Saturday, 22 March 2008 01:00

Reggie Middleton on Assured Guaranty

This is the result of my research on Assured Guaranty (AGO). Since it is rather extensive, I will only post the industry and company highlights in HTML. The full version has valuation, mark to market losses, peer group comparisons, pro formas, etc. Technically this is still a draft/release candidate, but I will release it to the public domain (registered blog members) anyway. Beware, it is (as is everything else) a work in progress and subject to change. You can download it here:

icon Assured Guaranty_Consolidated (796.13 kB 2008-03-21 12:12:42) or continue on for the industry overview.


AGO remains vulnerable to continued bond market troubles

Assured Guaranty (AGO) has until now fared better than its peers in credit and capital markets owing to a significant cushion that it has in the form of a relatively higher share of superior grade investments in its insured portfolio. While stocks of other bond insurers, specifically Ambac, MBIA and Security Capital Assurance, have fallen sharply over the last few months, AGO has sailed successfully through the rough waters with its stock performance hardly bearing the brunt of the current turmoil in the bond insurance market. This has been primarily on the back of the favorable ratings AGO has till now enjoyed from various credit agencies. However, despite AGO's strong fundamentals the debacle in the credit market could seriously impact its financial position, causing rise in default losses and mark-to-market write-downs of its portfolio. The rating agencies, which have so far maintained triple-A ratings on AGO and have been under constant pressure to review all bond insurers' ratings, are likely to start considering a rating downgrade in view of projected losses from defaults. Any downgrade of AGO rating will seriously impact its advantageous position over other bond insurers and make it more competitive for the Company to insure new offerings.

I.1. Investment concerns

o Destabilizing US bond insurance industry. Having been hit hard by the unfolding debacle in subprime mortgage debt, the bond insurance industry is witnessing large-scale losses and rating downgrades. Large insurers like MBIA and Ambac which are striving to maintain their triple-A ratings are trading at 6.5% and 15.1%, respectively, to their last 12 month high. FSA and AGO are the only insurers which have managed to retain top ratings right through the debacle. While a large number of market participants are contemplating a further downgrade of ratings (including for AGO and FSA) in view of current gridlock in the credit markets, many of them are also projecting a rise in the global speculative-grade default rate which was at the lowest level at 0.7% in February 2008 in the last 12 years.

o Credit ratings likely to be a case for question. Credit agencies including S&P, Moody's and Fitch have maintained triple-A rating on AGO all this while, injecting a lot of confidence in the investors, but questions are being increasingly raised on the authenticity and justification of credit agencies' ratings in view of the subprime and credit market meltdowns. Ambac and MBIA commanded triple-A ratings until huge losses on their portfolio surfaced and their stocks lost over 80% of their value. Recently, while S&P reaffirmed an AAA rating for these two stocks, Fitch downgraded Ambac to AA and is considering downgrading MBIA. In addition, the fact that AGO also assigns internal rating to its portfolio raises a lot of doubts over possible revision amid a likely increase in default rates off worsening credit conditions.

o Increasingly challenging environment to retain triple-A ratings. Bond insurers including AGO are under constant pressure to maintain triple-A ratings to ensure that their ability to guaranty new issues does not deteriorate. With an estimated $250 billion of subprime mortgage write-downs still projected to be in the pipeline and bond insurers like Ambac and MBIA having already eroded a substantial portion of their capital, it is going to be extremely hard for them to retain the top ratings. Rating agencies are also under constant pressure to review their ratings amid rising concerns that the cushion the bond insurers have against possible (and rising) defaults is inconsistent with triple-A ratings. AGO, which has a relatively higher exposure to investment-grade securities, is likely to bear the brunt of losses and face a possible revision in its top-rating. While this may impact AGO's ability to insure new bond issues, it may also endanger the additional $750 mn financing arrangement from Wilbur Ross, which is contingent upon maintenance of triple-A rating by the Company.

o Stress on municipal bonds. Mounting fears of US recession led by weakening macro-economic fundamentals have raised concerns over a rise in defaults on municipal bonds. With conditions in the US residential and commercial sector continuing to worsen, municipal authorities face a difficult task of achieving their tax receipt targets which could in turn lead to increased budget deficits. California's deficit, for instance, had already ballooned to $16 bn in February 2008 from $14.5 bn in January 2008 off reduced tax collections caused by falling housing prices. Lowering employment levels (as evidenced by the biggest layoffs in five years of about 63,000 jobs in February 2008), fast declining capital expenditure and decelerating industrial output are adding to the woes.{mospagebreak}

