Moody's recently announced that it is placing the ratings of Ambac (ABK) and MBIA (MBI) on review for possible downgrade. I was disappointed but hardly surprised, given Moody's history of constantly moving the goalposts. This article provides a brief critique of Moody's action and the rationale behind it, followed by a discussion of the probable and possible extent of the economic damage to MBIA, Ambac, and the municipal bond market. Finally, I update my investment thesis and tactics on my holdings in the two companies.
Moody's action – the rationale behind the review lies in Moody's increased estimates of cumulative loss rates on 2006 sup-prime first lien mortgages. These have been raised from 14-18% to 22%. The corresponding stress case estimates are now in excess of 30%. Moody's expects these changed assumptions to have a significant impact on the firms' capital positions and states that multiple notch downgrades are possible.
There is a serious logical problem with Moody's approach. They totally overlook the fact that we are currently in the stress case scenario, electing to treat the present situation as the base case and then adding stress on top of stress. The worst of it is that after first underestimating the risks involved in a massive quantity of MBS, creating today's crisis, they now go to the opposite extreme, and overestimate the possible losses, adding to the crisis by threatening the bond insurance companies, who may experience losses caused by unwarranted downgrades that could be avoided by a measured and rational approach.
Both Moody's and S&P would deny it, but at this point they are so cowed by the predictive power of credit default swap spreads that they are using this short-term information, thinly traded and subject to manipulation, as a basis for their decisions. They talk a good game, and provide a rationale for everything they do, but the bottom line is that if credit swap spreads go up for any reason they will downgrade. Ditto for share prices going down. They are in panic mode. This type of action will not restore their credibility – indeed, it may make them irrelevant in the post-crisis credit market.
Effect on Ambac – in their second quarter earnings call presentation, the company provided a table of the collateral requirements that would be triggered in their asset management business by various downgrades. A one notch downgrade would not have created any problems. A multi-notch downgrade would have called for collateral and termination payments approximately 1.3 billion in excess of the market value of investments. The insurance business is not subject to any collateral calls. Ambac has received authorizations from the Wisconsin OCI (its regulator) to use up to 1.2 billion of insurance company assets to loan to the asset management company for the purpose. This is the same maneuver that was briefly on the table for AIG during its crisis.
Commenting on Moody's action, CEO Mike Callan said: “Ambac believes that Moody's rating actions continue to cause confusion, uncertainty and the risk of material economic damage if their assumptions ultimately prove to be too onerous.” I read this to say that Ambac will be seriously harmed by a multi-notch downgrade, perhaps experiencing a liquidity incident. This development places the Connie Lee project on hold, perhaps permanently, and may lead to expensive efforts to enhance liquidity under time constraints.
Later, in a letter to shareholders, ABK clarified the effect of Moody's action in light of the current circumstances, which include Lehman's (LEH) bankruptcy filing. Because Lehman was a CDS counter-party to transactions in the asset management business, ABK gets collateral calls which place their liquidity status in doubt. They have provided a new disclosure on this situation and any downgrade will create a liquidity crunch. Corrective action so far consists of contacting the OCI for a possible increase in their authorization to do inter-company transactions. They are also proposing that Moody's back off on their actions until the new Federal program is finalized and until Moody's rather extreme projections can be substantiated.
The asset management is not a core business for ABK and it is in runoff. There are a large number of industry players, many substantially larger than Ambac. Perhaps they can work something out with another industry participant.
This is a very sudden turn of events – just a month ago ABK estimated that they had 3 billion of excess capital by Moody's standards and was planning to put 850 million to work in reactivating Connie Lee as a triple A bond insurer. Now the company is exposed to a potential liquidity crisis, reminiscent of AIG's difficulties. Of course, the sudden demise of LEH, rated A1 by Moody's as of 6/30, was a contributing factor.
Moody's capital model and the assumptions that drive it are mystery to me, but based on their conduct to date I fear a harmful downgrade for ABK. Because it is getting late and a lot of players have been carried off the field, I am guessing that a way will be found to keep Ambac in the game. After all, the company has been gaining strength and running with the ball.
Effect on MBIA – following Moody's previous punitive multi-notch downgrade, MIB posted collateral as needed without any liquidity incident. They have restructured their portfolio to minimize the impact of further downgrades. In responding to the Moody's action, MBI describes itself as “a business that's not dependent on capital markets for funding.” I don't know how that came to be, but I like the sound of it.
CEO Jay Brown commented: “The reality is we have worked for the past three months to minimize actual economic loss caused by changes in rating opinions and have plans in place to deal with any outcome of this review.”
One possible result would be derailing the plan to have MBIA re-insure FGIC's book of municipal bond business, which would cause the loss of an excellent chance to get back into the game, writing new business.
Moody's has already downgraded MBI well below what was necessary based on capital considerations alone, citing a depressed share value as indicative of lack of financial flexibility, as well as “aggressive capital management.” The share price as since recovered, and MBI states they are not dependent on capital markets for funding. The fruits of aggressive capital management no doubt are accumulating in the till. Since MBI is well able to meet its obligations, I think Moody's will avoid embarrassing themselves with further downgrades.
Effect on Municipal Bond Business - unacceptable. Downgrades would lead to a serious game of political football, made all the more intense by election year posturing. While these contests are gripping spectacles, full of trick plays and theatrical confrontations, outcomes are difficult for the uninitiated to predict. One very easy fix would be for Moody's to back off for a few months to see how the Federal plan and loss experience actually develop. That would reduce the harm done by their previous culpable negligence. A gentle friend like Mario Cuomo might make this suggestion in a kindly manner.
Effect on Investment Thesis - My thesis for MBIA has been that the company will avoid serious damage to its NonGAAP adjusted book value and that the share price will ultimately return to that level, 39.63 as of the last financial statements, This latest development may delay the expected outcome but does not prevent it: I plan to hold my position (long shares) and continue to monitor results, as I have a 5 year time-frame in mind.
My thesis for Ambac was that they would push aggressively to commute more of their insured CDO exposures, increasing GAAP and rating agency capital to where they could get the Connie Lee subsidiary up and running at triple A. I expected them to realize some losses on insured CDOs that could have been avoided by holding the positions, but saw the plus as a quick (within 2 years) return to some semblance of their previous operations, but focused on municipal bonds. My target was 15 per share. That has been deferred, perhaps indefinitely, in favor of a gut-wrenching liquidity crisis which may include unnecessary economic loss.
Because the outcome is now in serious doubt, I have cut my guess at value to 7, which includes a generous allowance for the possibility of a go to zero scenario.
Tactics - My position in ABK has been long shares, which I cut in half taking profits before this recent blow from Lehman and Moody's, and long Jan10 2.50 calls. I bought the calls when the stock stood in the 1.50 area, planning to use them to replace the shares after the price recovered and get around the go to zero possibility. Too bad for me I didn't sell the other half of the shares – I had the chance after the last news came out but didn't think quickly enough.
I expect extreme volatility while this plays out. Thinking Ambac shares are worth 7.00, but guessing that the price will decline from Friday's 2.83 After Hours close, I plan to sell some shares and see if I can replace them later with the Jan10 2.50 calls at a lower price. It's not really rational, but I still have a certain amount of optimism on Ambac. Perhaps it's because management is doing their best to be open and transparent under these trying circumstances.
MBI also declined on Moody's announcement. I had been slowly paring my position as the stock rallied, and I started adding back as prices declined. If MBI continues to decline, I will pick up a few extra shares to sell on the next rally.
Disclosure: Long ABK, AIG and MBI, no position in MCO or LEH