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Download a "Window" into Ambac's Problems |
| Written by Reggie Middleton | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Saturday, 05 January 2008 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Two simple, but unflappable tenets that I follow when investing are: 1.) Economic profit must be evident in order for the investment to be worthwhile. Economic profit exists when the reward achieved exceeds the risk assumed in getting such reward; and 2.) Simpler is better (KISS - Keep it Simple). A lack of transpasrency in the money trail of an investment diminshes its value. Tenet number two is often misconstrued on Wall Street. Complex 'high finance' investments are not necessarily better than simpler ones. As a matter of fact, seen in light of tenet number one, increased complexity increases risk, thus reducing value. Often vendor orientated profit is the reason for excessive complexity. If customers cannot understand the pricing (due to lack of transparency) the vendor can charge more. Vendors can then play on the customer's insecurities in that customers feel more sophisticated, knowledgeable and "cool" if they have the latest product that only the special and intelligent can understand - ala Marketing 101. After talking with friends that specialize in structured products, risk management, and auditing industries, I came up with the idea for this piece. Why not try to offer a simplified method of looking at the risk of the monolines for the layman? Now, of course many professionals will say that the business is too complex for the layman to grasp the risks and rewards involved. Hey, that may be true, but that also brings us back to tenets one and two. If it so complex that risks cannot be seen, or so complicated that rewards are not easily applicable to the business then how valuable is the business and how risky is it really? Does such complexity really warrant a AAA rating, especially in the face of so much adversity? Complexity sure as hell appears to have stumped the management of the monolines, since they have both insured and invested in structured products for which they aren't sure of the payouts in the event of default(see below). There are simpler ways of looking at risks. When in doubt, one can always default to the market - Ambac's credit default swap spreads are reportedly trading at, or near, junk levels indicating a 20%+- probability of default (so they say on the trading desks). I performed a decent amount of research on the two biggest monolines, which, besides being a little jovial, brought up some damn good points, not the least of which was the potential for insolvency! Nouriel Roubini queries (and rightfully so since I have queried the same and I am NEVER wrong:-), the delay in rating agency downgrading the monolines - "a business model that cannot survive without a AAA rating is a business model that cannot fundamentally deserve a AAA rating ".
I am going to run down a quick list of things I have gleaned from a little perusal of Ambac's released docs and my relationship with Microsoft Excel, which I will then share with the registered users via the Ambac portfolio mini-app that I have for download (see
In the Sagittarius CDO default and liquidation - involving over $1 Billion, MBIA was the actual senior tranche investor, not simply the insurer. Nevertheless, they still were not clear on the liquidation rights and ended up in court in an attempt to determine who gets what, dukin' it out with several banks. MBIA just revealed that they insured over $30 billion of this stuff, and to quote Julia Whitehead, a senior adviser at valuation advisory firm, Miller Mathis, "No one has cracked the code on how to work these out and divvy things up," So, with so much ambiguity and lack of clarity, not to mention a total lack of credible claims and loss history, exactly how do you price insurance on these things? Or better yet, should you even be insuring these things?
Knowing this, the only way to truly ascertain the value of any portfolio is to mark it to market - period. It is worth whatever you can sell it for. Well, Ambac and MBIA have at least figured out the pricing dilemma of insuring derivative/structured products based on assets going through a bust without relying on market prices - Just make up your own prices and ignore the market. "I took a look at the business model and said, �My God, how can this business model possibly work? How can you take less than what the spread is in the marketplace indicates and make it work over time?' You know, essentially what it says, we take a portion of the spread. We [earn] spread on the risk, or the spread on a structured risk is 50 basis points. We take in 15, 20, 30 [basis points] over time. We say that model works. It's called risk selection. And our goal in life is to do it right all the time."
Joseph W. Brown
_____________
Analyst Question: "Just quickly again just highlight the bullet points of why there is a model that the quotes are an input to, rather than just {the quoted prices} being used purely."
