Warning: this is an opinionated blog article that may offend those employed by large rating's agencies or monoline insurers. Recommend reading as a backgrounder:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton.
  2. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap
  3. Follow up to the Ambac Analysis
  4. Bill Ackman of Pershing Square - How to save the Monolines

From Bloomberg news:

MBIA Inc. fell the most in more than 20 years in New York trading after Moody's Investors Service said the biggest bond insurer is ``somewhat likely'' to face a shortage of capital that threatens its AAA credit rating.

A review of MBIA and six other AAA rated guarantors will be completed within two weeks, Moody's said in a statement today. Moody's revised its assessment from last month that MBIA was unlikely to need more capital after additional scrutiny of the Armonk, New York-based bond insurer's mortgage-backed securities portfolio.

``The guarantor is at greater risk of exhibiting a capital shortfall than previously communicated, (about a week and a half ago - my, aren't we fickle with our opinions) New York-based Moody's said. ``We now consider this somewhat likely.''

Published in BoomBustBlog
Tuesday, 04 December 2007 00:00

Follow up to the Ambac Analysis

I have been receiving a lot of feedback on the Ambac article and the MBIA one as well. Many want more in terms of clarification, assumptions, additional calculations, data, etc. I just want to remind all that this is a blog on my commentary and thoughts on the markets and my investments. My primary occupation is investing, not blogging. I disseminate my research and opinions to provoke discussion and I love to blog on these topics, but I have limited bandwidth to return emails. I do not want the lack of answers to email questions to appear as if I am avoiding them, it is just that after a certain level of volume it distracts me from my day job. Please keep the emails coming, just be aware that I may not be able to answer all of them. That being said, I will present some additional data from my Ambac research, and am considering posting a what-if scenario of Ambac insuring E-trade (I am sure that will garner some interest). After that, we will be moving on to the commercial real estate, investment banking and consumer finance sectors where I am arranging additional bearish positions and will blog on them. I will, of course, enjoy and entertain discourse on these or related topics.

Published in BoomBustBlog

I came to this conclusion after a detailed analysis of Ambac's portfolio (at least what Ambac has made public, which was sufficient) covering exposure in the Structured Finance, Sub-prime RMBS and the Consumer Finance business. Ambac's management was forthcoming enough to publish a portion of their insured portfolio which allowed me to review each structure.

I am short Ambac and MBIA (for whom I have also released research), so be aware of my position as I present this opinion. I profit not necessarily from whether ABK can continue as an ongoing concern (which is in doubt and wouldn't hurt my shorts to say the least), nor from an infusion of capital (whether it be debt or equity, either of which would be a poor investment from my perspective) but from the significant decline in value of the existing shares in which I have taken a bearish position. To determine my short position, I calculated relative nominal book valuations, actual economic book valuations and produced standard financial forecasts. Of interest is the loss tail analysis wherein I have estimated the present value of the future losses.

As it stands now, ABK's equity value will be totally wiped out with a 175 basis point move in their insured's underlying - which seems like a very, very likely possibility. My Ambac analysis is much more granular than that of MBIA's (see A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton ) where I discussed the predicament of the ratings agencies, the monolines, and in particular, MBIA.

The referenced predicament is exacerbated by the fact that some, such as Ambac, are truly insolvent, thus a mere waiving of the "Magic Ratings Wand" will not pay the claims when they come due. More to the point, the monolines have grown too big for their capital base, specifically their equity base. They are insuring much more than they can handle in the case of an outlier event. I don't consider the burst real estate bubble and the consequent mortgage debacle much of an outlier, for anyone could have seen it coming if they simply opened their eyes.

Now, if a big monoline fails or is even downgraded, a large part of the credit market goes with it. This level of catastrophe may be too much for the powers that be. This portends a bailout of some sort or fashion, or maybe the players will just be forced to take their market medicine. Only the future will tell.

Six Degrees of Separation: Guess who Ambac insures!

Bank of America issued a report on the monoline insurers on July 30th, 2007 that states that ABK's RMBS exposure to troubled companies is limited to only 4 cos. with vintages primarily in the early years excluding two relatively well performing underwritings. Despite this, they failed to include in this caveat the consumer finance insureds:

  • Countrywide, which probably has one of the worst performing portfolios in the industry;
  • GMAC, who has also suffered significant losses that GM has been forced to cover, hence hampering a clean sale of the company;
  • Indymac, another company that is saddled with mortgage related losses that is on the insured's list (Indymac and Countrywide have had their shares more than halved in the last few months. I was short these companies. CFC may go bankrupt);
  • Lehman brothers has some losses to contend with as well, but I don't know to what extent since I don't follow it - I do know that they are the 2nd largest MBS house on the street, next to Bear Stearns;
  • Greenpoint Mortgage Funding is defunct, wound down due to losses;
  • Then we also have Citimortgage (SIV king whose own mortgage portfolio is a mess);
  • Accredited Mortgage Loan (bankrupt or close to it);
  • Wachovia (just reported a billion plus writedown on mortgage assets);
  • Countrywide Revolving Equity Trust/Alt-A trust (need I say more about undocumented 2nd lien loans from this lender);
  • Option One Mortgage Trust (nearly defunct due to mortgage losse);
  • BofA, mulit-billion dollar mortgage asset writedown;
  • and Newcastle - who I believe is either out of business or close to it. I stopped following it some time ago.

