Ambac, MBIA: Moody's strikes again

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

.

Comments

[Ishortyou:]

AMBAC has been working hard on remediating their books from toxic liabilities such of those CDO's containing NINJA loans, unfortunately came the Lehman fiasco which cause this liquidity calls. It would have been nice is they continue their hard work in delevering despite the erratic Moody's rating model. Their strategy eventually will pay off but it will take some time before they get to see the results of this titanic work.

2008 Sep 22 04:29 PM

[apppro:]

A very nice long article, but it comes down 3 words 'self-fulfilling prophecy’.

2008 Sep 22 05:02 PM

[gph:]

Thanks for this. Disouraging re: ABK, but that's reality

2008 Sep 22 05:37 PM

[oldlures1:]

apppro and gph - I agree, its a self-fulfilling prophecy (has been since late last year) and it is "reality"....sadly.

I continue to be suprised at the blatant subjectivity of the rating agencies, particularly as it relates to manipulation and/impact to the marketplace. The rating agencies wield a very powerful sword...with impunity....unaccounta... unregulated. One could naively assume, as I've done in the past, that said agencies would utilize the tool of ratings in a fair, objective, consistent and honest manner, but such is clearly not the case. They continue to act irresponsibly and with very harmful outcomes, and yet they are allowed to continue.
I don't understand.

2008 Sep 22 06:03 PM

[User 165980:]

As they say, Moody's is not the sharpest knife in the drawer.

2008 Sep 22 06:08 PM

[Ishortyou:]

GICs business is probably the backbone part of AMBAC and MBIA book of business, unfortunatelly this is getting destroy but irresponsable Moody's downgrade, and the regulator no where to be found, this is absurd!

2008 Sep 22 06:53 PM

[User 267439:]

Unfortunately Moody and S&P are moron's they do not live in a real world, this is not the time to slam your thoughts using a 'normal or best case scenario" give the companies a break and let them recover, every bit of bad news 'the sky is falling' just adds to the confusion, we now of course the press does not help either...

2008 Sep 22 08:33 PM

[buddhatt:]

While you are at it, why don't you look in to the connection between Davis Select Advisers(owns 40 mil of ABK) who is a large owner of Moddys along with Warren Buffet , who would like ABK. And the trading that has been going on this last two weeks. Something stinks.

2008 Sep 22 09:05 PM

[glassbox:]

buddhatt

I wished SEC would have disclosure rules that require disclosure of stocks lent by longs and disclosure of shorts and where they borrowed their scrips from. This woudl minimise any opportunities to create stinking trades.

2008 Sep 22 09:57 PM

[dusty_m_45:]

buddhatt and glassbox have hit the nail on the head. Manipulation is rampant in most areas of the market and this one is being played like a finely tuned piano. The SEC is viewed as an impotent beuracracy of the financial govenment and it is still very obvious that shorting is still rampant here as well as other financial stocks on the "no short list". These people are making millions and IF they are caught they may have a fine of a hundred thousand to pay. They should ban all involved from trading for 3 years. Let's see how much illegal shorting goes on then.

2008 Sep 22 10:44 PM

[pcyhuang:]

The huge market for credit default swaps, a derivative behind many of
the problems roiling the financial markets, will get some regulatory
oversight from New York state, Gov. David Paterson announced Monday.

Credit default swaps are contracts that enable institutional investors
to bet on the likelihood of companies defaulting on the debts. The
market for these contracts has grown from nothing a decade ago to $62
trillion of notional volume this year. Despite this extraordinary
growth, the credit default swaps market has remained outside the
purview of federal or state regulators, largely because they accepted
Wall Street’s argument that swaps are not securities or insurance
policies.

That seems poised to change. Mr. Paterson said the state Department of
Insurance issued guidelines to establish that credit default swaps are
a form of insurance and, hence, subject to state regulation.

“We are going to ensure that whoever sells them [credit default]
protection is solvent, in other words, can actually pay the claims,”
said Eric Dinallo, the New York state Department of Insurance
superintendent. “There is currently no such protection for
policyholders.”

Credit default swaps were a major factor in the difficulties
experienced by American International Group Inc., the giant insurer
taken over by the federal government last week. AIG wrote insurance
against tens of billions worth of credit default swaps and had to post
billions of additional collateral when the value of those swaps
declined due to growing mortgage defaults, causing the losses that
nearly bankrupted the firm.

"The state of New York should proceed very cautiously and in
consultation with federal regulators before acting in a way that may
ultimately cause more harm than good," said Robert Pickel, executive
director and chief executive officer at the International Swaps and
Derivatives Association, a trade group representing Wall Street firms.

Source: www.crainsnewyork.com/...

Comment: Great boost of confidence in ABK, MBI and other licensed
financial guarantors.

2008 Sep 22 10:55 PM

[glassbox:]

CDS market regulation - long long overdue!