Answer: "Yes. If not -- and this is in some of the new accounting standards, but you need to calibrate the model -- if not, you would have losses upon origination of the contract." _______________ You see, the monoline business model as it is implemented just can't work using market values. The problem is that we live in the market, and not in Ambac's or MBIA's spreadsheet model. Now, many industry pundits have told me that the marking to market of the monoline structured insured products is misleading because the products are held to maturity, and any unrealized losses are amortized till the end of the contract. Okaaayyy, so what is misleading about marking them to market? If the potential losses or payouts have increased on the insured products, shouldn't that be reflected in the books as unrealized losses? Isn't that what they are? Suppose spreads widen dramatically, and as was stated these insurers plan to hold the product till maturity - then a default and liquidation event occurs forcing a sale at substantially below par. This puts the insurer on the hook for a lot more than would appear on the books if the portfolio were not marked to market. I am not making this scenario up either, for it is happening now. About 40 consumer-debt backed CDOs have declared an event of default (most due to funding or valuation issues), with a face value of $US45 billion - 7 per cent of the $US640 billion rated by Moody's. Under the terms of many CDOs, an event of default prompts a shuffling so that more payments are shifted to senior investors who originally took the least risk in return for a lower yield. Three mortgage-related CDOs, Carina CDO, Adams Square Funding I and Vertical ABS CDO 2007 I, have decided to liquidate. This liquidation prompts fire sales with asset values traded at a level significantly below par, which the insurers are most likely on the hook for. When you get the time, read through the following links...
Ambac, in particular is at risk, for they insure a significant portion of lower quality BBB and below investment grade tranches of pools from the highest of high quality issuers such as Countrywide, American Home, Impac, and a plethora of other companies that are either out of business or close to it due to the horrible performance of their loans stemming from careless, "OPM" (other people's money) underwriting. For a representative glance at what goes on in some of the companies involved in Ambac's portfolio, see "more info on Countrywide and Washington Mutual" and Opinions on Countrywide's business practices. This brings me to a note from "Mark" one of my blog's regular readers: "Before taking a short position on Ambac (which I have not yet done but plan to), I decided to begin to look at things optimistically over the week-end. I reasoned that Ambac's exposure to sub-prime mortgages in 06 and 07 was not that high, and the prime and mid-prime stuff for these years will probably perform worse than other years, but may do OK. In addition, despite the market price drops on Ambac's ABS CDOs, who really knows what will happen to these? That was until I decided to look at one randomly selected auto securitization for 2006 -- Triad. Here is what I gleaned from the prospectus. Total collateral $1.174B Ambac insured layers: $1.092B (i.e., 7% subordination) New car collateral: $277M, average FICO 565 Used car collateral: $898M, average FICO 567 The weighted average APR for the total pool is 17.31%. Losses for 2002 and 2003 pools are around 13%. 2004 and 2005 look a little better. It is somewhat surprising that losses have not begun to chew away at the securities that Ambac insures on the 2006 deals, but I am willing to bet that this will start very soon."
Looking at the auto receivables, some of which aren't very deeply subordinated, written against new and used cars with a decent amount of sub-600 FICOs, we get, using an average 20% subordination, results that look like it could conceivably wipe out Ambac's margin for operating error. This will bring the debt to equity ratio down below that which their loan covenants call for and potentially resulting in a margin call or getting the credit line pulled - and that is just the auto receivables, a small portion of the portfolio. Ambac's revolving credit facility of $400 million with Citibank is subject to various financial covenants like maintaining a debt to capital ratio of 30% and stock holder's equity of greater than $ 2.9 billion. I anticipate the huge losses that the company could witness owing to its subprime, affordability mortgage product, consumer finance, and structured product exposure in its portfolio could erode its shareholder's equity significantly. As of 30th September 2007, Ambac has a shareholder's equity of $5.7 billion (and apparently dropping fast) and a debt/total capital ratio of 19.7%. BTW, for those who think I am speaking Urdu, consider subordination like a deductible on an auto insurance policy.
You can download a full breakdown of the expected losses on the auto portfolio here:
So, what does Ambac look like when its portfolio is marked to market? I'm glad you asked I'm assuming Ambac moved that portfolio data on their site so nosy analysts and laymen bloggers such as myself wouldn't mess with. I did find the Option ARM data though. Pretty optimistic considering all of it is considered AAA by Ambac's internal rating system. If you read the link on Countrywide above (one of Ambac's more prolific insureds), you'll know why their delinquency rate was %6.52 for ALL of its loans (the option arm portfolio went negative amortization quarters ago and boasts a higher delinquency rate). The option ARM's were special though, and sometimes went over 100% LTV and were almost always 90% or more. They were a high end investors tool transformed into an instrument to profit (albeit temporarily, as we now see) from people who couldn't afford what they were buying. Since they are optionally negatively amortizing (which meant that the loan principal increased instead of decreased) and had more lax underwriting standards, hence almost no documentation for income and assets, we have absolutely no reason to believe that these loans aren't doing much worse than the average Countrywide loan that happens to be doing rather bad.