These are the companies and exposure that I am familiar with, at first glance in the consumer finance portion of Ambac's portfolio, without any research. Just imagine if I took a real hard look at the insureds.

Now, using some common damn sense, would you think that the company that is insuring these guys' mortgage and finance products with 90x leverage may be having some problems that they may not be coming forward with. I have over 100 pages of proprietary analysis and calculations costing me weeks of analyst hours, that tell me Ambac may be out of business soon - but I really didn't need to do all of that math and research if I just glanced at the bullet list above. I used the loss statistics from the BofA report as a baseline for the losses in my models on Ambac. I know they are too conservative (and to be fair to BofA, they were contrived before this mess got worse), but that should only lend credibility to my findings. Click here to download ambac loss tail.pdf.

The ACTUAL quality of the ABK's insureds is truly suspect in my opinion and the underwriting quality of their insureds needs to be investigated further. Unfortunately, I have very limited resources. I literally told my team that "this is worth digging in and spending time on, for there are many who are now trying to go long on this stock due to its price and nominal book valuation. If they are wrong, it can be a very profitable opportunity". Well, that's what we did. By investigating the losses on similar books written by the originators for the vintage in question, one can guess the performance of the books underwritten by AMBAC. The policy terms must be examined to see where the breakpoints are for losses, of course. Exposure to Countrywide alone is a cause for suspicion, IMO. As stated earlier, the default estimates in the B of A analysis are assuredly too conservative, but are used for the sake of prudence over alarmism (with some mandatory tweaks to edge them towards reality). Why do I say they are conservative??? Take a look at the REO rates and land value forecasts in my blog, and then look at the target prices for the insurers in question on the first page of B of A's analysis, right before you query the prices of these stocks today. For those that don't have access to the report, I will reveal just this one tiny part:

Bank of America Top Picks (June 2007)





























Ticker

Rating

Price

Target

Price as of 11/29/07

Profit on the BofA Call

% Profit

SCA

B

$23.60

$37.00

$6.69

($16.91)

(71.65%)

MBI

B

$60.33

$85.00

$30.04

($30.29)

(50.21%)

Least Favorites

NONE

You really can't get rich listening to these guys. Hopefully, you can see where the use of their default data is a conservative approach (even a bit rosy), albeit tweaked ever so slightly for the sake of reality. As you may have ascertained, I do not put a lot of faith in sell side research. I have even less faith in the big three rating agencies research (although Fitch is trying to be taken seriously). Thus, even if they deem ABK and MBIA not in need of more capital, that is near meaningless in my book. These are the same companies that rated the insured portfolios AAA a year or two ago that are now taking up to 20%+ losses.

We also have to contend with the moral hazard/bailout issue. If you read my earlier missive on MBIA, I detailed the rating agencies' dilemma.

The calculations in this analysis are only estimated losses in 4 insured categories (of many, they are enough to generate significant losses). I am expecting higher losses in Public Finance as well due to the loss of property tax revenues (lower tax base) and income tax revenues led by housing value declines and loss of corporate revenue and jobs, respectively. Many municipalities created huge budgets during bubble times (like everyone else) and failed to prepare for the bubble to burst. Now unfunded services run rampant. The shortfall will have to be covered somewhere, and default on debt service is not out of the question.

In the base case scenario created, we expect the company to report losses to the tune of $8 billion+ in its Structured Finance, Subprime RMBS and the Consumer Finance portfolio. This loss will wipe out the company's remaining equity and it will need to raise an additional $2 billion in order to function as an ongoing concern. Moreover, we think the company will need to reinsure a higher percentage of its portfolio in order to transfer risk and free up capital.

"The Truth! The Truth! You can't handle the Truth!"

