Ambac Needs Capital Infusion to Keep Its AAA Rating

I have completed a deep dive of Ambac's (ABK) insured portfolio. The conclusion: I don't see how it maintains a AAA rating without raising new capital.

The Challenge

First let's consider what Ambac needs to do to retain a AAA rating. All three of the major ratings agencies have a similar methodology for bond insurers; They need to survive a Great Depression-type scenario. The agencies then estimate how much capital an insurer would need to survive such a scenario. As long as the insurers have capital above this minimum, they get their rating.

Currently Ambac has between $1.1 billion and $1.9 billion in "excess" capital over what's needed to retain a AAA/Aaa rating, depending on the agency.

What Matters

The ratings agencies have said that mark-to-market losses are "not predictive of future claims" and therefore not a focus of their analysis. I understand where they're coming from, I wrote about a similar idea in AI's recent discussion of Freddie Mac (FRE). I'm not sure that alternative methods are likely to come up with more predictive results, but I'm not the one who gets to make up the ratings.

So right or wrong, the ratings agencies are going to focus on a forecast of credit losses when deciding capital adequacy.

Nature of ABS/CDO Insurance

Insurance policies written on ABS and CDOs are in the form of "pay as you go" CDS. What that means is that in the event of a default, Ambac would only be responsible for paying any interest shortfall and ultimately, any principal shortfall.

So for example, say Ambac insured a senior, AAA-rated subprime RMBS tranche. Let's say that losses in the pool are such that the junior tranches get wiped out, but the senior tranche only suffers a 20bps/year interest shortfall. Ambac would only be responsible for paying that 20bps. And those payments would occur over time. This is in contrast to typical CDS contracts, where the seller of protection must buy the reference item from the buyer of protection upon default.

This allows an insurer to absorb credit losses over time. Even if, say, a $1 billion ABS tranche were to suffer a 100% interest shortfall, Ambac would only pay out annually the interest that went unpaid, probably something like 6%, or $60 million.

Note that this is a good reason why mark-to-market losses aren't everything for bond insurers. Given a default event, the insurer might write down their position entirely, but pay out the claim over an extended period of time. So in terms of capital adequacy, the insurer might be able to earn enough premiums over time to offset losses.

How Bad Will Subprime Defaults Be?

In order to make loss calculations, I needed to estimate what percentage of subprime loans will be foreclosed upon. I think in the 2006 and 2007 vintage, 25% is a good starting point. That is about the percentage of stated income loans underwritten during this period. Of course, not 100% of the liar loans will default, but you got to think the overwhelming majority will.

For 2004 and earlier, I assumed foreclosures would be around 9%, which is the highest level we hit during the 2001 recession. Given that job growth is still positive, I think that's a conservative figure. For 2005, I assumed around 15% defaults.

Recovery should be lower than the historical average as well, due to weak home price appreciation. Older deals, like 2003 and earlier, might recover at normal levels, but then again, anyone with strong HPA probably will be able to refi or at least work out a loan mod. The overwhelming majority of losses will come from the 2006 and 2007 vintage.

How Much In Losses?

Regardless, I think the way to attack Ambac's capital adequacy is to consider how much in principal losses its ABS and CDO portfolios are likely to eventually suffer. I believe that if this amount is in excess of the $1.1-1.9 billion figure used by the ratings agencies, then eventually Ambac would be forced to raise capital in order to retain its rating.

Ambac's biggest problems will be in its CDO portfolio. I estimate it will suffer $4 billion in losses from its CDO portfolio. This will be almost all in the ABS CDO and CDO of CDO portfolios, which will suffer from the structured squared problem. Losses in other types of CDOs would seem to be within typical historical levels.

Losses in direct RMBS positions look to be in the $2 billion area. Many of its positions will probably suffer no losses at all, as Ambac usually has significant subordination. But most look like they will suffer some losses.

How Much in Capital?