The last time I looked at their books, outstanding principal was increasing, due to the payors not paying the full monthly payment (or at all), thus negatively amortizing the loan. Now, 90 -110% LTV loans like these, in areas where appraisers tacked on an extra 10% due to bank pressure or greed, whose housing stock has already fell more than 15% (CA, FL, NV) puts these loans anywhere from 15% to 40% underwater, in an environment where it is already very, very hard to sell a house. Ask the homebuilders. And we have a very long way to go before prices stabilize. Look at this example, where this home mortgage is NO LESS than 32% underwater. That's the mortgage, not the house, since it is already REO'd. The reason why I say it is at least is because it cannot sell, and is still sitting on the bank's books, backed by loans that you have most likely labeled as AAA. We don't even know what the recovery will be on this, but we know it won't be more than 60%, and when you add in transaction expenses and carrying costs, you could probably kiss away 40-50% as well.
That's assuming it is not in an MBS owned by a CDO, since it appears to me that the CDO tranches insured by Ambac will receive little to no recovery of assets since the insured tranche is a promise of cash flows only and has no ownership or rights to the underlying assets. Wow! Why would anyone write a policy on something that has no recovery potential and such a significant chance for loss? I can understand why many may have overlooked this since CDOs really haven't had enough of a loss history for anyone to prudently insure them in the first place!
Still not convinced of the folly of the faux AAA! Looking at the Countrywide Foreclosures Blog (yes, there actually is one), I found this article: 14,196 Homes Offered For Sale on Countrywide Financial's Website . I browsed through some of the site, and the small sample of numbers that I looked at seemed accurately reported. It also seems to mesh with Housingtracker.net. Browsing through the comments, someone noticed that the bank and trust offerings were not included. I looked, and at first glance, it seemed like he had a point. Now, it is a lot of work to verify all of this and beyond the scope of this article, but if it does pan out (and it looks like it does), Countrywide has nearly 100% of its market capitalization outstanding as REOs - in a market where houses just aren't selling and property values are falling fast. This is totally discounting each and every underperforming and underwater mortgage asset they have on their books. Now, you can even assume these numbers are 50% off, and it still bodes quite ill for the future. Does this seem like a company that does triple A underwriting? Does it even seem like a company whose products can be spun into AAA creations? Ambac sure does insure a LOT of stuff like this. We may have a problem here. Mr. Ratings agencies, are the underlyings of your other AAA ratings as well off? The ratings agencies have been so far off the mark here that I believe their credibility to be shot. I think any prudent investor worth their salt will agree. The problem is that since Ambac hasn't released the details of their entire portfolio, we are all speculating. The ratings agencies had access to it, but it appears to have done them no good since they failed to forewarn of the losses coming down the pike in both the insured products and Ambac itself. From the company's most recent 8K: Fitch's review indicates that Ambac's capital adequacy under Fitch's Matrix financial guaranty capital model currently falls below guidelines for an "AAA" insurer financial strength rating by around $1 billion. Fitch stated that if at any time during the next four-to-six weeks, Ambac is able to obtain further capital commitments and/or put in place additional reinsurance or other risk mitigation measures, that would help improve the Company's Matrix result at an AAA rating stress, Fitch would anticipate affirming Ambac's ratings with a "Stable Rating Outlook". So, the ratings agencies are trying to grow some kahunas now... But are they enough??? After all, it is Fitch who admitted that their original models that granted the AAA status assumed that housing price appreciation would continue on a positive slope in perpetuity. _________________ "What are the key drivers of your rating model?" They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years. My associate then asked, "What if HPA was flat for an extended period of time?" They responded that their model would start to break down. He then asked, "What if HPA were to decline 1% to 2% for an extended period of time?" They responded that their models would break down completely. He then asked, "With 2% depreciation, how far up the rating's scale would it harm?" They responded that it might go as high as the AA or AAA tranches. Adding to this appraisal, in a recent study by Joshua Rosner, managing director of investment research firm Graham Fisher & Co., and Joseph R. Mason, associate finance professor at Drexel University, "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," they