I calculate that Ambac will need to raise an additional $2 billion in order to continue as a going concern. In order to maintain AAA status they will need $5.4 to $7 billion, according to how I perceived the comments of its CEO in the last conference call (they say they are an average of $1.4 billion above what is needed to maintain a AAA status from the three main rating agencies - without my little economic reality marking here). In the base case scenario below, Ambac will need to bolster its reserves by $6.8 billion. A fellow blogger that I follow, Mike Shedlock, commented that Citibank has recently sold approximately 5% of itself to a foreign investor to raise $7.5 billion dollars. Citibank is much more diversified, with a much larger capital base, than Ambac. Let's be realistic here - no let's not - Let's be highly optimistic with pretty rose colored glasses, and say that ABK can fetch a significant premium to Citibank's valuation. ABK's current market valuation is $2.26 billion. Where in the world will they get this kind of capital from and who will be the risk cowboy to give it to them??? These guys are in a real solvency dilemma, and it is a shame that the ratings agencies and the sell side guys have yet to admit it. I guess it takes entrepreneurial investors and bloggers such as me to ferret out the truth, and the truth is hard to find in detail. You remember what Jack Nicholson said in "A Few Good Men"? "The Truth! The Truth! You can't handle the Truth!" I had two analysts and I work on MBIA and ABK for weeks, when I should have been able to just buy a report... Yet, everyone expept Ackman from Pershing Square was unrealistically optimistic. There are some big losses ahead of us folks. If the real estate bust was the impetus for the current debacle, we have a long trip ahead of us because the real estate bust has just started!

My full analysis is bulky, but well documented, and will be posted as a .pdf if I get enough requests. Most should be satisfied with this lengthy summary























































































































































































































Here we have a loss tail analysis of the forecasted losses of the Structured Finance, Direct RMBS and Consumer Finance portfolio, expecting the losses of the vintage year 2005 to be paid over the next 5 years in 2006-2010. We have calclualted the loss ratio of the company which is deteriorating from 2007 onwards (denoted by Paid losses/Written premium ratio).

Base Case Analysis

Calendar year payout

Year

Gross written premium

Expense ratio

Total Expected losses

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2003

1,144

172

972

22

2004

1,048

157

891

61

2005

1,096

164

932

200

2006

997

150

847

504

2007

1,006

151

855

1,260

2008

766

115

651

1,928

2009

690

103

586

1,880

2010

635

95

539

1,741

2011

597

89

507

1,437

2012

561

84

477

671

Calendar year paid losses

22

61

200

504

1,260

1,928

1,880

1,741

1,437

671

Cumulative losses

22

83

283

787

2,047

3,975

5,855

7,596

9,033

9,704

Report year written premium

1,144

1,048

1,096

997

1,006

766

690

635

597

561

Paid Losses/Writtem Premium ratio

2%

6%

18%

51%

125%

252%

273%

274%

241%

120%

Outstanding loss reserves

950

1,780

2,512

2,856

2,451

1,174

(120)

(1,321)

(2,251)

(2,446)










































































































































































































































































Alternatively, we have calculated the provisioning for losses that Ambac will need to make every year on the basis of the anticipated losses that the company will have to pay in coming years. In doing so we have assumed that the 85% of the premium written from 2007 onwards (excluding 15% as underwrting expesnse) will be transferred to the loss expense reserve every year. The loss reserve uptill 2007 is taken from comapny's balance sheet. The losses have been calculated on the basis of various default probabilities assummed in Strucutred Finance, Direct Subprime RMBS and Consumer Finance portfolios. We have assumed a duration of 5 years to spread the losses on various vintages over the coming years. We anticipate the company will have to create a provisoin of $ 6.8 billion under the base case scenario.

Base Case Analysis

Calendar year payout

Year

Gross written premium

Loss and loss expense reserve

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2003

1,144

189

22

-

-

-

-

-

-

-

-

-

2004

1,048

254

-

61

-

-

-

-

-

-

-

-

2005

1,096

304

-

-

200

-

-

-

-

-

-

-

2006

997

220

-

-

-

504

-

-

-

-

-

-

2007

1,006

279

-

-

-

-

1,260

-

-

-

-

-

2008

766

930

-

-

-

-

-

1,928

-

-

-

-

2009

690

1,517

-

-

-

-

-

-

1,880

-

-

-

2010

635

2,056

-

-

-

-

-

-

-

1,741

-

-

2011

597

2,563

-

-

-

-

-

-

-

-

1,437

-

2012

561

3,040

-

-

-

-

-

-

-

-

-

671

Calendar year paid losses

22

61

200

504

1,260

1,928

1,880

1,741

1,437

671

Cumulative losses

22

83

283

787

2,047

3,975

5,855

7,596

9,033

9,704

Provision for losses


4

(150)

(588)

(1,202)

(1,276)

(1,294)

(1,202)

(930)

(195)

Total

(6,832)



In our base case analysis of the CDO and the Subprime RMBS portfolio, we have assigned default probabilities based on collateral; wherein we have assumed an average default probability on its subprime collateral of 6% and on its ABS CDO mezzanine a default probability of 25%.














Average default probabilities (by Collateral)

Subprime RMBS

6%

Other RMBS

6%

ABS CDO High Grade

6%

ABS CDO Mezzanine

25%

CDO Other

10%

Other ABS

10%



In our base case analysis of the consumer finance business, we have assigned default probabilities largely based on ratings. We assigned a average default probability of 2% on its AAA rating portfolio and 11% average default probability on its BIG (Below Investment Grade) portfolio.












