Tom A's Stock Picks

Bond insurance update - loss settlements

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Recent settlements by SCA with Merrill Lynch and Ambac with the counterparty of its AA Bespoke transaction are now providing some information on the final value of losses for bond insurers. The implications for market participants vary, but clearly Ambac and MBIA look like better investments in light of the settlements. Following Ambac's announcement of their settlement, the shares have been up .88 or 35% as I type this. MBIA is also up strongly, 1.10 or 18%.

First, the size of SCA's settlement with Merrill needs to be placed in context. Eric Dinallo, Superintendent of the NYSID, was involved in that deal because SCA was on the brink of insolvency. Because Dinallo's political allegiance is to the municipal bond insurance policyholders, and his agenda is to conserve capital to support their protection, Merrill had no alternative but to take what they could get before the window of opportunity closed. Dinallo, in a TV interview, was careful to differentiate between Ambac and MBIA, which are well capitalized, and the likes of SCA, which was on the verge of insolvency.

Merrill mentioned in their press release that they were negotiating with MBIA on a settlement. I would anticipate that MBIA's position will be that they pay their obligations when due and in full, and that their obligations are to pay principal and interest when due on the insured transaction. Any acceleration would be at their choice. Further, MBIA would plan to assert any rights or remedies available to them to remediate the loss. Any settlement with MBIA will be arms length and will provide a far better indication of what bond insurance settlements will be worth than the SCA deal with Merrill.

My concern to is find evidence which can bridge the gap between mark to market losses and the impairments or loss reserves established by MBIA and Ambac. The companies have been asserting that a large part of the mark to market losses will never result in actual losses. Moody's has stated that this is "broadly consistent" with their view, based on expected losses.

Ambac's settlement of the AA Bespoke transaction is the first clue on mark to market vs. actual losses. Ambac had a mark to market loss of 1 billion, and recognized an impairment of 789 million as of 3/31/08. The settlement, which I believe was a genuine agreement between two parties who were under no pressure to compromise, was for 850 million. Doing the math, the difference between Ambac's impairment and the mark to market was 211 million, of which 150 million, or 71%, was reversed. In this case, the mark to market overstated the actual loss.

Food for thought: Ambac's cumulative Mark to Market losses as of 3/31 are 5.6 billion over what they have recognized by reserves or impairments. If 71% of that is going to reverse, then Ambac's GAAP book value is going to increase by 13.85 per share as the magnitude of the the losses is clarified by the passage of time. Not too shabby for a company that has recently traded as low as 1.05 per share.

As a bonus, the Ambac settlement was less than the rating agencies' stress case estimates, so it increases their capital cushion.

It would not be useful to extrapolate too much from one piece of information. The "AA Bespoke" transaction was a CDO squared stuffed with mezzanine sub-prime RMBS and not typical of Ambac's portfolio or of anything MBIA insured. But I am encouraged by this development and will continue to hold my long positions in ABK and MBI.

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The Tyrannical Rule of King Market

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Mr. Market, once regarded as a genial, if mentally unstable, partner, has now morphed into King Market, the totally deranged arbiter of all value. Part of this can be blamed on mark to market accounting rules, but an equal if not greater part can be attributed to the vociferous support of those who benefit from his foibles and follies.

As an example, oil recently spiked upward toward 150 per barrel, then just as suddenly tanked to 119. While the upward march was in progress, numerous sage talking heads debated whether the cause was speculation or the beneficent rules of supply and demand. Everyone saw fundamental supply/demand equations as supporting 150 oil, if not 200 oil. Now, an equal number of energy gurus see demand supporting oil under 100, maybe even 70 per barrel.

The attitude of the press and other commentators on mark to market accounting is similar. As financial companies report huge mark to market losses on hard to value assets, they are praised to the extent they capitualte and sell the offending assets for a fraction of what they are worth. There is honesty there, healing, cleansing - going to the confessional, lancing the boil, so on and so forth. John Thain (CEO of MER) is a poster child for this phenomenon.

However, when the whole farcical folderol is taken to its ultimate peak of fatuity, there seem to be dim glimmerings of dissent. Of course I am talking about bond insurance, my dynamic duo, ABK and MBI.

