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Insurance as a Political Football is an old American pastime: in point of fact, insurance is the ideal political football - it is poorly understood, everybody has a stake, money is involved, crises can be created, and there are no body bags, amputees, PTSD cases, or other horrible consequences to pay when the game is over. Only religion is better, but that game is discouraged in this country. Of course Political Football has a lot to do with bond insurers ABK and MBI - it defines the current state of the bond insurance industry.
My task as an investment manager is to consider the current political climate as it affects my investments, so I went on the Internet and located the website for the House Committee on Financial Services, where there is information on the hearing on The State of the Bond Insurance Industry, held on Feb. 14. I could have listened to the oral testimony, but in the interest of avoiding severe heartburn I contented myself with reading the Prepared Testimony. By my nature I am far more comfortable with facts and figures than with politics, but here is my take on the politics:
The main source of political support and power here is the interest of debtors and debtholders in the municipal bond industry - the states and municipalities who issue debt and need triple A ratings to get the lowest price, and the pension and retirement funds that are required to hold triple A debt, much of it municipal. NY Governor Spitzer, and NY Superintendent of Insurance Dinallo, who are the primary regulators here, have determined that their biggest political advantage can be derived from protecting the interests of the municipalities and those who own municipal debt. Spitzer will direct Dinallo to put money in anybody's pocket who can make municipal bondholders secure, and Dinallo will stretch or exceed the authority of his office to meet this directive.
Dinallo, with the wisdom of Solomon, has offered the suggestion that they cut the beastly babies in two. Bond insurers can be separated, with the good half being the municipal bond insurance and the second, evil half the Structured Finance. FGIC, a monoline bond insurer that is not publicly traded, and is more seriously undercapitalized, has apparently accepted this alternative. Its second half is particlarly evil. Ambac President Callan has commented that the split offer would be among their alternatives, adding that the two businesses would be of interest to different types of investors, which I would take to be an endorsement of the political attractiveness of the idea.
By different types of investors, I think he was less concerned with shareholders such as myself than he was with potential providers of capital. Wilbur Ross, for example, has been circling this situation interminably, and has an interest in the sub-prime area. He bought American Home, a sub-prime lender: what could be more natural than to buy a Structured Finance Insurance company, which would have the alchemic ability to turn sub-prime plutonium into some kind of higher valued metal, perhaps gold, more likely silver, would you believe lead?
Buffet, having rewritten the specs for the municipal bond insurance business to his entire satisfaction, will benefit somehow. The specs now are, that the rate is 50% higher than it used to be and the insurer holds more capital than would ever be needed to pay claims, which historically have been negligible. Whether he infuses capital, on his terms, or buys outright, on his terms, or has the business handed to him by Dinallo, I don't know.
The importance of the specs is, when you split the baby, or divide the Siamese twins, which half keeps the vital organs, or, in this case, the capital. Municipal bond insurance, according to the rating agencies, does not require very much capital. According to Buffet, it requires more money than God. I think Dinallo will tread a fine line, favoring the municipals, but eventually fiddling the regulations so as to make Structured Finance half acceptable from the point of view of statutory capital adequacy. Bear in mind that both MBI and ABK have an ample excess of statutory capital and they are in no way anywhere near insolvency.
Fitch's role among the rating agencies has been as the heavy. They have now upped their estimate of cumulative losses form 2006 sub-prime to 23%, which is totally beyond anything that will occur. It will be like 15% in my opinion. Try the math: if the collateral is worth half of what it should be, and half of the loans are foreclosed, then cumulative losses are .50 X .50 = .25. Half of these mortgages are not going to end in foreclosure, because house prices are still increasing in half of this country and because that many people put out of their homes will not fly politically. Homeowners are a large constituency and this hits them where they live.
Where does all this leave MBI and ABK? MBI is still triple A - they are playing for the role of the survivor with unblemished ratings, and the ratings agencies are going to be under some pressure to back off and let time provide a factual answer to the loss potential. MBI has plenty of capital, so I don't think there is too much dilution left to be perpetrated no matter how this plays out. Allowing for dilution so far, adjusted book value is in the area of 39 per share. With the stock trading at 12.20 I will continue to hold and may enlarge the position if it moves against me.
