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The Ambac FAQ |
| Written by Reggie Middleton | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Friday, 28 December 2007 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Below is an excerpt from the FAQ that Ambac posted on their website, along with my comments. The most of the full FAQ and more of my comments are seen further below.
What percentage of the $550 billion par of guaranteed obligations are represented by direct subprime RMBS and by CDS on ABS CDOs, including the CDO-squared deals? Ambacâ€TMs portfolio is a highly selective sub-segment of the market. As of September 30, 2007, our direct subprime RMBS business represented 1.6% of Ambacâ€TMs $550 billion in guarantees outstanding and CDS on ABS CDOs represented 4.8% of the portfolio. Okay, so you have $3,520,000,000 here that you recognize here, but if you add that to the $22.4 billion above and then add that to the risky consumer finance (which, luckily for you, has avoided media attention) and the potential increeases in muni exposure due to under funded budgets and the decreasing revenues from practically all product lines as expained above - Houston, we have a problem! With just these two paragraphs, excluding consumer finance and 95% of ALL of your other insured liabilities, we still have $26 billion of some of your riskiest exposure compared to $1.65 billion of book equity, a $2.6 billion market cap, and $14 billion of claim paying ability! And we are only talking about 5% of the total risks insured here. Less than 10% in claims in your RISKIEST business (quite plausible) exceeds your market cap in terms of losses. Less than 6% in losses (the lower end of the current trend in the products mentioned) wipes out your book equity. Houston, we do indeed have a problem. Equity investors, take heed! I'm tired. It's 5 a.n. in the morning, and I think we have reliably come to the conclusion that we do, indeed, have a problem.
FREQUENTLY ASKED QUESTIONS I. AMBACâ€TMS FINANCIAL STRENGTH A. CAPITAL
Ambacâ€TMs “excess capital†is defined as the amount of its capital in excess of that required by the rating agencies for it to maintain its AAA ratings. Each rating agency has a formula for “excess capital†that takes into account both claims-paying resources and modeled losses, giving effect to the unique characteristics of our portfolio. Excess capital increases as a result of the following:
In December 2007, Ambac announced a reinsurance transaction with Assured Guaranty for $29 billion of Ambacâ€TMs insured portfolio, which is an example of our current capital raising options. Under this arrangement, Ambac has agreed to cede a quota share in a portfolio of transactions that is broadly representative of our total portfolio, with the exception of RMBS and CDO transactions. But you never told us how much capital you raised. Why are you avoiding the question? The lack of an answer causes the market to assume the worst. You should know that by now. It obviously wasn't much, or you would have lauded it by now.
Ambacâ€TMs claims-paying resources totaled $14.2 billion at September 30, 2007. Claims-paying resources are comprised of available resources to pay claims that may ultimately arise.And how much is your potential exposure? Over $400 billion if I am not mistaken. Can you afford an 8% combined ratio (losses plus expenses)? B. LIQUIDITY
Ambacâ€TMs liquidity resources include:
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Ambac does not currently anticipate reducing its common stock dividend. This has always perplexed me. You guys are supposed to be running a business. Thus you do what's best for the business, not what makes Wall Street most happy. If you need capital, cutting the dividend is the cheapest source of capital. Smart, patient shareholders will understand, even applaud the move. The fickle investors that sell off aren't the ones you want for your stock in the first place. Good riddance. That doesn't seem to be your mentality though.
Ambacâ€TMs financial guaranty policies and credit default swap contracts are designed to limit liquidity demands. Our policies and CDS contracts generally require Ambac to pay scheduled interest and ultimate principal in the event of a loss. Ambacâ€TMs policyholders do not have the right to accelerate payments. How about a more straightforward answer. "Yes, those liquidity demands are known as losses and claims." C. RATING AGENCIES
On December 14, 2007, Moodyâ€TMs affirmed Ambacâ€TMs Aaa rating with a stable outlook. Moody's has yet to learn its lesson. I think this will definitely come back to bite the credit wizard . On December 19, 2007, S&P affirmed Ambacâ€TMs AAA rating with a negative outlook, reflecting the potential for further mortgage market deterioration relative to our capital cushion of approximately $1.8 billion. On December 21, 2007, Fitch placed our AAA rating on rating watch negative following an assessment of our current exposure to structured finance CDOs backed by subprime mortgage collateral, including CDO-squared securities and a $3 billion commitment to fund a pool of other structured finance CDOs, as well as our exposure to RMBS. Just to be clear here... You have a $3 billion commitment to FUND a pool of structured product CDOs??? Is this part of the AAA holdings you mentioned above that was supposed to be your capital cushion? The CDO squared exposure seems like guaranteed losses to me. Can you elaborate?
