Thursday, 29 November 2007 00:00

Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billi

I came to this conclusion after a detailed analysis of Ambac's portfolio (at least what Ambac has made public, which was sufficient) covering exposure in the Structured Finance, Sub-prime RMBS and the Consumer Finance business. Ambac's management was forthcoming enough to publish a portion of their insured portfolio which allowed me to review each structure.

I am short Ambac and MBIA (for whom I have also released research), so be aware of my position as I present this opinion. I profit not necessarily from whether ABK can continue as an ongoing concern (which is in doubt and wouldn't hurt my shorts to say the least), nor from an infusion of capital (whether it be debt or equity, either of which would be a poor investment from my perspective) but from the significant decline in value of the existing shares in which I have taken a bearish position. To determine my short position, I calculated relative nominal book valuations, actual economic book valuations and produced standard financial forecasts. Of interest is the loss tail analysis wherein I have estimated the present value of the future losses.

As it stands now, ABK's equity value will be totally wiped out with a 175 basis point move in their insured's underlying - which seems like a very, very likely possibility. My Ambac analysis is much more granular than that of MBIA's (see A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton ) where I discussed the predicament of the ratings agencies, the monolines, and in particular, MBIA.

The referenced predicament is exacerbated by the fact that some, such as Ambac, are truly insolvent, thus a mere waiving of the "Magic Ratings Wand" will not pay the claims when they come due. More to the point, the monolines have grown too big for their capital base, specifically their equity base. They are insuring much more than they can handle in the case of an outlier event. I don't consider the burst real estate bubble and the consequent mortgage debacle much of an outlier, for anyone could have seen it coming if they simply opened their eyes.

Now, if a big monoline fails or is even downgraded, a large part of the credit market goes with it. This level of catastrophe may be too much for the powers that be. This portends a bailout of some sort or fashion, or maybe the players will just be forced to take their market medicine. Only the future will tell.

----- EXTENDED BODY:

Six Degrees of Separation: Guess who Ambac insures!

Bank of America issued a report on the monoline insurers on July 30th, 2007 that states that ABK's RMBS exposure to troubled companies is limited to only 4 cos. with vintages primarily in the early years excluding two relatively well performing underwritings. Despite this, they failed to include in this caveat the consumer finance insureds:

  • Countrywide, which probably has one of the worst performing portfolios in the industry;
  • GMAC, who has also suffered significant losses that GM has been forced to cover, hence hampering a clean sale of the company;
  • Indymac, another company that is saddled with mortgage related losses that is on the insured's list (Indymac and Countrywide have had their shares more than halved in the last few months. I was short these companies. CFC may go bankrupt);
  • Lehman brothers has some losses to contend with as well, but I don't know to what extent since I don't follow it - I do know that they are the 2nd largest MBS house on the street, next to Bear Stearns;
  • Greenpoint Mortgage Funding is defunct, wound down due to losses;
  • Then we also have Citimortgage (SIV king whose own mortgage portfolio is a mess);
  • Accredited Mortgage Loan (bankrupt or close to it);
  • Wachovia (just reported a billion plus writedown on mortgage assets);
  • Countrywide Revolving Equity Trust/Alt-A trust (need I say more about undocumented 2nd lien loans from this lender);
  • Option One Mortgage Trust (nearly defunct due to mortgage losse);
  • BofA, mulit-billion dollar mortgage asset writedown;
  • and Newcastle - who I believe is either out of business or close to it. I stopped following it some time ago.

These are the companies and exposure that I am familiar with, at first glance in the consumer finance portion of Ambac's portfolio, without any research. Just imagine if I took a real hard look at the insureds.

Now, using some common damn sense, would you think that the company that is insuring these guys' mortgage and finance products with 90x leverage may be having some problems that they may not be coming forward with. I have over 100 pages of proprietary analysis and calculations costing me weeks of analyst hours, that tell me Ambac may be out of business soon - but I really didn't need to do all of that math and research if I just glanced at the bullet list above. I used the loss statistics from the BofA report as a baseline for the losses in my models on Ambac. I know they are too conservative (and to be fair to BofA, they were contrived before this mess got worse), but that should only lend credibility to my findings. Click here to download ambac loss tail.pdf.