o Escalating mark-to-market losses on CDO/CDS. Widening credit spreads in the fast deteriorating credit markets have resulted in large scale write-down in value of RMBS and other underlying securities. The US housing and mortgage sectors have hardly shown any positive response to Fed's aggressive rate cuts in the recent months to ease panic liquidity conditions stemming from uncertainty over the future of the US economy. The falling values of the underlying RMBS and CMBS are putting serious downward pressure on CDO/CDS that AGO underwrites impacting the Company's bottom-line. AGO reported mark-to-market losses of $221 mn and $411 mn in 3Q07 and 4Q07, respectively, resulting in negative earnings of $115 mn and $260 mn in these periods. AGO's mark-to-market write-downs are likely to be equally significant in 2008 and 2009 since the macro economic indicators have not demonstrated any recovery amid a growing probability of recession, which could result in further widening of credit spreads. As a result, we expect AGO to report $598 mn and $469 mn mark-to-market losses on CDS exposure in 2008 and 2009, respectively.

o Significant exposure to highly default-prone structured finance. AGO
has a considerable exposure to credit products which are highly prone
to defaults. Of the Company's total exposure of $200 bn (net par
outstanding), around $74 bn or 37% is in structured finance products
including RMBS and CMBS which have a relatively higher chance of
defaults. The composition of the Company's RMBS exposure is again a
cause for concern as 92% of the total RMBS exposure is in the RMBS with
vintages 2005-2007, which raises a red flag in respect of a probability
of defaults. Although most of these products fall under the super
senior or AAA category (based on AGO's internal ratings), rising
investor doubts over bond insurers' ratings command lower investor
interest. As of December 31, 2007,
AGO's closely monitored portfolio, which the company considers as most
venerable to default, stood at $2.1 bn against shareholder's equity of
$1.7 bn

o Exposure to troubled markets. A
close review of AGO's geographical exposure might raise investors'
concern over AGO's financial performance in the near-to-medium term.
AGO has nearly 10% of its exposure in the troubled states of California
and Florida, which have witnessed a steep decline in the housing prices
over the last one year. In addition, within the AGO's international
finance, exposure to the UK stands at nearly $25 bn or 13% of its net
par outstanding. With elevating corporate default rates in Europe, we
believe that AGO's international exposure could also face higher
losses. As on December 31, 2007 mortgage guaranty risk in force from
the UK stood at nearly $0.9 bn out of $1.1 bn total (international)
mortgage guaranty risk in force.

o HELOC securities by Countrywide could be a complete washout. Most
of AGO's $2.4 bn exposure on HELOC is rated BBB ($0.5 bn) and
below-Investment grade ($1.8 bn). This is because around 88% of the
HELOC securities underwritten by AGO ($2.1 bn) are issued by
Countrywide Financial. Countrywide has been downgraded by Moody's and
Fitch and placed on negative watch by S&P. We believe AGO's HELOC
exposure will convert into a complete default considering the financial
state of Countrywide. An assumed 100% default on HELOC securities will
wipe out AGO's entire $1.7 bn shareholders' equity (as of December 31,


o Soaring default rates and losses. Delinquencies,
defaults and foreclosures on home mortgages have spiked significantly
over the last one year, negatively impacting the performance of RMBS
transactions which are now expected to absorb higher mortgage losses
than was originally anticipated. According to S&P, delinquency
rates for pooled subprime loans issued in 2005 have increased to 34.4%
while those for Alt-A and Prime jumbo loans have soared to 18.1% and
18.2%, respectively. For HELOC loans issued during 2005 and 2006,
delinquency rates are up 6-7%, while for closed-end home-equity loans
delinquency rates have increased to 12%. As a result of a higher
default in the housing sector, we expect bond insurers to experience
higher defaults under their RMBS and CMBS transactions. As housing
problems creep further into consumer spending affecting corporate
profitability and lower tax revenues for the government, default rates
will rise over their historical rates for the corporate and municipal
bonds. We have computed total expected losses of $2.1 bn, $2.4 bn and
$2.8 bn under the best case, base case and worst case scenarios,
respectively, (The assumptions under the three scenarios have been
detailed in the later sections of this report).