say, "the senior levels of these structures are probably not as safe and secure as the rating companies have said, as an investor would assume, or as regulators are counting on." In an interview, Mr. Rosner commented that whether the top-rated classes of these securities are downgraded, "depends on home price appreciation. It is a strong possibility that there could be downgrades." There goes that credibility again. What we know about the actual portfolioNow that we have seen anecdotal evidence of what is really happening in the housing markets and how it effects real estate related securities, let's apply some of that reality to Ambac' portfolio. If you remember not too long ago, Citadel bought a lot of E*Trade's mortgage and ABS book for about $.25 (that's right 25 cents) on the dollar. There are a lot of pundits screaming that this is not a normal economic transaction and this does not reflect a market price, but a fire sale. Well, listen up baby - If everybody around you is on fire, than any fire sale is a normal market transaction. The market is on fire! Get it? Every transaction of like securities saw a big haircut (Thornburg, E*Trade, etc.), and the more recent the transaction the shorter the haircut. Why? Because the market prices are in a state of deterioration. Fool yourselves if you wish, but the market prices for these assets are very low. It's as simple as that. Asset holders say that they have significant value because they are paying income. I say, well then why sell it if is worth so much and the market is so wrong! Keep it and buy some more at the expense of the foolhardy market. Just make sure you reference those Countrywide, REO graphs, and links above, before you do. Now, I am the last to say that the market cannot be irrational. Look at Ambac's stock price for instance - this for a company that is at serious risk of insolvency. The difference here, you see, is that I am willing to actually take a bearish stance on Ambac, and not just sit back and complain about the market. So, all of those pundits who don't believe the market is pricing these accurately, do as I do and act on your convictions - buy them much closer to par. Below is a snapshot of the "window to Ambac's potential liability" - an Ambac mini-app that I am making available for download (see Ambac_PortfolioAnalysis_Etrade_mini_app (383.5 kB). It captured some of what I perceived to be some of the higher risk portfolio obligations that they had originally posted on their site (but then moved) and allows you to easily slice and dice it to display exposure by:
Merry Christmas and Happy New Year!
I used this mini-app and some additional calculations to produce the numbers below in a marking to market of the Ambac portfolio to the market based price produced by the E*trade/Citadel deal. This is Ambac's current portfolio as it stands on their books
E*Trade's portfolio was inherently better underwritten than the stuff that Ambac insures, with a much lower level aggregate LTV, and much higher FICO score and ratings. The following are notes on the assumed marks above
Thus, if forced into liquidation, the assets outlined here on Ambac's books would be marked down to about 13 cents on the dollar (45% of the total portfolio insured by Ambac is rated BBB and below resulting in a lower value on the insured portfolio). That, my friends, is a significant hit. A hit that Ambac will not be able to earn their way out of considering the recent turn of events, particularly the waking up of the municipal issuers (Muni Insurance Worthless as Borrowers Shun Ambac... are discovering that buying municipal bond insurance from MBIA Inc. and Ambac Financial Group) and the introduction of a "real" insurer into the monoline space (Buffet to launch a municipal bond insurance unit, posing a threat to monoline insurers struggling. ... Bond insurers feel heat as Buffett enters sector). Now, as investors, do you feel you should be aware of this additional risk and potential liability by a mandated mark to market, or should we just pretend everything is rosy since Ambac "intends" to hold the contracts to maturity? We all have the best of "intentions", unfortunately reality doesn't always play into our intentions. In addition to what you see above, we have done the analysis of the issuers on the basis of current ratings and analyzed the issuers on the basis of various types of collaterals backing the securities. If you download the mini-app, the one's marked yellow in the Issuer_Analysis Sheet have a higher percentage of BBB rated collateral. The ones marked in red have proven significantly subpar underwriting prudence (ex. again, Countrywide et. al.), hence are showing outsized losses in their loan products. The above analyzed assets and their relation to even further losses to Ambac These assets are directly insured by Ambac, but in addition, they are also directly related to the outsized risks that Ambac and MBIA hold in their CDOs. (This section borrowed from Vinod Kothari). Inherently, all "CDOs are cast in a model - unlike the portfolio of a usual balance