Showing posts with label Ambac. Show all posts
Showing posts with label Ambac. Show all posts

Tuesday, July 22, 2008

Whose definition of subprime?

There is no standard definition of subprime. I used to think of the world in terms of “Household International Subprime” and “Conseco Financial Subprime”. The guys at Household didn’t think you could ever write loans at the Conseco level profitably over a cycle (discussion in year 2000). The HI credit modellers I talked to were well aware of the risks of the business – but thought it was unlikely that there would be severe stress on it outside periods of large unemployment. (They were wrong!)

Nonetheless the year 2000 distinction between Household and Conseco could be given with FICO scores:

· Household Subprime was FICO620 to 680, and

· Conseco subprime was below 620.

I think the guys at HI were more-or-less right. The HI business might be profitable on average over long periods and the Conseco business was hopeless at the outset. [Profitable over long periods does not make it a good business.]

After that conversation the world changed and everyone started doing Conseco subprime. There were plenty of issuers who worked with FICOs of 575 and below. I was short several – not because I thought a blow-up was inevitable –just that that sort of business cannot be profitable over a cycle.

High FICO defaults – or why FICOs were misleading

FICOs have proved not to be a great indicator of default.

There are deals done with a weighted average FICO of 710 which are defaulting very badly – see the FICO in Mish’s bad deal for instance. These deals consisted almost entirely of refinances – often cash-out refinances. A person with very poor credit could show as having good credit if they always repaid their last loan. They can achieve this by sequential cash-out-refinances. (A rolling loan gathers no loss.)

Deals with average FICOs above 700 that are behaving that way usually contain a very large number of cash-out-refis.

Why I mention

One of my games is to look at the definition of subprime that people were using (particularly prior to the recent credit crisis). Lots of companies wanted to deny they did subprime loans – so all they did was define subprime to be a credit notch below where they were. Defining the loan as Alt-A doesn’t make the bad credit go away – but it made you look safe. [See IndyMac for a company that denied doing bad credit by defining good as what they did.]

Anyway here are two definitions that stand out for me. The first is from MGIC – a mortgage insurer. The second from Ambac.

Here is MGIC’s definition (2006 annual report):

A-minus and subprime credit loans are written through the bulk channel. A-minus loans have FICO scores of 575-619, as reported to MGIC at the time a commitment to insure is issued, and subprime loans have FICO scores of less than 575. [MGIC defined prime loans as having a FICO above 620.]

To me this definition was astounding. The whole of Households year 2000 business would be prime by MGIC’s definition.

Ambac drank the poison too. It drank less poison but was less aware that it was doing it. The word FICO never appears in the 2006 annual which is full of soothing words about how they had reduced their underwritings in the subprime area. By the 2007 annual report they included a FICO definition:

FICO scores range from 300 to 850. Though there are no industry standard definitions, generally FICO scores are as follows: prime (FICO score over 710), mid-prime (FICO score between 640 and 710) and sub-prime (FICO score below 640).

The entire MGIC midprime business and some prime business is subprime by Ambac’s definition.

I knew in advance that MGIC’s underwriting standards were worse than Ambac. Much much worse. I was short MGIC and had sold out of Ambac. [I always wanted to be long Ambac as much as anything because I liked the CEO. I just did not like the credit cycle and some deals they were underwriting - so I sold my position well before the top.]

MGIC will pay almost 2 billion in claims this year. They are paying less claims than they anticipated – but not for any good reason – it is just that state legislatures are passing bills to slow down foreclosure and the courts are jammed and there are delays.

Ambac pays about 20 million in claims a month (admittedly rising).

Ambac has many times the claims paying capacity of MGIC and a small fraction of the claims rate.

But MGIC is still writing business and Ambac has almost ceased.

They might both be bust – indeed I express no opinion about the insurance companies. But if MGIC remains solvent and Ambac fails then the world is a very strange place indeed. [I will explore MGIC in more detail in a future post. Suffice to say I have no position long or short and the world might indeed be strange.]

Changing tone on MBIA

I have just sold my small holding of MBIA. I have been convinced - following a careful examination of documents issued for GICs - that this post is incorrect in several important ways. In particular the GICs at MBIA have a larger effect on parent company liquidity than GICs at Ambac.

I still have no opinion whatsoever on the solvency of the insurance company. [I intend to do that work - and if I form an opinion that is worth having then I will again take a position in the stock.] I now however take the view that if the insurance company is bad the parent company is likely bad.

And that the statement by Jay Brown about parent company liquidity in a recent letter to shareholders is actively misleading.

I have retained my holding in Ambac.

