Ambac’s CDO Woes

| About: Ambac Financial (AMBC)

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. 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 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.