MCDX: We had better start the evacuation

A few months ago I heralded the MCDX as a potential game changer in the muni market. I'm afraid its failed to live up to its potential, and arbitragers are likely to step in and push it into oblivion.

For those who did not read the original article, the MCDX is credit default swap (CDS) index of 50 municipal credits. By buying (or selling) the index, you are in effect buying (or selling) equal portions of 50 different protection contracts. If one of the credits within the MCDX defaults, the buyer of protection delivers a qualified obligation of the defaulted credit to the seller of protection. In return the seller of protection pays 100% of the face value. The par amount of the bond delivered is equal to 1/50th of the original notional amount.

The current 5-year MCDX spread is 86.25bps. This means that in order to buy $10 million in default protection against the 50 names in the MCDX, investors make the equivalent of $86,250 in annual payments, assuming a new contract were created today.

Historically, defaults on municipal credits have been very rare, particularly in comparison to corporate credits. According to Moody's, there was only 1 default of a "general obligation" (GO) municipal (meaning a state or local government with taxing authority) from 1970 to 2006, and that default was cured in 15 days. Among investment-grade, non-GO municipal bonds, only 0.29% defaulted within 10-years of issuance, according to Moody's. This compares with 2.09% of investment-grade corporate bonds.

However, the weak economy generally, and declining property tax collections specifically, could result in unusual pressure on municipal credits. Yet, the particular credits within the MCDX are among the safest in the market. Property taxes are usually collected by states, but distributed primarily to cities, counties and school districts. While other revenue sources, from income and sales taxes to toll collections are likely to be impacted by the current economy, those revenues are likely to follow a more typical recessionary pattern, which municipalities have weathered in the past. The MCDX includes only 4 cities (New York, Los Angeles, Phoenix, and Columbus, OH), one county (Clark County, NV), and one school district (Los Angeles).

So perhaps municipal default rates will rise in the future. But wouldn't we expect corporate default rates to rise as well? Compare the MCDX with the CDX IG, an index of 125 investment-grade corporate credits. The CDX IG closed on Wednesday at a spread of 144bps.

Using standard recovery assumptions for both indices (80% for munis, 40% for corporates), one can calculate the expected default rate based on each index's current spread. The graph below shows the cumulative expected default rate based on current spreads for both indices.

As you can see, the MCDX is trading at levels that imply nearly 20% of the municipals in the index will default within 5 years. Again, it seems likely that municipal credits will be more stressed than in years past, but given that the credits within the index are only mildly exposed to property taxes, a 20% default rate seems unlikely.

In addition, because of the stronger recovery expected in municipals, the current spread levels imply greater default levels for municipals than investment-grade corporate bonds. This is tough to imagine. We know consumers will be pinched, but given a choice between paying their taxes (and avoiding jail) versus buying goods from corporate America, I think its obvious which way people will go.

So why not sell protection on the MCDX versus a half as large long protection position in the CDX IG? The trade would be slightly positive carry, and your only bet would be that losses among the 50 municipals are less than half of the 125 corporates in the CDX IG. Or if recovery is similar to historic norms, then merely that municipal defaults will be about the same as corporate defaults. Whatever your view of the economy, this should be a relatively easy trade.

I think at some point, arbitragers will put this trade on, and it will expose a lack of deep liquidity in the contract. Talking to various traders, it looks like much of the trading in the MCDX has been macro hedgers, not betting on munis in particular, but using municipals as a means of hedging against a disaster event. But at current levels, the hedge is too expensive, and given a little positive momentum, it will be exposed as such.

Accrued Interest Job Posting

I know times are tough in the finance business so I figured I'd pass along a job opening I know of. Its a chief compliance position for a trading firm. I don't know that much about what they are looking for, but I'd assume some compliance experience is required. E-mail your resume to "accruedint *AT* gmail.com"

GSE Bailout: Alternative forms of persuasion

The other day I wrote about a possible form of a GSE bailout. In the spirit of stimulating creative ideas, here is another possibility. Bear in mind that its looking more and more like a bailout isn't imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

Despite what all the talking heads are saying, no one really knows, maybe not even Henry Paulson, what a bailout will actually look like. But there are ways that a bailout could be structured to both protect senior bond holders and help prevent the need for another bailout in the future. Now is a good time for people with good ideas to come forward.

