Ooof, I am in possession of a hefty and detailed presentation on MBIA and Ambac by an investor that is short the stock of the two holding companies. I believe it is kosher to summarize its findings, particularly since it is all derived from public information. And you probably didn’t want to something that long anyhow.
It is one scary and persuasive document. The bottom line: there is no way these companies will survive. Their liabilities are so far in excess of their capital that there is no hope, nada.
Mind you, I have read enough analyst and consultant reports so as not to be fooled easily (in fact, I sometimes get hired to vet them). This work is the real deal.
Having read this, I owe a very big apology to the New York State Superintendent of Insurance, Eric Dinallo. I had criticized him last week for contacting Berkshire Hathaway in November and encouraging them to enter the bond insurance business. I had said the move was badly timed, since Buffett’s entry was another nail in the bond insurers’ coffin. If Berkshire was uncommitted, the fantasy that the Omaha insurer could ride in as a rescuer was still a possibility. And the shocker that a supposedly savvy private equity firm like Warburg Pincus would step up at such a late hour to commit up to a billion in equity to MBIA suggested to me that there might be other chumps, um, investors out there.
But no, Dinallo was right. Neither a rational calculus or sexual favors can explain Warburg Pincus’ planned investment; it must have been extortion. I had somehow thought that there was enough reason to keep the bond insurers on life support (the collateral damage will indeed be dreadful) that some sort of group might step forward and keep them going a while (a year? eighteen months?) till the worst of the fixed income crisis was past, and their downgrades wouldn’t be as damaging as when market psychology was fragile. But I now cannot imagine that will happen given the dreadful fundamentals.
And the truly bizarre thing is that there is so much concern and focus on the imploding equity bases of the big banks and securities firms, and the tsuris of the bond insurers is treated as a sideshow. Yet a crisis at MBIA and Ambac will feed into and amplify problems in Wall Street. Dollars spent rescuing the guarantors (not as ongoing entities, BTW; forbid them to write new business and put them in run-off mode) will stem more damage than pumping a comparable amount of dough into faltering investment banks.
Now to the high points of the treatise:
The stock in MBIA and Ambac is that of their holding companies. It is their insurance subsidiaries that are regulated and write guarantees. The insurance companies can pay dividends of 10% of their surplus per annum, plus special dividends if the powers that be permit it.
For credit guarantees to be attractive to customers, the premium has to be lower than the credit spread assigned by the market. This business model worked for municipal general obligation bonds, which never defaulted (at worst, they missed a few payments) yet the rating agencies graded them more harshly than corporate credits. By contrast, as we have seen, rating agencies have given structured credits higher rating than corporate issuers with similar default probabilities would garner. Thus, the guarantors have gone straight from a low/no risk model to not merely a high-risk model, but one where the economics could not work unless they got exceptionally lucky. To make matters worse, Investors have systematically taken too little spread for the risk of structured bond deals, and the bond guarantors were demanding only a fraction of that already inadequate risk premium for its ratings upgrades.
Now for some numbers:
Annual Premium as a Percent of Exposure:
MBIA 18 basis points
Ambac 21 basis points
Note this figure happens to equal each company’s excess capital/credit exposure. HhhmLeverage (Net Debt Service Outstanding/Statutory Capital)
MBIA 147X
Ambac 143X
The next section goes through the bond insurers’ exposures by business segment. For example, it applies the 3Q CDO writedowns taken by Citi and Merrill, which like the guarantors, were exposed mainly to highly rated paper. Note we’ve had more stunning deductions since then (note that MBIA is using “mark to model” on nearly 93% of its net derivatives exposure). For home equity loans and CES (closed end second mortgages), while mortgage insurers like Radian and MGIC have taken considerable reserves that the market still regards as too low, bond insurers have taken virtually no reserves against these exposures.
