The Real Risk: Ambac Loses its AAA Rating

The stock market has been abuzz with speculation over the possibility of a bailout for Ambac (ABK). Ambac is the troubled bond insurer that recorded $5.2 billion of write-downs in the fourth quarter, and now is in jeopardy of losing its all-important AAA credit rating. Ambac is hugely affected by the credit crisis and is tied to the consumer debt and mortgage backed financial instrument markets, both of which are deteriorating. A sharp increase in defaulted mortgages could spawn a wave of defaults among bonds backed by those loans.

If Ambac were not to keep their AAA rating, then their bond insurance business would struggle to stay afloat. This has ramifications that extend way beyond just Ambac. Citigroup (C), Wachovia (WB), and UBS (UBS) among others need to keep Ambac healthy as the ripple effect from an Ambac bankruptcy would be massive. Oppenheimer estimates that the major banks have $70 billion of exposure to Ambac and the bonds they insure.

Clearly, Ambac losing its credit rating of AAA or declaring bankruptcy would be catastrophic. If the worst were to occur it would make the housing crisis pale in comparison. The banks act as underwriters for billions of dollars in corporate bonds of which Ambac and MBIA (MBI) are the two main insurers. So, it would be disastrous for Ambac, to the point that these banks or the government would likely step in to keep the insurer of over $556 billion worth of bonds surviving in this extremely rough period. The banks are hoping that this $3 billion capital infusion will be enough to cover the liability of those bond sets that are in default.

Looking just at the balance sheets of Citigroup, UBS, and WB, for example, shows that in 2006 these banks made almost $40 billion in combined net profit. The potential ramifications of Ambac going under would hurt these banks so badly that they would likely be willing to continue to pour money into Ambac in order to keep it operating. From their prospective, it would be better to have reduced earnings for 2 years or so as an alternative to Ambac defaulting and the disruption that would result.

By any valuation rating system Ambac will appear undervalued compared with its historical normal ranges, but clearly there is reason to be cautious in such an uncertain market environment. We cannot advise buying given the current market climate. As long as Ambac does weather the storm then it is almost certainly going to rise to more normal valuations, and it appears that Ambac is too important to the financial system for banks to allow it to go bankrupt.

The real loser in this could be the bond funds who attempt to identify undervalued bonds, if indeed Ambac does lose its AAA rating the result would be an immediate deflation in bond prices backed by Ambac. These bond funds could very well collapse under the pressure of the portion of their portfolios that is insured by Ambac losing value so rapidly. It will certainly be interesting to watch all of it unfold over the coming few quarters.

Disclosure: None

Comments

[CrossProfit]

Finally, someone is writing about the bigger picture. There is more to this, but this article is a start, even though the author takes an overly simplistic 'scary' venue.

It would be nice to see an article that incorporates how the banks perceive Buffett's foray into the muni business.


CrossProfit

[User 147557]

I strongly believe that Ambac will not lose the AAA rating NO MATTER WHAT. The credit rating companies no longer have credibility. They just try to buy time for these insurers. At the end, it will be like MBIA that still get to keep the AAA rating from S&P. The whole credit rating system is rotten.

[darth_vader]

Its End-Game... Ratings are nothing more than false insurance yet to be exposed. The truth is there are more losses in the system than equity, so bankruptcy is just a formality at this point. The end result of maximum debt inflation is asset implosion -- we're already there. So sit back and watch as the rats and roaches cannibalize themselves in a last ditch effort to survive.

[North Bear]

If AMBAC maintain their AAA what rating will the agencies give to those companies above the "Verge of Bancruptcy" line?
Does anything less than AAA mean a company is already seeking Chapter 11?

[Gary McCamey]

I"m not real familiar with the market business, but in an article written by Jim Cramer about two weeks ago he stated: "I pick AMBAC as the stock of the year in 2008". Does this mean he thinks it is a good opportunity for investors to take a risk, small risk according to the article, and make some really good profits for 2008? I noticed the high in the past 52 weeks for AMBAC was $96. (Give or take) If AMBAC does turn out to be the stock of the year in 2008, and it has a potential of $50. to $75./share, then instead of running and screaming, "The Sky is Falling", investors should take some of the money they have put into their old socks, baby powered it and buy as many AMBAC shares as they could risk losing on a small risk investment. I"ve seen people bet $1,000. on a horse that paid 2 to 1 odds, and not bat an eye when that old horse came in last. If AMBAC got up to it's old price, then it'd pay almost 10 to 1, and if it just gets to half it's value before the fall, then it's 5 to 1 to win big. Like the article stated, if AMBAC fails, then the USA will likely fall to. I don't think Uncle Sam will let that happen. Tomorrow I'll scrape up some pennies and try to buy 1,000 shares of AMBAC at $12./share. Gee, I stand a chance of making $48,000. on that $12,000. investment. We poor guys who can't buy a million shares at one time don't get a chance to make $48,000. in one year, not very often. Considering Uncle Sam is on my side, I think it's a little risk, but a little risk well worth taking. Mr. Cramer I hope you are right by picking AMBAC to be stock of the year, 2008. I'll know around Christmas time this year. The skys not falling and a lot of people are going to make a lot of money off Ambac. Captain Gary

[sasian]

Captain Gary.. AMBAC has served its purpose and has to be reinvented or better re-engineered and if you think you are going to make four times your initial capital layout this year you maybe better off playing the even money favourite ..

[PaulinKansasCity]

I seriously doubt Jim Cramer wrote an article naming Ambac stock of the year; maybe short of the year. But we don't have to guess; search the TheStreet.com archives; i looked and didn't see it. In my opinion this post is another internet smear on the guy. He has been bearish on these companies for a long time and deserves credit for beig right!

[sffil]

Has anyone considered the effect of an Ambac (or like entity) downgrade on the CDS market? This could be catastrophic; since the market is so lightly regulated, it's difficult to say what the level of exposure is on a systemic basis. But if "credit events" start occurring frequently, assets will be sold to provide the cash needed to settle the obligation. It's difficult to say if this is plausible but if so, the stability of world markets is at risk.

[cheesecake]

that's why god invented beer and (loose) women :)