First we have to consider what the goal of a bailout should be. In this case, its very simple: ensure liquidity to the mortgage market. This protects banks which have committed to home loans assuming one of the GSEs would buy them. This also keeps mortgage borrowing rates stable.

Beyond that though, there needs to also be some long-term solution to the GSE situation. Fannie Mae and Freddie Mac cannot return to business as usual. Another structure needs to be devised that reduces the systemic risk surrounding the mortgage GSEs. On the other hand, a simple "demonstrable privatization" is not a near-term solution either. Currently Fannie Mae, Freddie Mac, and Ginnie Mae are the only thing standing between here and absolutely zero market for home loans.

Many solutions being bandied about presume the long-term model for mortgage securitization remains in tact. But why? A big part of the inherent problem in the GSEs' current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie's guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We'd wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds? Remember that a covered bond is backed both by the credit of the issuing bank as well as a pledged pool of mortgages. So in order for anyone to take a loss on a covered bond, the bank would have to be bankrupt and mortgages would have to be defaulting.

Let's say the newly recapitalized GSEs are restructured more like an insurance company, where the GSEs would guarantee to investors some percentage of par, say 95%. Banks would remain on the hook for losses within the pledged pool as long as the bank itself remained solvent. But in the event that the bank goes under, covered bond investors would have a known limit on their losses. The GSE would also have contained costs, since in most cases the pool of mortgages which had originally secured the covered bond would have some residual value.

This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

That leaves what to do with the old GSE guarantee portfolio. Assuming the Treasury has infused Fannie Mae and Freddie Mac with new capital, those portfolios could simply be allowed to run off. Alternatively, the Treasury could require the new GSE to buy preferred shares of the old Fannie and Freddie, helping to offset tax payers costs. Eventually this new GSE could be "demonstrably privatized" as market confidence is regained.

GSEs: No takeover this weekend

Merrill Lynch is telling clients that a source within Treasury says they want to keep the GSEs in their current form, as in shareholder owned. That implies no "takeover" any time soon. It also implies that some alternative to a full blown takeover would be the first step.

I'd say that tells me that Treasury buying MBS is very likely in the near term.

What Treasury needs to do is simply give the market a plan. What if they came out and said "If either or both of Fannie Mae or Freddie Mac's capital ratios fall below the regulatory minimums, the Treasury will [insert plan here]" The plan would spell out where the Treasury's investment would be, which would give some picture to all investors in any part of the capital structure.

The market doesn't care what happens to GSE common holders. The market needs some visibility about the possible outcomes.

Student Loan ABS: Do or do not!

The world of asset-backed bonds (ABS) is in disarray. While home-equity securities have grabbed the headlines, other types of ABS have suffered as well. Student loan ABS are one example of the baby being thrown out with the bath water.

There are two basic types of student loan ABS. Some are constructed with private student loans, and these carry risk of those borrowers failing to make payments. Others are made up of Federal Family Education Loan Program (FFELP) loans. FFELP loans are at least 97% guaranteed by the Department of Education (loans made before July 2006 have a greater guaranty).

Despite the guaranty, the yield spread on FFELP student loan bonds has widened substantially, creating an opportunity for investors looking for income securities which are not significantly exposed to credit risk.

A typical FFELP student loan securitization will include approximate 5 tranches. The first four will usually be labeled something like A1, A2, A3, and A4. These are all senior securities. The last tranch is a junior security, commonly called the B tranche. In the most recent Sallie Mae student loan securitization, the B tranche represented 3% of the entire deal structure, exactly the amount uninsured by the Federal government. This effectively eliminates credit risk for the senior securities.