sheet transaction, CDO portfolios are completely synthetic."Synthetic" is close to "unreal", that is, the portfolio is completely virtual. It is constructed not by actually originating credits, but simply by synthetically selling protection on the target names. Therefore, the idea of a synthetic CDO is that of calendar beauty - it is perfect in every respect. It is an idealized portfolio where everything is only as much as you would love to have. This idealized perfection is attained to fit into rating agency models that compute the expected losses of the CDOs, and therefore, in a not very discrete way, it is the rating agency models that have been instrumental in the spurt of CDOs in the market." Let me be a little less discrete in my pronouncing the underlying theme here. The rating agency models weren't developed to ascertain the realistic risk of CDOs. CDOs were developed to fit into the synthetic risk parameters of the rating agencies - in a synthetic, perfect world. Both Moody's and Fitch have had to revamp their models because they underestimated losses in the subprime mortgage sector. According to many, all three of the big three agencies are guilty of this model masturbation, some of which relied on prices only going in one direction - UP! As I understand the casting of the new models, they will fail in accuracy as well, for they have yet to address the inherent and fundamental cause of the significant uptick in defaults. I have been crooning since the beginning of this blog - this is not a subprime mortgage problem. Subprime mortgages simply had shorter teaser rates and higher aggregate interest rates, so they were the first to break out of the proportionate mold of historical losses. They were the first, and will not definitely be the last. Many media pundits are labeling this natural progression I just described as a subprime "contagion". It is no such thing. It is simply what happens when banks underwrite loans that they don't give a damn about. The problem here is the moral hazard had from asset securitization itself. This would have never happened if companies like Countrywide or Washington Mutual knew they were forced to keep their underwritten risk on their books. Alas, they didn't have to - and you know the saying, its "other people's money". This may seem overly simplistic, but it is at the root of understanding the losses to come. Rating agency CDO models are based on the concept that you can lump a bunch of differently rated and underwritten assets into a pool, and that lack of correlation - or diversification - stemming from all of the disparate cash flows will give you XX% margin of safety. Now, each CDO is split up in slices called tranches, and each slice has its own expected risk and reward. Now, all Ambac has to do is insure the slices higher up the totem pole that will be the last to get hit with losses, and all will be fine. "It is the guys on the lower end that get hit, not us", they say. The greater the perceived risk, the greater the perceived reward. I say perceived, because they are all off the mark in their "perceptions". To begin with, the concept behind the modeling is faulty. Asset prices do not always rise. My 7 year old son knows that, they should have consulted him. Maybe they did, since they revamped their model to actually take prices going in more than one direction into consideration. Yet, in doing so, they hard-coded another fundamental flaw in their models which significantly overvalues these assets and Ambac itself. They are still trying to differentiate between subprime and prime, investment grade and non-investment grade loans -- basically, trying to rate the asset classification instead of rating HOW THE ASSETS WERE UNDERWRITTEN! You see, it is not so much what you underwrite, but how you underwrite it. Subprime lenders have been making money for many years now, but only suddenly did everybody go out of business and the very thought of the term connotes toxic sludge. Why? Asset securitization and OPM. "Hey, I don't give a damn about underwriting, it ain't my money!" An extremely significant contingent of the loans made in the last three or four years will prove to be highly correlated, since they were mostly written under the same auspices - to people who couldn't afford them, collateralized by quickly depreciating assets. Teaser rates, adjustable rates, negative amortization, pay options, 40 year amortization, interest-only - these are not the instruments used by people who could afford what they are buying. Thus, when times get tight, the so-called "PRIME" risks are going to behave just like the alleged "subprime" risks - like they can't afford the asset that they took the loan out for. Do you want to know why they will be acting the same? I'm glad you asked. Because for all economic intents and purposes, they will be the same for they will all be in the same boat, trying to stay afloat in a property that is underwater (no pun intended). In addition, it is exacerbated by the falling asset values, as described above. Well, there goes all of that diversification theory.