The ACTUAL quality of the ABK's insureds is truly suspect in my opinion and the underwriting quality of their insureds needs to be investigated further. Unfortunately, I have very limited resources. I literally told my team that "this is worth digging in and spending time on, for there are many who are now trying to go long on this stock due to its price and nominal book valuation. If they are wrong, it can be a very profitable opportunity". Well, that's what we did. By investigating the losses on similar books written by the originators for the vintage in question, one can guess the performance of the books underwritten by AMBAC. The policy terms must be examined to see where the breakpoints are for losses, of course. Exposure to Countrywide alone is a cause for suspicion, IMO. As stated earlier, the default estimates in the B of A analysis are assuredly too conservative, but are used for the sake of prudence over alarmism (with some mandatory tweaks to edge them towards reality). Why do I say they are conservative??? Take a look at the REO rates and land value forecasts in my blog, and then look at the target prices for the insurers in question on the first page of B of A's analysis, right before you query the prices of these stocks today. For those that don't have access to the report, I will reveal just this one tiny part:

Bank of America Top Picks (June 2007)

Ticker

Rating

Price

Target

Price as of 11/29/07

Profit on the BofA Call

% Profit

SCA

B

$23.60

$37.00

$6.69

($16.91)

(71.65%)

MBI

B

$60.33

$85.00

$30.04

($30.29)

(50.21%)

Least Favorites

NONE

You really can't get rich listening to these guys. Hopefully, you can see where the use of their default data is a conservative approach (even a bit rosy), albeit tweaked ever so slightly for the sake of reality. As you may have ascertained, I do not put a lot of faith in sell side research. I have even less faith in the big three rating agencies research (although Fitch is trying to be taken seriously). Thus, even if they deem ABK and MBIA not in need of more capital, that is near meaningless in my book. These are the same companies that rated the insured portfolios AAA a year or two ago that are now taking up to 20%+ losses.

We also have to contend with the moral hazard/bailout issue. If you read my earlier missive on MBIA, I detailed the rating agencies' dilemma.

The calculations in this analysis are only estimated losses in 4 insured categories (of many, they are enough to generate significant losses). I am expecting higher losses in Public Finance as well due to the loss of property tax revenues (lower tax base) and income tax revenues led by housing value declines and loss of corporate revenue and jobs, respectively. Many municipalities created huge budgets during bubble times (like everyone else) and failed to prepare for the bubble to burst. Now unfunded services run rampant. The shortfall will have to be covered somewhere, and default on debt service is not out of the question.

In the base case scenario created, we expect the company to report losses to the tune of $8 billion+ in its Structured Finance, Subprime RMBS and the Consumer Finance portfolio. This loss will wipe out the company's remaining equity and it will need to raise an additional $2 billion in order to function as an ongoing concern. Moreover, we think the company will need to reinsure a higher percentage of its portfolio in order to transfer risk and free up capital.

"The Truth! The Truth! You can't handle the Truth!"

I calculate that Ambac will need to raise an additional $2 billion in order to continue as a going concern. In order to maintain AAA status they will need $5.4 to $7 billion, according to how I perceived the comments of its CEO in the last conference call (they say they are an average of $1.4 billion above what is needed to maintain a AAA status from the three main rating agencies - without my little economic reality marking here). In the base case scenario below, Ambac will need to bolster its reserves by $6.8 billion. A fellow blogger that I follow, Mike Shedlock, commented that Citibank has recently sold approximately 5% of itself to a foreign investor to raise $7.5 billion dollars. Citibank is much more diversified, with a much larger capital base, than Ambac. Let's be realistic here - no let's not - Let's be highly optimistic with pretty rose colored glasses, and say that ABK can fetch a significant premium to Citibank's valuation. ABK's current market valuation is $2.26 billion. Where in the world will they get this kind of capital from and who will be the risk cowboy to give it to them??? These guys are in a real solvency dilemma, and it is a shame that the ratings agencies and the sell side guys have yet to admit it. I guess it takes entrepreneurial investors and bloggers such as me to ferret out the truth, and the truth is hard to find in detail. You remember what Jack Nicholson said in "A Few Good Men"? "The Truth! The Truth! You can't handle the Truth!" I had two analysts and I work on MBIA and ABK for weeks, when I should have been able to just buy a report... Yet, everyone expept Ackman from Pershing Square was unrealistically optimistic. There are some big losses ahead of us folks. If the real estate bust was the impetus for the current debacle, we have a long trip ahead of us because the real estate bust has just started!

My full analysis is bulky, but well documented, and will be posted as a .pdf if I get enough requests. Most should be satisfied with this lengthy summary.