2008 Sep 23 12:15 AM

[Castrese Ti...:]

What is really disturbing of the current financial crisis is the substantial impunity surrounding the main culprits.

Apart from politics (they are irresponsibles by definition), you can confidently put the blame of the current financial chaos on inept, greedy and corrupt banks managers, and the rating agencies.

As penalty the first ones got liquidations that ordinary people should work for centuries to get, while the second ones keep on belching their useless and harmful analysis, adding fuel to the fire they roused.

I’d strongly urge Paulson et al to insert a few lines in the bailout package they’re working on, to put an end on their unbearable legal monopoly to utter financial nonsense; they are one of the main source of market instability.

Look at the Lehman rating when it collapsed!

2008 Sep 23 05:22 AM

[Ishortyou:]

Buddahtt has a point, looks like there is some manipulation on this issue, it seems at first glance that they would try to hammer AMBAC and MBIA to buy them on the cheap, somthing doesnt fit very well here, there is a lot of conflict of interest. And yes the CDS marekt should be regulated and transparent, they need to show what they got!!!

2008 Sep 23 07:15 AM

[CT Programmer:]

If we're pointing fingers here, I think this entire financial crisis can be laid in the lap of the rating agencies. They have an entire generation of actuaries that didn't learn about risk. Just because an asset class is going up (real estate) doesn't mean it doesn't have risk, and everyone racing to pile more and more money into that asset class doesn't reduce the risk. It's only been 25 years since our last housing depression. This is the kind of big picture thinking that actuaries are supposed to earn their paycheck from, not the day to day stuff of traders or returns-chasing. Also, these ratings agencies failed to see that the derivatives market was mushrooming to huge proportions. If they had said "wait a minute guys, you're taking on too much risk and leveraging to uncomfortable levels", then maybe those companies that were just chasing profits for their shareholders would have pulled in the reigns more to retain their ratings and not stretched themselves so far. That applies to MBIA, Ambac, AIG, Lehman, anyone in the financial arena.

Also, Adam Smith's "invisible hand" sometimes doesn't work so well, and you do need regulators. We have a derivatives market of mind-blowing proportions. Jim Jubak has a good article this week specifically on the derivatives market melt-down:

articles.moneycentral....

He estimates that the entire market is $455 trillion. TRILLION. And this is an unregulated market, where the companies doing business don't necessarily follow reporting standards (I'm not sure if there really are any for these confusing contracts), and the rating agencies have largely ignored.

I don't really follow Ambac, but I am long on MBIA. It would have been nice to sell them after the last rally like you did and then bought back in lower (I was up 70% at one point but now up only half of that), but I'm long. I try not to time too much, but just sit and wait and ignore the day to day fluctuations. I believe Jay Brown when he says they don't need to go to the capital markets. They haven't in over 6 months. They have a ton of cash, and frankly, their ratings don't really mean much anymore. However, as bullish on them as I am (I see $30+ within 2 years), I don't think that Moody's projecting a "worst case scenario" beyond what is currently market conditions is too unreasonable. No matter what the current conditions, it can ALWAYS get worse. Have we hit bottom? Will things now improve? That is supposition, not certainty, and Moody's is factoring that things COULD get worse into their equations. That doesn't mean they will, but they could. I am still worried about the commercial real estate market collapsing. It has been struggling for a while, and all kinds of other news has taken the spotlight away. I think that could be the next financial shoe to fall.

2008 Sep 23 10:01 AM

[pcyhuang:]

Federal Reserve Chairman Bernanke testified today before the Senate Banking Committee. and explained that “hold to maturity” valuations are greater than the current fire sale market value, and the difficult balance between promoting higher pricing to support financial institutions and causing tax payer losses by being excessively generous..

Imagine if ABK would be able to liqudiate its CDS portfolio according to "hold to maturity" valuation.

Cheers,

Cheers,

2008 Sep 24 05:26 AM

[Ishortyou:]

pcyhunag you could be right, the problem that derivatives are just plain contracts for almost anything, even for JUNK, and they are traded on unknown, occult markets and no one knows its true value at the moment, I guess a point would be to put any contract or derivative on a transparent market just like a common stock and see who is willing to buy and sell according to simple supply and demand standard but this is going to take some time before it gets implemented.

2008 Sep 24 07:59 AM

[Ambac Fan:]

Considering the fragil economic situation, it is criminal for Moody's to downgrade Ambac and MBIA. Come on! Just plunge the knive deeper, you son's of Bs! Why don't you try to help by putting a hold on your "downgrades". Don't you see people are losing money every time another company goes belly-up?

2008 Sep 27 12:20 AM

[pcyhuang:]

glassbox:

SEC tightening rules on short selling:

www.investorvillage.co...