Where's the beef? Who's hiding the sausage? Someone is insuring the $2 trillion of CDOs! From Wikipedia: "CDOs originated in the late 1980s along with the initial conflagration of 2nd generation derivative products. They emerged in force a decade later benefiting from the fast asset-backed synthetic securities market, of which they were the fastest growing segment. Since CDOs satisfied yield hungry investors who wanted something more than mere treasury rates, this rapid growth most likely reflected institutional demand, or institutional (read rating agency and investment bank) market pushes, since it is nigh impossible to differentiate between the two these days. CDOs are consumed by insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, and believe it or not, other CDOs and structured investment vehicles (ex. CDO squareds and cubed - where risk and leverage is compounded by multiples). As stated earlier, the pushing of these instruments are probably also the cause of their popularity, reflecting the greater profit margins that CDOs provide their vendors and servicing agents - primarily investment banks and rating agencies. Most derivative products represent significant profit opportunity for Wall Street vendors, especially when pricing is opaque, as it always is in the beginning since the only ones who really have any grasp on the pricing are the ones who created the (proprietary) pricing models. It is oft believed by this author, that even the vendors do not have a firm grasp on pricing, especially as it relates to the purchasers compensation for the risk assumed. This is the benevolent way of looking at it. There is a perspective to approach it from, but we won't go there. In 2001, the introduction by David X. Li of Gaussian copula models, which allowed for the rapid, although still highly theoretical, pricing of CDOs, which caused the wholesale production of these vehicles to begin in earnest. According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled USD $157 billion in 2004, USD $249 billion in 2005, and USD $489 billion in 2006. Research firm Celent estimates the size of the CDO global market to close to 2,000 billion towards the end of 2006." Hmmm! Well, if this is accurate, then someone is not coming clean. MBIA has already dropped one bomb since I started writing this article (took too long to get it out), so that partially validates my claim, but there is still much more to come. Let's see, MBIA $32 billion, AMBAC (who knows the truth but them, but let's hazard a guess at $30 billion) that leaves a whole lot more to be accounted for before we get to the numbers quoted above. Even if we assume only a minority were insured, which I doubt, there are some guys out there to be left holding the bag. I have written much more juicy stuff on monolines with plenty of analytics, cartoons and jokes. A little something for everybody:
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Comments (4)
  written by Mark Edmunds, January 06, 2008
It also strikes me as ironic that someone like Ackman is so strident in arguing that bond insurers should mark-to-market when he profited so handsomely from an extreme case of the market pricing risk inefficiently (e.g., MBIA and Ambac credit default swaps being priced at 15-20 bps).
 written by Reggie Middleton, January 06, 2008
I understand your point on Roubini's comment, but fundamentally I have to agree with him.
AAA is a very high standard, and if your business model relies on AAA status for survival, then by default you have not attained that AAA status. It is a circular argument of sorts, I realize that. As you have said, this is a purely academic argument, for structured product insurers and AAA should not be mentioned in the same sentence.
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Reggie Middleton has 3,000 subscribers, worldwide!
First, Nouriel Roubini's argument about AAA rated companies not being able to withstand a single notch downgrade strikes me as juvenile. There are lots of rating sensitive businesses. The bond insurers are just a more dramatic case. This is purely academic as respects MBIA and Ambac (as well as SCA and FGIC) because the AAA ratings are a farce based on their exposure to risk.
In an ideal situation, where the ratings actually meant something, the MBIA situation might unfold something like this. MBIA discloses $1.5B in losses (MTM plus reserves), but this is the real ultimate exposure. In response, the rating agencies cut MBIA's AAA rating to AA or A reasoning that AAA-rated companies can't lose over 20% of their capital in a quarter and keep the AAA, even if they raise $1B (or $2B) at the same time. MBIA then goes into runoff. The losses are ultimately reversed as unearned premium reserves flow through income. Equity capital is partially eroded by operating expenses, but all claims and debt obligations are honored. Of course, in reality, MBIA underwrote so much nasty exposure that these losses are just the tip of the iceberg.
Second, the idea of having a backstop (like the bond insurers) in case markets start behaving irrationally holds some merit in my view, and therefore I do not buy into the argument that they should need to mark-to-market when they understand the exposures reasonably well (e.g., muni bonds, perhaps some vanilla non-agency RMBS). Again, this is an academic atgument, because they should probably need to mark-to-market complicated stuff like ABS CDOs. This should also be academic because it is utterly ridiculous to afford a AAA rating to a company that writes lots of complex and nasty crap like ABS CDOs or HELOC deals with no iniital subordination or subprime used car deals with 7% subordination or manufactured housing securitizations, etc.
P. S. I can't wait to read and learn from the new stuff you posted on the commercial real estate market.