Tom A's Stock Picks

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."