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.
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.
Here is the relevant text from the 8-K: On August 1, 2008, Ambac Financial Group, Inc. (“Ambac”) announced that it had settled one of its largest CDO exposures, AA Bespoke, in exchange for a final cash payment of $850 million to its sole counterparty. AA Bespoke is a $1.4 billion transaction that originally comprised AA rated CDO of ABS tranches, most of which have been downgraded to below investment grade since the inception of the transaction.
ReplyDeleteAs of March 31, 2008, Ambac had recorded approximately $1.0 billion of mark-to-market losses, including an impairment loss of $789 million, against this transaction. As a result of the settlement, Ambac expects to record a positive pre-tax adjustment of approximately $150 million to its aggregate mark-to-market. In addition, the stress case losses in the rating agency capital models for this transaction exceeded Ambac’s final payment and, therefore, the settlement will result in an improved excess capital position for Ambac Assurance Corporation.
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Apparently, the 1bn MTM loss was the GAAP loss, but the impairment for regulatory purposes was 789mm which means it's a loss from that perspective. I'm not sure which of these numbers is more relevant.
Good insight, AI.
ReplyDeleteAs I understand it, it originally an exposure of 1.4B over the life of the CDO (30 years). In the deal to reduce the liability to 850m, is it possible that Citi took a cash settlement now (SWAG $250m)and another portion over the duration? In such case, this may create a new problem mentioned by
NY Insurance commissionar Dinallo said in a WSJ article that he was concerned now that everyone will come to the bond insurers for a settlement to make sure that they get their piece of the pie too.
Any insight on immediate cash on hand issues versus resources extended over 30 years.
The commutation of the deal had to be a 'win' / 'win' from an accounting perspective for the companies. When you have multiple valuations GAAP, MTM, Statutory Insurance, Rating Agency -- you have a situations where a cash payment can improve the financial optics of both companies.
ReplyDeleteThis is too complex to fully understand given the level of detail available
Among other things, anything about a cdo ^ 2, including the insured cash flows are complex. It would seem that over 50% of exposure in cash is high. That is, the present value of the insured payments would be less. Once again, being a cdo ^ 2 who knows.
Anyway, AI's comments are spot on. At least some accounting is conservative. I would imagine that the uncertainty of Ambac as a counterparty AND the recognition of it made it compelling for Merrill/Citi.
If you layer multiple valuations and counterparty risk -- it is really complex. Among other things, the better Ambac looks AFTER this valuation the less compelling future commutations will be because the counterparty risk lessens.
Overall, as odd as it may sound, this is as close to true mark to market as possible.
Al,
ReplyDeleteIf Moody’s believes that uncertainty surrounding the future of monoline insurance is important enough to remove the AAA rating from Ambac, MBIA or FSA why shouldn’t Berkshire Hathaway Assurance be stripped of its AAA rating?
Tony: Although the future of the monolines' business does not look great, the credit downgrades are because of the potential liabilities from their past business. Berkshire didn't write protection on the toxic structured products so it makes no sense to lump them in.
ReplyDeleteTony:
ReplyDeleteMoody's answered this in a FAQ today. BHAC would have a Aa2 rating except that they enjoy a direct backing from their Aaa parent.
Lockstep:
I think if they keep doing deals like the Citi deal, cash won't be a problem. Because they have such large reserves against those deals, that the cash is already "spoken for."
Bond insurance doesn't really matter. I've never seen these guys pay on a defaulting muni issuer. They just let the investors sink. I don't know how they get out of paying, but they do.
ReplyDeleteVery helpful piece of writing, much thanks for this article.
ReplyDelete