Tom A's Stock Picks

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