Here we have done a loss tail analysis of the forecasted losses of the Structured Finance, Direct RMBS and Consumer Finance portfolio, expecting the losses of the vintage year 2005 to be paid over the next 5 years in 2006-2010. We have calcluated the loss ratio of the company which is deteriorating from 2007 onwards (denoted by Paid losses/Written premium ratio).

Base Case Analysis

Calendar year payout

Year

Gross written premium

Expense ratio

Total Expected losses

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2003

1,144

172

972

22

2004

1,048

157

891

61

2005

1,096

164

932

200

2006

997

150

847

504

2007

1,006

151

855

1,260

2008

766

115

651

1,928

2009

690

103

586

1,880

2010

635

95

539

1,741

2011

597

89

507

1,437

2012

561

84

477

671

Calendar year paid losses

22

61

200

504

1,260

1,928

1,880

1,741

1,437

671

Cumulative losses

22

83

283

787

2,047

3,975

5,855

7,596

9,033

9,704

Report year written premium

1,144

1,048

1,096

997

1,006

766

690

635

597

561

Paid Losses/Writtem Premium ratio

2%

6%

18%

51%

125%

252%

273%

274%

241%

120%

Outstanding loss reserves

950

1,780

2,512

2,856

2,451

1,174

(120)

(1,321)

(2,251)

(2,446)

Alternatively, we have calculated the provisioning for losses that Ambac will need to make every year on the basis of the anticipated losses that the company will have to pay in coming years. In doing so we have assumed that the 85% of the premium written from 2007 onwards (excluding 15% as underwrting expesnse) will be transferred to the loss expense reserve every year. The loss reserve uptill 2007 is taken from comapny's balance sheet. The losses have been calculated on the basis of various default probabilities assummed in Strucutred Finance, Direct Subprime RMBS and Consumer Finance portfolios. We have assumed a duration of 5 years to spread the losses on various vintages over the coming years. We anticipate the company will have to create a provisoin of $ 6.8 billion under the base case scenario.

Base Case Analysis

Calendar year payout

Year

Gross written premium

Loss and loss expense reserve

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2003

1,144

189

22

-

-

-

-

-

-

-

-

-

2004

1,048

254

-

61

-

-

-

-

-

-

-

-

2005

1,096

304

-

-

200

-

-

-

-

-

-

-

2006

997

220

-

-

-

504

-

-

-

-

-

-

2007

1,006

279

-

-

-

-

1,260

-

-

-

-

-

2008

766

930

-

-

-

-

-

1,928

-

-

-

-

2009

690

1,517

-

-

-

-

-

-

1,880

-

-

-

2010

635

2,056

-

-

-

-

-

-

-

1,741

-

-

2011

597

2,563

-

-

-

-

-

-

-

-

1,437

-

2012

561

3,040

-

-

-

-

-

-

-

-

-

671

Calendar year paid losses

22

61

200

504

1,260

1,928

1,880

1,741

1,437

671

Cumulative losses

22

83

283

787

2,047

3,975

5,855

7,596

9,033

9,704

Provision for losses

4

(150)

(588)

(1,202)

(1,276)

(1,294)

(1,202)

(930)

(195)

Total

(6,832)

In our base case analysis of the CDO and the Subprime RMBS portfolio, we have assigned default probabilities based on collateral; wherein we have assumed an average default probability on its subprime collateral of 6% and on its ABS CDO mezzanine a default probability of 25%.

Average default probabilities (by Collateral)

Subprime RMBS

6%

Other RMBS

6%

ABS CDO High Grade

6%

ABS CDO Mezzanine

25%

CDO Other

10%

Other ABS

10%

In our base case analysis of the consumer finance business, we have assigned default probabilities largely based on ratings. We assigned a average default probability of 2% on its AAA rating portfolio and 11% average default probability on its BIG (Below Investment Grade) portfolio.

Average default probabilities (by Rating)

AAA

2%

AA

5%

A

6%

BBB

8%

BIG

11%

Valuation

In the case of Ambac, and most of my analyses, I draw a distinction between accounting (or nominal) book value and actual economic book value - the stuff I get paid for as an investor. Below you will see comparable valuation based upon nominal book value which actually has ABK underpriced. You will also see the forensically scrubbed economic book value, which in the most optimistic scenario (which I can tell you now, just ain't gonna happen) has Ambac valued at about $9 per share. You don't want to know what the base case and pessimistic scenario portend.