I make plenty of mistakes. This sort of mistake I enjoy. I made a profit.

Thursday, July 10, 2008

MBIA and GICs - a follow up

Heard on the Street takes exactly the opposite view of MBIA credit default swaps as me.

One hedge fund manager also emailed me with the same possibility – that the GICs issued by MBIA (and MBIA) will impact parent company liquidity through cross default provisions.

Not so fast

With Ambac it is easier. Here is a corporate structure of Ambac.



The GICs are written by the a subsidiary of Ambac Capital Corporation – not by the parent. They are reinsured by the main reinsurance entity. After that they are guaranteed by Ambac Financial Group (the holding company).

If the GICs get called Ambac has a simple option. Bankrupt Ambac Capital Corporation and pay out of the insurance company. It won’t touch the holding company liquidity provided that the holding company has not guaranteed Ambac Capital Corporation (which as far as I know it has not).

I believe the same structure applies at MBIA. Indeed this Moody's report notes that the GIC business is carried out by a separate subsidiary. If that is the case then the WSJ is straight wrong. It’s a little harder for me to identify the relevant subs because I have not read the contractual terms of any GIC. If you have such documentation let me know.

Wednesday, July 9, 2008

MBIA holding company credit default swaps

Warning: This post needs serious modification to be correct. Several errors are in it and (like most my opinions) should not be relied on. A follow up is here.

As regular readers know I have no opinion as to whether Ambac and MBIA are long-term insolvent at the insurance company level. I really have no idea whether losses will be 2 billion or 20 billion. [I am long the stocks as of a few days ago - but I have no opinion about long-term solvency and when I purchased them I thought there was a reasonable chance that the end-game for both companies was zero.]

I believe that losses will be lower than is implied in the market prices of mortgages, but higher than is indicated in the loss reserves of most banks. That is a very wide band – and for detail within that band you are reading the wrong blog.

I do have something to say about the insanity of the market at the moment. It is about MBIA parent company credit default swaps… I think people holding that parent company default swap are insane.

Background

It is highly unusual in the US for the parent company of an insurance company to guarantee regulated subsidiaries. Fairfax Financial has guaranteed TIG in exchange for getting some Odyssey Re stock out. However that is the exception rather than the norm – and the (California) insurance regulator got the guarantee in response to a specific deal.

Most the time it is possible for the parent company to go bankrupt without the insurance subsidiary (as happened with Conseco) or for the insurance subsidiary to go bankrupt without the parent company (as happened with Freemont General).

It is possible after the bankruptcy of the subsidiary for the regulator to sue the parent company based on fraudulent conveyance or some other rule. But the regulator has no prima-facie right to go after the holding company. (The California Commissioner sued Fremont General arguing fraud. Fremont settled for a large sum of money - but the holding company is still not on the hook for the insurance company liabilities...)

So how is it with MBIA?

MBIA holding company to the best of my knowledge (and having read a few statutory statements) has never guaranteed the insurance subsidiary.

MBIA holding company has well over a billion in cash (including the recently raised money). It got this with its recent capital raising – and was originally going to inject that cash into the regulated subsidiary to maintain the AAA rating.

The rating agencies told MBIA that would not be sufficient to maintain the rating and so MBIA kept it at holding company. The insurance commissioner is peeved – but there is little he can do unless he can prove fraud.

So the MBIA holding company is loaded. Indeed the net cash holdings of the holding company is slightly larger than all holding company obligations. At some point (somewhat lower than here) MBIA becomes a Ben Graham stock.

The point however is that it is highly unlikely for the holding company to go insolvent. Moreover almost all of the holding company debt is due after 2012 – often quite a long time after 2012.

The credit default swaps on the holding company imply a very high chance (well over 50%) of holding company insolvency.

Is everyone mad?

How can MBIA holding company go bust?

I can think of a few ways the holding company can go bust:

  • Well the first way that the holding company can go bust is to inject the holding company money into the insurance company and not be able to get it back. That is what Whitney Tilson – a vocal short – wants to happen. It is also what the insurance commissioner wants to happen but the insurance commissioner motivations are different.
  • The second way is that MBIA uses its holding company loot to buy back lots of shares at the current price – and runs itself out of holding company cash. Certainly MBIA has indicated that it is interested in buy-backs – but I doubt they are that interested.

  • A third way is for the company to inject the money into a new (and hence AAA rated) subsidiary and not be able to get it out of the new subsidiary. Ambac is trying to do that with its existing subsidiary (Connie Lee). However that money is to come from the regulated insurance company and not the holding company.
  • A fourth way is that the insurance commissioner manages to successfully sue the holding company. That seems unlikely to me – but courts are a crap-shoot and anything is possible.