Ambac does not rely on the agencies in either approving transactions or assigning internal ratings to the deals it approves. We conduct our own independent analysis of each transaction and the transaction is reviewed by one of our respective Senior Credit Committees pursuant to our credit process and policies. The Committee also evaluates the recommended rating for the transaction at that time. Closed transactions are analyzed by our Portfolio Risk Management Group; and our original internal ratings are confirmed or revised, as appropriate. Does it matter? You and the agencies have totally missed the boat in this entire topic, so both of your methodologies have proven to be extremely flawed.
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II. AMBACâ€TMS MARK-TO-MARKET A. MARK-TO-MARKET (MTM) ON CDS CONTRACTS
Broadly speaking, Ambacâ€TMs MTM adjustment represents the change in the present value of what Ambac estimates it can charge as a premium/or fee on the notional amount for issuing the CDS from the rate actually charged. For example, if the estimated premium rate doubles, then Ambac will suffer a negative MTM of that increase, equal to the present value of the difference over the life of the CDS. What is that currently? Oh never mind. I'll do it for you in my next blog post.
While both Ambac and the investment banks are subject to mark-to-market requirements relating to their CDO portfolios under FAS 133, Ambacâ€TMs mark is significantly different in nature from the typical mark taken by an investment bank. Investment banks typically hold investment securities in their trading portfolio and must mark-to-market the change in the securitiesâ€TM value. In contrast, Ambac intends to retain its obligations for the life of the contract (just as it does with a financial guarantee policy). Therefore, absent any real credit losses, any MTM adjustments will reverse over time. Theoretically, yes, but realistically NO. The causes of the adverse marks in the REAL world have led to senior tranche holders forcing liquidation of the CDO in order to get paid or in an attempt to be made whole. That is the point where your mark becomes a an actual event of claim - and it is happening now at an alarmingly increasing rate. Another bit or reality. You hold these reduced marks on your books with the expectation that they will revert to the value of inception, and when it is time to roll them over (if it ever gets to that point) you will find that you will be trying to write premiums at 13 cents on the dollar because you misled yourselves all the way concerning the value of your book in the first place. Additional potential sources of the difference between Ambacâ€TMs mark and marks of the banks are based on structural distinctions and include:
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As S&P outlined in its October 31, 2007 report (entitled “Significant Mark-to-Market Losses on Credit Derivatives Not Expected to Affect Bond Insurer Ratingsâ€), while bond insurers are required under FASB 133 to mark their credit derivative exposures to market, the mark, in itself, has no effect on Ambacâ€TMs capital adequacy. S&P notes that the re-pricing of risk in the mortgage-backed and corporate debt markets is the source of the significant third quarter negative marks to market of the financial guarantors in the third quarter. As S&P notes: “Mark to market accounting for credit derivatives introduces inconsistent treatment within insurersâ€TM financial statements (relative to the similar risk encompassed in a traditional guarantee arrangement) based solely on the form of the risk assumption agreement and not on the substance of the risk assumed. Moreover, it substitutes market judgment for managementâ€TMs judgment in setting loss reserves and results in income statement volatility that may have little to do with the actual risk of loss. For these reasons, while Standard & Poorâ€TMs assesses the marks for actual credit deterioration, in the absence of it we do not ascribe any analytical significance to these negative marks as relating to our assessments of capital adequacy or profitability.†We understand that Moodyâ€TMs and Fitch hold similar views. I understand that you are making excuses. If you hold a CDS that is market down to market by 90%, the chance of that CDS causing a payout has increased dramatically. Don't you agree? Do you really mean to tell me that you truly believe there is no more risk in that CDS for you as there is when the agreement was originally penned? If (or when) that CDS does result in an actual claim, that claim will be for 90% (just guessing at the math, but you get my point) more than you anticipated. Do you expect us to believe that this significant increase in risk should not be reflected on your books?
