Friday, July 11, 2008

A New Monoline: Its our only hope

On Tuesday, Ambac announced it is making progress on recapitalizing its Connie Lee subsidiary. This sent Ambac and MBIA's stock prices soaring (+52% and 22% respectively) and their credit-default swaps plunging (about 6 points each). CDS on both company's insurance arms are now 20 points below the wides. What are their plans for recapitalization and what does it mean for municipal bond investors?

Both Ambac and MBIA are facing three grim realities:

1. They cannot raise enough new capital to regain a AAA/Aaa rating, especially since the ratings agencies have shifted their focus away from capital adequacy and onto financial flexibility.

2. They cannot write new business without a top rating.

3. It will take at least two years before the extent of their residential mortgage losses are known. Even given a very favorable outcome, too much time will have past for them to rebuild their franchises.

There is a faint glimmer of hope, however. Despite all the problems monolines have faced recently, there is continued demand for municipal bond insurance. During the first quarter, about 24% of new municipal issues carried insurance. Down from the historical norm of 50% or so, but still a reasonable market. So if Ambac or MBIA could just start fresh, there is some chance they'd be able to rebuild their reputations for financial strength. Its probably a long shot, but its not impossible.

The plan to get this fresh start is relatively simple. Ambac Financial Group (the parent company) plans to transfer $850 million out of Ambac Assurance Corp., which is their primary insurance subsidiary. This is made possible, ironically, because Ambac Assurance has reduced capital needs now that they are only rated Aa3/AA. The cash would go to Connie Lee, which is in essence a dormant registered insurance sub. In theory Connie Lee could operate with its own assets and liabilities, with its own relation to Ambac's current insurance operation being a common holding company owner. Hence there would be no mortgage exposure at Connie Lee. This would presumably allow for a AAA/Aaa rating and possibly the ability to write new municipal bond policies. MBIA's plans are substantively similar.

Where does that leave existing policy holders? At one time, there was talk that the new insurance subsidiary would reinsure all the existing municipal bond policies. In effect, transferring existing municipal insurance from Ambac Assurance to Connie Lee. This was legally complicated, as it would have in effect benefited one class of policy holders (munis) at the expense of another (structured finance). There would be lawsuits and the plan would get tied up in court for years. So now it appears that this kind of plan is dead in the water. Therefore even if Ambac is able to capitalize Connie Lee and get a fresh AAA/Aaa rating, there will be no direct benefit to current Ambac policy holders. In fact, Ambac Assurance will lose $850 million in capital in the process, putting existing policy holders in a somewhat weaker position.

On the other hand, if the plan were to actually work, if Connie Lee is able to start writing a reasonable amount of new muni business and therefore Ambac Financial is able to remain solvent, existing municipal bond holders will probably benefit. Over time, Ambac's structured finance exposure will dwindle, either because they realize losses or because the underlying bonds pay off. If indeed the parent company survives this process, they may be able to regain a top rating, or perhaps merge the existing Ambac Assurance with Connie Lee and regain a AAA/Aaa rating that way. Again, MBIA's plan would work similarly.

What are the odds the plan will work? It depends on how the market perceives Connie Lee vs. Ambac. Does the market think that Ambac's poor credit work was to blame? Or will the market separate the poor judgement Ambac showed in the structured finance market from their decisions in the municipal market? It will probably take Connie Lee accepting a relatively low premium and/or insuring weaker credits at least at first. Then slowly repairing their reputation. The odds are against them, but like I say, not impossible.

So how should muni investors treat Ambac and MBIA insured bonds? The reality is that any bond with an Ambac or MBIA (as well as FGIC, XLCA or CIFG) insurance is trading weaker than the underlying rating would imply. In other words, bonds are trading as though there is a penalty for once carrying Ambac or MBIA insurance. While this would seem to present a buying opportunity, be sure you can handle the illiquidity. Many institutional municipal buyers don't want to explain to their clients why they hold so much MBIA paper, so even at higher yields, bids can be hard to come by. I wouldn't expect the "penalty" to go away any time soon, so buyers of this kind fo paper need to have a long time horizon.

As far as MBIA or Ambac debt, proceed with extreme caution. Both companies are in Hail Mary mode, as current conditions have left them with very few options. In such situations, bond holders are not given much consideration by management. Preferred shareholders are in particularly precarious position, as they sit behind both insurance policy holders and senior debt holders.

The common stocks of both companies saw a significant short-covering bounce. One has to wonder about the wisdom of shorting a stock trading at $1 anyway. Common shareholders should view these latest plans as a last-ditch effort to create any kind of value for shareholders. Given that is the situation management is in, nothing more needs to be said about the risk of owning the common.


Gringcorp said...

It's possible in theory, but even the slightest cloud over the new Connie Lee will create a risk premium for bonds carrying its wrap over what Assured or FSA could offer. There's this assumption that some type of insurer has to emerge from the ashes of MBIA and Ambac. It doesn't. Sure, their downgrades have an outsize importance, but there's no reason why a new player can't just hire management from Ambac and MBIA and get going that way. I bet Macquarie is looking at doing so for the new monoline they're considering. The barriers to entry in the monoline are mostly financial - finding a cheap enough source of capital. Monolines are pretty thinly staffed (remember, Ambac once had the highest profits per head of any US corporation), require no specialised equipment, and a huge amount of their due diligence is outsourced to the ratings agencies. That means the minnows can scale up pretty quickly if the big guys fall down, so long as they don't go chasing after the nasty business as well as the nice stuff.

capitalhill said...

Will there really be strong demand for bond insurance in the muni market going forward? The rating agencies are moving towards rating munis on a "global scale"--as AC has discussed before--and a lot more of the market will become "natural" triple-A. Not all, but more than now.

Accrued Interest said...

I think that monolines will continue to insure about 20% of new issues. We'll see, but that's my view.

Still think the odds are long for ABK or MBI.

Gringcorp said...

Those monolines never cease to surprise me. Ambac just wrapped $250 million-odd in notes for a military housing deal. They're slightly unusual credits, but nothing that I'd imagine an Ambac wrap would be much help with.