The four senior tranches pays floating interest quarterly based on a spread to 3-month LIBOR. The spread is set at issuance. In the secondary market, the bonds will trade at a premium or a discount to par based on the relative attractiveness of the original issue spread. Principal on these issues is paid sequentially, with all principal flowing to the A1 tranche until that tranche is completely repaid. Then all principal flows to A2 and so on. As a result, the tranches have very different average lives. Usually the A1 tranche has an average life of around 1 year. The average lives of the other tranches varies from deal to deal, but typically there is a 3-year and 5-year tranche as well.

According to Merrill Lynch, 1-year FFELP student loan ABS currently yields 65bps over 3-month LIBOR. 3-year paper has a spread of 100bps, and 5-year 125bps. These spreads had been relatively constant in the 0-15bps area for several years before widening rapidly last fall. So far in 2008, student loan ABS spreads have moved higher or lower with the tide of liquidity. Spreads peaked in March, tightened in April and May, and have recently widened to near March levels again.

In a fixed income market where many securities are offering historically wide spreads, student loan ABS offer some unique advantages over other short-term alternatives. The structure is most similar to a corporate floating rate note (FRN), but of course the student loan paper has no substantial credit risk. Consider that John Deere Capital (rated A2) just sold $350 million of a new 2-year FRN at LIBOR+50bps. Investors could buy a 1-year average life student loan bond and get more yield with less credit risk. Other alternatives, like agency discount notes, collateralized mortgage obligations (CMOs), or other ABS, either yield less or exhibit more credit risk.

Of course, student loan ABS has widened for a reason. General market liquidity is the primary reason. In consort with the lack of liquidity is the fact that funding of leveraged positions has become more difficult. So buyers who might have arbitraged away the wide spreads in student loans are just not able to do so. Indeed, there is no obvious catalyst for student loan ABS to tighten from current levels.

But these securities allow investors a place to hide from credit risk while still earning attractive interest rates. Eventually the fundamental value of these bonds will bring in buyers weary of losses in other sectors.

GSE Bailout: It's not impossible

I had previously argued that the GSEs should be broken up into 10 or so separate private companies. On Monday, Alan Greenspan spoke favorably of the same idea. Yesterday, Richmond Fed President Jeffery Lacker argued that the GSEs needed to be nationalized, then "demonstrably privatized" by selling off the remains, likely into more than just 2 pieces.


Such a plan is probably the least risky to tax payers. It also would result in a cleaner and more permanent solution than some kind of Treasury-backed equity investment.


How might this work?


First we'd need to make the GSEs sellable, which they currently are not, as evidenced by their share price. To do this, there would need to be meaningful deleveraging, which has to come at tax-payer risk, I'm afraid. I think the solution is to use GNMA program. Treasury announces they are tendering some amount of Fannie/Freddie MBS. The bonds tendered would be exchanged for GNMA bonds of the same coupon. This would ultimately be similar to the MEGA program. It could be stipulated that all tendered loans would have to meet standard FHA guidelines, so like most hybrid-ARM securities wouldn't qualify. But so what? We'd get the leverage of the GSEs down by a certain degree.


Note that the tender would be initially profitable for the Treasury, because of the spread between GNMA securities and FNMA/FHLMC MBS, currently just under 1 point on 6% MBS, and 2 points on 5.5% MBS. Say GNMA offered to tender any eligible FNMA/FHLMC MBS for 1.5% of the principal balance. GNMA could tender say 10% of the total FNMA/FHLMC balance (about $4.3 trillion) and collect $6.5 billion up front.


The Treasury then fully guarantees the principal of all outstanding Fannie Mae and Freddie Mac senior securities. More on this in a moment. The Fed also extends access to the discount window for some extended period of time, like 3-years or so, to the new owners of the former GSE businesses.