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III. AMBACâ€TMS RMBS, SUBPRIME AND CDO EXPOSURE
Below is a list of deals and current par exposure as of September 30, 2007 for which the lead originator has discontinued operations:
In addition, in the case of the New Century exposure, the servicing rights have been sold to an outside party; as of September 30, 2007, performance since the transfer has continued to be good. In the case of each of the other exposures, servicing has remained, to date, with the original servicing entity. This is nothing to be happy about. You didn't mention how servicing performance was with the other exposures. I guess that means pretty bad. More importantly, it is quite misleading. Looking forward, not looking backward, your exposure to weak originators is quite significant. See Ambac analysis one and two for details.
Ambacâ€TMs exposure to Subprime RMBS bonds has steadily decreased over the last couple of years to $8.8bn in September 2007. This is a result of Ambac having been very selective in underwriting new direct RMBS exposure in the last two years. Only four transactions were done in 2006 and 2007 for a total of $1.8bn. Our focus was almost exclusively on fixed rate loans as well as transactions in which a separate party takes a first loss risk position (i.e. pool insurer). We have reviewed each of these transactions and, as of September 30, 2007, they were performing within expectations. We continue to monitor all of our transactions for any adverse changes. But the majority of your expected losses are in structured finance and consumer finance!
As of September 30, 2007, Ambacâ€TMs current insured portfolio was comprised of $7Bn Alt-A securitizations, $6Bn in deals backed by Option ARM collateral, $12.5Bn Home Equity Line of Credit securitizations and $5.7Bn in deals backed by Closed End Second liens. Of the $13Bn of Alt-A and Option ARM exposure, $11.5Bn or 88% was comprised of AAA risk. Please see the Ambac web site for further details (http://www.ambac.com) So that's 22.4 billion or so in the riskiest end of the market representing a mere small fraction of your portfolio and you only have $14 billion dollars of claims paying ability and $1.65 billion of equity over a $2.6 billion market cap? That's a hell of a lot of exposure. I have also made clear that the current mortgage losses wre never a subprime mortgage issue, but a subprime underwriting standards issue that stemmed from securitization and lack of an imetus for originators to exercise proper due diligence. As a result, we have products which you just described makes up more than you total claims paying ability and are good for a minimum of a 6% loss rate (currently, and getting worse) which nearly wipes out your equity capital. Where is the upside in this? See A note on mortgages, overly optimistic recovery rates and recent events.. and Welcome to the World of Dr. FrankenFinance!
Ambacâ€TMs portfolio is a highly selective sub-segment of the market. As of September 30, 2007, our direct subprime RMBS business represented 1.6% of Ambacâ€TMs $550 billion in guarantees outstanding and CDS on ABS CDOs represented 4.8% of the portfolio. Okay, so you have $3,520,000,000 here that you recognize here, but if you add that to the $22.4 billion above and then add that to the risky consumer finance (which, luckily for you, has avoided media attention) and the potential increeases in muni exposure due to under funded budgets and the decreasing revenues from practically all product lines as expained above - Houston, we have a problem! With just these two paragraphs, excluding consumer finance and 95% of ALL of your other insured liabilities, we still have $26 billion of some of your riskiest exposure compared to $1.65 billion of book equity, a $2.6 billion market cap, and $14 billion of claim paying ability! And we are only talking about 5% of the total risks insured here. Less than 10% in claims in your RISKIEST business (quite plausible) exceeds your market cap in terms of losses. Less than 6% in losses (the lower end of the current trend in the products mentioned) wipes out your book equity. Houston, we do indeed have a problem. Equity investors, take heed! I'm tired. It's 5 a.n. in the morning, and I think we have reliably come to the conclusion that we do, indeed, have a problem.
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We concur with the widely-held consensus that the large wave of resets scheduled for 2007 and 2008 will contribute and most likely has already contributed, to higher levels of defaults unless mortgage refinancing opportunities significantly increase from current levels. However, as of September 30, 2007, of the $1.6 billion in direct Subprime RMBS exposure that Ambac had to the 2006 and 2007 vintages, 92% was to fixed rate collateral.