The report also looks at the sorry state of the commercial real estate market and other types of exposures, particularly MBIA’s incestuous relationship with its captive reinsurer, Channel Re. After estimating all types of loss exposures, the study concludes that it will take roughly $7 billion per bond insurer to keep their AAAs, if you properly account for their exposures. And that was using end of third quarter levels for the loss estimates, which are now being surpassed by a wave of even greater writeoffs.
And we haven’t even gotten to why their investments might be a tad overstated…..
MBIA also bought back equity back from insiders in 2007 after it suspended its open-market share buybacks (buying back $700+ million of stock when the credit markets were deteriorating is another example of highly dubious judgment).
There is also a section on allegedly abusive holding company/insurance subsidiary transactions by MBIA which allowed “disguised dividends” of hundreds of millions to be upstreamed to the holding company (note dividends are supposed to come only from insurance company surplus and need to be approved by regulators).
The document also has a section on how to salvage the bond insurers (which can only be done by the regulators): eliminating dividends to the holding companies, voiding illegal contracts and guarantees (CDS and synthetic CDO, guarantees on medium-term-notes issued by affiliates, and possibly home equity loan can CES liabilities). Note that this program is consistent with the short of the holding company stock, but it does make sense. The regulators’ and investors’ concern is with the fate of the insurance companies, not their parent.
25 comments
Comments are closed.
Congratulations on the best post yet to appear on the monolines. Much appreciated,
Thanks but I wish I could take credit, or had the time to do such nitty gritty work (I actually enjoy in-depth fundamental analysis). I was just the scribe for a very good document.
Gotham Partners was saying things like this in 2002. I never saw the monolines as viable businesses.
Any chance you could do a very high level primer for the uninitiated on the typical balance sheet of a bond insurer?
I presume these exposures relate to their insurance liabilities and effective equity positions. What do their assets look like generally?
I wrote on the monolines and Gotham Partners (GP) on 20 December. Ackman, then of GP unmasked the monolines in late 2002. Bethany McLean of Fortune wrote about them in 2005. That they have lasted all this time is amazing.
The one thing that is missing from the analysis(s) that purport to shown that MBIA, AMBAC and FGIC are doomed is a list of specific issues indured by any of them that are either in default as to principal and/or interest or can reasonably be expected to be in default in the foreseable future. All of the issues insured by MBIA, AMBAC and FGIC are in the public record. Cant anyone list any specific issue that is in default?
Here’s one
Ambac Now Has a Municipal Bond Issue to Worry About: Joe Mysak
The captain has turned on the “Fasten your seatbelts Sign”..”””Back to your seats boys and girls”””
(From the Citigroup Business Update Call on November 5, 2007 via Seeking Alpha)
Guy Moszkowski – Merrill Lynch
…Maybe you can comment for us as a follow up on the dependence or lack thereof in any of the vehicles that you have exposure to on guarantees or credit support from the mono line insurers like MBIA or AMBAC that have obviously had some pretty significant credit spread blow outs?
Gary Crittenden [Citibank CFO]
We haven’t quantified what that exposure is. They obviously are important counterparties for us in a number of different instruments. I think you raised an important point which is all that I have talked about today are our direct exposures and there’s obviously potentially secondary and tertiary exposures that potentially could exist for the company that are not part of what we have talked about today. This is really the direct exposure that we have. But I would assume virtually everyone else that is a significant financial institution have counterparty exposure to the monoline.
Maybe rating agencies are being “friendly” because part of the problem is of their own.
I wonder what the auditors (KPMG for ambac, PricewaterhouseCoopers for MBIA) would do. Remeber Arthur Andersen
Excellent post. What I wonder is whether there’s someone out there willing to bailout MBIA or ABK a la Bank of America? CFC should have gone to zero, but it remains afloat thanks to BAC. Am I comparing apples to kumquats, or is there someone lurking to “buy” one or both of these companies? The number you present seem to portray a reality even worse than the condition of CFC, but there seems to be a clear agenda that has thus far kept a major financial/corporate meltdown from happening.
