Tom A's Stock Picks

Update - bond insurers - ABK & MBI

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I'm back with the same portfolio for SLO2. Because my large positions in ABK and MBI will take a while to play out, I prefer to stay with the portfolio even though my NAV is well under 10. I want to show how I actually invest, which includes holding through in these cases. On Jan 23, I doubled down on ABK, adding 6,900 shares at 8.01, a substantial discount from my original buy at 25.xx. With the stock at 13.xx, that decsion looks good so far.

Both companies have reported 4th quarter and Year end results for 2007, showing substantial mark to market losses as well as actual loss reserves. I listened carefully to both conference calls and updated my workbooks, with particular attention to the adjusted book values (a Non GAAP metric used in the industry) and the adequacy of loss reserves. Also important is developing a feel for how their capital raising efforts are developing. Additional developments include a rescue effort led by the NY Ins Dept., much speculation about possible involvement by billionaire Wilbur Ross, and various rating agency downgrades and pronouncements.

Where I hang my hat is on the price of the stocks compared to the adjusted book values. For ABK, the adjusted book value as pf 12/31/07 is 55.20, with the stock trading at 13.xx, if loss reserves are anywhere near accurate the stock is seriously underpriced. Similarly, for MBI the adjusted book value is 60.31, with the stock trading at 16.xx. In the past, both companies traded in a range with the midpoint more or less equal to adjusted book value.

The adequacy of loss reserves is a difficult issue. The magnitude of potential worst cases losses is also difficult to assess. Both companies had some explaining to do as results for the 4th quarter were far worse than 3rd quarter conference calls suggested. For ABK, David Wallis, who presented, explained that they have changed their approach to what they call a structural or collateral survival approach. Basically what drives losses, and is utilized in this approach, is the combination of rating agency downgrades and the operation of legal provisions in the CDO squared deals. For ABK, this generated a whopping 1.1 billion loss provision related to such deals. For MBI, problems surfaced in the quality of the collateral for HELOC (Home Equity Line of Credit) and CES (Closed End Second mortgage) deals. These were prime, not sub-prime, but 14 deals went bad, due to lower quality collateral than previously seen in such deals. Assumptions used in calculating the reserves included more or less zero recovery from foreclosures, and no effect from rate cuts, fiscal stimulus, or increased involvement by FRE or FNM. The housing market contraction was projected to last 2 years.

I believe both companies have made a strong and conservative effort to assess and accuaretely report their losses, and would not look for further severe adverse development. S&P, Moody's, and Fitch use different methodologies, but arrive at similar estimates of worst case losses. MBI was proactive in raising additional capital and so far has stayed ahead of the curve. ABK was downgraded from triple A to AA by FItch, but they report that they have been talking to credible parties in exploring their startegic options. MBI sounded enthusistic about raising additional capital, but specifics were necessarily lacking. I would guess that their discussions with Warburg Pincus have developed some creative ideas. Both companies generate capital to the extent they stop writing new business - for MBI that figure is about 1 billion per year and over time should ameliorate their situation.

Recent weeks have seen an increased awareness on the part of all market participants of the importance of maintaining stable ratings for the bond insurers to maintain an orderly and competitive bond market. The involvement of the NY Ins Dept and a coalition of 8 banks is a possible plus. Wilbur Ross has given some interviews and encouraged speculation about his intentions. The estimates of how much capital is needed to salvage the industry or make any one insurer fully credible are varied. Egan Jones, an independent credit rating agency hostile to the bond insureres, has estimated 200 billion. WIlliam Ackman, also hostile, has talked about losses in the 20 billion area for ABK and MBI combined. The rating agencies seem to be moving the capital requirements as the situation develops, but as I write this MBI is triple A with three agencies and ABK is triple AA with two. I personally think that the next 500 million will solve the problem for MBI. For ABK, they need to produce Fitch's 1 billion and probably another 500 million. Because these sums are small compared to the potential harm to the entire bond industry and the economy which would be caused by a further loss of credibility, and becuase the actual solvency of MBI or ABK is not really the question, I expect the money will be found somewhere.

I should also add that Gary Dunton, CEO of MBI, talked about the need to be more assertive in combatting the misinformation and disinformation that is being spread about MBI and other industry participants. Spcecifically, company and industry critic William Ackman of Pershing Square has written and said numberous things which need to be contested. MBI made a point of answering any questions put forward by Ackman on their conference call. I am pleased with this approach - as a stockholder, my legitimate interests in my property are at stake and the company needs to defend itself vigorously. I do not want to lose money because Ackman is selling the stock short and elects to support his efforts with negative publicity.

The industry has also come to the awareness that what they were doing with COD sqd and some other transactions was simply too complex. They had lawyers and underwriters designing these deals, the war of weasal words, we'll figure out what it means when something goes wrong, see you in court, so on and so forth. Securitisation is not dead, because the banks prefer to originate and sell mortgages. When it resumes, it will be simpler and more uniform in structure. I don't think the rating agencies, the mortgage originators, the bond insureres, or any other party fully understood the nature of the transactions and the risks they entailed. Now they do. They won't do these things quite the same way again. With the knowledge gained, future transactions will be grounded in economic reality, 100 cents to the dollar.

The business model is sound, but was extended into areas that were not fully understood. Innovation sometimes has unexpected results. But going forward, I think the industry will be a good one. The insurance will have performed its function of providing protection. When that becomes clear, the insurance will again be in demand and a good profit will be possible. Over time, the share prices of both MBI and ABK should tend to revert to approximately 1X adjusted book value, with a corresponding profit to those who bought lower.

Tom