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IV. THE FINANCIAL GUARANTEE MARKET A. NEW BUSINESS GENERATION
When Ambac issues a policy or CDS on a bond issuance, we conduct a rigorous, in-depth analysis of the structure and originator or collateral manager as part of our own, independent credit underwriting process. This due diligence and underwriting is totally separate from the process of the rating agencies, who are providing their own independent rating on the underlying transaction. Ambac also has direct involvement in structuring terms of the transactions that it guarantees and will incorporate protective trigger levels and other covenants to ensure the deal can continue to perform even in the event of stressful situations. Ambacâ€TMs large market presence and usual control-party status in individual deals usually gives us direct and regular contact with company management as required to monitor deals and industry trends.
In the RMBS market, we continue to underwrite deals meeting our criteria. In CDOs, the focus is primarily in the corporate-backed CDO space (AAA rated). However, current market conditions have decreased the number of opportunities for new business in both of these areas.
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B. AMBACâ€TMS CREDIT DEFAULT SWAP (CDS) SPREADS
The CDS market for monoline names is a thinly traded market. It is viewed by some as a relatively inexpensive way to hedge the mortgage market. We believe that the majority of the trades in this rapidly growing market over the past six months are written by speculators seeking to hedge long positions in other assets they hold, including mortgage pools and CDOs unrelated to any position held by Ambac.
In fact, Ambac is not a proxy for the mortgage market: we are not a mortgage guarantor, we did not wrap any of the deals on the ABX index and we have wrapped only a fraction of the hundreds of deals that have been downgraded by S&P, Moodyâ€TMs and Fitch. As of September 30, 2007, our direct subprime RMBS business represents 1.6% of Ambacâ€TMs $550 billion in guarantees outstanding.
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C. STOCK PRICE
The rating agencies base our ratings on many factors, including capital adequacy. Ambac Financial Group, Inc.â€TMs stock price, however, has little impact on its ratings or its ability to meet its obligations.
Since the window opened on October 26, 2007, directors and executive officers of Ambac Financial Group, Inc. have purchased 75,561 shares through December 9, 2007. D. REGULATORY QUESTIONS
Under Wisconsin law, we must obtain the regulatorâ€TMs consent to pay “extraordinary dividends†from AAC to AFG. An “extraordinary dividend†is one which, when added to all other dividends paid during the preceding 12 months, exceeds $369.8mm (10% of AACâ€TMs surplus to policyholders as of December 31, 2006). We have paid dividends in the amount of $190.2mm in 2007 and can, therefore, pay additional dividends of approximately $179.6mm without Wisconsinâ€TMs consent.
Yes. We used the proceeds of the “extraordinary dividend†to repurchase shares.
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V. GENERAL
Ambac is a premier provider of financial guarantees and other financial services to public and private sector clients around the world. Ambacâ€TMs triple-A rated guarantee ensures the timely payment of principal and interest due on bonds in the event an issuer or borrower cannot meet its financial obligations. For issuers, our credit enhancement strengthens financings and broadens access to capital by lowering borrowing costs and broadening investor appeal. For investors, our insurance provides “Financial Peace of Mind.®â€.
Shares of Ambac common stock trade on the New York Stock Exchange under the ticker symbol “ABKâ€. Ambac does not offer a Direct Purchase Plan at this time. If you would like to purchase shares in Ambac, you should be able to buy it from any financial institution that provides brokerage services.
Yes, the company currently pays a quarterly dividend. At its October 2007 Board meeting, the Board of Directors approved the regular quarterly cash dividend of $0.21 per share of common stock. The dividend was paid on December 5, 2007 to stockholders of record on November 12, 2007.
Ambac went public July 18, 1991 at $6.67 per share split adjusted.
Ambac Assuranceâ€TMs revenue comes from two main sources: from the premiums on financial guarantee products and interest income on our $10.4 billion high-quality investment portfolio.
The 2008 Annual Shareholder Meeting will be held on May 6, 2008 at 11:30am in New York City.
Ambac had over 350 employees as of September 30, 2007.
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