Ambac (ABK), the beleaguered financial guarantor, looks to be close to liquidation on the surface. Its share price has fallen a stupdendous amount, from around ninety dollars before the subprime implosion, to two and change today.
This drastic decrease in market capitalization appears warranted on the surface -- Ambac, along with many of its peers, strayed from the lucrative business of plain-vanilla municipal bond credit enhancement. The company's foray into exotic and ill-conceived structured finance deals has placed unprecedented levels of stress on Ambac's financial position, leading to exaggerated pronouncements of doom from the media and various investment professionals. The company itself, perhaps understandably, has continually claimed it has ample resources to fulfill all contractual obligations.
In determining the veracity of the claims of both parties, it is essential to understand the nature of the insurance Ambac has written.
Ambac's irrevocable guarantee of either i) timely interest and ultimate principal or ii) ultimate principal on insured deals limits the possibility massive one-time payouts, and ensures that the company will have many years -- in some cases, multiple decades -- to pay for impaired exposures.
In the vase majority of cases, Ambac's exposure to problematic asset classes is hedged by a variety of failsafe risk mitigation techniques. Ambac's insurance written on Collateralized Debt Obligations [CDOs] targeted the most senior tranches of the transactions in question, which are only affected by credit deterioration when tranches subordinate to them are fully eroded -- in many cases, north of 20% of the transaction must be eroded before any Ambac-insured tranches are affected.
Also, many are not aware of the profound effects accounting techinicalities have on reported monoline earnings -- which are horrendous to behold. Because most SF transactions are insured via Credit Default Swap [CDS], the monoline industry must establish a "fair-value" figure for insured exposure -- forcing industry participants to "mark-to-market" a product for which there is no market. This has caused a grotesquely distorted picture of actual expected claims, relying on market panic over industry-standard computer models and not accounting for mitigating factors as explained above. Credit impairment, not unrealized MTM price fluctuations, is the metric by which losses should be gauged.
Ambac's claims-paying-resources totaled 13 billion dollars, invested in specificially timed treasuries and other high-quality paper. Due to market concern over the company's creditworthiness, amortization of insured credits and steady income from installment premiums and investment income, Ambac expects to be cash flow positive this year -- and is aggressively engaging in remediation, which, when one considers the highly concentrated nature of the impairment, could materially improve the company's prognosis.
Ambac's recent attempt to transfer $1 billion from its insurance subsidiary to a dormant affiliate, Connie Lee, looks questionable in light of the recent rating agency actions against Assured Guaranty and FSA. Notwithstanding, the recent deal to insure $264 million in military housing shows AA rated guarantors can still find profitable business -- while an eventual return to AAA would be optimal.
Beyond the current turmoil Ambac is undergoing, one must look to the FG industry's promising future. While such a statement might seem outlandish -- Moody's (MCO) recently changed the method by which it rated municipalities, resulting in mass upgrades; uncertainty over the financial positions of guarantors has lead to a dropoff in insured paper issuance -- broader, international trends lend merit to its veracity. Many states run budget deficits of 8% or more annually, and overall issuance is almost certain to rise in years to come. Guarantors serve an invaluable service by enhancing the creditworthiness of bonds, and broader macroeconomic trends speak to the importance of this business model. The global infrastructure boom will also increase demand for sound, reliable credit enhancement -- one a more careful and measured FG industry will exploit.
Ambac is a long-term play on intrinsic value withstanding market volatility, and one I would advise any investor to look into carefully.
Disclosure: Author holds a long position in ABK