Yves,
Interesting post. I would love to know if this is Pershing or another new perspective we’re looking at. I’d also love to know how they come up with their loss assumptions. I guess they don’t really want the details of their report published. Too bad.
Insurance guy,
Pershing has gotten a lot of play, but they aren’t the only ones down on MBIA and Ambac.
As for the analysis, per the CDO and home equity/second mortgage discussion, they relied on public company proxies where possible. When not, they used indices or estimates by others (investment bank research, rating agencies).
The reason I took their work seriously was despite the overwhelmingly negative conclusion, they went through other types of comparables for their loss/downside estimates, and picked middle of the road comparisons rather than the most dire.
Yves:
Is this your 100 page document of the monlines?
http://pershingsquare.valueinvestingcongress.com/files/How%20to%20Save%20the%20Bond%20Insurers.pdf
Thanks, Yves. Sounds scary. I wish I had access to the paper.
Love your site by the way. Its become a staple of my morning read. Thanks.
I have just finished reading that Bond Insurers report. It is insane!
Forget about highway robbery this is far more profitable.
Wow! You sure called this one in advance…
As a buy-side fixed-income analyst who has followed the bond insurer saga very closely, I have several problems with the Pershing analysis.
First, the CDO loss projections are simple approximations from the market prices of indices such as ABX and TABX. These indices are largely hedging vehicles that have been driven down disproportionately by massive Street hedging, as well as momentum-driven fast money bets. Many analysts concede that the level of cumulative losses implied by the ABX is higher than their projections. The indices are also a poor proxy for the broad market, as they are weighted toward lower quality deals.
Furthermore, the quality of bond insurers’ portfolios is higher than that of the broad market. You can verify this not only by checking out each insurer’s disclosure of the vintage and asset class composition of its CDOs, but also by referring to S&P’s December report that stated that the downward ratings migration of the broad universe of RMBS and ABS CDO securities was over 4x that of similar exposures insured by the monolines.
There is a lot of debate and uncertainty on how to measure projected CDO losses, so you could argue my points above. However, regarding CMBS, almost every CMBS analyst would agree that extrapolating cumulative losses of CMBS from the current level of CMBX is ridiculous. The extent to which CRE will fall is debatable, but current CMBX levels are driven by contagion from other stressed structured products, namely ABX.
Also, the argument against the mark to model approach that market spreads are a “probabilistic assessment of default risk and recovery” ignores the fact that current CDO and RMBS spreads incorporate huge liquidity discounts, in that any sellers are forced sellers at distressed prices.
The Pershing document linked above, if it is the one you’re referring to (sounds like it is), is from the end of November. Obviously Ackman and co. have gotten the call right, but the monolines’ downfall since November has been almost entirely due to market issues, rather than the fundamental risk of their insured portfolios going up.
The decrease in confidence in the monolines because of the efforts of those such as Pershing has driven down the stock price of the insurers, which in turn reduces their financial flexibility and their capital adequacy. This has continued to spiral into a self-fulfilling prophecy in which the bears may turn out to be right just because the market believed they were right.
The actual level of losses incurred by these companies may not be known for many, many years, as the obligations are relatively long-term in nature and take a while to play out. In particular, since the insurers hold the super-senior positions on the CDOs they insure, if and when insured CDOs breach triggers they will choose not to liquidate but to accelerate payments to their senior tranches, thus reducing their par at risk.
Furthermore, even all loss subordination is breached and the insurer has to pay a claim, the insurer is only liable for scheduled interest and principal payments when due, not the entire amount all at once.
These are all important points to consider when you make broad, sweeping conclusions like “there is no way these companies will survive.”
S,
Did you read either what I wrote, or what the Pershing document said? It most certainly did NOT base the CDO loss estimates on the indices. It used the average of Merrill and Citi 3Q writedown. Both firms claimed their holdings were almost enirely AAA (Merrill said AAA, Citi said “super senior”). This would make their exposures similar to the sort that the monolines are exposed to.