Average default probabilities (by Rating)

AAA

2%

AA

5%

A

6%

BBB

8%

BIG

11%



Valuation

In the case of Ambac, and most of my analyses, I draw a distinction between accounting (or nominal) book value and actual economic book value - the stuff I get paid for as an investor. Below you will see comparable valuation based upon nominal book value which actually has ABK underpriced. You will also see the forensically scrubbed economic book value, which in the most optimistic scenario (which I can tell you now, just ain't gonna happen) has Ambac valued at about $9 per share. You don't want to know what the base case and pessimistic scenario portend.




















































































































































































































Ambac Financial Corp

Relative Valuation

Nominal Book Value

FY2007

All Figures in Millions of Dollars, unless othrerwise stated


Mean Multiple

High Multiple

Low Multiple

BVPS



53.67

53.67

53.67


Equity Value Per Share

$22.5

$34.4

$12.7



Current Stock Price

$21.8

$21.8

$21.8

(Discount)/Premium to Fair Market Value

(3.11%)

(36.60%)

70.93%

Book value as marked to market (Optimistic Scenario)

FY2007

All Figures in Millions of Dollars, unless othrerwise stated


Mean Multiple

High Multiple

Low Multiple

BVPS



21.4

21.4

21.4


Equity Value Per Share

$8.97

$13.71

$5.09



Current Stock Price

$21.8

$21.8

$21.8

(Discount)/Premium to FMV

142.89%

58.93%

328.49%





Book value as marked to market (Base Case Scenario)

FY2007

All Figures in Millions of Dollars, unless othrerwise stated


Mean Multiple

High Multiple

Low Multiple

BVPS



-14.0

-14.0

-14.0


Equity Value Per Share

($5.87)

($8.98)

($3.33)



Current Stock Price

$21.8

$21.8

$21.8

(Discount)/Premium to FMV

(470.93%)

(342.71%)

(754.38%)








Peers

Name

Ticker

P/B '07

Price

BVPS '07

MBIA Financial

MBI

0.38

22.3

58.5

Assured Guaranty

AGO

0.64

20.17

The PMI Group

PMI

0.25

10.45

42.43

Primus Guaranty

PRS

0.59

5.91

Security Capital Assurance Ltd

SCA

0.24

5.32


Price to Book Value









Average


0.42

High


0.64

Low


0.24




The Effects of Adverse Spread Movement






An Increase in spread of 175 Bps would erode the entire equity


Residential Mortgage Back Security and CDO Exposure

Here you see Ambac has significant exposure to some of the worst vintage years, and as detailed above has some of the worst possible clients one would want ensure. These ingredients mix to become a very toxic cocktail, indeed.













































































































AMBAC

Total subprime exposure with in insured portfolio

Total MBS portfolio

53.9

RMBS subprime exposure

8.8

% of total RMBS portfolio

16.3%

Sub prime porfolio by vintage

vintage 1998-2001

1.2

13.6%

vintage 2002

1.2

13.6%

vintage 2003

2.4

27.3%

vintage 2004

0.8

9.1%

vintage 2005

1.6

18.2%

vintage 2006

1

11.4%

vintage 2007

0.6

6.8%

Direct Subprime RMBS

8.8

100.0%

36.4% of the subprime portfolio belongs to vintage years of 2006-2007 when credit writing standards has been on its low.

Total CDO portfolio (in US$bn)

High yield

24.3

34.0%

Investment grade

8.6

12.0%

ABS > 25% MBS

29.2

40.8%

ABS < 25% MBS

3

4.2%

Other

2.80

3.9%

Market value CDOs

3.60

5.0%


71.5

100.0%

Breakdown of CDO of ABS's subprime collateral by rating

2Q 07

3Q 07

AAA

3.8%

7.4%

AA

39.7%

39.0%

A

47.2%

36.9%

BBB

8.6%

8.7%

Below investment grade

0.7%

8.0%

















































































































































































































































































































Sensitivity Analysis - Default probabilities - Base case

Vintage

Sub-prime RMBS

Other RMBS

ABS CDO High grade

ABS CDO Mezzanine

CDO other

Other ABS

1998

2%






Average defualt probabilities (by Collateral)

1999

2%






Subprime RMBS

6%

2000

2%






Other RMBS

6%

2001

2%






ABS CDO High Grade

6%

2002

5%






ABS CDO Mezzanine

25%

2003

5%






CDO Other

10%

2004

8%

5%

5%

15%

10%

10%

Other ABS

10%

2005

8%

5%

5%

15%

10%

10%

2006

15%

8%

8%

35%

10%

10%

2007

15%

8%

8%

35%

10%

10%

Sensitivity Analysis - Deafulat probabilities - Worst case

Vintage

Sub-prime RMBS

Other RMBS

ABS CDO High grade

ABS CDO Mezzanine

CDO other

Other ABS

1998

5%






1999

5%






2000

5%






2001

5%






2002

10%






2003

10%






2004

20%

10%

10%

30%

15%

15%

2005

20%

10%

10%

30%

15%

15%

2006

30%

15%

15%

70%

15%

15%

2007

30%

15%

15%

70%

15%

15%

Published in BoomBustBlog
Thursday, 29 November 2007 00:00

Welcome to the World of Dr. FrankenFinance!