Finally, all current mortgage guarantees would be owned pro-rata by the new companies. So if we created 10 new "GSEs" they would each be responsible for 1/10th of any losses that arose. In this way, the old agency MBS securities would still trade generically, as opposed to being passed off to a new guarantor.


So here is what the buyers of the GSE's broken pieces would get:

1. Relatively certain liquidity from the discount window
2. Reduced balance sheet due to the GNMA tender
3. Pro-rata ownership of the GSE's tax loss carry forwards
4. Freedom from the GSE's old "public" mission of providing affordable housing
5. Freedom to price their guarantee however they wish
6. Freedom to participate in any segment of the mortgage market, not just "conforming" mortgages

In exchange, the buyer has to put enough capital into the new company to realize bank-type leverage levels. Exactly what those leverage levels should be is up for debate, but it should be enough to engender some degree of market confidence.

The market as a whole would get...

1. More capital put into the GSEs (viewed in aggregate) provided by private investors, which is all but impossible now.
2. A limit on tax payer's costs. GNMA would collect a profit on the initial tender of MBS, which would offset losses taken in those pools. Plus the government would get cash from the buyers of the GSE pieces. All this would serve to mitigate losses significantly.
3. A long-term solution to the GSE problem. If there are 10 new entities, none would be too big to fail. All would have to maintain bank-like capital levels, rendering the system safer.
4. Certainty as to the end game with Fannie and Freddie.

As for common shareholders, they become victims of the GSEs declining capital base. Preferred shareholders and sub debt holders would see their interests split among the new firms. But that would surely result in an increase in the valuation from current levels.

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts. I hope they at least consider something along the lines of what I've proposed here.

GSE Preferreds: I don't believe it!

Fannie Mae and Freddie Mac preferred stocks rose ~$3 in the last hour of trading. Yes you read that right. Something like 25% off the lows of the day to finish some 10-15% higher for the session.

I couldn't find anyone who knew why, but all the traders I talked to suggested it had a certain "The Dukes know something!" feel to it. Who knows. Shit like that happens all the time. Sometimes someone actually knows something. Sometimes its just a very thin market and someone just thinks they know something. Anyway, theories are welcomed.

That bad huh?

CDS trading is looking real panicky this morning. Lehman is 40ish bps wider, other brokers 20 wider. Zero liquidity. Swaps wider again, although mildly. Fannie and Freddie senior spreads unchanged. MBS look slightly wider after finishing basically unchanged yesterday.

Dow currently down less than 100 points. Financials down ~2%. That ain't gonna be enough. I wouldn't be surprised if we suffer through another 200 point day.

The market continues to obsess about housing starts, which is a completely worthless statistic here. I'm looking at housing sales and delinquencies as the key stats.

UPDATE
FRE and FNM preferreds are down another 20% or so today, threatening the $10 area on FRE Z. One trader told me he's started to see bottom fishing here, which seems incredibly stupid to me. Bottom fishing can work as a strategy, but no one can put odds on whether the impending GSE nationalization will make preferred shareholders whole or not. This isn't about financial analysis anymore. I'd rather bottom fish in WaMu or Lehman or National City any day. At least those are actual businesses where management will be making every effort to survive. Fannie and Freddie are going to get taken out regardless of how the housing crisis plays out from here.

GSEs: Fear leads to suffering

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I've heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he's been up to his eyeballs in 100 bond lots today. Haven't heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

The catalyst was Barron's (followed by Barclays and Merrill Lynch) saying that a Treasury-backed infusion was only a matter of time, and that common shareholders would be wiped out. Barron's also suggested that preferred shareholders would lose their dividends. I doubt that very much, but more on that later.

The ultimate problem here is best described by Merrill Lynch's Ken Bruce. You can dive into Freddie Mac or Fannie Mae's balance sheet and make a good case that they don't need new capital, at least under current forecasts for housing. You'd therefore conclude that if they were a truly private company, they'd best serve shareholders by trying to stick it out. But they aren't a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs. The case will be made that the collective needs lower mortgage rates, and only a strong, liquid and publicly minded GSE can help bring that about.