ABK recently reported a surprising profit. After taking mark to market losses on its portfolio of insurance provided in CDS form, the company wound up with a profit because it had to mark down the value of these liabilities to reflect the public perception of their creditworthiness. The situation developed as follows: when ABK and MBI were downgraded by Moody's & S&P, the already astronomical cost of CDS protection on their creditworthiness spiked to insane levels. According to GAAP, the companies are required to use this information when evaluating their liabilities.

Several commentators have published articles accusing ABK of parlaying an accounting technicality into bogus profits. As Ambac made abundantly clear on their conference call, they are simply playing by the rules.

There seems to be this underlying belief that King Market is wiser than Solomon, totally clairvoyant, able to peer into the future with uncanny insight. I am sorry to inform you that this is not the case: by far to the contrary, King Market is a riff-raff, an unruly mob of speculators and manipulators, a vigilante posse armed with the pretext of capital adequacy.

Fortunately, King Market's subjects seem to quietly subvert his idiotic rulings, going on with their lives in a more or less orderly manner while maintaining the pretense that his directives have some basis in fact. An example: ABK has gone from a low of 1.04 to 5.85 at yesterday's close, an increase of of 462%. Nobody seemed to notice too much, but I was watching in wonder as the fruits of what my friendly critic Fernando called a "double down rampage" accumulated in my portfolio.

AIG reported last night - more mark to market - I will listen to the conference call and try to sort it out. MBI is scheduled to report on Friday. No doubt there will be more mark to market idiocy in their financials. I don't know how King Market will respond. But I will look at the adjusted book value, weigh the mark to market against management's estimates of actual losses, and govern myself by reason.

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AIG - candidate for surgery

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AIG just reported its third consecutive quarterly loss, (2.06). The shares were pummeled, trading at 23.62, down 18.8% when last I looked. I have been a buyer of AIG at prices under 30 and initiated a very small position in my Marketocracy portfolio today. I listened to to the conference call and browsed the presentations on their website. My take: AIG will be downsizing and simplifying itself, resulting in a well capitalized international multi-line insurance company, solid but not glamorous. However, there is substantial risk of unnecessary hemorrhaging.

The process will involve surgery, in the form of selling non-core operations and reducing the risk profile of assets and liabilities. Over the past ten years AIG has grown rapidly and profitably, but under today's economic conditions is revealed as bloated by excessive risk and complexity of operations. I think mark to market losses are overstating the company's difficulties: and, accordingly, the test of the surgeon's skill and patience will be the extent to which assets and liabilities are taken off the balance sheet without holding a fire sale. Other financials, such as Merrill Lynch, seem to be willing to buy their way out of trouble, to the detriment of shareholders.

The resulting slimmed down company would do P&C Insurance, Life and Annuities, and Aircraft Leasing as core operations. Businesses such as AIG Financial Products Corp, with its super senior credit defult swap portfolio, which has generated a stunning run of mark to market losses, would not be part of the core and would require to be dealt with.

Earnings going forward might be 3.00 per share, book value could be maintained at 30 per share, and a realistic target price would be around 42 per share. From where the stock is trading today, you could make money. However, I see less value than I did a week ago.

My estimated outcome is not very ambitious - the reason being, 2 month CEO Willumstad sounds resigned about mark to market losses, already in capitulation mode. My view is that the credit crisis has got the value of all mortgage related assets and liabilities way out of sync with the performance of the underlying collateral. With a balance sheet that has large amounts of both assets and liabilities that are mortgage related, it would be all too easy to erase a lot of value needlessly, in the interest of placating shareholders who have lost their appetite for risk.

In addition, Willumstad was unwilling to rule out a capital raise. AIG has already raised 20 billion: shareholders do not need further dilution. A capital raise would drive the stock down further, resulting in a self-fulfilling loss of value. AIG uses an Economic Capital Model that is driven by market values. They complain of the difficulty of getting a stable indication of required capital. I interpret that to mean that if market values of their assets decrease further, or if they have to take more mark to market losses on their bond insurance, they will raise capital to meet the rating agency double A requirements.

The company's discussion of the super senior CDS portfolio mark to market was strange: last quarter, they saw 1.2 to 2.4 billion of maximum stress losses: now they see 5 to 10 billion of maximum stress losses. Their representative declined to provide a figure for expected losses, saying only that it was less than 5 billion. They talked about new processes to stress test the business: I would guess it's like ABK's AA Bespoke transaction - AIG's underwriters missed the point when they wrote the business and now they see their error as losses are on the horizon.

