Tom A's Stock Picks

Mr. Market is jonesing

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Already the familiar symptoms are beginning to manifest themselves. Any bad news is catastrophic in its potential implications. Occasionally there is an attempt at a rally, which is promptly squashed by a wave of selling. Volume is high, a broad based decline sets in. Puts are at a premium. The VIX is over 20 again. Credit markets will seize up again.

Fortunately the patient has an appointment scheduled for January 29-30. The kindly Dr. Bernanke and his colleagues will give him a complete checkup. The wonders of modern economic science will enable them to determine the exact cause of his malady and prescribe a fitting remedy.

The outcome is inevitable, known to all the participants in advance. The only cure is a prescription for the drug of choice - rate cuts. Dr. Bernanke will emerge from a consultation with his colleagues, pad in hand. He will write out the scrip. Will it be 25 bps or 50? 25 bps is only a maintenance dose; the patient will walk away in surly disappointment or collapse in despair. 50 would be more like it, the party could go on.

Years ago the somewhat firmer and less gentle Dr. Volcker used other methods of treatment, painful at the time, but in retrospect effective as the symptoms abated.

But this time will be different - stagflation will never set in, there will be no need to resort to any of these harsh and draconian remedies, we can ease the patient off his medications in a little while, wean him as it were, maybe sometime after the middle of the year... maybe early next year. We certainly do not want to provoke a crisis by asking the patient to go cold-turkey. No, that would not be good, the symptoms would get worse, it would be horrible.

If only Dr. Greenspan had been more careful writing prescriptions. He could have done better, he would have done better if he had known how, he should have done better. Sometimes we hear from him: he contributes his wisdom to making a diagnosis. Any day now he will announce that the prognosis is grave.

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A rational suggestion - bond insurer ABK

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Today Andrew Moloff of Evercore Asset Management published a copy of a letter to Ambac's (ABK) board, in which he suggested strongly that they give up on their capital plan and let the company go into runoff.

His reasoning, which is impeccable, is that the company is worth far more to the shareholders that way than if they give it away by raising equity capital. Because Adjusted Book Value, which was over 80 a share as of the end of the last quarter, is radically higher than the current market price, as low as 4.50 today, the shareholders stand to realize far more in a runoff than if the company raises expensive equity capital.

After doing the math on hypothetical equity offerings at 6 a share, I think management would be well-advised to decline to raise capital under today's prohibitive conditions. Assuming S&P's stress case loss estimates, adjusted upward due to their recent change to 19% cumulative losses on 2006 Sub-prime, are an accurate estimate, I see in excess of 40 per share salvage to the shareholders.

On the other hand, If over 1 billion of capital is raised by issuing equity, the share value would be more like 19 a share after accounting for losses, and assuming valuations return to normal.

I own ABK in my personal portfolio and I will be writing to the board, making the same suggestion. Perhaps it is time for Ambac to take their ball and go home. That seems better than giving in to the insanity of the marketplace.

Tom

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Bond insurers - why I continue to hold ABK and MBI

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Krishna Gullapalli suggested I amplify my reasons to hold these stocks. There is an article from Monday's Barron's (the online version is available today) on MBI, similar to ABK. MBI now trades at 8.xx. The writer from Barron's sees 30-40, and explains his position in more detail and with more clarity then I can do myself.

Of great interest is some third party consultant work which Warburg Pincus relied on in agreeing to become involved with MBI. It gets down to the real nitty-gritty, how much money actually goes out the door in any one year. The answer is, under "Armageddon-like" condition, 250 million per year, well within MBI's capacity.

It should be noted that ABK performed a "drill-down" analysis on the CDOs of mezzanine ABS which constitute the worst part of their exposure, and concluded at the time that the deal broke even at 22% cumulative losses on 2006-7 sub-prime. David Wallis presented these findings on November 5. While we don't have a third party verification, I would question specifically Fitch's analysis which appears to see these as more a less a total loss, which they say is why they require ABK to produce another billion of capital to support their ratings.

ABK, if it goes into runoff, has similar attributes to MBI in that it would produce a steady flow of cash in excess of claims payments. Adjusted Book Value/share for ABK, which includes the equity in the unearned premium reserve and the present value of future installment premiums, was 88.07 as of 3Q07 per ABK's website. The book value stood at 55.64. ABK, in pre-announcing their 4th quarter results, which include 5.4 billion pre-tax mark-to-market losses, notes that book value per share will be approximately 21 on that basis. 1.1 billion pre-tax of the mark-to-market represents probable losses, the rest should revert to zero over time.