And indeed, tax payers take the least risk the sooner action is taken. The more unsettled markets become, the harder it will be the stabilize. And the more unsettled things become, the more losses will be alread baked into the GSEs book. If the tax payer's position in FRE/FNM's capital structure is ahead of preferred shareholders and behind senior debt holders, the risk of the government actually losing money should be low. Where sub-note holders fall remains to be seen.

As for wiping out preferred shareholders... Remember that the big preferred shareholders are smaller banks. I don't think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don't think its necessary to protect tax-payers interests. With Treasury backing, the GSEs will have a luxury they don't currently have: time. Within 3-years or so, I'd expect FNM and FRE to both be profitable on a cash-flow basis. At that time the government can spin it off for a profit or fold it all into FHA.

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don't know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury's next move is.

Citigroup: Do you think I had a choice?

Citigroup issued $3 billion of a new 5-year senior bond issue on Tuesday. This was Citi's first offering since May, and the first billion dollar sized new issue from a major financial since Berkshire Hathaway came with a 5-year deal on July 30.

Access to the bond market is critical for all large financial institutions. Citigroup's issue proved that access is very expensive. The new issue was sold at a yield spread of 337.5bps over the 5-year Treasury. Prior to the announcement of the new issue, Citigroup's 5.5% bond due in April 2013 was bid at +275. Since the 5.5% bonds have approximately the same maturity and seniority of the new debt, its yield spread is directly comparable to the new issue. Hence the difference in spread levels means that Citigroup had to pay more than 60bps in extra yield in order to find enough investors to buy their debt. Not good.

This highlights some very telling facts about today's market. First, this is an extreme concession for a plain vanilla debt sale of a Aa3 rated bank. In 2006, the concession might have been 5 or 10bps at the most for a new issue. Alternatively, Baa-rated Deutsche Telecom recently brought a new 10-year issue, and the concession was around 15bps. This tells you that while there are buyers of Citigroup debt, they pretty much have to give it away.

Second, at a spread to Treasuries of +337.5, the deal has a very large negative basis to credit default swaps. This means that buyers of Citi bonds could also buy CDS and realize an arbitrage. Citi CDS closed Tuesday at 160bps and 5-year swap spreads closed at +98.5. You own the bond at +337.5bps, swap out the interest rate risk for 98.5bps, and the credit risk for 160bps. You are left with 79bps for free. This arbitrage won't last long, at least not at that level, so expect Citi cash bonds to tighten and CDS to widen in the near term.

Finally, this highlights an important risk of owning bank and brokerage bonds, and the opportunity that new issues offer. Under normal conditions, banks and brokers are routine issuers of new debt. The fact that accessing the bond market is currently so expensive is keeping issuers on the sidelines, but in fact, that's pent up demand for debt financing. As soon as conditions improve, expect a flood of new bond issues, all of which will come at a substantial concession to secondary trading levels.

But its common for the initial trading of the new debt issue to be tighter than the initial offer spread. The idea is that while Citigroup needed to pay a significant yield premium to clear $3 billion in bonds, once that initial supply has cleared, trading in the issue should resume at close to pre-supply levels. Indeed, the new Citi bond is traded initially about 10bps tighter than its original spread, although it now only slightly tighter.

So even if you believe we're already past the bottom for financials, tread carefully into financial bonds, and wait for new issues to make your allocation.

Auction-Rate Securities: You are now mine!

Several banks/brokers, lead by Citigroup, have either reached a settlement regarding auction-rate securities (ARS) or are offering to repurchase the securities from customers. As of this writing, Merrill Lynch, Morgan Stanley, and UBS are among those ready to buy back at least some ARS from customers. Several others are either in negotiations with the New York AG or remain part of the inquiry.

Citigroup's settlement states the bank will purchase approximately $7 billion in ARS which are currently not clearing from individuals, small institutions and charities. The announcement on Thursday immediately sent Citi's stock down 4%, and pushed the shares of other major municipal bond dealers sharply lower as well.

