Readers are familiar with my opinion on the proper valuation of Ambac (ABK) and MBIA (NYSE:MBI). GAAP metrics are not useful: the non-GAAP adjusted book value is the proper measure of their worth, and share prices should recover to that level over the next several years. The primary considerations that are keeping a lid on prices revolve around credibility – specifically, an intertwined set of issues between the bond insurers, their most severe critics (led by Ackman), and the rating agencies, S&P and Moody's. The purpose of this article is to present my analysis, which demonstrates that the reputation and credibility of ABK and MBI have been needlessly impugned, and to lead the investment community to a better understanding and appreciation of the quality and value inherent in these businesses.
To summarize how the present impasse arose: Ackman attacked the bond insurers, claiming they were insolvent, and was able to impair their reputations to the point where the share prices plunged and CDS spreads widened to the level of junk. The rating agencies, already suffering from self-inflicted damage to their own credibility, eventually downgraded both companies, citing not inadequate capital, but rather lack of financial flexibility as a primary concern. That was a euphemism and referred to the share price: with prices beaten down to artificially low levels the companies cannot raise capital on economic terms.
In essence, the rating agencies validated Ackman's attack, not because it was correct in fact, but because it achieved its goals. The agencies did not have sufficient credibility to give the triple A rating any meaning or to dispel misinformation and distortion fomented by Ackman. As time passes, it is becoming clearer, day by day, that both companies are more than adequately capitalized, responsible corporate citizens going about their business, providing protection and paying claims. It is time to recognize these facts.
The status of the rating agencies is all too clear. Those who bought bonds backed by sub-prime mortgages, on the grounds they had investment grade ratings, experienced shocking losses. Investigations by the Attorney General of the State of New York revealed that rating agencies had neglected to require adequate information before applying their ratings. They were being paid by the investment banks, and in the interest of getting the fees they became very easy to do business with.
Of course, when the trouble started, they ran amok trying to cover their footsteps, and vigorously downgraded most of the bonds they previously saw as investment grade, many to the level of junk. When rating the bond insurers, they assiduously kept moving the goal posts - more capital, more reviews, more revisions to the model and the forecast, more impossible stress case scenarios. Triple A ratings did nothing to help the bond insurers attain access to capital markets, as the rating agencies' credibility had been hopelessly compromised. So much for the agencies – those who trusted them lost a lot of money.
Moody's, when dishing out the totally gratuitous 5 notch downgrade to MBI, cited "aggressive capital management," such as but not limited to share buybacks. Now, with a stock worth 40 dollars beaten down to under 5, management would normally find it a no brainer to buy back stock in copious quantities, publicize the operation as a fait accompli, and restore share prices (and financial flexibility) to proper levels.
Similarly, confronted with unremitting attacks from all angles, MBI management very prudently elected to maintain capital at the holding company level, so as to be able to deploy it effectively in self-defense. Moody's took umbrage, interpreted the funds out of existence, and launched a punitive downgrade, which precipitated a needless but well-contained loss in the Asset Management business. MBI, to its credit, has taken action to insulate itself from further harm from this source. In a nutshell, Moody's has gotten way off base, attempting to apply a straitjacket to prevent any possible vestige of financial flexibility from manifesting itself.
In my opinion, Moody's, having done a miserable job of managing its own affairs, used its capital adequacy models and rating powers in an effort to dictate to the management of MBIA.
How about that most vocal and persistent of industry critics, William Ackman? He made money, there is no question about that. But his credibility will not stand the test of time. The dire scenarios he predicted have not come to pass. There is the dawning realization that ABK and MBI will not go to zero. There will be no bagels, no double donuts. He misled market participants, fanning the fires of fear, for his own financial benefit. Donating the proceeds to charity will not give him clean hands, The whole thing was a sort of negative Ponzi scheme, you made money if you got out early enough.
Now we come to the bond insurance companies. Here the record is mixed – Security Capital (SCA) settled at a discount, with Dinallo in the wings. Aca Capital (ACA) is on the ropes, trading on the pink sheets. But, barring a financial cataclysm of unimaginable scope and severity, policyholders of MBI and ABK will be paid in full. They believed their investments were safe because of the bond insurer's guarantee. As the smoke clears, they are receiving principal and interest when due. Those who take lump sum settlements will do so as their own free choice, because they need immediate cash or prefer to eliminate uncertainty or indeed desire to profit by exiting their hedges simultaneously.
