Wednesday, 05 March 2008 00:00

AGO update - I peel the covers back and find a naked body!

This is an update of the work I am doing on AGO. Since I don't feel like putting out my usual eloquent proseCool, I'll just get right to the point. We have built-in subordination where tranche-wise information is available. For RMBS, we have this information only at an overall level (year wise) and not tranche-wise. We have subordination rate of 38% for 2007 for Prime Closed End Seconds. Had this information been available into AAA, AA, etc tranches, we would have applied this to compute net loss. However, we have tried to be realistic (to the extent there is visibility under the current credit market conditions) while applying default percentages.

Later on, I will post AGO’s pro-forma statements incorporating loss and mark-to-market write-downs.

At an overall level, AGO’s future performance and losses hinge upon the credit market which is being squeezed by serious credit crunch. My previous post gave anecdotal evidence of the the underlying RMBS and CMBS facing fire sales, thus putting serious downward pressure on the CDS that AGO writes. The current turmoil is likely to get much, much worse in view of aggravating recessionary conditions and worsening macro-economic factors.

We have estimated default loss under three scenarios:

Loss on default ($ mn)

Best Case

Base Case

Worst case

U.S Public Finance

438

461

506

U.S Structured Finance

1404

1545

1888

International

307

349

406

Total Loss

2,149

2,354

2,800

While the above loss figures have been based on detailed assumptions on default percentages for each category of AGO’s exposure, it can also be substantiated by AGO’s exposure to some of the high-risk securities

· CDO exposure: AGO has huge outstanding amounts of exposure in leveraged structured products, and even more so when viewed in light of their equity capital. The total notional amount of insured CDS exposure to CDOs outstanding as of December 31, 2007 and 2006, and included in the Company's financial guaranty exposure was $71.6 billion and $49.4 billion, respectively against its equity base of $1.6 bn.

· Mark to market loss: As a result of continued widening of spreads, AGO is expected to report mark-to-market loss of $600 mn and $474 mn in 2008 and 2009, respectively. Continued market-to-market loss on the company’s CDO’s exposure will impact AGO’s financial performance.

· HELOCs: As of December 31, 2007, AGO had nearly $2.4 bn of exposure in HELCO ($1.6 bn in direct and $0.7 bn in reinsurance). Within direct writing, AGO has nearly $1.5 bn exposure in below grade investments (nearly its entire equity) while in reinsurance AGO has nearly $0.3 bn of exposure below investment grade.

Of $2.4 billion related to HELOC securitizations, $2.1 billion are transactions with Countrywide which were recently downgraded by Moody's and Fitch and placed on watch negative by Standard & Poor’s. Countrywide Financial Corp was forced to take a $704 million charge against its $32.4 billion prime HELOC portfolio in 4Q2007. Look here for a glimpse of info on why anything originated out of Countrywide is totally bad news.

In view of the recent problems relating to Countrywide further fuelled by the fact that AGO has just under 1% subordination in HELOCs, we believe that AGO could see some additional mounting losses under HELCO exposure. Under our base case scenario, we expect total losses from RMBS exposure to be approximately $1,045 mn out of which $895 is relating to HELOCs.

  • Exposure to troubled markets: AGO has its largest exposure in the most troubled markets with California and Florida together accounting for nearly 10% of its net par outstanding as on December 31, 2007.
  • Closely monitored risk : Even in view of the company (which is not as bearish as I am, of course), it has nearly $2.2bn of its exposure under closely monitored risk, out of which $838 mn is towards category 2, 3 and 4 which have high probability of loss. This is approximately 50% of their equity capital, and still over one third of the equity capital even if they get the full equity commitment from Wilbur Ross, which is far from a done deal.

Stay tuned for a more explicit analysis and my strategy regarding where I think the bubble burst momentum is going next. As usual, this is my collection of insurance and monoline analysis in the Insurers and Insurance section of my blog.

Last modified on Wednesday, 05 March 2008 00:00

7 comments

  • Comment Link Reggie Middleton Wednesday, 12 March 2008 19:10 posted by Reggie Middleton

    I believe I addressed most of your comments in the new article.

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  • Comment Link Mark Edmunds Monday, 10 March 2008 11:36 posted by Mark Edmunds

    This will probably get me another long blog post award, but here goes. From an investment standpoint point, it is unfortunate that Assured’s situation is complicated and may not yield a clear-cut answer.

    Assured Guaranty’s situation seems more binary than most companies. If losses turn out to be very ugly, MBIA, Ambac, and the weaker players will be decimated, and Assured Guaranty and FSA will probably be forced into run-off. Under a less severe scenario, MBIA and Ambac go into permanent run-off, but AGO, FSA, and Berkshire remain healthy and dominate the market and benefit from dramatically higher spreads and better underlying credit risks than in the recent past.

