MBIA Reports a Profit: $1.1 Billion in Expected Recoveries on Claims

MBIA (MBI) reported 2nd quarter EPS of 4.30, an upward surprise although not directly comparable to consensus which called for a loss of (.92). Volume in the two days leading up to the announcement was extraordinarily heavy, with 28 million shares trading Tuesday and 13 million on Wednesday, for a stock that has been trading about 2 million shares a day. The high volume may have been due to quicksilver messengers, warning short-sellers of the impending surprise, or it could have been intuition, instinct, or simple prudence. In any event, the shares reportedly changing hands were sufficient to cover the entire short-interest.

Expected Recoveries - MBIA has recorded 1.1 billion in expected recoveries due to warranties and representations included in 2nd lien mortgage securitizations. Basically, if the mortgages don't conform to requirements, they are to be removed or replaced. The two prime offenders, Countrywide and ResCap, have been stonewalling: they have only provided 24% of the files requested for review and have declined to replace or remove the subject mortgages. MBIA has been paying the claims when due and has suits outstanding against Countrywide and ResCap.

In previous quarters, the company has refrained from recording any credit for expected recoveries, but this quarter they have booked 1.1 billion in expected recoveries from warranties and representations on 2nd lien RMBS. Given their prior reluctance to claim any benefit for their efforts at remediation, I think the 1.1 million figure is good. This would account for most of the profit for the quarter.

I think the amount of ineligible collateral contained in the deals will prove to be in excess of the claims payments made.

Conference call - I came in late on the conference call. Most of the analysts were concerned with the 1.1 billion: the questions would be 1) can MBIA win a judgment and 2) can they collect. Also, the 1.1 billion is only for the individual mortgage files that have actually been examined: approximately 70% have not been looked at and no credit has been booked for them.

The collection issue would primarily be about ResCap, a subsidiary of GMAC. GMAC has been back to the trough for more TARP money, but there is still speculation that they may walk away from ResCap and permit it to go bankrupt. MBIA did not furnish a breakdown for how much of the sum involved is for ResCap nor for the size of the valuation allowance for collectability, if any.

These questions will take time to resolve. Jay Brown put it at 2 to as much as 3 years.

Keeping my eye on the ball – the statistic of interest to me is adjusted book value, a non-GAAP metric provided by the company which excludes the effect of mark-to-market losses and includes the present value of future installments and unearned premiums. This came in at 40.01, up from 37.61 at the end of the 1st quarter and down from 40.06 at the end of 2008. Leaving GAAP out of it, this says to me that the company broke even for the first six months of 2009, no small feat. In point of fact ABV stood at 39.63 at the end of the 2nd quarter 2008. MBIA is not hemorrhaging nearly as fast as its critics are looking for.

I also updated my weighted average valuation estimate, presented later in the article.

Pending litigation – the recoveries mentioned above arise from contractual rights, the normal representations and warranties that are included when mortgages are sold or securitized. The party submitting defective collateral is required to remove or replace it. Claims against Merrill Lynch involving fraud in the process of getting MBIA to insure various CDOs have not resulted in recording any expected recoveries, although the suit is still pending.

There is also litigation against MBIA's transformation, by 1) Third Avenue in Delaware court, and by 2) a group of banks as well as 3) others lead by Aurelius Capital in New York court. All suits allege that MBIA Ins. Corp (the structured finance subsidiary) is effectively insolvent and that the transformation involved a fraudulent transfer of assets to National Public Financial Guarantee (the muni-only subsidiary). The press release includes a statement by CEO Chuck Chaplin to the effect that MBIA Insurance Corp has more than adequate resources to pay its claims and that he expects the company will ultimately prevail in litigation. The 1.1 billion in expected recoveries that has been recorded substantiates this claim.

Valuation – MBIA is the largest municipal bond insurer. If the company is able to resume writing new business at profitable rates share prices should recover toward ABV, 40.01 as of 6/30/09. Trading at $6.30 after hours, there is ample room for appreciation. Obstacles include the litigation, the period of time required to determine the ultimate loss from RMBS and CDOs, and the need to resolve rating agency issues. My guess is that it will take about 4 years to get this worked out.

