Seeking Alpha
Value, contrarian, bonds, long-term horizon
Profile| Send Message|
( followers)

Bond insurer Ambac Financial (ABK) has warned bankruptcy is a distinct possibility, sending its shares plummeting more than 30% Tuesday.

What is intriguing about this pending bankruptcy is how this company escaped bankruptcy in 2008, was downgraded continually in 2009, yet just reported billions in profit 5 days ago. Now it warns of bankruptcy?

This story also is related to municipal bonds.

Rewind to July of last year and Ambac was headed to zero fast after having been downgraded by S&P the month before. Basically, their business model of using a AAA rating to guarantee bonds (a sort of credit default insurance) was rendered non-viable by the credit crunch.

But in November, Ambac was able to forestall the inevitable. On November 19th, MarketWatch reported:

Ambac said late Wednesday that it commuted, or tore up, roughly $3.5 billion worth of guarantees on complex mortgage-related vehicles known as collateralized debt obligations. The company’s main bond insurance unit paid counterparties $1 billion in cash to settle the contracts.

The deal will improve the capital position of the bond insurance unit for rating agencies, Ambac said.

Later the company eliminated its dividend.

When the company rejected an unsolicited offer by Warren Buffett to reinsure $800 billion in municipal bonds insured by Ambac and MBIA (NYSE:MBI) in December, this was generally seen as a sign of strength. But, the company was holding on by a thread.

Then came the potential for a big bailout in March. MarketWatch again:

Life and bond insurers soared after the announcement Monday that they will be eligible to participate in the Treasury Department’s Public Private Partnership Investment Program.

Bond insurer Ambac Financial Group is one that will investigate Treasury’s offer to backstop a market for securities it holds in its investments, said Ambac spokeswoman Vandana Sharma.

The public-private program will use $75 billion to $100 billion in money from the Troubled Asset Relief Program called TARP to generate $500 billion in purchasing power to buy legacy assets held by investors, with a government backstop encouraging private sector investors to purchase the assets.

Ambac did not get TARP money. All the while, the two companies MBIA and Ambac continued to be downgraded by the ratings agencies – dead men walking.

But just five days ago, Housing Wire reported the following:

Bond insurer Ambac Financial Group posted net income of $2.2bn, or $7.58 per share, in Q309, compared with a net loss of $2.4bn in the year-ago quarter.

Quarterly results were impacted by unrealized mark-to-market gains in the New York City-based financial services and insurance firm’s credit derivatives portfolio and gains from Q309 reinsurance cancellations.

The firm experienced a positive $2.1bn change in fair value of credit derivatives, driven by the adjustment made under Financial Accounting Standard (FAS) 157 relating to Ambac’s widening credit spread…

Nice, right? Well, now they could be filing for bankruptcy.

The muni connection comes from the fact that Ambac was a large guarantor in the municipal bond market. Witness this ill-timed article from Fortune in February 2008:

Forget what you may have read in the newspaper about state budget problems or bond insurer meltdowns. This is a perfect time to be buying municipal bonds. The economy is slowing, the Federal Reserve is poised for more interest rate cuts (boosting bond prices), and a Democratic win in November would probably lead to higher taxes on the rich, thereby enhancing munis’ tax advantages. Throw in munis’ microscopic default rates, and you’ve got an ideal landing spot for investors weary of the stock market roller coaster…

As we said, the default rate on munis is minuscule, especially for GOs, water-and-sewer revenue bonds, and the other plain-vanilla offerings that make up the majority of the muni market. Even triple-B-rated munis – the lowest rung of investment grade – have a default rate of only 0.06 percent…

Over the years, this incongruity has fueled the growth of Ambac, MBIA and other bond insurance companies. By selling states and cities insurance that turns triple-B and single-A bond issues into triple-A’s – reducing government borrowing costs in the process – the bond insurers manage to pocket much of the extra yield that would otherwise go to investors. Best of all, bond insurers rarely had to pay claims, certainly not on the plain-vanilla GOs and water-and-sewer bonds. "In my opinion," says Paul Disdier, who oversees the municipal bond fund division at Dreyfus, "the worst thing to happen to the muni market is the spread of bond insurance."

I’m sure you know that the spread is actually not the worst thing here. It’s that risk was being underpriced. That’s why Ambac is hitting the wall. And so it is again.

By the way, the Fed and the Treasury are on record as being leery of guaranteeing anything in the municipal bond market. So, with Ambac crumbling and no Federal government backstop, there is no safety net for bad investments in munis. Caveat Emptor.

Source: Ambac: Now It Warns of Bankruptcy?