There is a key element of this that hasn't been well reported. A very large percentage, something like 80%, of the true "municipal" auction-rate securities have either been refinanced or are actually succeeding at auction. Most of what's left are related to student loan financings. In a typical student loan securitization, a trust is formed which holds the actual loans. The trust then sells securities to the public. This trust is bankruptcy remote from the originator of the student loans. So if Citigroup arranged your student loan, they probably put it into a trust labled Student Loan Corporation. The loan is then considered off Citi's balance sheet.

Very few student loan auction rate securities (SLARS) have been refinanced. This is because the trust which issued the SLARS has no incentive to refinance. Or more precisely, there is no real decision maker for the trust, at least in terms of their outstanding debt. In addition, SLARS typically have relatively low maximum coupon rates in the event of an auction failure. Without a tight limit on the rate, it would be possible for the SLARS to carry a higher rate than the underlying student loans.

So now Citi (and others) are going to need to find a way to create liquidity in these securities. Unfortunately with many SLARS, a simple refinancing, even if Citi were willing to somehow subsidize the transaction, may not be possible. Its also not realistic for Citi to just starting making a market in the ARS and assume liquidity will follow. In other words, Citi cannot just go back to their market-making role of years past. Investors will be once bitten, twice shy this time around.

So this is going to take some creativity. You can bet that Citi already has legions of investment bankers working on structuring something to create an out. Perhaps some sort of resecuritization where Citi puts a series of these SLARS into yet another trust and then sells bonds with a legal put to fund the trust.

Either way, its good news for investors stuck in ARS. It should free up some cash which will most likely flow into short-term municipal bonds. Ultimately it should be something with which Citi (and other dealers) can handle liquidity wise. Remember that student loan ABS are eligible collateral at the discount window and the TSLF, and most of the underlying loans are government-backed. But it will be a distraction.

Big day for the monolines

Wednesday was a big day for municipal bond insurers Ambac and FSA. Muni investors may be seeing some light at the end of the monoline tunnel. Stock investors in Ambac should be careful.

FSA announced a net loss of $330 million in the second quarter after increasing its estimated claims on residential transactions by $603 million. But the bigger news was that parent Dexia has contributed $300 million in fresh capital to FSA, and in addition has assumed all risk in FSA's guaranteed investment contracts (GICs). In response, S&P affirmed FSA's AAA rating, although the outlook was revised to negative. Fitch affirmed FSA's rating at AAA with a stable outlook.

There is no word yet from Moody's, who had put FSA's Aaa rating on negative watch in July. However, Moody's did release a very telling FAQ on their ratings methodology for the monoline insurers. Moody's claims that their ratings methodology has not changed, but a simple read of ratings reports from late 2007 indicated a focus on excess capital beyond "stress case" losses. In putting FSA on negative watch in July, Moody's emphasis has clearly shifted to financial flexibility. One might conclude that Moody's now views losses on structured finance products as too uncertain to estimate, and therefore has shifted their focus on an insurer's ability to raise new capital no matter the loss level. Nothing in the Moody's FAQ says this in so many words, but there are statements that hint at this sort of thinking: "Moody's believes that both FSA and Assured [Guaranty] will be able to meet claim payments with a very high degree of reliability. However, the compositions of their insured portfolios... may leave them vulnerable to a higher degree of volatility than their existing business models can sustain at the current Aaa ratings."

Meanwhile, Ambac reported first quarter profit of $823 million. Unfortunately, that figure reflects a $976 million gain due to deterioration in Ambac's own CDS spread. Its a frustrating quirk of the mark-to-market accounting rules and it really renders Ambac's as reported income statement irrelevant. But the rationale is quite simple. If a CDS contract with Ambac as the counter-party were traded on the open market, there would certainly be a discount for Ambac's credit worthiness. Since Ambac is effectively short all these CDS contracts, if the value goes down for any reason that's a gain for Ambac! Worth mentioning that Ambac's CDS have improved significantly since June 30, (quoted at 18 points up front, down from 36). On the conference call Ambac indicated that the $976 million gain would have swung to a $1.3 billion loss had they used 7/31 CDS figures.