There are probably other ways that the holding company can go bust. I don’t know them all. But the holders of the credit default swap are awful sure that holding company insolvency is inevitable. Too sure.



Full disclosure: the position in Ambac is many times as large as the small position in MBIA. More so after yesterday's trading...

Thursday, July 3, 2008

Things I stuffed up – edition one - Interest rate risk versus credit risk

Anybody that trades stocks makes mistakes. I have made plenty. I would prefer sweep those under the carpet but a little bit of healthy self-flagellation is good for the spirit. Besides I hope it will make me a better investor. Besides I just posted that I purchased Ambac - something that could (easily) wind up as the next mistake. So you should know just how much I stuff up.

So this is the first of (almost certainly) many posts detailing things I stuffed up.

The list for the first choice is long. How about these?

(a) Believing that regional banks of Credit Agricole (which are very good) would offset the losses at the investment bank (which is very bad). Stock is down from 36 to 12.

(b) Believing that the mortgage insurers would blow up this cycle but the bond insurers would probably be OK. Ambac is down 90 to 1ish and is no longer writing much business. MTG (which was my favourite short) is down from 60 to 6 but is writing plenty of business. Got the wrong shorts… and didn’t short the bond insurers…

(c) Believing that the (seemingly extreme) valuation difference between News Corp and other media stocks would solve itself by New Corp’s stock price rising. It didn’t as a stock price comparison of Viacom, Time Warner and News Corp will attest. (It was a wash – all the stocks lost a little.)

(d) Buying Origin Energy at under $2 and selling it at about $4 on the basis that the utility parts of the business were fully recognised. I sold it despite loving the management. It is currently under hostile takeover at $15.60 – and the Aussie dollar in which it is priced has almost doubled. I didn’t recognise just how good the gas assets were. This was non-trivial as the fund I worked for owned almost 5% of the company – and left more half a billion dollars on the table and it was my fault.

Against this it should be pretty hard to tell what the worst intellectual error I made in the past five years is. But I have a candidate. I thought that the interest rate risk in US banks would blow up before the credit risk.

Background

The US has a very unusual mortgage market. Most mortgages have the peculiar term of being fixed rate when rates are rising – but being refinanceable if rates fall. This means that customers pay more for their mortgages than most jurisdictions – but that all the interest rate risks fall on the financial sector.

For instance in most markets the difference between central bank fund rate and the average mortgage rate is less (often much less) than 200bps. In the US it is unusual to get a conventional mortgage at under 6 percent – and the feds fund rate is 200bps. Mortgage margins in the US are more than double most countries.

For this however the system as a whole takes an awful lot of interest rate risk. If short rates were to go to say 8 percent there would be 5-7 trillion in mortgages that yield less than that. Individual institutions might say they were hedged – but the system as a whole cannot be hedged.

I spent an awful lot of time looking for banks and other institutions that were particularly levered to interest rate risk. WestAmerica Bancorp (an otherwise pristine bank) stood out. If you look at the balance sheet I linked in my previous post you will see that it contains $1.5 billion in fixed rate securities financed floating. That number is very significant compared to pre-tax income of 120 million or tangible book value of about 270 million. And WABC is by no means the largest offender.

My back of the envelope calculation was that the system had about 400 billion of pre-tax profits. That included all brokers, all banks, all insurance companies, fund managers – the works.

The US system had 7 trillion of interest rate miss-match. Almost half the profits of the entire US financial system could disappear in a 200bps rise in rates across the yield curve. And they would have disappeared without a penny of credit losses. A lot of institutions would lose their profits entirely. They would in my view all try to hedge simultaneously guaranteeing the dynamic hedging strategies that were in place did not work.

And I thought with Alan Greenspan setting the tone of the Fed the stuff up on inflation and hence interest rates was inevitable. Greenspan never saw a problem he could not fix by pumping more liquidity into the system. I thought Helicopter Ben was even more likely to use a little inflation to get the US out of its mess. Indeed that is where the “helicopter” moniker comes from – a speech to that effect. So essentially whilst I thought that credit problems were sort of inevitable – the US would inflate their way out – and hence the real manifestation would be an interest-rate-risk debacle.

So I spent a couple of years getting completely obsessed about interest rate risk. It led to some OK shorts (eg Fannie and Freddie) but meant I underestimated the credit story.

The credit risk I thought had been passed pretty heavily to the non-bank sector. It existed in the Europeans (I sort of knew about UBS). It existed in the investment banks (including Citigroup). It existed in some regional banks (I knew about Bank United). But I was stunned it wound up quite so bad at Fifth Third. Just stunned.

