Tom A's Stock Picks

When buybacks make sense - ABK & MBI

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Following their downgrade by S&P, and in view of the threatened downgrades from Moody's, both companies face a decision as to what to do with the funds that were previously dedicated to sustaining their triple A ratings. The answer is simple - buy back shares.

As a general rule, it is appropriate for a company to buy back its own shares when they are trading at a significant discount to their fair value. In the case of Ambac, the math works like this:

ABK traded at 2.50 during the day yesterday. They have 700 million capital in excess of S&P's triple A target requirement, yet S&P has downgraded them anyway. Using the 700 million to buy back their shares at 2.50, they can repurchase 280 million of the 287 million shares outstanding. That would leave 7 million left, of which 25 million have been sold short.

Adjusted book value per share is a nonGAAP metric, used in the bond insurance industry, that includes the present value of future instatllments. Until recently, bond inurers traded at 1 X this metric. For Ambac, on 3/31/08 this stood at 15.83.

15.82 x 287 million shares gives an enterprise value of 4.542 billion. Subtracting the 700 million used to repurchase shares, that leaves 3.842 billion. Dividing 3.842 billion by 7 million shares outstanding (some of which I own), gives 548 adjusted book value per share. Even at todays paltry multiple of .17, that gives a share value of 86, a very nice increase. How the short-sellers, who borrowed the shares and sold them, locate shares to return is not my concern.

Once this operation has been completed, Ambac will enjoy excellent access to capital markets. Capital could be attracted at proper terms and deployed profitably in the financial guarantee business. This in turn would satisfay the rating agencies concerns on the topics of share prices and new business production, if anybody still felt that triple A ratings had any meaning.

The numbers work along the same lines for MBI so I won't go through it again.

I wrote a letter to Jay Brown, CEO of MBIA, suggesting this alternative, but in that case I used the 42.15 intrinsic value per share (another nonGAAP) which he recommended to shareholders. I also wrote to the board of Ambac, along lines similar to this post.

What it comes down to is that capital deployed in attempting to maintain a triple A rating against the shifting requirements of S&P, Moody's and Fitch is a complete waste, because their ratings have no effect on the marketplace. They don't improve either access to capital or underwriting credibility. At this point, there is little to do but wait for time to demonstrate whether ABK and MBI can pay their claims and have anything left over. I believe they can, and that what they will have left will be substantial.

As a practical matter, the possiblity of loss on an insured bond is a compound probability. In order to lose money, it is necessry that 1) the borrower defaults and 2) the insurer is unable to pay. If there is a 1% chance of either, the chance of both occuring is .01%. Buffet appreciated this math when he was able to collect full premiums to backstop policies issued by ABK and MBI. He will be laughing all the way to the bank. Perhaps the market will function better when this line of thinking is properly appreciated and the concept of perfect security is abandoned. There is no perfect security.