Pershing has concluded that MBIA’s holding company will run out of cash in a best case scenario, by the end of 2008, but under a different scenario, in six months. I suggest you read their reasoning before taking issue with it.
The only place Pershing used indicies as a proxy for loss exposure was with CMBS, not CDOs.
Your comment indicates you have not read the document. I suggest you do so.
Using Merrill and Citi exposures as proxies for the writedowns is as similarly misguided as using the indices. Why? Because Merrill and Citi based their writedowns on their estimates of what they could get for their exposures if they had to sell at current market prices. And in cases in which there are no current market prices for particular CDOs, they estimate market prices based on index levels. Merrill and Citi HAVE to do this because their CDO exposures are classified as trading assets. It doesn’t matter what they think actual losses will be if held to maturity, they need to mark them to what they would be worth in a liquidation scenario.
I did read the document and I very much liked the part on how the bond insurers mark to model. I agree that the model methodology understates the insurers’ loss exposure relative to actual market spread levels, but that is if actual spread levels correctly reflect the level of ultimate losses. So again you get into the issue of predicting losses based on market levels.
As a second point, although retained investment bank CDO exposure is largely super senior AAA (I believe Merrill also specified this in its 3Q call commentary), there are huge differences in CDOs such that you cannot group all super senior ABS CDOs together and state that if one portfolio of super senior ABS CDOs has this percentage of losses, then another should as well. Important distinctions include CDO vintage, high grade versus mezzanine CDOs, asset class collateral composition, exposure to ‘inner’ CDOs, and loss subordination protection levels. These distinctions make HUGE differences in the amount of losses that may ultimately be incurred, especially at the super senior AAA level of a HG ABS CDO. These are complex instruments of which there was little standardization, so it is very difficult to approximate the losses of one portfolio of CDOs based on another without much more information.
Here are some of the commonly attributed reasons for why the CDO portfolios of Merrill and Citi may be worse than that of the bond insurers. The investment banks utilized bond insurers to get some super senior risk off their balance sheets, and fully retained other risk. The writedowns were on the fully retained portion, not the insured portion (yet). CDOs retained by the IBs may have been those that they could not find attractive insurance for, as some bond insurers stepped back from the market in 2007. Also, bond insurers are (believe it or not) selective with what they insure, so that which was not insured could be deduced to be riskier and therefore less attractive to the bond insurance underwriter.
Furthermore, retained IB exposure (again, refer back to Merrill’s 3Q conference call commentary) of CDOs is primarily from this year; much of the older vintage CDOs are no longer on the books. CDOs from this year contain collateral from early this year and 2006, which are the worst vintages. CDOs containing older vintages are less toxic. While bond insurers certainly have plenty of exposure to 2006 and 2007 vintage CDOs, the proportion of their insured CDOs in the worst vintages is likely less than that of the retained portfolios of the IBs.
Thanks for your post, your commentary and the research you have done. I am not attempting to be combative, I am simply raising points that I know to be valid based on work I have done all year. I’m not suggesting that Pershing’s analysis is entirely invalid, but I do think that their arguments (and those of a lot of bears) had some problems in them. This is unfortunate because it became relatively easy for analysts such as myself and those in the Street to refute those arguments. Now, as the downgrades have begun, we are forced to admit that Ackman was right in his bearish call. But it is still relevant to bring up issues in methodology that may be incorrect, because the story is far from over. As the focus now turns to runoff scenarios, there will continue to be speculation and uncertainty regarding the actual levels of losses incurred by the insured exposures.
