Assured Guaranty (AGO) provides insurance against default on municipal bonds and, to a lesser extent, on various structured securities. Due to the heavy losses and subsequent ratings downgrades of the company's primary competitors, Assured Guaranty is the only remaining active bond insurer. The company has navigated the various financial crises of the past couple of years with tremendous skill, highlighted by the very accretive acquisition of Financial Security Assurance Holdings in 2009, which doubled the size of the company. The stock remains extremely undervalued primarily due to ratings agency capriciousness and overly pessimistic assumptions of future losses on municipal issuances. For the patient investor, Assured Guaranty represents a fabulous two- to four-year investment opportunity that combines a low valuation with increasing margins, as well as likely revenue growth as municipal issuances increase over the next couple of years.
2011 was a very profitable year for Assured Guaranty as the company generated operating income of $604 million, or $3.26 a share. Net income, which is a less important metric for the company due to confusing industry accounting methods, came in at $4.18 a share. Net income accounting includes volatile mark-to-market swings on credit default swaps, which aren't necessarily indicative of actual loss or profit development -- that's why I prefer looking at the operating numbers. Tangible book value is $25.89 and operating shareholders' equity is even better at $28.91 a share. Adjusted book value is the metric that the bond insurance industry used to trade near prior to the financial crisis, and for Assured Guaranty, adjusted book value currently stands at $49.32 (representing approximately 200% upside form current prices).
The municipal bond issuance market experienced tremendous volatility in the beginning of 2011 after a vocal analyst, Meredith Whitney, irresponsibly claimed on "60 Minutes" that there would be more than $100 billion in municipal bond defaults in 2011. However, her supposed painstaking analysis proved to be off by about 98%. Because of this volatility and, more importantly, the expiration of the Build America Bonds program, municipal bond issuance was down 34% in 2011, marking a 10-year low. Early in 2011, Standard & Poor's rattled the industry by changing its rating criteria, but even with all of these obstacles Assured Guaranty was still able to insure 1,228 new municipal bond issues -- which is more than 12% of the municipal issues sold. The company's target market are issuances of single-A underlying credit quality, where it successfully guaranteed 38% of the transactions. Because no other competitors have been able to offer insurance, Assured Guaranty is really the only company bidding on these deals and margins, clearly benefiting from its current monopoly.
Another possible reason for the stock's low valuation is due to potential uncertainty on recoveries of reps and warranty claims. In my opinion these fears are unfounded, particularly for Assured Guaranty, which has already produced a cumulative total of $2.4 billion in settlement and putback receipts and commitments from representations and warranties providers. Chief among these was the landmark agreement with Bank of America/Countrywide, which provided about $1.1 billion in cash payments to Assured Guaranty, along with the assumption of 80% of future losses up to $6.6 billion on 29 residential mortgage-backed security transactions. Competitor MBIA (MBI) has struggled and fought with representations and warranties providers, but there is very little doubt that the originators will end up having to honor their obligations. Evidence of this is that most of the banks have increased reserves for representations and warranties claims, and positive momentum continues to make its way slowly and surely through the court system.
Assured Guaranty's stock recently sold off due to a Moody's announcement of a potential downgrade of the company's credit rating. One of the reasons given was the supposedly bleak outlook for new business, which conflicts with the fact that the company has been able to keep writing profitable business. While issuance was down, penetration was still strong, so I think any downgrade would be unwarranted. In 2011, Assured Guaranty's riskier structured portfolio decreased by $33.5 billion, or 22% of net par exposure. Meanwhile, its U.S. residential mortgage-backed securities decreased by $3.6 billion, bringing its year-end balance to $21.6 billion. This higher percentage of municipal bond insurance vs. structured guarantees, in addition to the success of representations and warranties claims, makes Moody's most recent announcement just that much more puzzling.
If the downgrade were to occur, however, company management has shown strong leadership and would be likely to return excess capital to shareholders. In 2011, Assurance Guaranty bought back 2 million shares at an average cost of $11.66, or less than 50% of current tangible book value. It is my opinion that due to the continued ambiguity and recklessness exhibited by the ratings agencies over the past several years, the company should have a clearly articulated plan of what it would do if its ratings were downgraded to a level that would make it difficult to continue writing profitable municipal bond insurance. The best course of action would be to buy back stock and increase the dividend payout, which was recently boosted to 9 cents a quarter. CEO Dominic Frederico has done a wonderful job turning Assured Guaranty into the dominant participant in the bond insurer industry, but the challenge now is to become the aggressor as opposed to passively taking whatever the ratings agencies provide. By pursuing aggressive stock buybacks at a large discount to tangible book value, the stock will likely increase significantly. As the portfolio continues to run off, Assured Guaranty's financial strength will shine through, leading to higher ratings.
At T&T Capital Management, our target price for the company is $35 a share because we think a discount to adjusted book value is warranted due to the unattractive aspect of the industry having to rely on ratings agencies' fickle opinions. The stock is very volatile, so it also makes a great deal of sense to sell puts with the idea of getting put the stock at a cheaper price or pocketing the premiums. At the time of this writing, the $15 puts for January 2012 are going for $2.32, equating to a potential 18.3% profit on the maximum risk in 291 days. I think you can win big if Assured Guaranty continues to write profitable insurance or if it gets downgraded and, as a result, becomes more aggressive returning capital to shareholders.