So how much in capital would it need to retain its rating? Probably at least $2 billion. It has about $1 billion in either loss provisions or mark-to-market losses it's already realized. It should have earnings of around $800 million/year. If we figure that the $6 billion in losses is spread over 3 years, that's about $3.5 billion in internally generated capital. Plus Ambac has about $1 billion in "excess capital" over what it needs to retain the rating. That leaves us $1.5 billion short.

You'd assume that Ambac would want to raise more capital than the bare minimum, so I'm figuring $2-3 billion.

Could They Raise It?

Whether they can raise this kind of capital or not is difficult to see. It will be a question of whether a well-capitalized partner sees long-term value in the lucrative municipal insurance franchise in excess of the losses expected in ABS. I don't doubt that many potential partners would be interested in the municipal business. Munis never default, so writing insurance on them is like printing money. Berkshire Hathaway (BRK) has expressed interest in the muni insurance business. I'm sure that if Berkshire put, say, $1 billion into Ambac, then Ambac could subsequently do a couple preferred offerings. They'd be expensive, but with Warren Buffett already on board, I think they could get it sold.

On the other hand, stronger players in the municipal insurance business may also be looking for capital, most notably MBIA (MBI). Even assuming someone like Buffett would consider investing in a bond insurer, maybe he'd prefer MBIA, which has less ABS exposure as a percentage of total par insured. We'll see.

Timing of a Downgrade

Since the ratings agencies are focused on expected losses, it may be that Ambac and others have a fair amount of time to find more capital. This might allow stronger players - MBIA - to wait for a better market and do a simple preferred offering. Weaker players will likely be forced to raise capital privately. FGIC is particularly in trouble, as its primary owners are two private equity firms and the PMI Group (PMI). The latter is obviously unable to provide capital at the moment, and the private equity firms - Cypress and Blackstone - don't want to be in a "good money after bad" position.

Consequences of a Downgrade

A downgrade of any of the big 4 insurers - MBIA, FSA, FGIC, and Ambac - would send chills through the municipal bond market. The result might hurt all of them, even the one not downgraded. Muni buyers may permanently devalue insurance, causing more deals to come uninsured.

As for the downgraded firm, I suspect it would wind up running off its existing policies, rather than trying to remain a going concern. Perhaps they'd sell to another insurer at a steep discount to book value. Once downgraded, even to just AA, their business model would be destroyed. Ironically, Radian (RDN) would be in a much better position if downgraded, as its business model was never predicated on any particular rating.

Why Didn't You Say So Before?

Admittedly, I've been more sanguine about the muni insurers until now. My mistake was being overly focused on survival, as opposed to just maintaining the rating. Ambac would be able to survive the $6 billion in losses if they were occurring over time. But I don't think it will keep the AAA-rating without help.

How to Play a Downgrade?

This is a tough call. Going long CDS is a tough call. First, it's awfully expensive, as CDS spreads are extremely wide. Second, Ambac could get a capital infusion or do a distressed merger, and the CDS would wind up not paying off.

It is also possible that Ambac itself did better than average credit work. In other words, that its insured deals wind up performing better than the average RMBS and/or CDO deal. If in the CDO world, its deals do only 5% better, losses would drop considerably.

Short the stock seems like a better play, but the stock is already trading at less than half of nominal book value. Still, the headlines are likely to remain bad, and any capital infusion is likely to be dilutive. I'd at least avoid the stock.

Disclosure: No positions in any bond insurer, although I own many insured municipal bonds.

Comments

[pillx:]

Outlook for Bond Insurers Not So Dire After All

Bond Buyer, Arrival Time: 2007-11-23

By Bob Meyer


There has been a great deal of misinformation reported in the financial media in recent months predicting the demise of the bond insurance industry. Although the insurers and rating agencies have made a valiant effort at explaining the risk exposures in their mortgage-backed security (MBS) and collateralized debt obligation (CDO) portfolios, the unrelenting bashing has blurred the industry's fundamental strengths. This has resulted in exaggerated and unjustified investor fears of a widespread liquidity crisis and credit rating downgrades.
The guarantors will be affected by the current turmoil in varying degrees, and a small number may be placed on ratings watch lists for possible downgrades. But the majority - and in particular, Ambac Assurance Corp., Assured Guaranty Corp., Financial Security Assurance Inc., and MBIA Insurance Corp. - should emerge from the current crisis with their triple-A ratings intact. Furthermore, new business volume, premium rates, and profitability at these companies can be expected to be at or approaching historically high levels. Here are the reasons why:

