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.