Thursday, August 07, 2008

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.


Dave M. said...

I am still perplexed as to why FSA's bonds are trading 50 cents on the dollar. It seems that with the backing of Dexia, the chances of the bonds being "money good" are quite excellent. Yes/No?

Tony Towers said...


Dexia's decision to assume liability on FSA's GICs may be more important than the capital infusion it made to FSA. Moody's will be hard pressed to lower the AAA rating after FSA's and Dexia's actions this week as well as the affirmation of its AAA rating by S&P and Fitch yesterday.

Tony Towers said...

The market today seems to be giving second thoughts about Ambac's prospects being all that good. Ambac was down almost 6% while the S&P was up more than 2%. I'm now inclined to believe that Ambac will struggle with or without Connie Lee and eventually be bought by another monoline as this industry consolidates.

Tony Towers said...


dave m. rasied a good question when he asked why FSA's bonds were trading 50 cents on the dollar. Here's my thought on why this is the case: Those bonds plummeted after Bill Ackman held his meeting with other hedge fund traders and said that FSA was going the same way as Ambac and MBIA and had purchased FSA's CDS. They have never recovered since then. The only way these bonds will recover, in my opinion, is if Moody's affirms the AAA rating for FSA regardless if the outlook is stable or negative. Your thoughts?

Accrued Interest said...

There is also an element of just general credit. Most preferred issues, even of relatively strong issuers, are trading at significant discounts. So if FSA is at a 50c discount, at least 20c is just the market for all credit.