First and foremost, the historical underwriting record of the triple-A financial guarantors has been exceptional and paid losses few and far between - approximately $2 billion in losses of total insured debt of $5.8 trillion in the industry's 36-year history. This record attests to the rigorous credit, structuring, and risk-management principles that are the foundation of the insurers' business models and franchise-critical triple-A ratings.

Taking recent assurances from the guarantors at face value, there is strong reason to believe that residential mortgage-backed securities (RMBS) and CDO transactions insured in recent years were underwritten to the same high standard. While it is difficult to estimate size or probability of occurrence, some level of losses will undoubtedly materialize. However a majority of the triple-A insurers are expected to side-step ratings-crippling losses on these remote-risk exposures.

In the event that major losses materialize, however, a majority of the triple-A insurers are well-prepared to handle the crisis.

The credit default swap (CDS) contracts sold by the financial guarantors are structured to replicate traditional financial guaranty insurance policies, and specifically structured to avoid liquidity risk. Unlike most CDS contracts written by commercial and investment banks, the triple-A insurers are not subject to collateral posting requirements under any circumstance, including mark-to-market declines in value, and they are not required to make cash settlements as defaults happen, regardless of their size and regardless of the insurer's own credit rating.

Furthermore, in the event of a claim, the insurer's obligation is to pay interest and principal on a pay-as-you-go basis, on the earlier of the originally scheduled legal maturity of the collateral or the liquidation of that collateral, and not on any accelerated basis. This feature of predictability of payment timing, together with the guarantor's surveillance and remediation efforts, enables the guarantors to have sufficient cash reserves and liquid investments in place to cover losses.

It also substantially lowers the concern that large, sudden losses could result in an immediate and substantial drain on liquidity and claims-paying resources. The absence of acceleration risk is the most significant liquidity safeguard the guarantors have, and together with stringent underwriting and risk-management standards and substantial claims-paying strength, forms the foundation of their business models and extremely high ratings.

The insurers' books of existing risk exposures are cash-generating engines. For the more established insurers, 90%-plus of their earned premium is locked in before the new year even begins. The combination of this annuity-like revenue stream flowing from previously written multiyear contracts; available credit lines and other highly liquid claims-paying resources; premiums from new business written and refundings; after-tax investment earnings; and the freeing up of capital as existing insured exposures runoff, provide substantial sources of liquidity for the insurers that is available to pay claims.

While the prospects for triple-A-crippling losses may be low for a majority of the insurers, it is probable that one or more will be required to make up deficiencies in the claims-paying resources required by the rating agencies to meet minimum triple-A-rating standards ("rating agency capital"). This is likely to be the result of additional rating agency downgrades of RMBS and CDO collateral. While the specific method of calculating rating agency capital varies, one commonality is the comparison of assumed losses in a worst-case claims-paying environment to worst-case total claims-paying resources.

Standard & Poor's, for example, refers to this ratio as the "margin of safety." From its standpoint, a margin of safety of 1.25x - which is the minimum margin of safety for triple-A insurers - indicates that a guarantor's worst-case claims paying resources plus worst-case losses exceeds worst-case losses by 25%. Stated another way, losses could have been 25% larger before claims-paying resources were reduced to zero.

It is noteworthy that reductions in capital resulting from mark-to-market losses are not considered by any of the rating agencies in determining rating agency capital. This is entirely appropriate because the market value of an insured CDS portfolio is not necessarily indicative of future losses, especially for an industry that holds its liabilities until maturity.

