Tom A's Stock Picks

Let's talk about the Elephant in the Room - MBI & ABK

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Moody's is reviewing MBI and ABK for likely downgrades to Aa, or in MBI's case, A. This has generated a lot of news coverage, but rather than rehash that information this post will focus on the question - why the prices for CDS referencing ABK or MBI imply junk status, while the ratings agencies have been holding the line at triple A or double A? This has been referred to as the Elephant in the Room, so's let's start a discussion.

MBI and ABK at one point had 9 A's each, 3 from each of the major rating agencies. Right now, they have 8 A's, missing one from Fitch. It is likely that soon they will have 7 A's, missing one from Moody's and one from Fitch.

CDS protection on MBI or ABK has been trading at prices that imply junk status for at least 6 months. Yesterday, the price for 5 year CDS protection on MBI or ABK was in excess of 20% up front, plus 5% per year. Somebody is wrong here: the probablility of default by a company with 7 or 8 A's is nowhere near 25%.

MBI CEO Jay Brown addressed this question in a letter to shareholders. http://investor.mbia.com/phoenix.zhtml?c=88095&p=irol-newsArticle&ID=1116687&highlight= Brown summarizes the question about CDS spreads and then walks the reader through MBI's cash flows for the next five years, concluding that there is no danger of liquidity issues arising. He then attributes the price spread to manipulation of the news media by short-sellers intent on getting profits by inflating the price of CDS protection on MBI.

MBI's 1st quarter earnings presentation goes over potential liquidity issues at some length, displaying information as to future cash receipts from premiums and investment income and future disbursements from loss payments. It also includes a presentation of collateral requirments for their Asset Management businss, addressing the need to post collateral in the event of a downgrade. The chart demonstrates that they are good down to BBB and Chuck Chaplin states during the presentation that they have no material exposure to additional collateral requirments due to downgrades to less than BBB. Here is a link to the presentation: http://investor.mbia.com/phoenix.zhtml?c=88095&p=irol-presentations

While I am sympathetic to Jay Brown's point of view, I am starting to wonder whether it is logically possible to sustain so large a discrepancy based on a theory of manipulation. There aren't that many suckers out there, and any of them that got into the Credit Default business wouldn't last all that long. Apparently there are a lot of buyers who are wiling to pay a premium price to bet against MBI or ABK.

Possibly these traders have information about something the rating agencies don't know and the companies involved won't confess to - that would be massive losses above and beyond what has already been recognized by mark to market accounting, and beyond what the agencies assume in their 99.9% stress scenarios.

I took a look at Ackman's Open Source document, which is available on line. What I got was a spreadsheet that was too big for my hardware/software combo - I could look but I couldn't change the information to test assumptions. Many of the loss estimates had apparently just been dropped in - there were no formulas in evidence. Perhaps a macro accessed a program to develop the loss estimates, but the nature of that software and the assumptions employed are undocumented. Using ABK's available disclosures on line, I created a similar Excel workbook, and using assumptions that I felt were severe I could match mark to market losses but higher than that seemed unrealistic.

On the other hand, I was able to locate the prospectus for a number of ABK's CDO deals on the Irish Stock Exchange and they were large and complex documents, full of risk warnings, and none too reassuring. Noting ABK bought the farm on a couple of CDO squared transactions, it is not possible to rule out further egregious underwriting error.

ABK and MBI in presenting their losses detail the assumptins used, which are conservative and do not make any allowance for remediation efforts. Remediation could consist of warranties and representations claims, among other things. MBI and ABK expect recoveries to be "material" or "substantial." Countrywide Financial and Merill Lynch (who acquired First Franklin) have reserves for representations and warranties arising from securitizations and the sums involved are material, so there is some credibility here. Intuitively I feel there would be some problems in any book of mortgages that you look at carefully, and more in books that originated as the housing bubble was maxing out.

I suppose anything is possible, but the price on CDS protection on ABK or MBI exceeds my conception of a fair price for "anything could happen."

How about hedging as an explanation? In the event of default, CDS on ABK or MBI can be cashed in by presenting any of the bonds they insure. Some of the bonds they insure are worthless without their guarantee and valued at full face if the guarantee holds. Maybe there is some kind of a trade there, the CDS on MBI or ABK hedge long positions in junk which they insure. I don't know anything about that market. Here the elephant in the room is more of a black hole, dark matter, so to speak.

The earthquake analogy is a good one. Tectonic plates move inexorably, creating stresses that are relieved periodically by earthquakes. The longer between quakes, the more stress accumulates and the more severe the outcome. CDS spreads say junk, rating agencies say 7 A's, nobody is moving very fast to close the gap. Large financial bets are being made in two directions. Eventually something is going to give.

My job is to make buy/sell/hold decisions and I am going to hold. These companies are trading at extreme discounts to adjusted book value, and as long as losses stay within what is implied by mark to market accounting things should work out to a profit in the long run. I like the odds, but I am unable to rule out the possibiltiy that something neither ABK nor MBI has forseen will occur.