Ambac Financial Corp

Relative Valuation

Nominal Book Value

FY2007

All Figures in Millions of Dollars, unless othrerwise stated

Mean Multiple

High Multiple

Low Multiple

BVPS

53.67

53.67

53.67

Equity Value Per Share

$22.5

$34.4

$12.7

Current Stock Price

$21.8

$21.8

$21.8

(Discount)/Premium to Fair Market Value

(3.11%)

(36.60%)

70.93%

Book value as marked to market (Optimistic Scenario)

FY2007

All Figures in Millions of Dollars, unless othrerwise stated

Mean Multiple

High Multiple

Low Multiple

BVPS

21.4

21.4

21.4

Equity Value Per Share

$8.97

$13.71

$5.09

Current Stock Price

$21.8

$21.8

$21.8

(Discount)/Premium to FMV

142.89%

58.93%

328.49%

Book value as marked to market (Base Case Scenario)

FY2007

All Figures in Millions of Dollars, unless othrerwise stated

Mean Multiple

High Multiple

Low Multiple

BVPS

-14.0

-14.0

-14.0

Equity Value Per Share

($5.87)

($8.98)

($3.33)

Current Stock Price

$21.8

$21.8

$21.8

(Discount)/Premium to FMV

(470.93%)

(342.71%)

(754.38%)

Peers

Name

Ticker

P/B '07

Price

BVPS '07

MBIA Financial

MBI

0.38

22.3

58.5

Assured Guaranty

AGO

0.64

20.17

The PMI Group

PMI

0.25

10.45

42.43

Primus Guaranty

PRS

0.59

5.91

Security Capital Assurance Ltd

SCA

0.24

5.32

Price to Book Value

Average

0.42

High

0.64

Low

0.24

The Effects of Adverse Spread Movement

An Increase in spread of 175 Bps would erode the entire equity

Residential Mortgage Back Security and CDO Exposure

Here you see Ambac has significant exposure to some of the worst vintage years, and as detailed above has some of the worst possible clients one would want ensure. These ingredients mix to become a very toxic cocktail, indeed.

AMBAC

Total subprime exposure with in insured portfolio

Total MBS portfolio

53.9

RMBS subprime exposure

8.8

% of total RMBS portfolio

16.3%

Sub prime porfolio by vintage

vintage 1998-2001

1.2

13.6%

vintage 2002

1.2

13.6%

vintage 2003

2.4

27.3%

vintage 2004

0.8

9.1%

vintage 2005

1.6

18.2%

vintage 2006

1

11.4%

vintage 2007

0.6

6.8%

Direct Subprime RMBS

8.8

100.0%

36.4% of the subprime portfolio belongs to vintage years of 2006-2007 when credit writing standards has been on its low.

Total CDO portfolio (in US$bn)

High yield

24.3

34.0%

Investment grade

8.6

12.0%

ABS > 25% MBS

29.2

40.8%

ABS < 25% MBS

3

4.2%

Other

2.80

3.9%

Market value CDOs

3.60

5.0%

71.5

100.0%

Breakdown of CDO of ABS's subprime collateral by rating

2Q 07

3Q 07

AAA

3.8%

7.4%

AA

39.7%

39.0%

A

47.2%

36.9%

BBB

8.6%

8.7%

Below investment grade

0.7%

8.0%

Sensitivity Analysis - Default probabilities - Base case

Vintage

Sub-prime RMBS

Other RMBS

ABS CDO High grade

ABS CDO Mezzanine

CDO other

Other ABS

1998

2%

Average defualt probabilities (by Collateral)

1999

2%

Subprime RMBS

6%

2000

2%

Other RMBS

6%

2001

2%

ABS CDO High Grade

6%

2002

5%

ABS CDO Mezzanine

25%

2003

5%

CDO Other

10%

2004

8%

5%

5%

15%

10%

10%

Other ABS

10%

2005

8%

5%

5%

15%

10%

10%

2006

15%

8%

8%

35%

10%

10%

2007

15%

8%

8%

35%

10%

10%

Sensitivity Analysis - Deafulat probabilities - Worst case

Vintage

Sub-prime RMBS

Other RMBS

ABS CDO High grade

ABS CDO Mezzanine

CDO other

Other ABS

1998

5%

1999

5%

2000

5%

2001

5%

2002

10%

2003

10%

2004

20%

10%

10%

30%

15%

15%

2005

20%

10%

10%

30%

15%

15%

2006

30%

15%

15%

70%

15%

15%

2007

30%

15%

15%

70%

15%

15%

Last modified on Thursday, 29 November 2007 00:00
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