I would suggest to you that you not place too much focus on a single document. If you have access, I suggest the UBS piece put out on January 8th, which is the most comprehensive piece put out recently, as well as the reports from Citi Equity and BofA Equity this week (in which they threw in the towel on their Buys). Beyond simply gloating about the fact that these guys were wrong, you should pick up some of the other issues at hand and focus on what may come going forward. If you are truly interested in this issue, I would also suggest that you look closer at these companies, examine their disclosure (ABK’s is the best), listen to their past conference calls and presentations, and look at some of the Street research from the past several months so that you can understand why, from an analytical perspective, many did not believe prospects for these companies would become as dire as they have in the last week.
Buffett is spelled with 2 t’s.
S,
Agreed with your points re the merit of considering other research and conference calls. However, not being an institutional investor, I have to rely on the kindness of readers in either passing it on or highlighting where to find it, on those comparatively rare occasions when document are made available in toto.
Your observation about Merrill having junkier CDOs by virtue of having unsold recent inventory is valid; not so certain re Citi, since their exposures came by virtue of their having structured CDOs where the senior debt was commercial paper, and they had a obligation to fund if the CP couldn’t be rolled. My impression is that they had been doing that longer (perhaps as far back as 2005).
Also, remember as of 3Q, the new FASB provisions regarding Level 3 assets were not in effect. Merrill and Citi may well have used indices for valuation purposes, but it would have been kosher for them to use other methods. I haven’t listened to their conference calls, but my recollection (and apologies for not checking) is the writedowns were lower (meaning more favorable to the bank) than the level at which the ABX for AAA instruments was trading.
The media has also blurred over the differences between the two. Ambac is far more heavily exposed to CDOs; MBIA has meaningful exposures to commercial real estate and below investment grade securities, and, as Pershing discussed at considerable length, its problemmatic relationship with ChannelRe.
I don’t see how the holding companies can make it, nor do I see how the insurance subs won’t be downgraded. To me, that is pretty devastating for them. it would be better if I were wrong, but it still seems that a likely endgame is that they are put in runoff mode by the regulators. But if that happens, presumably there will be more forensic work on exactly what they own, and a much better reading on how undercapitalized they are.
Anon of 4:02 PM,
Thanks for the catch. Have fixed it. As regular readers may know, I have a real problem with typos (I have spelled Buffett correctly in other posts). I do appreciate it when people point them out. They are embarrassing!
Buy side analyst:
I don’t believe that Merrill’s marks on their mezz CDOs should be viewed as overdone by some short term market phenomenon and neither apparently does John Thain. From the Merrill conference call:
———————
“Prashant Bhatia, Citigroup – Analyst
And then, can you give any sensitivity to the [subprime] cumulative loss assumptions, I think, you said 16 to 21%. It’s clearly not linear so if it ends up being higher or lower can you give any kind of sensitivity there on the impact?
John Thain, Merrill Lynch & Company, Inc. – Chairman, CEO
The problem is, as you know, that the, it’s very dependent on the deal structure on a name by name basis. It’s dependent on the vintage of the mortgages. The 16 to 21% was intended to give you the kind of the average range that we’re looking at. It’s very hard to get much more detailed to that other than, unless you actually run the individual positions….
Prashant Bhatia, Citigroup – Analyst
And maybe asking it another way, you’ve taken over $20 billion in writedowns over the last couple of quarters. What percentage of that would you say is a writedown to reflect a market environment that exists today that may not exist tomorrow? For example, how much do you think is really a liquidity type mark based on the environment?…..
John Thain, Merrill Lynch & Company, Inc. – Chairman, CEO
Yes, I’m not sure if you’re trying to get at whether there’s the ability to recover some of the losses.
Prashant Bhatia, Citigroup – Analyst
That’s exactly what I’m trying to get at.
John Thain, Merrill Lynch & Company, Inc. – Chairman, CEO
That’s what I thought. I think on the CDOs specifically, I think it’s not likely that these things are going recover because the fundamental assumptions as to home price declines and cumulative losses, I think, as I said, I think we’re being conservative but I don’t think that we’re likely to get much back on these things.