The mark to market on the investment portfolio was mostly moving losses from Accumulated Other Comprehensive Income to the Income Statement. Book value is not affected, but earnings are reduced. Most of the portfolio is investment grade and performing adequately. Losses have been realized for accounting purposes, but there has been no fire sale as of yet.

To summarize, I see a lot of value but question management's ability and willingness to solve the problems in the best way for shareholders. I can't figure out whether it's a deer in the headlights sort of thing, or management being deliberate in exploring their options. I plan to hold my small position through September, when Willumstad should be articulating his plans to get the company back to its core businesses. If I hear a good plan and the resolve to execute it properly, I will stay with the position: if not, I will exit. I expect a downward trajectory of the stock, and increasing clarity as to the values that can be salvaged and the prospects of future earnings. Somewhere in this process there might be a very interesting buy point.

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Portfolio in Recovery - planning ahead

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I am continuing to track my performance against the Strategy Lab, and have retained my portfolio from SLO1-2. I am still still carrying large unrealized losses on my bond insurers MBI and ABK, but my strategy modifications and plan of recovery made in February are developing favorably. For the past month, the portfolio is up 39%, driven by a strong recovery from my two problematic investments.

I had been operating on a pure value strategy, with poor results. The change was to add consideration of momentum to my thinking. I started to add and remove stocks based on value criteria, which I supplied, and momentum criteria, which I got from the rating scheme used by my brokerage, Schwab. A stock had to satisfy both criteria. MBI and ABK, which had huge unrealized losses, where left out of this strategy as I expected them to recover. Broadly speaking, the combined value/momentum approach worked well, and the expected recovery in the dynamic duo has started to materialize.

Looking at my portfolio from a sector point of view, here is where it stands:

Financials - 52.00%
Informatin Technology - 26.50%
Industrials - 9.77%
Consumer Discretionary - 7.52%
Health Care - 3.86%

There has been much debate as to whether we have seen the bottom on Financials. I think we have, based on my view that the Case/Shiller housing index overstates house price depreciation or appreciation, as well as reviews of servicing agency reports on troubled CES, HELOCS, and subprime portfolios, which suggest stabilization in delinqency trends. The recovery in financials has a long way to go. However, now would be a good time to start reducing my exposure to this sector: I will be gradually whittling it down, and putting the proceeds to work elsewhere. I recently sold a few shares of ABK and MBI as they rallied off their extreme lowpoints, although I continue to believe they both have ample room to increase.

The Information Technology sector has been good to me. My largest profits are from JBL, and I have started to pare that position.

I have no Energy positions. A feature of current markets which I dislike is the prevalence of what I call negative momentum strategies. Once anything starts down, short-sellers pile on and pummel it mercilessly. Fundamentals are brushed aside, creating extreme value entry points. You don't want to get in front of this process while it is steam rollering everything in its path, but following along in the wake of the destruction there is money to be made. I will start easing my way into Energy, because I see the upward movement of oil prices as a long term phenomenon driven by supply and demand. I missed the boat the last time around and I will start accumulating a position during this pullback.

I will look at COP, APA, DVN, XOM, OIS, SU, BJS, RIG, DO, FTO, VLO & TSO. Most of them are stocks I have owned successfully in the past, a few are recommendations from other investors whose opinions I value. I expect to develop my positions slowly, as funds are liberated from Financials, hopefully by not making any sudden moves I will achieve a smooth transition and avoid any large timing type losses.

Other ideas are in auto parts & supplies, JCI and MGA. These are quality companies that have made money for me in past automotive downturns.

The short financials/long energy and commodiities trade has broken down and reversed itself. Thre were so many hedge funds and other momentum players doing the same thing, it is not surprising that the shift has been sudden. From where I stood in February, I think I played it right, to sit and wait for the turnaround. But I wound up fighting the tape for a long time, very painful. My goal is to get ahead of the rotation, rather than fighting it: hence the cautious and incremental approach to the transition.

Aside from that, I have a lot more positions than I usually carry. I will cull, using the combination value and momentum approach, and add using the same criteria.

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Homebuilders - survival of the fittest

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In today's difficult business environment, many investors are looking to play the survival of the fittest theme: the thinking is, if you can identify the strongest players in an industry that is consolidating, you buy the predators rather than the prey. That theme probably will work well in homebuilders such as Toll Brothers (TOL), KB Homes (KBH) and Ryland (RYL).

