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The past week has been hectic as the bond insurance crisis has drawn increasing attention due the NY Insurance Superintendent Dinallo's efforts to bring the parties together to arrive at a solution. In particular, his willingness to permit a split of the bond insurers between municipal bonds and structured finance (good bank/bad bank) has drawn a lot of public debate and analysis of the effect on various stakeholders. I have a lot of opinions on the issues, but staying on task entails reviewing my portfolio in terms of recent developments and making any changes required.
The two largest positions are bond insurers Ambac (ABK) and MBIA (MBI), in which I have substantial unrealized losses. My original thesis, that their losses from sub-prime would be manageable within the context of their existing capital structure, has been shattered. For MBI, I took a ride from 31 down to a low of 6.75: for ABK, I went from 25 to a low of 4.50. Both have rallied off their lows, MBI is at 12.29, and ABK stands at 10.90. I have added to both positions since they hit their bottoms, and achieved some reduction in my losses by doing so. There has been a deluge of new information, and I need to re-evaluate my positions accordingly.
Sunk Costs - When I am doing it the way I think I should, I make my investment decisions without considering the size of my unrealized gains or losses. For ABK and MBI, my unrealized losses are a sunk cost - I look at their market price today, compare it to my best estimate of a target price and date, and make my decisions accordingly. While this decision making technique is logical, it can let you dig a pretty deep hole on a stock that continues to decline, as these have done until recently. Those who cut their losses at 10% or 20% can only shake their heads in wonder.
Ambac rallied 20% late Friday, on rumors of an impending capital infusion by a consortium of banks who own debt it has insured. Ambac has publicly stated that splitting the company is an option, and commentators have suggested that recapitalizing the company would be a necessary first step to the split. Ambac also notes that it owns Connie Stevens insurance, licensed in 47 states and available as a vehicle for the split. Options activity on ABK has featured the heavy buying of calls - on Friday 22,844 of the March 10 Calls traded, vs. an open interest of 21,556. For the May 10 Calls, 25,798 traded vs. and open interest of 5,646. Something is moving around under the water: information is leaking out, or misinformation is being spread. New York Governor Spitzer asserted on the 14th that he would be imposing a 3-5 day deadline on the parties. Now everyone wonders, was that calendar days, Governor, or was it working days?
My replacement thesis holds that the outside limit for losses can be estimated by referring to S&P's estimate of the same, published after it revised its estimate of 2006 sub-prime cumulative losses from 14% to 19%. That thesis is supported by Fitch's testimony before the House Committee on Financial Services - Fitch has a 23% estimate of cumulative 2006 sub-prime losses but does not envision insolvency issues for either MBI or ABK. Based on this interpretation, I see most of ABK's 12/31/2007 adjusted Book Value, 55.20, as being available to support the share price, currently 10.90, normally around 1 x adjusted book. The question is how much will be lost to dilution or as profit to those who participate in creating the solution.
Mike Callan is serving as Ambac's CEO, and he gave an interview in the WSJ, published Feb 14th, in which he noted that negotiations are all about time, urgency and deadlines, adding "you have to be willing to walk away from the table." Ambac cited difficult market conditions and shareholder concerns about dilution when it cancelled an earlier equity offering. I see grounds for optimism, that management will not give away an excessive amount of shareholder value in forging a solution. I am planning to hold until word about the outcome of the recapitalization negotiations comes out. When that occurs, it will in all likelihood include some dilution of shareholder value - my decision making process will be to recompute the adjusted Book Value per share, compare that target to the current share price, guess at a time frame for the price to recover and , and take it from there. In point of fact today's WSJ has an article, citing "sources close to the matter," which sees 2.5 billion equity and .5 debt. Perhaps the equity part is a back stop arrangement to a rights offering, in which case my decision is whether to participate at the price available. I put some assumptions into my spreadsheet and I am ready to decide quickly.