I thus covered a Fifth Third short many years ago. (Ooops.) I was short a bunch of interest rate risk sensitive banks (such as North Fork which was purchased by Capital One) and I didn’t short MBIA and Ambac. Indeed I was tempted to go long (but fortunately I did not). I made money on a few interest rate shorts – but altogether it was not a profitable activity.

A few years ago the short end of the yield curve was at about 1%. The long end in the 4s and quasi-government guaranteed mortgages were in the high 5s. Borrowing short to buy Fannie Mae backed mortgages was the seeming no-lose trade. Everyone was on it. It didn’t even carry much credit risk because everyone knew the government backed Fannie.

However it carried – and still carries – massive interest rate risk. Everyone seemed to ignore that. My usual reaction – if everyone is doing something then it will probably lose you money. I would rather be on the other side.

Still I remain convinced that this is a theme that will play out. Warren Buffett says inflation is heating up – and he doesn’t stretch the duration of his assets.

There are good people who think inflation is highly unlikely. Paul Krugman (who I admire) suggests that Bernanke should ignore the inflation naysayers. Mish writes for ever on how inflation is not likely – see here and here for examples.

I will get back to this shortcoming one day soon.

John

Wednesday, July 2, 2008

GIGs and Ambac

Warning: Wonkish. Read only if you are interested in Ambac.

The Whitney Tilson post I wrote up on the weekend goes through the issues of GICs and MBIA. The story is that when a municipality raises a bond it doesn’t need all of it straight away. So the bond insurers (using their contacts with the municipalities) sold “guaranteed investment contracts”. These contracts were invested in primarily high-grade instruments (but not Treasuries). A guaranteed return was offered to the municipality. Withdrawal was usually limited to term giving MBIA several opportunities for profit by structuring investments to match total maturity schedules.

The problem for MBIA was that the GICs could be accelerated in the event of a ratings downgrade – either that or the company could be forced to post collateral. The collateral requirements are causing MBIA difficulties.

Ambac has also written GICs and they too can be accelerated. Here is the disclosure in the last annual filing. Note the section bolded by me which says that Ambac has “de-emphasized” this business for reasons primarily related to liquidity needs.

It is clearly a problem in the event of “well defined credit events” (which I presume is a ratings trigger). As to whether this ratings trigger is an issue for the stock: I report – you decide. As to whether these are ultimately parent company liabilities? I will leave that for another post. But if you want to know any earlier than that - read the statutory statements of the insurance subsidiaries.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations, net obligations under interest rate, total return and currency swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded from its operating cash flow, the maturity and sale of its invested assets and from time to time, by inter-company loans and repurchase agreement transactions. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities or sales of securities from its investment portfolio and net receipts from interest rate, currency and total return swaps. The investment objectives with respect to the investment agreement business are preservation of capital by maintaining a minimum average quality rating of AA on invested assets, maximize the net interest rate spread as compared to investment agreements issued and to maintain a liquid floating rate investment portfolio, which includes short term investments, to minimize interest rate and liquidity risk. As of December 31, 2007, the investment agreement business floating rate investment portfolio approximates $6.3 billion or 84% of the investment portfolio related to the investment agreement business. Recently, Ambac decided to de-emphasize the Financial Services businesses. Ambac’s decision to decrease outstanding exposure to the financial services businesses was primarily due to the different liquidity needs of the business compared to the Financial Guarantee business, rating agency views relating to non-core businesses and to allow management to enhance its focus on the financial guarantee business. Ambac believes that this decision should not materially impact the Financial Services business liquidity.

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of the investment agreements. These unanticipated withdrawals could require Ambac to sell investment securities at a loss to the extent other funding sources are unavailable. Ambac utilizes several tools to manage liquidity risk including regular surveillance of the investment agreements for unscheduled withdrawals. In general, Ambac has characterized the portfolio of investment agreements into two broad categories, contingent and fixed withdrawal. As of December 31, 2007, approximately $4.5 billion relates to contingent withdrawal investment agreements. Contingent withdrawal transactions include contractual provisions that allow the investor to withdraw principal and require minimal notice to Ambac. The vast majority of these investment agreements can only be drawn in the event that well-defined, observable events have occurred, primarily credit events. As of December 31, 2007, approximately $3.3 billion relates to fixed withdrawal investment agreements, of which $1.8 billion include provisions where under certain circumstances our counterparty has the ability to withdraw funds during 2008.



