Ambac’s CDO Woes

Ambac Financial Group Inc. (ABK) is in serious trouble.

Monday’s high trader for the day, the company has seen its share price deteriorate from a high in May 2007 of $96 to yesterday’s close of $2.73. MidasLetter.com correctly predicted the collapse of this stock in the February 2007 issue of the Resourcex Investor.

It is believed the company is now the victim of rumors swirling on Wall Street suggesting the company may become illiquid and might not be able to meet its ongoing obligations.

A statement from the company refutes the innuendo however. "We have ample liquidity to manage our commitments going forward," said Michael Callen, Chairman and Chief Executive Officer.

Ambac’s woes are due entirely to its Collateralized Debt Obligation underwriting business. The company’s total CDO exposure now totals $64.7 billion, prompting Standard and Poor’s and Moody’s to downgrade its credit rating to “AA,” though the company was recently removed from S&P’s “CreditWatch” list.

The downgrade however forced the company to post an additional $506 million in collateral and terminate $270 million in investment agreements. If Ambac is downgraded one more notch, it would trigger an additional $1 billion in collateral requirements.

The company managed to raise $1.5 Billion in March this year through the issuance of 171,111,111 shares at $6.75 a share, which now seems like throwing good money after bad.

The question is, however, is Ambac now a “buy”? Or is it on the verge of collapse?

In defense of the investment case, Executive Vice-President Douglas Renfield-Miller illuminated the company’s strengths at the Keefe Bruyette & Woods Diversified Financials Conference in New York in June. He focused on the company’s $12 Billion portfolio of high quality liquid investments, its ability to continue to access capital from equity raises, and the fact that a minimum of $400 million in installment premiums are to be collected during each of the next three years.

He outlined the company’s aggressive damage control strategy, which is focused on reducing volatility through “aggressive remediation, appropriate reserving and risk transfer.

He also stressed the fact that credit concerns going forward were concentrated in “relatively few transactions,” and that the credit crisis was in fact an endorsement of the company’s core business of guaranteeing financial transactions.

Understanding the relative valuations and models that Ambac uses to succeed financially is next to impossible for the average lay investor, so really it’s a matter of making a judgement call based on the evaluations of analysts who purport to know how.

Besides that, the possibility of credit worthiness downgrades are really not very predictable, as many factors occur outside of the company’s sphere of influence that can trigger a downgrade.

So the question becomes, how risky is this company for the individual investor? It was at $95 once, and as the market will teach you, its much easier for a stock that has tasted the rarified air in the stratosphere to reach it again than it is for one that never has.

How can the risk be quantified?

The bottom line is it simply can’t.

Consider the company’s business.

Using complex mathematical formulas, it bets that the amount it is going to pay out as an insurer of large financial commitments will always exceed the cost of providing the insurance. When market conditions for one of the asset classes it insures suddenly deteriorates rapidly, it is caught on the wrong side of the bet, and the near collapse we are witnessing results.

The good news is, CDO’s are not the company’s only business. It also provides financing structures in just about every configuration imaginable, with the only limiting caveat really is just that the transactions be extremely large.

So the ultimate question is, can the company survive its bad bets in the CDO department, and recover sufficiently through the conduct of these other financing business units to reach profitability again?

That is tough call, but we at MidasLetter.com think the answer is yes. However, we caution that an equity investment in Ambac should constitute only a small portion of the portfolio over all, and that it only be undertaken by individuals with a high risk tolerance.

Stop losses are to be deployed judisciously.

Comments

[fxtrader07]

'The question is, however, is Ambac now a “buy”? Or is it on the verge of collapse?'
what? if what we saw over the past 15 months wasn't THE collapse then i don't know what else must happen before you call it a collapse.

regarding risk: the risk of the stocks short term movements can't be quantified in advance, true. However, the risk of the stock becoming intrinsically worthless can, even if a just on a probability basis. Taking Ackman's presentations and assuming a very bad scenario instead of total and complete armageddon the company will survive in a run-off scenario which may unlock residual value in the 12-18$/share range over the next 5-8 years. assigning a -very high- probability of 20% for ackman's bk call we arrive at a probability-weighted value of ca. 10-15$/share.
that would make for a 400-650% appreciation from todays close (2.12$) over the next 5-8 years, or 25-37% Compound annual rate of return. not bad, but of course it's a highly speculative stock nonetheless.
btw, looking at risk-reward, whoever is still short the stock and hasn't covered over the past week must be defined as dumb money

[weiwentg]

It would seem to me that "collapse" should be defined as the loss of ability to pay claims. that has not YET happened over the last 15 months. they maintained an AAA rating for quite some time, meaning that they (according to our friends at S&P and Moodys) had the ability to pay just about any claim. they've been downgraded, but they still should have the ability to pay most claims.

It's still highly uncertain how much they'll have to pay. If they don't end up paying much, and/or the credit crisis passes relatively fast, then shareholders should make out well. If they pay out a lot, and then are forced to raise equity or debt at distressed prices, they'll be in trouble and shareholders will either get diluted or will lose everything.

I think it's impossible to predict what's going to happen, and so I'm staying out. Maybe someone like Marty Whitman, who makes a living off distress investing, can give a reasonable estimate of what might happen.

[Ishortyou]

The bears are running away they are covering shorts like mad and the hedgers are hedging up.

In respect to AMBAC and MBIA, they need to keep and save all the cash possible including stop paying dividends, deleverage AGGRESSIVELY from all their risky liabilities specially those CDS-CDO's, RMBS-ABS of uncertain value, in order to remediate their book values, once their book values are sound they need to reinstate their triple A rating again to write new low risk public bond insurance business. They can also open or extend a line of credit to make sure to continue operations and dissipate doubts. This will also prevent further downgrades from rating agencies.

They are already doing these, so it will take some time to deleverage their books from uncertainties and rewrite new business again. This coming back will be the best advertisement to recruit new clients.

[TomArmistead]

I think the risk to reward is very good here, the stock has traded as low as 1.05 and over time, if actual losses do not exceed what mark to market implies, it should increase to 15 or 16. Maybe 10% chance it could go to zero, 90% chance it gets up to the 15 or 16.

Recent announcements about buying back 50 million of stock and/or contributing 850 million to the Connie Lee subsidiary to start writing municipal business at a triple A rating are encouraging, also the discussions with the Wisconsin Insurance Dept. about making the insurance company assets available to prevent liquidity issues in assset management seems like it might reduce that risk.

It was disappointing that their buyback plans are conditioned upon the completion of the equity offering. I take it that some of the shares offered at 6.75 were not resold and are still with the underwriters. Otherwise, even a small amount of buybacks would create substantial value for shareholders at today's prices.

[G.R.]

i hope abk and others survive. they were good companies overall, they just ignorantly (for more money) placed their stamp of insurance on the bonds that the banks/investment firms created to profit.