In reviewing the 2Q 08 Conference calls for the above (transcripts are available at Seeking Alpha), much of the focus of the Q&A was on cash flow/positions and opportunities to build land pipelines at an advantage, by acquiring the assets of small to medium builders, either directly or from banks that may wind of owning them as construction loans go bad.

When things are booming, you could own a homebuilder and look at a steady flow of earnings, but then you look at the cash flow and say "Where's the beef?" The problem is that profits are plowed back into acquiring land. But when the housing market slows, well-run builders continue to sell houses, but do not replenish land inventory, generating cash. Some will sell land, to raise cash and perhaps use the cash later to buy better positioned land at a discount. TOL, KBH, and RYL all have cash and lines of credit which they believe position them well to load their pipelines with land when the timing is right, which will be soon now - they are looking at deals.

There has been a lot of press about how Regional and Local Banks are overloaded with construction loans and will wind up owning the land involved, taking losses. The stronger national homebuilders will be there, to pick off the best assets at bargain prices.

I have been playing homebuilders on a tangible book value basis, looking to buy at a price to tangible book of 1 or less and planning to sell at 1.5 or better. Because writedowns are ongoing, the target has been moving: however, my impression reading the conference calls was that this trend is stabilizing. Also, marked down land will generate larger profits when recovery commences, and some deferred tax assets that have reserves against them may in point of fact be realized if and when the industry recovers. Because of that, I tend to think book values for homebuilders may understate assets in the event of a recovery.

Homebuilders have rallied on and off this year. I have owned TOL and RYL in my Marketocracy and personal accounts since last year, taking some profits when they would rally and then buying the shares back on the dips. As of this moment, I plan to add to the positions on the dips and be a little less willing to sell until they reach my target prices.

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Bond insurance update and thoughts on "high conviction"

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Bond Insurers Ambac (ABK) and MBIA (MBI) at 5.22 and 10.92 are up 400% and 300% respectively from their 52 week lows, reached in late June and early July. I was there at the bottom, buying 8,000 shares of each as the market careened toward its July 15th low point. In addition to being extreme values by my methods, both are exhibiting signs of momentum. Market Edge, which relies on technicals, rates both "Long." Following their 2nd quarter earnings, I have completed a review, and believe that both still have ample gains ahead.

I have been working these two on "adjusted book value," an industry specific nonGAAP metric which adjusts book value by adding the present value of unearned premiums and future installments. MBI now defines adjusted book value to include adding back mark to market losses on the insured portfolio of CDOs, to the extent they exceed impairments. ABK provides a comparable figure. MBI's adjusted book value is 39.63: a comparable figure for ABK is 28.68. Working with these two cases over the past year, I have become convinced that GAAP accounting seriously distorts the actual values, by overstating liabilities and understating assets. In a best case scenario, both would trade at around 1 X adjusted book value, so they possibly could quadruple from their current prices.

For that to happen, the main requirement is clarity around the size of housing/credit crunch losses. The ultimate trajectory of the housing crisis drives losses, and then there is the secondary issue of how accurate the companies are in estimating losses for years into the future.

My clearest window into this situation is Servicer Reports on direct RMBS. For ABK, I have identified 5 problematic loss cases which I track monthly: Bear Stearns Second Lien Trust 2007-1, First Franklin Mortgage Loan Trust 2007-FFC, Saco I Trust 2006-2, Saco I Trust 2006-10, and Saco I Trust 2005-10. The reports come out on the 25th, and include a wealth of information, including graphs of monthly default rates. What I saw, in 4 out of 5 cases, was default rates that are stabilizing or declining. This is consistent with ABK's conference call: "Outside of normal volatility, a reasonable takeaway is the delinquencies appear to be flattening out, whilst default rates, with a lag as one would expect, may have begun to decline."

The two worst cases, Bear Stearns and First Franklin, are looking better but are still reserved for cumulative losses of 70% and 65%. To me, these numbers are credible.

ABK also went into some detail on remediation. When mortgages are sold, warranties and representations are made as to the quality of the collateral. A good size survey, part random, part selective, revealed a shocking number of misrepresentations and breaches of warranty. ABK has booked 263 million of credits for remediation based on this information, and expects to do more. In some cases, the potential recoveries were well in excess of the losses that would be payable after considering subordination.