o Recent opposition of municipal bond rating mechanism. Of
late, municipalities have been opposing adoption of different standards
for rating corporate bonds and municipal bonds on the pretext that the
same set of guidelines be applied for rating municipal bonds, which are
less risk prone than the corporate bonds. This is also in view of the
fact that municipalities have been experiencing a rise in interest
rates or fall in bond values owing to a recent less favorable outlook
being assigned towards them by the rating agencies. The interest costs
on auction-rate securities issued by municipalities have nearly doubled
since January 2008. Issuance of municipal bonds in January 2008 were
38% lower than a year before in part due to lower confidence levels now
associated with the municipal bonds. From a bond insurer's perspective,
any move towards bringing parity in the rating mechanism will mean that
most of the municipal bonds would secure triple-A rating. This will
translate into lower premium income for bond insurers, or in other
words, softer insurance markets lead to diminishing costs for the
municipalities, as is being increasingly demanded by them. Another
emerging trend is that an increasing number of municipalities are
becoming wary of securing insurance for their bonds on the fear that a
possible negative outlook associated with the bond insurer could impact
the response to the municipal bonds. Of the more than $20 bn issued in
municipal bonds during February 2008, just $5.4 billion or 27% were
covered by financial guarantors, compared with more than half of the
$39 bn issued during the same period a year before.

o A possible split of municipal and corporate bond business. Over
the years monolines have successfully built a mixed portfolio of the
high-yield and riskier corporate bonds and the relatively safer
municipal bonds. Municipal bonds have effectively worked as coverage
for a crash in the corporate bond market as has been witnessed in the
course of last year's credit market meltdown. However, of late the
prolonged problems in the corporate bond market have spilled over to
the municipal bond market endangering the values associated with
municipal bonds. As a result, talks of mandatory splitting of the two
lines of monoline businesses have started doing the rounds. In fact,
FGIC has already filed for a split while Ambac pondered, but eventually
decided to issue highly dilutive stock to raise capital. A split will
create havoc for the structured finance business of any bond insurer
including AGO. It is believed that a stand alone structured finance
insurance business will be a complete wipeout dragging along with it
the values of the insured securities. Since this will mean serious
threats to security values, many investment banks have been rumored to
have been pooling money into the monolines to safeguard their vested
interest. As of the penning of this document, all the banks have
offered was an ambiguous back stop of a dilutive offering of Ambac
shares to the tune of $2 bn. AGO, though still regarded as a safe bet,
has also secured capital commitment from Wilbur Ross to safeguard
against an impact on its capital from a possible slowdown of its
structured finance insurance business and to pursue municipal business.
The introduction of Warren Buffet's companies into this field is akin
to the elephant in the room, with their vastly superior capital base,
superior ratings outlook, extensive experience in insurance and risk
management, as well as his marquis brand name, he significantly changes
the competitive landscape in an industry facing considerably less
demand from its constituencies.{mospagebreak}

I.2. Investment positives

o Superior fundamentals relative to peers. Relative
to its peers, AGO commands stronger fundamentals and has higher equity
coverage to its exposure. At $200 bn net par outstanding, AGO's net
part outstanding-to- shareholders' equity is 120X which is lower
compared with those of its peers. AMBAC's net par outstanding of $524
bn is 230X its shareholders' equity, while MBIA's exposure of $673 bn
is 184X its shareholders' equity. Further, AGO's exposure (at $18.2 bn)
to the highly default prone US RMBS is also lower than $43.1 bn for
AMBAC and $45.2 bn for MBIA as of December 31, 2007.

o Considerable subordination levels. AGO's
RMBS transactions benefit from higher levels of structured credit
protection through subordination. The company has 38%, 39% and 23%
subordination level for closed end seconds, subprime and Alt-A RMBS
transactions, respectively. Additionally, the company has a 34.8%
subordination level for pooled corporate obligations and 35.3%
subordination for CDOs of mezzanine ABS. Although the Company stands to
benefit from any loss arising from exposure to these RMBS transaction
through higher levels of subordination, the lower level of
subordination at 1% for HELOC, the most vulnerable part of AGO's
insured portfolio, remains a key concern for the company.

o Favourable ratings relative to peers. AGO
is one of the few monolines which have been able to maintain top
ratings in an environment where rating downgrades are becoming an order
of the day. While in the recent months rating agencies including
S&P, Moody's and Fitch have revised their outlook on most of the
monolines mainly on the adverse side, on the back of the rising
probability of defaults and falling bond values, AGO has all through
been able to retain triple-A rating from all the three rating agencies.
The primary reason which goes in favor of AGO is the quality of its
exposure relative to its peers.

as mentioned above, credibility associated with such ratings has come
under scrutiny in the past year owing to the actual events/performance
turning out to be quite contradictory to the ratings, it can be derived
that AGO has had a stable and trouble-free journey till now relative to
its peers.

For the full analysis of AGO complete with valuation, marks to
market, peer group analysis and pro formas, join the blog if you have
not already done so and click here: You can download it here:

icon Assured Guaranty_Consolidated (796.13 kB 2008-03-21 12:12:42)

Last modified on Saturday, 22 March 2008 01:00


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