The range of outcomes for ABK is less clear. As of this moment, there has been no dilution, and management has affirmed their intention of keeping shareholder interests in the picture. If this takes the form of a rights offering, I will participate fully. The "cut the beastly baby in two" approach raises a classic investment question - is the whole equal to the sum of its parts? How do we do the math? Adjusted book value is 55.20, the shares trade at 10.10. Now we split it in two. Is the municipal bond business worth 1 x book value? Yes, always has been. That would be 27.60. Is the Structured Finance worthless? Hardly, it's a nifty speculative investment: when all those Mark to Market losses reverse to zero (provided there is no actual impairment, don't forget the weasel words), value will remain? Do I hear 5? 10?
Here's the rub. The great partitioners say "Here's a slice for the jackals, here's a couple of ribs for the hyenas, and let's dole out a few messy beakfulls (or is it beaks full) for the vultures." How much of the 55.20 will be left for Tom? Of course ABK isn't dead yet, its just a triple A rated company that has become the target of a witch hunt, instigated by a short-seller, perpetrated by politicians, stabbed in the back by the rating agencies that created its business model. With my average cost at about 18, if the feeding frenzy can be kept to half of the value I will still make out fine. If they only get a third, it will be excellent. Stay tuned. See you in court.
Tom
PS Have you been watching the game in Florida, Allstate vs. the Politicians? Bush league, totally bush. Same down in New Orleans, Louisiana politicians vs. the Insurance Evildoers, Katrina situation. That wasn't much good, the facts were too clear.
You want to see the Super Bowl? watch Social Security, technically OASDI, Old Age, Survivors and Disability Insurance. Insurance, the magic word, everybody has a stake, there is money involved, no body knows the facts, its complicated, you can create a crisis, no body bags, excellent for political posturing, this is America...have a nice day.
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Comments (12)
Love the post and the references... nice job. Gotta think about this new twist for a bit to get my head around it. The only thing I'm concered with now is to make sure that they don't rob Peter to pay Paul and take money saved for the muni backing to bolster capital for the structured finance side. You might make money off this yet Tom. ;-)
Uncle John
Posted by Uncle John | February 16, 2008 10:58 AM
Great post.
I don't follow the muni market, but would be very cautious. In communities with declining home values, assessments will trend lower taking property tax revenues along for the ride. That could put enough of a squeeze on municipalities to lead to defaults. Doubt it would be substantial, but if the default rate exceeds what the insurers have in their models...
Posted by Russell Krull | February 16, 2008 6:37 PM
I think your wrong on your loss estimates since, specially for mbi with their cdo squared, helocs, close end seconds, those losses alone will take out their triple A which in turn will prevent them from making new business WHICH WILL PREVENT THEM FOR USING THE LOSSES TO OFFSET INCOME TAXES(because they wont generate new income big enough to use them), this will make the losses BIGGER than what the rating agencies project(I believe they project something like $2b for mbi)
plus mbi has the off balance sheet exposure of channel re and ram re
but even lets say you are right and buy the stock, If I were you I would buy jan 09 puts contracts for the equivalent position that you hold, you would be paying a piece of your 'guaranteed' earnings you believe you will get in exchange for complete insurance in case the company goes to $0. i think thats a good idea because this is one of those $30 or $0 scenarios
Posted by tradingbr | February 17, 2008 8:52 AM
the taxes thing was something ackman noticed. the rating agencies calculated losses on a after tax basis
Posted by tradingbr | February 17, 2008 8:53 AM
Reply to fo9999:
Suggested reading:
Both MBI and ABK have released the text of their responses to Ackman's "Open Source Model." These responses are available on their websites at www.ambac.com and www.mbia.com. Both companies make very cogent cases - based on the facts and correcting distortions Ackman has used to fabricate his estimates.