There is a widely reported misconception that insurers whose rating agency capital falls below the minimum triple-A standard will be required to raise additional capital. This simply is not the case, especially for the stronger guarantors. In fact, the guarantors have a variety of other options available to them. The use of reinsurance is one such option. Although reinsurers would hardly be expected to provide capacity for distressed issues, it is quite plausible that they would step up and do so for a well-performing and attractively priced portfolio.

Overall, reinsurance transactions of this type would be a highly capital efficient means of addressing deficiencies in rating agency capital, as it reduces the amount of capital required under the rating agency "safety margin tests." Other, presumably stronger and less capital-constrained competitors, could be one source of this reinsurance capacity. There not only is historical precedent for such inter-company reinsurance arrangements, but one can imagine that the industry would regard the "bailing out" of one or more competitors as the lesser of two evils, since the downgrading of any one of the triple-A rated companies might possibly compromise investor confidence in the entire industry.

In addition to using reinsurance, a capital-constrained insurer could change the mix of its business (i.e., more domestic municipal business and less structured finance and international public finance) and/or slow down the growth rate of new business writings to the extent that the market has not already done this for them. This is to say that the market share of a triple-A insurer that is on credit watch is likely to decline quite significantly. The silver lining here is that as new business volume declines, less available capital is being consumed, and therefore more is available to meet liquidity requirements.

Some of the guarantors could privately place debt, equity, or hybrid securities that could be used to supplement capital. In fact, depending on future developments in the economy, one of the stronger guarantors could consider taking further steps to bolster its capital position to provide an additional cushion over minimum rating agency capital requirements, and/or to take advantage of potential new business or strategic opportunities in the marketplace, including the acquisition of a competitor.

Some insurers may have attractive subsidiaries that could be spun off to raise capital.

Finally, if all else fails, the extraordinary could happen again. Turn back the calendar to the fall of 1998 when Long Term Capital Management was on the brink of failure following the Russian debt default and the Federal Reserve Bank of New York brought the lenders together and brokered a bailout. At the time, the portfolio under LTCM's control was in excess of $100 billion and its swaps position was valued at $1.25 trillion. Fourteen or so banks contributed $250 million to $300 million each to raise a $3.65 billion loan fund, because of the fear that LTCM's liquidation of collateral and possible bankruptcy would result in substantial investor losses and create serious market disruptions. That fund together with LTCM's remaining equity enabled it to survive.

At year end 2006, there was more than $3.2 trillion(!) in guaranteed principal and interest on triple-A rated insured bonds outstanding. Of this amount MBIA had insured $900 billion, Ambac $800 billion, and FSA $550 billion - collectively representing 70% of the total. Although industry consolidation may be one result of current market stress, and no guarantor has publicly advocated the need for an industry bailout, a question remains whether any one of these companies, or others, would be allowed by the financial markets to be downgraded to double-A. Aren't they too big to fail?

Bob Meyer is the principal of Meyer Consulting Group Inc., a private practice providing consulting services to companies and private equity investors on matters relating to investments in the financial guaranty industry. He is the founder and former chairman and CEO of RAM Re, Bermuda, and president of Bond Investors Guaranty (formed in 1984 by AIG, Salomon Bros. et.al., and sold to MBIA in 1990). Mr. Meyer indicates that he owns no financial guaranty insurance company stock and is not being paid by any interested party to publish this article. He can be reached at mcgramgm

2007 Nov 26 09:53 AM

[bostongekko:]

Given the big drops in valuation, I think the key here is to invest in survivors and short the walking dead. Who are the companies that are hurting and unlikely to be bailed out?

2007 Nov 26 06:46 PM

[tigersong:]

What is your thought on MBIA now with the updated disclosure of the $8.1 billion CDO-Squares? Now that Buffet decided to open his own muni insurer(rather than bail out the troubled ones), what do you think it might affect the others in the long run?

2007 Dec 30 01:26 AM

[tigersong:]

What is your though on MBIA now after they disclosed their $8.1 billion CDO-Squares?

2007 Dec 30 01:28 AM