Disclosure: I have just purchased a fair size holding in Ambac and a smaller holding in MBIA. I think it is possible (even likely) that both companies go to zero - but I do not think that they do so rapidly. Ambac in particular is trading at out-of-the-money option value only. My expectation of return is high - but I can't eat my expected return and it is entirely possible I will lose 100 percent of my investment. I will sell a fair bit of the position on any big rally. I do not want too many "told you so" emails if I stuff this one up. But then I will not gloat that much if I get it right.

Sunday, June 29, 2008

Whitney Tilson on MBIA

There is a great Whitney Tilson post on MBIA on Seeking Alpha.

To me the key difference between the AA guarantors and the AAA guarantors was that by-and-large the new players in this industry (such as ACA Capital Holdings) had to post lots of collateral in the event of problems - accelerating liquidity concerns and hence bankruptcy. The AAA guarantors by-and-large had to pay when the liability fell due.

This is a huge difference. I have argued several times (see here and here) that the price of various bits of paper in the secondary market is irrational. However I have no idea what the rational price is. Nor does anyone else - not the shorts, not the longs - not anyone.

If you have to mark to market the books of financial institutions they are almost all insolvent. There is an enormous amount of paper that is 20 bid, 90 offered, price you could actually get something closer to 20. If you have to collateralise based on actual values you could get in a trade now (or sell illiquid assets to buy liquid ones for use as eligible collateral) you are stuffed. Simply stuffed.

But if you can sit it out then you are possibly OK. The reason - the defaults might be much lower than currently anticipated in market pricing. Regular readers will know my view is that defaults will be lower than current market prices. I just don't know how much lower and hence I don't know what the end-game is for someone who is levered to this stuff but does not need to post collateral.

ACA Capital Holdings had contracts that demanded it posted collateral and that smashed them up - simply smashed them. Their website is indicative of what happened to the company. But the case for Ambac and MBIA was that by-and-large they did not have to post collateral and hence had hope.

However we now know that MBIA in particular has large collateral requirements. I know of a few more contracts that potentially involve collateral at MBIA. Cumulatively they matter a great deal.

If you are thinking about the bond insurers as a buy (and I am) the collateral requirements are the critical issue. If you don't have collateral requirements then the end points are all that matter. If the things you have insured default at a (much) lower rate than the market currently thinks (something that is possible) then you will make money.

For now you have the hope of much lower end-point defaults. Hope means the stocks have value. Option value only - but as the end outcome is a long way away and a lot of things can happen there should be quite a lot of option value. [One possibility for instance - there is a lot of inflation over say ten years which reduces the real value of the liabilities or increases the nominal value of the assets that back them. That could be a blessing to a bond insurer.]

If you have collateral requirements then end-point solvency is not all that matters. You need to be continuously solvent and on current market prices you are not solvent right now. Whitney Tilson's article is the first widely available and easy to follow discussion of the collateral requirements of MBIA. And this is the critical issue for the stock. Read it.

Now please please contact me if you have done a similar run through Ambac. I have not - but I knew of far less that was collateralised at Ambac than MBIA. And that matters. It's why I sometimes think I want to punt on Ambac. [Indeed I have at various times - but have hedged the position shorting Ambac debt and made good profits by sheer luck. Those were not super speculative positions. Buying Ambac common without shorting the debt is a massively speculative position.]



John

A note - the saga of MBIA saying for years that they had few collateral requirements and then revealing billions of dollars worth of them tells you about trusting management. I can't just ring up Ambac management and ask them about collateral requirements. If you had done that with MBIA you got creamed.

Indeed some very fine fund managers got creamed doing precisely that.

Ronald Regan was right: "trust but verify".

=======================

Post script: I do not agree with everything that Whitney Tilson writes in his Seeking Alpha article. I strongly disagree with his assertion that MBIA has an obligation to downstream the $900 million sitting in the parent company. The buyers of guarantees from MBIA purchased them backed by stated regulatory assets of MBIA's insurance subsidiary not the MBIA parent company. I see no reason why MBIA parent company should increase those regulatory assets unless they are contractually obliged to do so.

Of course Whitney (talking his book) has a different view. I have a suggestion: next time Whitney invests in a stock that goes to zero he should pour more of his clients' money in just to make the creditors happy. (He argues that MBIA should do this with shareholder capital and its insurance subsidiary). If Whitney acts as irrationally as he is demanding the management of MBIA act then I am sure the creditors of his bankrupt investment would thank him.

For once - and perhaps the first time - I find myself strongly agreeing with Tom Brown of Bankstocks.com. [I can't tell you how many times I have thought Tom is speaking nonsense.]

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.