Bond insurer Assured Guaranty (NYSE:AGO) caught a surprise downgrade from S&P yesterday, from AAA to AA+, and dropped as much as 15% before rallying to close down 8% at 19.52. I know how to pick 'em. I had just started my research, and was considering taking a position, when the news hit.
S&P said nothing about capital adequacy: it was just excuses to get rid of the last of the triple A bond insurers. I took up a starter position, and regard AGO as buy with a long run ahead of it.
Financially the strongest of the bond insurers, AGO is rated Aa3 by Moody's. The company acquired FSA somewhat more than a year ago, and the merger has been proceeding smoothly. Neither company got involved with CDOs, or the dread CDO^2, and although there have been substantial RMBS losses, AGO has been actively asserting its rights under representations and warranties and is in the process of recovering an estimated 1.3 billion from originators.
Statement in response to S&P's rating action
We are surprised by this rating action, which comes on the heels of S&P's affirmation of our AAA ratings in June 2010 and at a time when we are seeing positive developments in our market share and new business production in the U.S. municipal business and achieving significant success in our loss mitigation efforts. We believe our GAAP and statutory capital resources and portfolio meet AAA standards. These new ratings represent changes in S&P's AAA criteria and market outlook rather than any material change in our credit profile or capital position. Further, in assigning these new ratings, S&P did not provide us with critical assumptions and key sensitivities used in their analysis of certain risks in our RMBS and TruPS portfolios or quantify their view of the extent of our AAA capital shortfall, all of which we believe is required under the Dodd-Frank Act.
Through the most challenging economic environment in recent memory, we have earned operating income in every quarter since our initial public offering in 2004. Furthermore, we expect that our third quarter 2010 operating earnings per share will exceed the consensus estimate of $0.80 per share, as reported by Bloomberg and Thomson Reuters. Additionally, as of mid-October, mortgage loan originators that have breached representations and warranties have repurchased or agreed to repurchase a cumulative total of $412 million of loans, of which $111 million were in the third quarter alone. We continue to find a significant amount of defective loans and expect to continue to make substantial recoveries.
AGO has been working a very steady and methodical program, getting access to the files, going through them, and issuing repurchase demand letters where appropriate. They have been able to set up a definite process for resolving the issues, including some success in developing a constructive relationship with Bank of America (NYSE:BAC). It is not an easy process.
From the 2Q 10 earnings conference call transcript:
I would describe our negotiations like Chinese water torture. They are very painful, have taken in a long time. I will say on the positive side, we're probably in the most constructive dialogue with Banc of America as opposed to any other originator or group that has liability in this area. Obviously, we've worked with them for a fairly long time. We've developed a process of loan review and rebuttal. We would like the process to work a lot better because it's still on a loan by loan basis which they've been very public about in terms of how they wanted to address the liability.
We're encouraged by the improvement in their disclosure. We're encouraged by the fact that they put up additional reserves and they did specifically mention in the monolines they are in constructive dialogue with, so since we have not sued them and have the continued dialogue, we're assuming that's us. And as you see in the quarter, we had a pretty good quarter relative to increase in the recognition on their part of the liability. However, it's still a long way to go. We're trying to push for a higher amount of quarterly settlement relative to the size of the asset and the asset is not getting smaller.
As we get more files to review the breach rates have been absolutely consistent throughout all review periods in the mid-80% and think about that, mid-80% of all files we look at contain a significant breach and the breaches are typically the big three. Income, employment and purpose of loan continue to be our biggest issue so it's not like we're out on the edge of some periphery of the rep. These are the big ones and our success rate continues to track with the breach rate, so we're optimistic.
Chinese water torture...while there is an emphasis on patience and the avoidance of litigation, the company is prepared to go to court if necessary, and filed claims against two originators during the 2nd quarter. In June, AGO sued Deutsche Bank for breach of contract on ACE Securities Corp. Home Equity Loan Trust, Series 2006-GP1 HELOC deal. In July, the company sued EMC (JP Morgan) for breach of contract on SACO I Trust 2005-GP1 HELOC deal.
The company publishes multiple versions of book value, including GAAP and adjusted. Here is a chart of the daily share price, together with quarterly GAAP and adjusted book values (click to enlarge images):
Clearly the share price centers around GAAP book value – the median multiple is 1.06. However, the largest constituent of adjusted book value is the unearned premium reserve, net of expected losses. Looking at this, the unearned premium, as it is earned, will migrate down into retained earnings. Under this scenario, book value will stair step upward for a number of years, particularly if the company is able to continue the production of profitable new business.
Consensus earnings stands at 3.10 for 2010, and 3.89 for 2011. That's a forward P/E of 5 on the 2011 earnings.
I'm investing on the basis that book value, currently 21.05, will increase 8% per year for five years, and that AGO will eventually trade at a P/B of 1.20. That would be a long term target of 37. To make that happen, the company needs to continue to write profitable business. S&P has made that task more difficult than it had to be, justifying a downgrade by their usual process of self-fulfilling and circular reasoning. However, the US government is unlikely to continue to slap guarantees on anything that needs propping up, and at some point the private sector financial guarantee business will revive. Having substantial size, and a strong balance sheet, AGO will participate.
Unearned Premium Reserve
To understand the significance of the unearned premium reserve, here is a snip from the company's quarterly financial supplement:
Doing the math, over the course of 6 months unearned premiums declined by 190 million, which would annualize to 380 million, or 2.07 per share. Since the amount shown is in excess of expected losses, this illustrates the company's ability to operate profitably even if new business writings are temporarily diminished by S&P's rating action. The unearned premium, after allowing for expected losses, is 24.36 per share, and is not included in GAAP book value.
The company includes a schedule of expected future year's developments in their financials. From the 2Q 10-Q:
For 2011, the 575 million works out to 3.13 per share. Because investment income is roughly equal to all other expense, the 3.13 is a good estimate of the company's earnings if they don't write any new business going forward. It's consistent with the consensus estimate of 3.89.
Risk here is relatively high, given the uncertainty surrounding putbacks and the potential for substantial municipal bond losses in the wake of the recession. The five year target of 37 implies 14% return per year, ample compensation for the risk involved. Beta checks in at 2.5, so position size could start small and there would be opportunities to trade around it as news and rumors would drive it one way or the other.
Shares are optionable, to include LEAPS. Implied volatility currently stands at 55.9%, making the sale of options attractive due to the premium levels available. The following diagonal call spread makes sense to me:
- Buy to open 10 AGO Jan 21 2012 12.5 calls @ 8.35/8.95 bid/ask
- Sell to open 10 AGO Apr 16 2011 22 calls @ 1.90/2.00 bid/ask
If AGO's share price in point of fact increases at a rate between 8 and 14% per year, a series of spreads of this type will earn about 35 to 40% annualized, not too shabby. Book value provides margin of security, while volatility provides an opportunity to harvest premium. Position size could be held small so as to leave room to enlarge the position if it moves against the investor in the early going.
Something in a covered strangle would also work pretty well here, start small as you might get assigned on the puts.
Disclosure: Long AGO and MBI, no position other companies mentioned