The situation is more complicated with respect to ABK's insured CDO portfolio, which garnered another 1 billion of impairments for the quarter. The CDO squared cases are easy: they commuted one, paying 850 million, and the remaining two large cases are reserved as total losses. Basically, rating downgrades of the RMBS collateral supporting the inner CDOs triggers adverse cash flow consequences for the outer CDO. The whole thing is ratings driven, and if downgrades are severe, total losses ensue.

ABK's CDO of ABS transactions contain mainly RMBS but also include varying proportions of inner CDOs, which behave the same as the inner CDOs of a CDO squared. Basically, if the total CDO collateral exposure exceeds the subordination, the loss potential increases radically. ABK has revised their disclosures on their website, providing a one page summary of each of the affected exposures. I reviewed the new disclosures, which clearly show the proportion of inner CDO collateral and the write-down taken, and I am satisfied that ABK has a handle on their losses and that there is a limited amount of additional pain coming in the future.

For MBI, last month I was able to review of sampling of their direct RMBS - I looked at reports on the Countrywide transactions and felt that performance was stabilizing at a relatively high default level, consistent with MBI's loss scenario which calls for current default rates to continue into the 2nd half of next year.

For MBI's CDO exposures, I looked at the disclosure on their website, Multi-Sector CDOs as of 6-30-2008. MBI did not take any meaningful additional impairments on this book, in marked contrast to AIG and ABK, both of whom made a trip to the confessional. My concern centered around the question as to what the difference might be, that no additional impairments are needed.

MBI discloses the percentage of CDO of ABS collateral included in their Multi-Sector CDOs, and it is significantly less than ABK's. As such, MBI has minimized the structural issue of losses triggered by downgrades. With that in mind, I am prepared to accept that MBI is being accurate and forthright in not taking additional impairments.

Finally, in the past week I have seen representatives of both Moody's and S&P on TV, giving out opinions that the housing crisis is stabilizing. To me, that says rating downgrades will be stabilizing, so that ABK's vulnerability on that issue may not yield further difficulties. Also, I saw Karl Case on TV, he is the other half of Case Shiller, the housing index, and he sees the situation as stabilizing.

So, with losses relatively well-defined, the path is clearing for shares of ABK and MBI to start gravitating upward toward the adjusted book value target.

Last year, with MBI at 31 and ABK at 25, I was of the opinion that they could triple or quadruple from that level. Sadly, I was wrong. Now, with MBI at 10.92 and ABK at 5.22, I am of the opinion that they could quadruple or quintuple from the current level. Am I sadly wrong? There is a difference - for starters, the stocks are far lower today than they were when I originally got on the bandwagon. But the main difference is in the information involved: when I got started on this trade, the companies didn't know what the future held in store, didn't understand their own exposures, and consequently couldn't provide clear disclosures. That has changed, the cards are out on the table, the losses are far worse than expected, but now the worst is known.

Looking at my portfolio performance, I am even with the S&P 500, reckoning from the beginning of SLO-1. I am outperforming the S&P 500 for 1,3 and 6 months. Aside from my losses on ABK and MBI, which total about 15% of my original NAV, I have made money on all other positions combined. When I last added to my position in MBI, I bought enough shares to bring it up to 15% of my portfolio: for ABK, I brought it up to 10%. Now, as MBI goes over 25% of a larger portfolio, I have been reducing the position to stay in compliance. When ABK starts to hit the 25% level, I will reduce it along the same lines.

If this situation develops along the lines I envision, I will be taking profits from MBI and ABK for the next six months, reinvesting the proceeds into other value ideas. My original error on MBI and ABK was that I started with too big positions. On these contrarian type catch a falling dagger ploys you need to start small as it could be necessary to average in repetitiously. Once I got into the situation, I felt my best odds of recovery lay in holding, monitoring carefully, and adding to my positions if the outlook improved. While it has been a difficult 6 months, results are validating my recovery strategy.

Another thought - these were experiments in a "high conviction" strategy. The idea was, to do a lot of homework, then make larger bets on the cases were I was extremely confident of my analysis. Unfortunately, getting to the high conviction point on a complex case such as these can require far more time and research than I anticipated when I embarked on the journey. It may involve learning things that only experience and the passage of time can reveal.

"A little knowledge is a dangerous thing:
Drink deep, or taste not the Pierian Spring."

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