    Mark-to-market losses appear to be by far Assured’s most significant short to intermediate term challenge. The MTM loss for the first quarter of 2008 could well be higher than your $600M estimate for all of 2008, but do you really believe that credit spreads will continue to widen significantly into 2009 (as implied by the projected MTM loss for 2009)? You mentioned previously that you thought losses will probably not be as severe as implied by current spreads. Doesn’t this suggest that losses will increase but spreads should stabilize or possibly decrease?

    From my perspective, public finance losses seem like the most difficult to estimate for AGO (at least partially because I do not understand this business well). Ultimate losses well under half of the $438M that you estimate seem entirely plausible. On the other hand, after reading a number of public finance deal write-ups, losses well in excess of a billion seem equally plausible. Any light you or any other readers can shed on this business will be greatly appreciated.

    The exact composition of your structured finance loss estimate is not clear, but the $895M for second lien exposure seems very high. I have not reviewed AGO’s insured HELOC deals, but I have reviewed quite a few others and they all look pretty much the same. These deals did not benefit from any meaningful initial subordination (between 0 and 1%), but the excess spread interest is very meaningful (in the 3%-4% range after pool expenses), and coverage applies to the entire deal (not isolated subordinated tranches). Based on my math, a 25% default rate translates to approximately a 26% loss rate as a percentage of the entire pool, but excess interest reduces the 26% to roughly 15% losses on the insured securities. Following similar logic, default rates of 25%-30% for 2007 and 15%-20% for 2005 translate to total direct HELOC ultimate losses in the $160M-$200M or less for Assured Guaranty.

    The 38% subordination on the 2007 CES exposure is probably more than adequate to absorb. Assuming the reinsured exposure (around $300M?) looks similar to the direct exposure, a reasonable estimate for total second lien losses is in the $175M-$225M range.

    Subordination levels on other RMBS leave a strong cushion relative to current and anticipated future defaults. As an example, 2006 and 2007 subordination levels for first lien subprime are 31.6% and 40% for 06 and 07 respectively. These compare with current default rates of 26% and 24%. It is difficult to imagine how losses would grow large enough to breach these subordination levels. The 2007 deals could probably experience default rates of 75% before resulting in meaningful losses. Overall, $250M seems like a reasonable estimate for RMBS losses – $800M less than your estimate of $1.05B.

    As an aside, after reviewing a number of RMBS prospectuses from various issuers, I think that Countrywide may be a little worse than average, but not much. Most of the deals from most issuers are pretty much a pile of crap (and this is being polite) from a credit risk standpoint.

    Your implied estimate of $500M ($1.545B - $1.045B) for other structured finance losses seems entirely plausible, and could possibly be on the low side. It is difficult to say without additional deal details (which I have been unable to find). However, actual losses would need to get pretty big (probably well in excess of $1B) to make a dent in shareholders’ equity after the first quarter of this year. Cumulative MTM losses on other SF business will probably exceed $1B by a significant margin as of the end of the quarter, so actual losses would need to exceed $1B result in a hit to shareholders’ equity.

    Finally, you mention that the Wilbur Ross investment may not go through. There is no denying this as a potential risk, but given that Warburg did not walk away despite MBIA’s dim prospects, are you be willing to bet that Wilbur Ross will walk away from Assured Guaranty, a company with prospects that look much better? The Wilbur Ross situation probably amplifies the binary nature of the investment. If the situation develops unfavorably, Ross is more likely to pull out. If not, he is likely to remain in the picture.

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  • Comment Link daan everts Friday, 07 March 2008 09:14 posted by daan everts

    In their GAAP statements they show sensitivity to CDS spread widening (53bn exposure as of 12/31/07). 100% widening in spreads 690mm pre tax loss, 50% widening 344mm loss). The I/G credit index has gone from 80 to 180 this year alone! Most corporates have doubled as well.

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  • Comment Link Reggie Middleton Friday, 07 March 2008 03:13 posted by Reggie Middleton

    Consider me short on anything I take the time to research and have significantly negative findings on. Conversely, you can consider me long on anything I have taken the time to research and have significantly positive findings on. Since I believe we are in a bear market and recession, the path of least resistance is to the short side. Some companies are in weaker positions than others. This is a long winded way of saying yes to your question. ;D

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  • Comment Link George Hadley Thursday, 06 March 2008 19:21 posted by George Hadley

    Thanks for the update on AGO.
    I am aware that you are not permitted to give investment advice and I am not seeking any, but am I correct in thinking that you are short on AGO?

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  • Comment Link Reggie Middleton Thursday, 06 March 2008 13:34 posted by Reggie Middleton

    Stay tuned. I will post a downloadable report in a week or two.

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  • Comment Link lowly bond trader Thursday, 06 March 2008 13:29 posted by lowly bond trader

    Best case $438 million public finance losses? You're joking right? Care to back that one up pls?

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