But, treating the mark-to-market losses as real, adjusted Book Value/share, which approximates runoff value, would be 53/share. ABK has not diluted existing shareholders by raising expensive equity capital. If they never write another policy, the value in runoff is very seriously in excess of Friday's closing price of 6.20.

Because of this I continue to hold large positions in my SLO portfolio.

Please also consider this: if ABK goes into runoff, MBI's prospects are vastly improved. If ABK liquidated over time at 50% of adjusted book value, the stock would go from 6.xx to 26. As the mark-to-markets revert to zero, the situation would improve quarter by quarter, and 26 would be low. MBI, for its part, would soon go over the 31/share the knowledgeable Warburg Pincus is willing to pay. Over time, Warburg would also make money on the warrants at 40/share. An investor paying 8.xx for MBI would make a killing.

It's about the losses. S&P published stress test losses that are well within the capacity of either company to handle. Warburg Pincus had a third party consultant who got results in the same order of magnitude. Perhaps ABK should call in the same third party consultant, if they have not already done so. That consultant could test the validity of ABK's drilldown analysis. The point is, there are third parties out there with the skills to make estimates based on detailed factual information. To the extent that has been done, it validates S&P's published stress test results. Using S&P's stress test as my basic loss assumptions, both stocks are excellent buys on the basis of Price/Adjusted Book Value per share.

I think ABK's decision not to raise equity capital is helpful to everyone concerned. Freddy Mac (FRE) incurred serious losses managing around its regulator's capital requirements. Basically, FRE took needless losses to raise cash by selling assets at fire-sale prices. If ABK manages around the rating agencies' capital requirements in today's insane, fear-crazed market, they will incinerate several billion dollars of shareholder's equity.

As far as MBI goes, I would advocate that they decline to raise any additional capital under adverse conditions.

To me, this is the emotional and intellectual bottom of the market. Both MBI and ABK are Triple A or Double A according to 3 rating agencies. An independent consultant gets results similar to S&P's on the projected losses. Both trade at massive discounts to conservative estimates of the adjusted book value. Both are solvent. Yet the market is starting to discount bonds insured by both, spreading the contagion of fear into the sedate municipal bond arena. I personally believe there is a lot of manipulation involved - the moral hazard involved in the abuse of CDSs for speculative purposes. The lack of an up-tick rule is not helping matters.

I continue to hold MBI and ABK and recommend them to all investors, whether long-term buy and hold or day-traders. You need a tolerance for risk.

Tom

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Mr. Market's malaise

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It got very bad over the weekend before Martin Luther King day. Mr. Market complained of sweats and chills, said he didn't think he would be able to function on Tuesday. "It's going to be just like it was before:" he said, "I won't be able to come up with any bid prices. The ask is easy, but somtimes I just can't come up with a bid. Like MBS, CDOs, ABS, RMBS, ABCP - I just can't do it. There's nothing there." All of us were worried.

Vad said he didn't need any more rate cuts, he could just go cold turkey like a man and he would be fine as soon as he stopped shaking. Duff Beer said all he needed was a couple of cool ones and he would be fine. Duff also suggested a system for bids, Mr. Market could write numbers on scraps of paper, put them into a beer can, and pull them out as needed. Eileen had been talking to Dr. Soros, and she was concerned that this could be serious. Jonathan thought a couple of shots of volatility would straighten him out in no time.

It was late at night. Mr. Market went to the window and looked out at the stars. It was very quiet. "I never planned to let it get to this point. At first, it made it a lot easier to come up with the bids, as soon as I got a rate cut everything would be fine for a couple of months. But now it seems like I need a rate cut every couple of weeks. I just can't function without it."

Finally we called Dr. Bernanke. He is so considerate, so calm, so concerned and thoughtful. We called him at his house. He came right to the phone and listened to the patient's symptoms. Then he called all his colleagues to consult with them. Soon he called back with the good news: we would give Mr. Market an immediate 75 bps and then check him out at his regular appointment.

Tuesday came, and as soon as Mr. Market got his rate cut, things settled down. By Wednesday, it got kind of crazy, he ran around shouting out bids for homebuilders and banks and all kinds of stuff nobody wanted the day before. I was worried - I thought I heard him on his cell phone, bragging about how he copped a prescription for 75 bps.

So here we are, sitting and waiting while Dr. Bernanke confers with his colleagues. Mr. Market has himself convinced he will get another 50 bps. I overheard him, on the cell phone again, I don't know who he was talking to, it might have been a sleazeball mortgage broker or a rogue trader. But what if Dr. Bernanke comes out and says everything's fine, the yield slope is pointing northeast, just like it should, 95% of the working population is employed, orders for durable goods are up. Suppose it's only 25 bps? What if we hear the dread words: "No rate cut for you." ? What then?

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