case can be made for 1.3x+ book value for AGO (or anyone else--other than possibly Berkshire, but that's not publicy traded). I have a feeling that no one is going to trade at 1.3x for long time (I'm not talking about short-term spike but a permanently high valuation). My impression is that the market placed a 1.3x book value multiple on Ambac and MBIA because of their profits from structured products (like RMBS, CDOs, ABS of various types, etc). Ambac had the highest profit margin in the S&P 500 last year and I suspect it would never have had margins like that without structured products that are causing problems now.

Anyway, I'm not bearish on AGO but just saying that I don't see the upside as much as you do. It'll be interesting how all this will work out in the end. Anyone betting on AGO is clearly investing in it as a growth stock, while MBI/ABK/etc are turnaround distressed investments. In the end, as Wilbur Ross said a few weeks ago, any bond insurer that survives intact will do very well... good luck to all the longs...

Accrued Interest said...

Dave: Radian's basic business model is to insure Baa-type risk and make it Aa-rated. But that business model is viable at an A-rating.

MBIA's model is to take Aa risk and make it Aaa. Obviously that doesn't work if MBIA is rated Aa.


It looks to me like their RMBS risk is low. They will take more losses than they planned, but they have little in CDO^2 risk, which is where the big losses are coming from. I just bot AGO on Fri.

Sivaram: I knew someone would say that about Buffett. :)

Anonymous said...

"If AGO actually can write more insurance, why are they giving up their capital to take on reinsurance (from Ambac in the latest example)?"

1) Great returns on invested cap.
2) Great press.
3) Imagine this, you are talking to a municipality who is looking for bond insurance.

Muni: "We usually go with Ambac"

AGO: Ambac? Great company, as a matter of fact, we just bailed them out.

Pretty good pitch...

Anonymous said...

Don't you think that ORI provides best value in the sector, compared to AGO too?

ORI quotes now at 4,39 times the average free cash flow of the last 5 years until 2006 (771,3 mln $), and 3,17 times the FCF of the last 12 m. (1,07 mld $).
Those figures for AGO are 11,24 (174,38 mln $) and 7,29 (268,78 mln $).

You can buy ORI for 0,86 the book value, and with a yield of 4,1%.
AGO quotes 1,1 the book and yield slightly more than 0,5%.

Though I have not the ability to understand deeply this kind of business and its accounting, I don't think ORI presents more risk than AGO.
Opposite, ORI looks like much more diversified.

Maybe it's not a pure player in the bond insurance business, but anyway....

cak said...

Reggie Middleton has weighed in on AGO & Ambac


Anonymous said...


ORI isn't a Bond insurer and so won't have the opportunity to capitalize on the hard market that AGO is looking at.

I like ORI by the way, but they focus on insuring different types of risks, such as Personal Mortgage Insurance, Title Insurance and General P&C. Its involved in different markets with different dynamics.

Anonymous said...

Another potentially interesting investment possibility is FSA. FSA has generally received very good evaluations from the rating agencies. Although FSA did insure some "financially engineered" structures, it stayed out of the worst stuff (ABS CDOs and CDO-squareds).

Although FSA is 100% owned by the Belgian bank Dexia, it has three exchange-traded bonds: FSB, FSE and FSF. These bonds have been hit and are now yielding junk-style returns. On Jan 31, they were going for prices which implied yields between 8.5% and 8.7%.

In FSA's Sept 30 quarterly operating supplement, the company said its third quarter "present value originations (a non-GAAP measure)" had increased by 179% over year-ago originations. The same measure increased by 54% year-over-year for the first nine months. From a March presentation: "FSA and Dexia have long expected problematic developments to arise in the ABS sphere, and more particularly in the sub-prime segment. We have thus strongly reduced our underwritings and investments in the sub-prime mortgage asset class over the last two and a half years"

There has been some favorable news coverage of FSA. Joe Mysak wrote that FSA was chosen in the secondary market for more than 50 out of 64 blocks -- these blocks, previously insured by others, were reinsured during the first three weeks of November. The Chicago education board chose FSA even though it was not the low bidder. "One issuer worried that FSA's insurance costs will increase with its growing popularity. 'They are in the cat-bird seat right now,' the issuer said."

Anonymous said...

Good commentary on AGO, however, muni bond insurance is a small fraction of their business.

They had some $8 bb of subprime mbs' on their books at the end of 2006.

They also took on $29 bb of ABK's problem children in a reinsurance deal, both don't bode well going forward specifically in regards to their 3rd quarter 10-q and the losses they had on their protfolio.