In the meantime, a weighted average computation might be used, along the lines shown above. The various book values are from the latest operating supplement. The probabilities are 2% a severe Depression, 20% a mild Depression, 10% full recovery for MBIA, and the balance 68%. The stock has been heavily shorted for a long time. If I were short I would be concerned at getting squeezed by headlines about legal outcomes, etc., not to mention the Armageddon (not) risk: what if the world goes on spinning, the sky does not fall, and the housing situation eventually stabilizes? What if MBIA's financials are simply management's best estimates of results, and not a pack of lies? What if the much ballyhooed next shoe to drop – CMBS – is not as severe as expected?

The economic scenario is becoming less of a question, now it is more about the probability of various outcomes on the litigation. My thinking is if MBIA wins the litigation on the warranties and representations on 2nd lien securitizations then the challenge to the transformation will become a moot point because MBIA Ins Corp will clearly be able to pay its claims.

Options Strategy – I own a few shares, but my main way of playing MBIA is by means of short puts, more or less at the money, using the proceeds to buy larger numbers of out of the money calls. As of the moment I am short 20 Aug09 6 puts and long 80 Aug09 7 calls.

The thinking is, at prices around 5, 1/8 of ABV, MBIA is priced for disaster, and that outcome is becoming less likely as the situation develops. Meanwhile, options prices totally disregard the somewhat remote probability that MBIA may eventually recover to the 40 area. The objective is to keep rolling the options position, with gains roughly equal to losses, until something gives. My guess is that when that happens the movement will be upward, sudden and large.

So far I have had several expirations where the options showed a nice profit, offset by one interlude where expensive calls expired worthless. Overall, the objective of controlling 8,000 shares at low cost while using the funds that would otherwise be tied up for more immediately productive uses has worked well. The earnings report is very encouraging, and I continue to believe that the shares are under-valued and that option pricing does not correctly reflect the range of possible outcomes for MBIA.

Disclosure: Long MBI as described in the article

Comments

[MBIAisDEAD:]

Management sure has been at projecting 2nd-lien paid claims.

$1.35 billion this year so far; what was the projection at Q4 '08? Check that out.

This firm is beyond insolvent, considering realized losses on wrapped ABS CDOs in excess of subordination are probably equivalent to MBIA's impairment at this point, not accounting for the burgeoning REO/30-60-90 Del pipeline losses.

LIBOR spikes and the discounting charades end.

Aug 06 01:22 PM

[jimmy46:]

Great analysis Tom,
I've been long myself thinking along your lines.

Aug 07 05:26 PM

[Tom Armistead:]

Thanks for your support, I noticed in the option update Friday by Andrew Wilkinson there was a large play in January options, someone sold 10,000 puts at 5 and bought 18,000 calls at 10, so there are a few others who have similar ideas.

Tom


On Aug 07 05:26 PM jimmy46 wrote:

> Great analysis Tom,
> I've been long myself thinking along your lines.

Aug 08 12:56 PM

[Ricard:]

Thanks for the perspective.

I've done a similar options play with my speculation on Citigroup with similar results.

I think given that the sky did not fall on us (the primary fear since the collapse last October), it's safe to assume that with a LOT of time, these stocks may eventually recover to some fraction of their pre-crisis worth. To expect stocks like MBIA and C to recover, say, 30% of their 2007 values within a year or two is totally reasonable, and options allow you to capture that rise with minimum capital outlays. Well done.

Aug 08 01:49 PM

[MBIAisDEAD:]

JPM Thinks ABV is -$40

Aug 12 04:08 PM

[MBIAisDEAD:]

JPM Thinks ABV is -$40

Aug 12 04:08 PM

[Tom Armistead:]

JPM is suing MBIA and their analyst did a hatchet job on the company to support their litigation. The report did not include a disclosure of the analyst's bias, a serious ethical lapse.

It should be further noted that JPM has a stake in taking the position that contractual rights afforded by warranties and representations are meaningless, because they bought Bear Stearns which had a huge exposure to claims of that type which was never reflected on the books. Ambac is suing over that.

Hence Daniels Kim's wretched hatchet job.


On Aug 12 04:08 PM MBIAisDEAD wrote:

> JPM Thinks ABV is -$40

Aug 12 05:28 PM

[MBIAisDEAD:]

What specifically do you dispute from JPM?

By the way I don't mean to be rude. Just trying to get a coherent long rationale.

What do you expect losses on 2nd-lien RMBS to approximate? Do you give MBIA's LAE any credence? I wouldn't as they are essentially booking losses on a quarter-by-quarter basis.