Media reports are going to focus on the CDS loss/gain shell game, but that's is all besides the point. What really matters to Ambac investors is:

• Clairty on their expected losses in structured finance
• Efforts to terminate CDS contracts, thus lending clarity to the their expected losses
• Progress on recapitalizing Connie Lee

On that front, Ambac reported mostly good news. Real clarity on structured finance losses isn't coming any time soon. The housing and economic picture is just too uncertain. But Ambac is now all but fully reserved on their remaining CDO squared transactions with large RMBS exposure. Therefore any recovery in these assets will be accretive to capital.

Ambac management suggested that they remained in serious talks to commute additional CDS contracts. Ambac had announced a deal with Citigroup on August 1 to terminate $1.3 billion of protection on a CDO-squared transaction in exchange for a cash payment from Ambac. When asked why Citigroup (or anyone else) would agree to terminate if Ambac is indeed a strong counter-party, company management suggested that some of their counter-parties may have bought CDS protection on Ambac and now have a large gain on that hedge. The way it was said leads one to wonder if Ambac in fact knew this to be the case. Either way, the company was positive on the prospects of future termination deals.

In addition, Ambac has been working to eliminate or reduce RMBS exposure by searching for violations of representations and warranties in their insured transactions. Finding such violations would allow Ambac to void some or all of an insurance policy. During the quarter, Ambac recorded $339 million in reduced loss reserves related to such violations. The company indicated that a survey of some of their higher delinquency transactions showed a 80%+ "hit rate" on representation and warranty violations.

Finally, Ambac indicated that progress on capitalizing Connie Lee, a dormant insurance subsidiary, is on schedule. The plan is for Connie Lee to capitalized with $1 billion in cash, be insulated from Ambac's existing insurance exposures, and therefore get a stable AAA rating. In theory Connie Lee could then begin municipal insurance underwriting. Ambac indicated they had completed the "second step" of what would be a 3-4 step process. Ambac believed Connie Lee can be up and running by October 1.

All this is making Ambac more likely to remain solvent, especially if more progress can be made on terminating CDS on structured finance. But the idea that Connie Lee can become a force in the municipal insurance business is still a long shot. And absent that, there is limited profit potential for Ambac. The most likely scenario seems to be that the company survives the next couple years and then eventually sells their remaining portfolio to some third party. That would likely leave some non-zero amount left over for common shareholders, but not much. So you really have to wonder about Ambac's meteoric rise over the last two weeks: from a low of $1.74 on July 28 to $5.85 today.

But any outcome where Ambac remains solvent is good for municipal investors. If Ambac can stabilize at any investment-grade credit rating, Ambac insured municipals will appreciate quite a bit.

Ambac: Perhaps she could still be of some use to us

Hot on the heals of Security Capital's agreement with Merrill Lynch to unwind 8 credit-default swaps (CDS), Ambac and Citigroup have reached a similar agreement. The arrangement has Ambac paying Citigroup $850 million to terminate approximately $1.4 billion of a CDS referencing an so-called CDO-squared transaction.

Collateralized Debt Obligations (CDO) with asset-backed securities (ABS) as collateral, a category which includes CDO-squareds, are the primary problem facing monoline insurers. While the monolines face losses beyond their initial expectations on a variety of structured finance transactions, monolines senior position in these transactions are limiting actual losses. ABS CDOs were creating using mezzanine ABS securities, many of which are already suffering massive losses.

These agreements to terminate CDS are a major positive for the monoline insurers, at least in terms of solvency. It turns an unknown into a known. Ambac's loss on the CDS in question was an unknown. Some even believed Ambac would take a total loss on the transaction. Now their loss position is known: $850 million. That's the end of it.