Cheers,

2008 Sep 27 10:07 AM

[Old Coach:]

ABK and MBI may survive. The bailout bill allows Cox to suspend mark to market accounting and commissions a study. I would bet that the study endorses the trailing average approach that Newt Gingrich and others have been pushing on Congress. Combined the toxic paper going to the gov't and M to M getting suspended/amended and the monolines could be sitting pretty.

SEC. 132. AUTHORITY TO SUSPEND MARK-TO-MARKET AC-
COUNTING.
(a) AUTHORITY.—The Securities and Exchange Com-
mission shall have the authority under the securities laws
(as such term is defined in section 3(a)(47) of the Securi-
ties Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to sus-
pend, by rule, regulation, or order, the application of
Statement Number 157 of the Financial Accounting
Standards Board for any issuer (as such term is defined
in section 3(a)(8) of such Act) or with respect to any class
or category of transaction if the Commission determines
that is necessary or appropriate in the public interest and
is consistent with the protection of investors.


SEC. 133. STUDY ON MARK-TO-MARKET ACCOUNTING.
(a) STUDY.—The Securities and Exchange Commis-
sion, in consultation with the Board and the Secretary,
shall conduct a study on mark-to-market accounting
standards as provided in Statement Number 157 of the
Financial Accounting Standards Board, as such standards
are applicable to financial institutions, including deposi-
tory institutions. Such a study shall consider at a min-
imum—
(1) the effects of such accounting standards on
a financial institution’s balance sheet;
(2) the impacts of such accounting on bank fail-
ures in 2008;
(3) the impact of such standards on the quality
of financial information available to investors;
(4) the process used by the Financial Account-
ing Standards Board in developing accounting
standards;
(5) the advisability and feasibility of modifica-
tions to such standards; and
(6) alternative accounting standards to those
provided in such Statement Number 157.
(b) REPORT.—The Securities and Exchange Commis-
sion shall submit to Congress a report of such study before
the end of the 90-day period beginning on the date of the
enactment of this Act containing the findings and deter-
minations of the Commission, including such administra-
tive and legislative recommendations as the Commission
determines appropriate.

2008 Sep 28 08:12 PM

[Old Coach:]

The legalese above comes from a draft of the bill.

2008 Sep 28 08:13 PM

[Tom Armistead:]

For Ambac if they could sell some of whatever is in the investment agreement business that would be helpful, it seems as if that is what creates the collateralization/liqu... risk.

Either that or drop the mark to market rules. I heard one Republican claim the SEC already has the authority to suspend it...

As you say, good for MBI and ABK


On Sep 28 08:12 PM Old Coach wrote:

> ABK and MBI may survive. The bailout bill allows Cox to suspend mark
> to market accounting and commissions a study. I would bet that the
> study endorses the trailing average approach that Newt Gingrich and
> others have been pushing on Congress. Combined the toxic paper going
> to the gov't and M to M getting suspended/amended and the monolines
> could be sitting pretty.
>
> SEC. 132. AUTHORITY TO SUSPEND MARK-TO-MARKET AC-
> COUNTING.
> (a) AUTHORITY.—The Securities and Exchange Com-
> mission shall have the authority under the securities laws
> (as such term is defined in section 3(a)(47) of the Securi-
> ties Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to sus-
> pend, by rule, regulation, or order, the application of
> Statement Number 157 of the Financial Accounting
> Standards Board for any issuer (as such term is defined
> in section 3(a)(8) of such Act) or with respect to any class
> or category of transaction if the Commission determines
> that is necessary or appropriate in the public interest and
> is consistent with the protection of investors.
>
>
> SEC. 133. STUDY ON MARK-TO-MARKET ACCOUNTING.
> (a) STUDY.—The Securities and Exchange Commis-
> sion, in consultation with the Board and the Secretary,
> shall conduct a study on mark-to-market accounting
> standards as provided in Statement Number 157 of the
> Financial Accounting Standards Board, as such standards
> are applicable to financial institutions, including deposi-
> tory institutions. Such a study shall consider at a min-
> imum—
> (1) the effects of such accounting standards on
> a financial institution’s balance sheet;
> (2) the impacts of such accounting on bank fail-
> ures in 2008;
> (3) the impact of such standards on the quality
> of financial information available to investors;
> (4) the process used by the Financial Account-
> ing Standards Board in developing accounting
> standards;
> (5) the advisability and feasibility of modifica-
> tions to such standards; and
> (6) alternative accounting standards to those
> provided in such Statement Number 157.
> (b) REPORT.—The Securities and Exchange Commis-
> sion shall submit to Congress a report of such study before
> the end of the 90-day period beginning on the date of the
> enactment of this Act containing the findings and deter-
> minations of the Commission, including such administra-
> tive and legislative recommendations as the Commission
> determines appropriate.
>

2008 Sep 29 09:10 PM