Taking a Closer Look at Ambac's CDO Loss Projection

My Thanksgiving special on Ambac (ABK) got quite a bit of attention, and I have unfortunately been swamped and unable to give too many good responses to the many quality comments.

I got several requests for some details about how I got to my loss assumptions. Here are my exact loss projections for all of Ambac's CDOs.

CDO losses are best estimated using cash flow models. So I built a crude cash flow model, moderated certain assumptions based on each CDO type and vintage, and ran each, assuming 15-25% in subprime defaults. I had to make an assumption about how much was in first lien vs. second lien paper, but given my knowledge of how ABS CDOs were constructed recently, I assumed there was more home equity paper than not.

For what it's worth, UBS (UBS) came up with almost the same figure for losses from Ambac's CDO portfolio.

That is only one of several assumptions that could drastically change the results. In addition, there are the following:

• How well foreclosed loans recover. Non-agency MBS deals were very heavily weighted in California paper. I think it's safe to say that subprime loans in the hottest markets may experience more negative home price appreciation, and therefore worse recovery. But it could be that Ambac was more cautious about loading up on the hottest markets. Hard to tell.
• How effective mods are. Various programs by banks and the FHA could have a large impact on Senior CDO performance. Remember that very small changes in loss rates cause very large changes in Senior CDO performance. This is the structured squared effect.

Readers EJ and LastToKnow have both pointed out that the 2007 vintage CDO^2 listed in Ambac's disclosures actually have older ABS collateral. I haven't confirmed this myself, but if true, that too could diminish losses materially.

I also got a note saying something to the effect that I didn't understand the ratings agency criteria, and that I should suppose that I understand their models better than they do. I never pretended that I understood the ratings agency models (which are proprietary). Furthermore, I do understand the fact that losses in insured ABS will occur over time, which I mentioned in the original post. However, if it's known that a given ABS tranche is non-performing, the ratings agencies will consider this in giving their rating. Some seem to claim that just because Ambac or MBIA's (MBI) claims will be paid out over time, that there is nothing to worry about. That would imply that a given insurer could become like a ship adrift with no crew: still afloat but bound to eventually hit rocks and sink. Once an ABS pool has gone bust, the ratings agencies are going to count those losses against the insurer's capital.

Now onto today's news. Ambac and others claimed at a Bank of America (BAC) conference that reinsurance could solve their problems. I'm sure that they can raise substantial capital that way, but only by buying reinsurance on parts of their lucrative municipal portfolio. It also sounds like they plan on using run off and retained earnings to bolster their capital over time.

Only time will tell whether they will eventually have to go to the market with an equity offering, either preferred or common. If Ambac is told it needs a relatively small amount in additional capital, reinsurance is a no-brainer. It may be that insurers get away with slowly increasing capital as losses mount. If so, that would be very bullish for the stock.

However both Ambac and MBI stock were sharply lower on the day, I suspect due to concern that re-insuring the safest part of their portfolio isn't ideal. Of course, doing a dilutive equity offering isn't such a great option either, so I don't know what shareholders were expecting. Perhaps Citi (C) and Freddie Mac's (FRE) efforts to raise new capital are causing Ambac and MBIA shareholders to realize just how expensive keeping their AAA rating is going to be.

As far as insured municipal bonds go, I think things are looking better. The companies seem to have a plan for retaining their rating. We'll see how things unfold, but I think it looks promising.

Those that are short monoline credits are going to be disappointed, I think. They will most likely be able to raise capital and keep their rating, and eventually their bond spreads will tighten.

Stock holders are looking at a bumpier road. The stocks are trading at massive discounts to book value. So if buying reinsurance solves the capital problem, it would seem likely that the stock price would move toward book value. However, raising capital will be expensive, no matter what path is chosen. And there remains the possibility that they need to raise equity in a dilutive fashion.

We must be cautious.

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