I think a sale of either half of the business is somewhat unlikely, because of issues around which half gets how much capital. The rating agency models say that the municipal bond business doesn't require much capital, but Buffet's munificent offer put a large amount of capital on the table, in effect proposing a model for the municipal bond insurance business that is more capital intensive than before. The politics of the situation leans that way. But if the structured finance half requires most of the capital, in effect it would be over-capitalized in my view, which holds that expected losses are over-estimated by most players. I see a shell game, in which the excess capital is the pea. If either half is sold, I have no control over the outcome - it's up to management to negotiate in my interest. If, as I would prefer, the split is effected by spinning one half off to the existing shareholders, I can evaluate each half separately and take it from there.
For MBI the situation differs in that they were proactive in raising capital, incurring serious dilution for shareholders, and paying an excessive rate of interest on the Surplus notes. Recent news is mixed - CEO Gary Dunton was replaced by his predecessor, Jay Brown, which drew little comment. My take was that Gary was a good enough manager under normal conditions, diligent and conformist, the captain at the helm on a serene cruise. The change may reflect the board's opinion that a more assertive style may now be in order, a tougher player in the game of political football: also, the new CEO is not associated with the bloodbath incurred in the interest of raising capital. Brown wrote a letter to shareholders, I responded with a doctoral dissertation, explaining what he needed to do. I felt better afterwards. Moody's downgraded Capital Re, which is 17% owned by MBI, and which reinsures a chunk of MBI's business, from AAA to AA3. MBI withdrew from AFGI, their trade association, citing reasons that did not seem to carry too much weight.
I was surprised and pleased to receive a brief note from Jay Brown, responding to my communication. He is a shareholder, 618,000 shares, and his views on industry issues are in many ways similar to mine. Based on his concern to include shareholder interests in the mix of what needs to be considered in arriving at solutions, I will be holding my MBI with more confidence, monitoring developments.
Olin (OLN) reported that they had invoked force majeure on deliveries of caustic soda. That means they are excused from honoring their contracts, due to conditions beyond their control. They cited weather, operating problems at certain plants, and reduced demand for chlorine, which has storage limitations and is produced in a fixed ratio to caustic soda in the Chlor Alkali process. I had reduced my OLN position somewhat in the interest of compliance. This is going to hurt their profitability short term, but I am planning to hold through, based on my opinion of long term potential.
I own some Homebuilders, TOL and RYL, they have at times been near their midpoint compared to their new book values, which include a lot of writeoffs. I reduced the positions a few weeks ago, near a high point, and now I am starting to think about "phantom" book value. I have seen commentators discuss how the mark to market losses on land and developments in progress may facilitate greater profits when housing recovers, so that the writeoffs need to be kept in mind when considering what their assets really are.
Applied Materails (AMAT) reported, better than expected. Significantly, Solar is beginning to ramp for them. The stock has rallied on the news, which supports my thesis, so I continue to hold.
Masco (MAS) reported, a disappointment and weak outlook. They are in building supplies, this is hardly surprising. I am holding based on long term potential.
BJ Services (BJS) is in oil and gas services, and has been rallying with the higher price of oil. I consider the stock seriously undervalued and will continue to hold.
JNJ is basically a safety/security ploy, undervalued but unlikely to move rapidly. I am holding the position, although it can be liquidated if I need funds to respond to developing opportunities.
Allstate (ALL) is an old standby, I love insurance, it's undervalued and I will hold. The position is unlikely to move quickly and is available to liquidate if I find a better use for the funds.
Novellus Systems (NVLS) is a recent addition, a semiconductor equipment maker, attractive on the basis of P/E, P/B, etc. The industry is not much in favor now, cyclical slowdown, but my new strategy of using my brokerage's recommendations as a momentum factor, to combine with my value factors, suggests this will perform well.
Monday and Tuesday could be exciting. The market rallied on the Ambac news Friday, and possibly a successful resolution early next week could provoke another rally.
Tom
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