Beyond that is the fact that Ambac had actually written the position down by $1 billion. So the company will be booking a $150 million gain. This proves, with an actual trade, that in at least one case Ambac was being conservative in its valuation of liabilities. While not proving anything per se, its fair to interpret this as a significant positive in terms of Ambac's future mark-to-market losses.

Finanally, this should improve the capital situation at Ambac Assurance. Not only will the company record a $150 million gain, but it has eliminated a significant source of loss uncertainty.

This is all great news for municipal bond holders. If Ambac and other monolines can stabilize, even at non-AAA ratings, the market will once again see municipal insurance as having some positive value. Currently bonds insured by any of the downgraded insurers are trading as though the insurance has negative value. So any sort of stabilization would probably cause these bonds to appreciate in value.

However, I'm weary of the run-up in Ambac's stock price. The day of the announcement the stock had risen over 60% at one point, and closed Monday even higher. In order for common shareholders to get value out of Ambac, the company will have to resume writing policies. While they might be able to do reinsurance with a AA rating, the opportunities will be limited.

Could Ambac regain a AAA rating? Consider Moody's rationale for putting FSA and Assured Guaranty on negative watch, namely uncertainty surrounding the future of monoline insurance in general. So even if Ambac, or other insurers, could significantly improve their capital situation, unless it is clear to the ratings agencies that Ambac's franchise is in tact and they can resume writing new policies, they will not regain a top credit rating.

And 15 once we reach Alderaan...

Today Ambac is out with news that they too have reached an agreement to terminate a CDS contract with Citigroup. The CDS had $1.4 billion notional and was settled for a payment of $850 million. On Monday, Security Capital reached a similar agreement with Merrill Lynch on 8 CDS, canceling $3.7 billion in CDS for a payment of $500 million.

Remember that a CDS is nothing more than an exchange of risk. One party agrees to pay a periodic fee, while the other party agrees to make up any lost cash flow on a referenced security.
So let's say you enter into a plain vanilla CDS contract referencing Kraft. Let's say its $10 million notional and the deal spread is 76bps (about what Kraft is right now.) Now let's say that the spread on Kraft CDS widens to 100bps. Your contract at 76bps has some positive cash value (about $110,000 on $10 million notional), because of the movement in spreads.

Why? Because you currently own protection on Kraft and only have to pay $19,000/quarter for that protection (76bps * 10 million / 4). Anyone who wants to buy protection now has to pay $25,000/quarter (100bps *10 million /4). Through the magic of Bloomberg, we can calculate what your contract is worth: about $110,000. This means that someone would be willing to pay up front $110,000 to "buy" your lower protection payments.

Now let's say Ambac was the counter-party on your Kraft CDS, and Ambac wants out of the trade. Maybe you are happy to monetize your profits so when they offer you $110,000 you agree.

The media headlines would say that Ambac had exited their $10 million in Kraft risk in exchange for a payment of $110,000.

Now let's look at the deal cut by SCA and Merrill Lynch. Since CDS on the ABS CDOs in question don't trade regularly, we can't tell what the "fair value" actually is. Safe to say that the deal between SCA and Merrill was in part a distressed exchange. If we look at the AAA tranches of the ABX index, the prices range from $88 to $44. It is my contention that ABS CDOs, even if they include large non-RMBS exposure, can't possibly be worth more than the ABX, assuming we're controlling for vintage.

We know that SCA paid Merrill approximately 13.5% of the CDS notional value. That'd imply a dollar price on the CDOs of $86.5. Its not quite that simple, but its close. Anyway, if the price range of the ABX is $88 to $44, the right value of these CDO positions is no better than $60. Probably more like $30. So you'd say that Merrill's acceptance of $500 million is anywhere from 1/3 to 1/5 of what they'd have received from a well capitalized counter-party. Admittedly, I'm completely wagging these numbers, but it's safe to say this was a distressed exchange.