So I don’t think it’s like just where you have an illiquid market where the liquidity comes back and you recover a lot of it. I don’t think that’s going to be the case here.”
——————
Moreover, the dubious nature of Ambac’s “models” was exposed in their most recent conference call. This is a long winded CYA type of explanation as to why their prior forecast of impairments have been so far off the mark – the plain unvarnished version is ” we finally got around to reading the documents and understanding the ratings triggers, and guess what, a bunch these CDO squareds are going to have their cash flows cut off since the collateral has been downgraded”. I think the credibility of the monolines loss estimates, to the extent it still existed before, went out the window with this conference call.
———————–
David Wallis Sr. MD Risk Mgmt:
“I’d like to focus on the key question — how have we computed Ambac’s likely $1.1 billion CDO impairment, primarily booked in respect to Ambac’s CDO-squared transactions? And what has changed from prior periods?
To cut to the chase, different loss estimates can arise from different methodologies and different assumptions within the same methodology. And what I will be discussing in some detail is an evolution of our analytic focus as we believed events have dictated…
Having talked about the ways in which the CDO-squared loss estimates may be computed, I’d like to make a few comments about their respective results. Leaving aside the market value approach, our analysis produces the result that it is the latter structure approach which produces the highest estimate of loss under our own assumptions. The approach also provides the most transparent and credible framework, given the combination of the current environment and our understanding of the transactions themselves. As stated previously, it is this methodology which forms the basis for the impairment noted.
To illustrate this further, let’s briefly discuss some comparative results and point out what we see as the main flaws in some of the discarded methodologies — the CDO model approach.
Aside from the possible tardiness or inadequacy of ratings as indicators of the probability of default — no criticism is intended here — the model approach has the deficiency of not being able to capture the legal and structural mechanics of the transaction as discussed earlier. As stated, the reason is that at a certain point the dominant driver becomes the affect of the degraded ratings in combination with the legal structure as against the model implied increase in default probability driven by collateral downgrade itself.
Essentially, collateral ratings may give off falsely optimistic signals given the legal structure. The models seize and assigns cash flow to assets that are structurally blocked. Fundamentally, past a certain point of rating degradation, structure likely triumphs over collateral default probabilities, as implied by ratings.
What about the cumulative loss approach? It’s really the same story as before. Here, structure triumphs over cash flow. Potential value in the underlying RMBS, which cusip level drill-down analysis may assert does exist given the vintage distributions, et cetera, simply doesn’t get to be realized by the insured CDO because of the impact of the intervening ratings and structural features. Again, cash flows are blocked.
So to summarize this discussion — and this will hopefully be clear from the above — what has changed and therefore led to the deterioration in loss estimates that we have announced? Essentially two things in combination. Firstly, an exceedingly rapid and substantial set of rating agency downgrades starting towards the middle of October and continuing thereafter.
Secondly, resulting from the above, an evolution in our analytic focus from model or drill down analysis to an examination which concluded that at a certain switch point, legal and structural mechanics will likely triumph over model expectations and the fundamental MBS cash flow analysis.”
————————
Full disclosure: I’m short the stock. But the bottom line is these guys went way off the reservation in deciding to insure structured finance assets for which there were no reliable loss estimates. The losses are going to be enormous and dwarf the pathetically thin capital bases reserved against these risks.
Yes, they won’t go out of business tomorrow, but that doesn’t matter to the rating agencies – it is the adequacy of the capital levels that count – and the rating agencies, at a time and place they view as politically appropriate, will come to the conclusion that the monolines need far more capital to retain a AAA rating. I see no way they can raise sufficient capital without effectively diluting their existing shareholders out of their positions.
“The bottom line: there is no way these companies will survive. Their liabilities are so far in excess of their capital that there is no hope, nada.”
They survived without a government bailout.
Ambac is trying to get a bailout even now. And they are effectively in runoff mode. They are not writing meaningful new business.