Ackman's loss estimates are a self-serving ploy to provide some evidence that he had any reason to believe his wild assertions about potential losses. Please remember that Ackman is a short-seller, with a personal vendetta against MBI which dates back to the demise of Ackman's previous hedgefund, Gotham, which went under due to short-selling MBI and other misguided speculative activity.
Ackman's tactics also rely on buying CDSs on MBI's debt. He is using negative publicity, including seriously distorted misinformation, to support his speculative activities and personal vendetta. He needs for them to have an Event of Default in order to make money, and he is trying to make that happen.
If you wish to continue as Ackman's Acolyte, that is your privilege, my friend, but it is perilous to your financial health.
Tom
Posted by Thomas Armistead | February 17, 2008 11:12 AM
Thomas, you dont think its on chuck chaplin($800,000 pay check plus stocks and options) financial interest to give his rosy scenarios on the future performance of the portfolio(like 'we will take no losses on heloc then oops it will be $800m', and recession is just beginning, you dont think its on marty whitman interest to pump the stock up on cnbc?
Posted by tradingbr | February 17, 2008 5:00 PM
tradingbr,
Everyone acts in their own self interest. However, most members of society do so in a manner that avoids unreasonable harm to others, and conforms to the laws enacted to protect us all. This is a point that I think you either do not understand or are unable to relate to.
I question whether Ackman ever had any reasonable reason to believe that the loss projections he publicized had any validity. The apparent purpose of his statements has been to harm MBI (and, incidentally, everyone who is protected by their insurance or is dependent on the financial stability of this country.) Analyses prepared by MBI and ABK show that the loss estimates Ackman claimed were prepared by an (anonymous) Global Bank were in point of fact prepared by himself on software purchased from Credit Suisse. In order to get losses high enough, his "analysis" was he "plugged" assumptions that would result in the intended amount of losses.
I personally am of the opinion that Ackman's actions will prove to be illegal when properly investigated by the SEC. I have filed a complaint with them by the means provided on their website under securities fraud.
If you think he will be successful in his vendetta, then by all means go out and buy puts on MBI, or short the stock, or buy Credit Default Swaps on MBI's debt, if you feel that is in your own best interest. I personally do not desire for anybody to lose money, but can hardly wish you luck.
Tom
Posted by Thomas Armistead | February 17, 2008 6:38 PM
in other words your with the mbia management when it comes to an stimated $800m loss on this portfolio
http://www.mbia.com/faq/faq_read_answer.jsp?FAQ_ID=338
being the apropriate number?
keep in mind since the recoveries tend to be close to 0 on these exposures whatever the default rate is it will be the ultimate losses, if US goes into recession will this portfolio blow up?I dont think you can invest prudently without knowing this but the management wont provide their shareholders details on fico,location,ltv data of this portfolio. is this the people you wanna trust?
Posted by tradingbr | February 18, 2008 2:21 PM
the management is a lagging indicator on their portfolio, they keep waiting till things look pretty awful till they say they will take losses, the credit protection on their cdos is giving time to breathe but I dont think anybody is expecting a snap back at the housing market and once the protection is burned they will have to announce losses.
Posted by tradingbr | February 18, 2008 2:30 PM
First let me tell you a little bit about myself, it may make my attitude toward the losses more understandable. I spent over 20 years in the Property & Casualty Insurance business, part of that time as an underwriting analyst, and noted that in any insurance business losses develop over time, and it is not possible to estimate them accurately when they first appear. An example would be the asbestos liability crisis, which caused severe losses a number of years ago. Over a period of a year or more, the ultimate size of the losses became clear and the companies adjusted their reserves accordingly. Even earlier, there was a similar pattern as the Products Liability Crisis unfolded.
The same situation is going to apply to these bond insurance losses. What drives the insurance losses, ultimately, is the cumulative loss rate on mortgages. Various rating agencies and others have made estimates of cumulative losses on 2006 sub-prime ranging from 6 or 7% a year ago to as high as 23% (Fitch) as of this moment. These curves stretch out for 10 years or more, and it is impossible to predict their shape based on early data. I personally believe the curves will prove to be front end loaded - and annual additional losses will be closer to historical averages as the 2006 vintage ages.