The realized losses on MBIA's multi-sector ABS CDO portfolio in excess of subordination will probably be > impairments by year end. Collateral losses will be catastrophic on the non UP only ABS CDOs.

As BBB CMBS tranches begin to be torched, and the deductible on these deals (these are not TI&UP deals, once deductible is torched they are AC&D) is exhausted we will see large cash outlays.

Here is a good way to see:

Look at the amortization of the ABS CDO portfolio over the last six months. Some deals have remained static, even though an EOD has been triggered and they are in rapid AM. The cash flow from subordinate tranches (which are now torched) has been diverted to senior classes, but soon cash flows will not even cover interest payments, let alone pay down principal.

Then MBIA steps in on these ~$16 billion in ABS CDOs. While paying ~$600 mm per quarter on 2nd-liens.

Also, notice the lack of comment on the Alt-A book? That was considered "adequately" protected in Q1? That is because it has been performing horrifically, with severities >55% and will incur significant losses going forward. Ambac has ~$1.8 billion in L/LAE on their (admittedly worse) Alt-A direct book. MBIA has zero.

MBIA also has no reserves on CRE whatsoever.

MBIA also has a gaping hole in it's ALM unit, not booked as a liability even though MBIA Insurance corp. Guarantees the sub's liaibilties.

No one -- and I mean no one but management -- believes the company can pay claims. They will not survive to win lawsuits.

Aug 13 10:37 AM

[Tom Armistead:]

JPM is welcome to have an opinion, I dispute the ethics of doing a hatchet job on a firm that you are in litigation against without disclosing the source of bias. I reported them to the SEC, let them figure out if JPM did anything wrong.

Briefly I rely on company presentations for the timing of the cash flows on paying off the ABS CDO claims. Similarly I rely on company LAE estimates on RMBS. It is normal for these loss estimates to develop over time.

Where I think you are missing the point is asserting that "they will not survive to win lawsuits." The suits on the 2nd lien RMBS are very simple, MBIA has contractual rights due to warranties and representations and it intends to assert those rights. BAC is the prime offender but all of the big investment banks seem to believe that their contractual obligations can be disregarded if they become inconvenient. That's not how it works.

I notice you are operating under a newly minted screen name and are concerned only with MBIA. If you have as much detail to contriubte to this discussion as you claim I would suggest you register with Seeking Alpha under your real name and make you case in a full length article.


On Aug 13 10:37 AM MBIAisDEAD wrote:

> What specifically do you dispute from JPM?
>
> By the way I don't mean to be rude. Just trying to get a coherent
> long rationale.
>
> What do you expect losses on 2nd-lien RMBS to approximate? Do you
> give MBIA's LAE any credence? I wouldn't as they are essentially
> booking losses on a quarter-by-quarter basis.
>
> The realized losses on MBIA's multi-sector ABS CDO portfolio in excess
> of subordination will probably be > impairments by year end. Collateral
> losses will be catastrophic on the non UP only ABS CDOs.
>
> As BBB CMBS tranches begin to be torched, and the deductible on these
> deals (these are not TI&UP deals, once deductible is torched
> they are AC&amp;D) is exhausted we will see large cash outlays.<br/>
>
> Here is a good way to see:
>
> Look at the amortization of the ABS CDO portfolio over the last six
> months. Some deals have remained static, even though an EOD has been
> triggered and they are in rapid AM. The cash flow from subordinate
> tranches (which are now torched) has been diverted to senior classes,
> but soon cash flows will not even cover interest payments, let alone
> pay down principal.
>
> Then MBIA steps in on these ~$16 billion in ABS CDOs. While paying
> ~$600 mm per quarter on 2nd-liens.
>
> Also, notice the lack of comment on the Alt-A book? That was considered
> "adequately" protected in Q1? That is because it has been performing
> horrifically, with severities >55% and will incur significant losses
> going forward. Ambac has ~$1.8 billion in L/LAE on their (admittedly
> worse) Alt-A direct book. MBIA has zero.
>
> MBIA also has no reserves on CRE whatsoever.
>
> MBIA also has a gaping hole in it's ALM unit, not booked as a liability
> even though MBIA Insurance corp. Guarantees the sub's liaibilties.
>
>
> No one -- and I mean no one but management -- believes the company
> can pay claims. They will not survive to win lawsuits.

Aug 13 11:06 AM