Why a monster, you ask?

Published in BoomBustBlog

I came to this conclusion after a detailed analysis of Ambac's portfolio (at least what Ambac has made public, which was sufficient) covering exposure in the Structured Finance, Sub-prime RMBS and the Consumer Finance business. Ambac's management was forthcoming enough to publish a portion of their insured portfolio which allowed me to review each structure.

I am short Ambac and MBIA (for whom I have also released research), so be aware of my position as I present this opinion. I profit not necessarily from whether ABK can continue as an ongoing concern (which is in doubt and wouldn't hurt my shorts to say the least), nor from an infusion of capital (whether it be debt or equity, either of which would be a poor investment from my perspective) but from the significant decline in value of the existing shares in which I have taken a bearish position. To determine my short position, I calculated relative nominal book valuations, actual economic book valuations and produced standard financial forecasts. Of interest is the loss tail analysis wherein I have estimated the present value of the future losses.

Published in BoomBustBlog
  • I've had this research on MBIA sitting on my desktop for some time now, too busy to convert it into a post for the blog. The macro situation stemming from the real estate bust is unfolding just as I have surmised, albeit a bit quicker and more far reaching than I originally thought. It is scary, for nobody wants to see bad things happen to other people, and I don't want to get caught in a financial downturn regardless of how well prepared I try to make myself. On the other hand, these situations create significant opportunity for gain, primarily from those who refuse to acknowledge the fact that the wave is not only coming, but has reached us quite a while back. I have learned unequivocally what many probably new for some time now. What is that you ask? You really just can't trust government data. Now, I don't want to get into politics and conspiracy theories, but the data as of late has been so far removed from the obvious reality for many that it is almost signaling that the government doesn't even want you to heed the data and is giving you the requisite warning signals. Examples of which are employment data and inflation. Alas, and as usual, I digress, as such is the mind of insane idiot savant that my kids call Dad.

    Now, back to the title - What so special about the number 104? It is the number that will probably scare the pants off of anyone who is in equity investors, or potentially anyone who is a customer, of MBIA's insurance and guarantee products. It is the number that when reached, will leave the equity investor with shareholder certificates worth nothing. It is the number where MBIA's equity is wiped clean. Why are you being so damn cryptic Reggie, you ask? Because, I need for you to go through this history of how we came to this point before I explain in detail, so as to get a clear and comprehensive understanding of the situation. That is part of it; the other part is just because I feel like it. Now, let me give you a little cartoon of what the number is, then a background of how we got in this mess to begin with, then an analysis that shows how I got to this number. As usual, you can click on any graph to enlarge it.

    And then...

    Some time ago I came across this report on the MBIA and ABK by Pershing Square and found it absolutely intriguing. I posted it on this blog on September 3rd, when these companies were trading in the 60's and 70's roughly, and respectively (sometimes it actually pays to read this blog:-). I was actually impressed enough to take a small short position of my own without doing my own forensic analysis. This is something that I regret. Why? Because I am willing to assume significant risk once I convince myself of the strength of a position. Using third party research, I dabble at best - and rarely do I use third party research. So, I dabbled when I should have looked harder and took a significant position. After the fact, I looked further into the industry on an anecdotal basis, then all of a sudden, Bam! The proverbial feces hit the fan blades. The stocks fell so far, so fast, I was taken aback. So, I asked part of my analytical team to take a look at these guys, for I knew that a major problem the monolines, the banks, and the builders all had was a lack of understanding and respect for the rate of decline in value and default of instruments linked to bubble real estate - combined with excessive leverage. So they took a cursory look for me, and they pretty much confirmed my suspicions, but it is not straightforward. There conflicts of interest issues that goes far and wide. So much so, that I will most assuredly not be making anymore friends with this blog. Many of the financial professionals know this, but the layman may not.

    What's wrong with the ratings agencies?