In effect, MBI and ABK provided the only credible credit analysis – they said their guarantees made bonds they insured safe, and they have every expectation and intention of delivering on that promise, to the tune of billions. Their credit determinations have credibility, in the best and most pragmatic sense: the bond insurers put their money where their mouth is, as compared to the rating agencies, who deny any responsibility for their mistakes.
An insurance policy from MBIA provides more security than an Aaa from Moody's, as an example. Think about it: if the Aaa security defaults, as many did, Moody's has no responsibility, it washes its hands of the whole matter. If a security wrapped by MBIA defaults, in contrast, policyholders receive principal and interest when due, exactly what they bargained for. When Moody's downgraded MBIA , I sensed ulterior motives, as if it could restore its own credibility by impugning that of others.
Of course, mistakes were made, and the management and employees of ABK and MBI were making decisions and providing information when that occurred. If you went back and listened again to the 3rd quarter 2007 conference calls and presentations, you would be puzzled and wonder how could anyone be so dumb?
The answer is, they had inadequate models that were ratings driven and not driven by the prospective performance of the collateral. There was an assumption that the ratings were predicative of future collateral performance – seriously in error. That points back to the rating agencies and the lack of due diligence – the ratings didn't provide a clue as to future collateral performance. Garbage into a flawed model, bad underwriting decisions out. In the final analysis, the best underwriting is innovative and entrepreneurial: it is about accepting risk and making money; and if underwriters don't make any mistakes they are dodging a lot of opportunities in the process.
If you would like to argue in the other direction, that MBI and ABK underwrote to a zero loss standard, or should be doing so, it doesn't create any logical problems. If they are successful in achieving the zero-loss goal, an insurance policy from them bestows an iron-clad triple A rating. Policyholders know there won't be any losses, but if there are, they will be paid. The best insurance policy is the one you never need to use. MBI and ABK provide a combination of loss control and risk management in the credit field, backed by a guarantee of results - timely principal and interest.
Credibility in a financial institution is largely a function of the balance sheet, business model, and corporate culture. It can be hard to accurately assess until the stress case arrives. ABK and MBIA were both subjected to a perfect storm, an unprecedented melt-down in the the housing industry, fueled by unparalleled dishonesty, greed and recklessness in the mortgage industry and among home buyers, together with an unbelievably vicious attack by a determined band of distort and short bear raiders.
I am talking about the financial world's equivalent of arson for profit. Ackman took out insurance, in the form of CDS, on MBI and ABK. Then he did his damnedest to create a loss so he could collect on the insurance – literally, he torched their reputations in an effort to take them down to zero. When I wrote "as the smoke clears," it fits pretty well: there was ample smoke, created by Ackman's efforts to incinerate his targets and obfuscate his own nefarious motives. Amazingly, this conduct has proceeded without undue regulatory hindrance, at least to date.
To extend the metaphor a bit further, arson does not work very well on fire resistant buildings. Here in Connecticut years ago, we had a case of arson: the perpetrator wanted to burn down the former Sponge Rubber plant in Shelton, which was fire resistant. Undeterred, he used ample quantities of dynamite, high explosives and incendiary devices, creating a sonic boom that was heard within a 50 mile radius, and leveling the building. He did time, and has not repeated the offense.
ABK and MBI are still standing, after an attack far more severe and prolonged than the scientifically placed detonations that took down Bear Stearns in a matter of days. Somewhat beyond fire resistant, they are fortress-like. The only permanent harm occasioned by Ackman's attack is the unnecessary dilution to shareholders, arising from his concerted efforts to drive down share prices while they were in the process of raising capital.
Although temporary, the harm done to the reputations of the two companies is severe and will take time to recover. But it will, because their performance defines their credibility. They have withstood the financial crisis and the highly unethical attack, and no realistic person doubts their ability and their determination to pay their claims. The entire credit system is in a state of flux, and it is not possible to predict the future landscape of the industry with any certainty. However, MBIA and Ambac will be there, bastions of strength, because they have stood the test. And, they will find ample demand for their products and services, because they can provide that most elusive of all commodities - financial security.
Implications for investors: Valuations for ABK and MBI vary substantially depending on whether one envisions a run-off scenario, a protracted hibernation, or a relatively prompt resumption of profitable new business activity, whether in providing triple-A protection for municipal bonds, or in other areas of credit enhancement. When the reputations of these companies are rightfully restored, the best case scenario will become reality.
Disclosure: Long ABK and MBI.