Tom A's Stock Picks

Financial Guarantors - misunderstood, unloved and undervalued

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MBIA (MBI) and Ambac (ABK) are monoline insurance companies that insure bonds against default, including those issued by governments and corporations, but also including Mortgage Backed Securities and CDOs, many of which are backed by sub-prime collateral. The stock of both companies has been severely punished over the past month, so that both are trading in the area of multi-year lows and well under Adjusted Book Value. Either of them could easily double from their current price.

The attraction here is that both have long histories of stable and profitable growth, increasing their book value approximately 10% (for MBI) to 15% (for ABK) annually over the past ten years. They underwrite to a remote loss standard, meaning that they issue their insurance in the expectation of paying minimal losses. In point of fact, the industry loss ratio is 12% of premium, on average. As a % of capital, losses run about 1% a year. As a % of net par outstanding (insurance in force) they run about .02%. Obviously insurance companies that don't pay a lot of losses are very profitable.

Both companies have insured substantial amounts of Securities backed in part by sub-prime mortgage collateral, and recently there has been a lot of speculation about the size of the final losses they will incur on this coverage. Based on the figures that have been bandied about, as well as the losses that appear to be built into the stock prices, the market does not understand how these transactions are structured and is seriously overestimating the loss potential. This creates an excellent investment opportunity for an investor who is willing to develop an understanding of the business and realistically weigh risk against reward. Basically, I do not expect either of these companies to incur losses from subprime that will prevent them from maintaining their Triple A financial ratings and continuing their profitable growth.

There is an abundance of factual material available, beyond the financial statements. S&P and Moody's have published analyses and statements, supporting the Financial Guarantors assertion that their capital positions are strong enough to maintain their Triple A status under extreme stress, and that such losses as do occur will be manageable. Both companies have disclosures available on their websites. ABK did a very informative conference today, which is available in replay. They have stress tested their book, working from the constituent loans up through the various layers, and with cumulative losses of 22.5% on 2006 and later vintage sub-prime, they would not incur meaningful losses. The 22.5% is a way out number - if loss severity was 50%, that would mean 45% of all sub-prime mortgages would go to foreclosure.

Basically, these companies pay claims on a mortgage backed security after the actual cumulative loss exceeds an attachment point, which could range from 15% to as high as 50% of the par amount. As of this moment, the cumulative loss on 2002 Vintage sub-prime mortgages stands at 5%. This vintage is seasoned and fairly stable. 2006 & 2007 are developing losses at a faster clip, and could very well wind up in the 10-15% range. From a common sense point of view, the maximum expected cumulative losses are under the lowest common attachment point of 15% and as such no losses would be payable. The situation is more complicated if the security insured is a CDO, which bundles other bonds. However, the general result is the same - the cumulative loss on the mortgage backed securities needs to exceed the attachment point, an extremely unlikely occurrence.

Both companies reported large mark to market losses on their Derivative Liabilities for the last quarter. They are providing insurance by means of Credit Default Swaps, and mark to market means they record these liabilities at what they (or their competitors) would charge in order to provide the same protection at today's higher prices. Both expect that these mark to markets will revert to zero as the underlying obligations mature. The mark to markets do not indicate the size of potential losses. This is actually very wonderful, as the price of the insurance goes up, it creates mark to market losses, which would justify higher premiums.

All companies in the industry have reported increased sales for the past quarter, with better premium levels. At this point in time, they are growing more rapidly than in the past, because the current uncertainty creates additional demand and pricing power.

These businesses generate a lot of cash: and, even if there were meaningful losses, they pay the losses on the same schedule that would have applied to the underlying collateral. That is, they pay interest when due and principal when due. As such, they could easily generate cash to pay the claims as this situation develops over a period of years.

I have made substantial investments in these two companies in my SLO portfolio. I think MBI can easily double from its current price, and ABK could triple. The question here would be one of timing. If and when the market develops an understanding of how these companies operate and what their loss exposure acutally is, the stocks should rise rapidly. Both are heavily shorted, and a serious short squeeze could develop. Eventually as the mark to markets revert to zero and as today's higher premiums are earned, these companies will be extremely profitable and will return to their former price levels.