    What's wrong with the ratings agencies? All of the major rating agencies feel MBIA is in good standing to weather the storm. Coincidentally, they all receive significant fees from the monolines and their customers. Hmmm! Now, there is this song by Kanye West, the rapper. A verse goes, "I'm not saying she's a gold digger…" Well, to make a long story short, any analysis born from compensation received from the entity you are analyzing will always be suspect, at least in my eyes. Conflicts of interest and financially incestuous relationships appear rampant to the paranoid conspiracy type (like me). If you remember my analysis of Ryland, I looked at data as far back as 1993. That gave a succinct, but barely acceptable snapshot of what to expect in turbulent times from a historical perspective. You would need much more data to analyze the more complex topic of MBS. It is believed by the naysayers, that the major ratings agencies have sampled data from only the good times, thus that is why their worst case scenarios still smell like roses. Their predictive prowess over the last few years doesn't look very impressive either. Massive swath of investment grade securities (that they, themselves, labeled investment grade - and were paid by the securities' issuers to do so) are being downgraded straight to junk. I know if I invested in AAA bonds that are losing principal and downgraded to junk in a year or two by the same rating that gave it an investment grade rating in the first place, I would be pissed. But, that is what happens without the proper due diligence, I guess. At least that is what the ratings agencies are bound to say. When looking at data gathered from the real estate boom, and not the busts, you get:
    ----- EXTENDED BODY:

    Data sets limited by favorable recent year trends

  • Low interest rates, which improving liquidity which allows bad risks to refi out of their situations
  • Rising home prices, which allow bad risks to sell out of their situations
  • Strong economic environment, allows for better earning power
  • Product innovation (hey, I can sell anything)
  • No payment shocks in existing (boom and bubble) data because borrowers have been able to refinance
  • Performance of securitizations benefited from required and voluntary removal of troubled loans

    Rating agencies assume limited historical correlation (20%-30% for sub-prime) will hold in the future (we've heard this line before) as the credit cycle turns (it is obviously turning now), correlations could approach 100%.

    Just imagine if the ratings agencies are as accurate with their opinion of MBIA as they have been with their opinions on the securities that MBIA insures. Look out below!!!

    Smaller advisories, coincidentally those that do not receive significant fees from the monolines and their customers, have a different take on the monolines. Take Gimme Credit, for example. Gimme Credit downgraded MBIA's bonds to "deteriorating" from "stable" earlier last week, citing the potential for write downs. They also stated that the other major agencies should have done so a while back. CDS market has also moved against the big monolines. I know everyone has an opinion, but the problem starts to look like a problem when you can prognosticate the opinions based on the incestuous nature of the money trail.

    Now, let's be fair to the big agencies

    To be fair to the big ratings agencies, they dance a precarious line. If they do downgrade the monolines, they, by default, downgrade all of the bonds and entities that they insure. That is not just mortgages and CDOs, but municipals, hospitals, etc. This ripples through various investment funds, government funds, the whole nine yards. Then again, it really doesn't look good when the companies that don't get fat fees from the insurers and their clients are so much quicker to downgrade than those that do. So they are damned if they do and damned if they don't. Then again, there a fair share of boutique research houses that say that it would take an extremely fat tail and near 100% correlation amongst the insured securities to cause failure in the monolines. Well, have you ever been to Tasmania? Tasmanian devils have very fat tails, as well as a whole host of other animals such as fat tailed skinks and occurrences with a 1 in 2 million chance of happening such as the outlier that took down LTCM. You see, when everyone is leveraged up, and there is one door when someone yells fire - it is going to get awfully crowded around that exit. Call it correlation, call it common sense, call it whatever, but I think we will soon be calling it a foregone conclusion. These fat tails don't have to be as fat as the financial engineers think they have to be. As for the 100% correlation, well that was briefly mentioned in the bullet list above, but from a common sense perspective, as the subprime underwriting really takes effect (what we have seen thus far is just the start), everyone in leveraged instruments (i.e. everyone) will start running for the exits at the same time - hence 100% correlation. I figured this one out without a model, nor a Financial Engineering PhD. I know there are those who disagree with me or may think that I don't know what I am talking about. Well, a few months will reveal one of us to be wrong. Somehow, I don't think it will be me.

    Relation between MBIA and Channel Re

    Channel Re is a Bermuda-based reinsurance company established to provide 'AAA' rated reinsurance capacity to MBIA. Renaissance Re Holdings Ltd, Partner Reinsurance Co., Ltd, Koch Financial Re Ltd and MBIA Insurance Corp are the investors in Channel Re. MBIA has a 17.4% equity stake in Channel Re and seeded Channel Re with the majority of its business. Channel Re has a preferential relationship with MBIA.

    Channel Re has entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA through June 30, 2009, and subject to renewal thereafter. Channel Re assumed an approximate of US$27 bn (par amount) portfolio of in force business from MBIA Inc and has claims paying resources of approximately US$924 mn. (source Renaissance Re 10K. Swapping Paper Losses Channel Re is insulated against huge losses because of adverse selection in terms of pricing and risk on the assumed portfolio of MBIA. The agreement between the Channel Re and MBIA protects channel Re against any major losses. This financial reinsurance scheme smells a little fishy.

