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Ambac (ABK) reported a third quarter loss of 8.45 per share, resulting in negative shareholder equity. Book value per share fell to (3.09). The primary cause was impairments of 2.5 billion on the company's insured book of high grade CDOs. Moody's response was swift and pridictable: a multi-notch downgrade to Baa1. Still investment grade, Moody's notes, in that their aggregate resources exceed their exected losses.
Ambac has immediate liquidity problems as a result of the downgrade - they will be required to post collateral or terminate deals in their asset management business. In reporting earnings, the company disclosed they are several billion short of what will be needed. To bridge the gap, they will need permission from the Wisconsin Insurance Commissioner, Sean Delwig, to make intercompany transactions. The issue has been under discussion but had not been resolved as of the earnings conference call this morning.
Ambac shares were running up before earnings, on rumors and speculation that Treasury would include the company in the TARP program. As the economic outlook darkened, I had been progressively more uneasy about Ambac's CDOs and reduced my Marketocracy position substantially.
In my personal portfolio, I had taken enough profits to lock in a breakeven on the whole misadventure. I have been playing the stock by use of options, Jan10 2.50 calls, under the theory that I could control more shares with less capital at risk in case the stock goes to zero. The bid/ask on the calls is usually fairly wide, and as I was trying to sell them yesterday it was hard to get filled, even at the bid. As a way around the problem, I sold enough shares short to offset most of the calls - made the position almost "delta neutral" in the parlance of the trade.
After the downgrade, Ambac shares are trading at 1.69, down 50%, in the after hours market, with fairly heavy volume. That leaves me with the question, do I close one half of the position and play the stock to go up or down, or do I just take my ball and go home? It has been a wonderful learning experience, swinging from a large loss to a large gain to a stalemate: maybe I should just look at it as a tuition refund and go on to something more constructive.
With the market down as far as it is, and with volatility still high, my preference is to play beaten down stocks, looking for the proverbial four bagger. There are a lot of them out there - no need to continue with Ambac when there are so many qualtiy stocks trading at prices that leave ample room for profit in the event of a recovery.
I have been using nonGAAP adjusted book value as my valuation metric - it is GAAP book value plus the present value of future installments. That now stands at 7.18 per share, and if you think mark to market losses will revert to zero over time, you could add them back and come up with an "adjusted analytical book value" of about 19. With the shares trading at 1.69, there is still quite a bit of attraction as a speculative value play, either by means of a bailout or by realizing the intrinsic values with the company in run-off.
Treasury could get involved by buying assets from Ambac's asset management business, by providing reinsurance which would increase rating agency capital, or by taking an equity position. If Treasury were to take an equity position, the question would be whether they would treat Ambac as kindly as Goldman Sachs, for instance, or whether Ambac would be treated like AIG, with 80% dilution to shareholders.
Ambac CEO David Wallis is pushing for the reinsurance solution - with good reason, it avoids diluting shareholders. He argues that Ambac meets the two basic criteria for assistance - systemic importance and solvency. My suggestion would be, call the main players in for a conference, make them accept a 5 billion infusion of capital by preferred stock, with warrants at the 20 day trailing average share price, and in the amount of 15% of the preferred capital. That would mean MBIA (MBI) and Ambac, as the two largest monolines, would be bailed out with sufficient captial to make the ratings unimpeachable.
I would gladly accept the dilution in favor of the immediate boost to share value and the improved rating stability, presumably at the triple A level. I don't have a clue whether any intervention by Treasury is possible or likely. As of this moment, I will look for the share price to get down under 1.00, at which point I will close the short position and take my chances with the calls.
P.S. after this was written, Ambac published a response to Moody's downgrade, which included this statement: "Based on Ambac's most recent analysis, the liquidity gap between the market value of the investment securities held in the financial services businesses and the value of the financial services liabilities that may need to be collateralized or terminated at the Baa1 rating is approximately $3.2 billion. Almost all of the transactions entered into by our financial services businesses are guaranteed by AAC. Ambac has received approval from the Wisconsin Office of the Commissioner of Insurance (OCI) to utilize the resources of AAC to resolve this liquidity gap." I take this to mean that there will not be a fire sale or an AIG style intervention.
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