That stands to reason since a large number of the early defaults in all likelihood consisted of speculators who were caught when the music stopped, or of outright fraud cases. Once that group has been cleared through foreclosure, things are going to quiet down a bit. Have you checked LIBOR lately? It is way down, and resets are going to be less onerous than projected.
Also, the rating agencies are applying the requirement for a cushion of excess capital to their 99.77% stress test which would approximate a Depression similar to what we had in the 1930's. There are a lot more safety nets in place now than there were then and that scenario is extraordinarily unlikely.
This is complicated, and that is why it is so easy for those who want to create a climate of fear and uncertainty to manipulate the market. The loss estimates that the companies use are checked by independent CPA auditors who could be put out of business if they mess up on a pending insolvency on something like this. They are tested by three different rating agencies using three different methods. They are reviewed by the Insurance Departments of several states, including New York, where the department is large and professional.
It is normal for losses to develop over time. This is not a question of management hiding anything and then pulling a rabbit out of the hat, its just how the business is. If losses could be known beforehand, why would anyone buy insurance? And why would anyone write it, knowing the losses were going to occur? But the losses, when all is said and done, are extremely unlikely to exceed the hypothetical stress test levels used by the rating agencies, and would not exhaust the claim-paying resource of either ABK or MBI.
In any event, I am 60 years old: I have watched a lot of crises unfold, many of them in the insurance business. My past experience has been that everybody exaggerates the seriousness of these situations. When it's over, the companies increase their rates and make up for what they lost. The higher rates attract competition, and then everything settles down. There have been several crises over the years in bond insurance and it all worked out fine in the end.
I don't have 20/20 foresight to predict the future, but as I get older I just figure it will be like the past. The past as I interpret it is that these things always provoke an over-reaction. The only difference this time around is the severity of the over-reaction, which is way off the charts.
And yes I support management. Insurance is a mighty popular political football, always has been, and sniping at management is part of the game too. Poor Mike Callan, he's like a quarterback being blitzed, maybe he will take a hit, the game goes on and on, there are no timeouts - then, surprise, surprise, somebody takes the ball and goes home and its all over.
Tom
Posted by Thomas Armistead | February 18, 2008 4:27 PM
1)regarding libor. I believe this is more than offset by declining home prices which is putting alt-a and prime mortgages on the list for losses, subprime borrowers are pretty damn likely to default too even if payments are still affordable on neg equity position. throw in a recession and declining consumer confidence and I think the resets were more than offset
2)regarding the 99.77% and the great depression simulations. this was all done on a after tax basis, if you remove the benefit of offseting future income taxes the losses as calculated by the rating agencies would grow substantially for a big corporation like mbia.
3)regarding the market panic and overblown losses, thats a good point, ackman could be overstating and management/agencies understanding, so I believe middle ground assumption, say $5B in losses on a $6.5b book, plus threats of instant book value loss in case dinallo takes over the muni business to give it away, the present value of $ distribution of a future liquidation to shareholders, which could take years to be finnaly realized thus decreasing its value, doesnt seem to be big enough to bother.
future muni market business will be taken over by buffett and players who didnt got downgraded and Structured finance future business is likely to be shutdown by dinnalo(chuck chaplin doesnt seem to mind and even agrees it might be a good idea)
thats why I'm saying if your a bull its better to buy the stock and a put at the same time to protect your downside at the expense of decreasing your upside a little. I stay bearish on these stocks but I'm open to the possibility of being wrong and constantly throwing arguments against my bias to see if im wrong
Posted by tradingbr | February 18, 2008 5:04 PM
this article says the decline in libor decreased payments by 8% on average, I dont think thats meaninful
http://www.bloomberg.com/apps/news?pid=20601009&sid=aulAek0aCrKM&refer=bond
Posted by tradingbr | February 18, 2008 5:29 PM