    Is MBIA dumping mark to market losses on Channel Re through reinsurance contracts?

    The SEC and the NYS Insurance Dept. thought so. In addition, there is overlapping risk retained through the relationship - MBIA has an equity investment of 17.4% in Channel Re. Channel Re assumes 52.37% of the total par ceded by MBIA of US$74 bn. The total par ceded not covered through reinsurance contracts due to the equity investment of MBIA in Channel Re is US$6.7 bn. Thus, there is a little under $7 billion dollars of risk that many think MBIA is covered for that it really is not. Then there is the case of diversity of Channel Re's portfolio. I have a slight suspicion that MBIA's business makes up much too much of it to be considered well diversified. Rennaisance Re, the majority owner, has also come clean admitting that Channel Re has a very high exposure to CDO losses and mortgage backed securities. Uh oh! This admission came from the extreme losses Channel Re took last quarter due to mark to market issues for mortgage backed paper. Again, is MBIA doing the old financial reinsurance scheme that was outlawed not too long ago? My gut investor's feeling tells me...For those not familiar with the reinsurance game, here is a primer on financial reinsurance

    Haven't we learned how dangerous leverage can be?

    Particularly when you don't have a firm grasp on the underlying collateral and risks involved

    Do you remember my exclamation of the incestuous relationships? There is the moral hazard issue of everyone getting paid up front except for the ultimate risk holder.

    Keep in mind, in terms of terms of the ratings agencies:

  • They only get paid of the deal closes favorably, and banks go ratings opinion shopping for the desired results - very similar to the residential real estate boom where brokers went shopping amongst appraisers to get the blessed number that they desired. Without that number, the appraiser/ratings agency just won't get paid.

  • Fairness opinion fees are only really not that synonomous with fairness, since the grand arbiter of fairness is the guy that paid to get the deal done in the first place.

  • Structured finance (like that of MBIA's business) is 40% of the rating's agencies' revenues and pay out considerably higher margins than the plain vanilla bond business

  • Reputational risk exists when opinions are changed quickly. They do not want people like me asking why a tranche can go from AA to CCC in a year!!! I think what companies such as Fitch are figuring out is that reputational risk exists in greater part when opinions are changed too slowly and are questioned by pundits publicly in the face of failure. I have noticed that Fitch has gotten much more aggressive than the other two major agencies.

  • There are several other reasons, which I won't go into here, which are bound to lead one to believe that conflicts of interests are rampant.

    So, if I am right, and the insurers are wrong, what happens as default rates increase?

    The 7 graphics immediately above are from the Pershing Capital Report linked above.

    Monoline insurers make a very unique counterparty. Unlike guidance of traditional ISDA contracts, and unlike traditional insurers, financial guarantors don't put capital up front, they don't post additional capital in the case of contract value decline, and need not post additional capital in the case of an adverse change in their credit rating.

    MBIA is woefully undercapitalized in the event of a major mortgage security default event, despite the opinions of the large ratings agencies. Look at the graph and use common sense.

    Image010

    As of Q3 of 07, they had approximately 35 basis points of unallocated reserve to cover net (of reinsurance, see the redundant risk through Channel Re note above) par outstanding financial guaranty contracts. Put in lay terms, MBIA, after buying reinsurance to cover itself for potential losses (some of which it has actually bought from itself), has 35 pennies to pay for every $100 of risk protection that it sells to its customers. This is cutting it thin, no matter which way you look at it. Particularly considering how reliably the subprime underwriting of the recent boom has caused defaults to occur, uniformly and with increasing correlation across multiple and historically disparate underwriting classes. Now, this 35 cents of protection coverage for every $100 of risk translates to extreme leverage. If you think the hedge funds took excessive capital risk due to leverage, you ain't seen nothin' yet.

    Image011

    MBIA easily sports 100x plus leverage for the last quarter or two.

    MBIA has increased exposure to Structured Finance during period of rapid innovation and lower lending standards. It's structured finance exposure has increased along with all of the other housing sector related companies during the boom, more than doubling in the last ten years.

    MBIA has significant capital at risk

    Source: Pershing Capital

    Source: Pershing Capital

    Source: Pershing Capital

    Being so sensitive and exposed to CDOs, one would be curious as to what happens if the CDO spreads widen. Well…

    Effect of Change in spread in CDO

    Figures in Million of dollars

    As of 31/12/2006

    CDO Exposure

    130,900

    Statutory Capital Base

    6800

    Assumed Duration of the CDO bonds

    5

    Change in Spread that can eliminate capital

    In bps

    104

    Capital Eroded

    6807

    Remaining Equity

    -6.8


    So, an increase of 104 basis points in CDO spreads wipes out the equity of MBIA, TOTALLY wipes it out.

    To put this into perspective, let me show you the entire sensitivity grid. Hey, no matter which way you look at, these guys are at risk. They have $6,800 in capital. Just move your finger over any combination of CDO duration and spread in basis points, and if you come close to that 6,800 figure, bingo! The current duration average is approximately 5 years. So the question is, "Will spreads reach 104, or more?" Well, look at the charts above that I posted from Pershing. Better yet, look at the subprime underlyings performance, which can be mimicked by the ABX from markit.com. Horrendous, indeed.


    Sensitivity Analysis

    Spread in BPS

    Duration

    100

    102

    104

    106

    108

    3

    3,927

    4,006

    4,084

    4,163

    4,241

    4

    5,236

    5,341

    5,445

    5,550

    5,655

    5

    6,545

    6,676

    6,807

    6,938

    7,069

    6

    7,854

    8,011

    8,168

    8,325

    8,482

    7

    9,163

    9,346

    9,530

    9,713

    9,896

    MBIA Valuation

    MBIA appears to have engaged in the all so popular share repurchase method of attempting to raise share prices when they don't have anything better to do with shareholder capital. They have authorized and pursued $2.4 billion worth of share repurchases and special dividends. This is unfortunate since one would believe that they need every dime of capital they can get. Did the "program" work? Well, let's see…

    FY2007

    FY2008

    All Figures in Millions of Dollars, unless othrerwise stated

    Mean Multiple

    High Multiple

    Low Multiple

    Mean Multiple

    High Multiple

    Low Multiple

    Tangible Book Value

    6,684

    6,684

    6,684

    7,513

    7,513

    7,513

    Diluted number of shares

    128.7

    128.7

    128.7

    123.71

    123.71

    123.71

    BVPS

    51.9

    51.9

    51.9

    60.7

    60.7

    60.7

    Equity Value Per Share

    $22.7

    $30.1

    $16.2

    $24.5

    $33.6

    $17.5

    Current Stock Price

    $35.2

    $35.2

    $35.2

    $35.2

    $35.2

    $35.2

    (Discount)/Premium to FMV

    55%

    17%

    117%

    44%

    5%

    101%

    Peers

    Name

    Ticker

    Mcap

    Price

    BVPS '07

    BVPS '08

    P/B '07

    P/B '08

    Ambac Financial Group

    ABK

    4,120

    26.39

    65.44

    74.538

    0.40

    0.35

    Assured Guaranty

    AGO

    1,570

    19.8

    34.33

    35.804

    0.58

    0.55

    The PMI Group

    PMI

    1,460

    13.12

    42.05

    43.57

    0.31

    0.30

    Primus Guaranty

    PRS

    420.8

    5.83

    10.05

    11.26

    0.58

    0.52

    Security Capital Assurance Ltd

    SCA

    918.34

    7.06

    22.647

    24.44

    0.31

    0.29

    Average

    0.44

    0.40

    High

    0.58

    0.55

    Low

    0.31

    0.29

    Book Value includes the effect of derivative and foreign currency loss

    So, in a nutshell, despite the significant drop in MBIA's share price, it is still trading at a 55% premium to it's mean adjusted book value comparable price.

    MBIA Management Issues

    • Resigned (5/30/06): Nicholas Ferreri, Chief Financial Officer
    • Retiring (1/11/07): Jay Brown, Chairman of Board of Directors
    • Resigned (2/16/07): Neil Budnick, President of MBIA Insurance Co.
    • Resigned (2/16/07): Mark Zucker, Head of Global Structured Finance

    Is it me, or do they have a vacuum of experienced management approaching? Worse yet, did these guys know something that we should be aware of? After all, looking at the graphs below, the industry is going to run into some rought subprime underwriting times!

    Image015

    Subprime Exposure by Vintage Among the Major Monolines

    Image016

    Remember, the Toxic Waste Vintages are '05, '06 and 1st half of '07

    Source: S&P

    Is Europe next?
    A third of MBIA's revenues stem from abroad, primarily in Europe. Most of the action in Europe is in the UK PFI market. These bonds finance roads, schools, rail projects, tunnels and public buildings. Italy, Spain, Portugal and France are also on the bandwagon. Niche sectors such as non-conforming mortgages in the UK (and possible Spain) are particularly susceptible, primarily for the same reasons they are here in the US. Over building, overvalued housing stock (particularly the UK, Spain and Ireland), lax (subprime) financing, and declining property values under loose regulation. It definitely will not help the European insureds if MBIA gets downgraded or CDS spreads widen considerably.

  • Published in BoomBustBlog
    Monday, 03 September 2007 01:00

    Are the Mortgage Insurers in Serious Trouble?

    A very interesting piece of work on the publicly traded mortgage insurers by an activist hedge fund manager. Well worth the reading.

    Download mortgagensurers.pdf

    Published in BoomBustBlog