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AMBAC – Making Head or Tail out of Accounting jargon etc etc

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August 07, 2008 – Comments (13) | RELATED TICKERS: ABKFQ.DL , MBI , RDN

I must say I am tad disappointed that there was not a single post in the Fool on AMBAC’s latest earnings. So I decided to trudge thru the earnings release and the 10Qs etc myself – ahem, may I admit for the very first time – tells you what due diligence is done on most Fool picks (Usually if you see me write a good long pitch – it means I DID go some stuff). This is more for my own edification – than anything else. If you find this useful – would appreciate a recommendation and a possible comment.

 

AND I will tell you it was not easy – to go thru the 10Qs, I mean. This is my very first Insurance company balance sheet analysis. I do peripherally understand the run-of-mill Term life/Health etc model – but Bond insurers are a different bunch.

 

But before we proceed – I guess you all know that the majority of the so called earnings Ambac generated this quarter was driven by an Accounting rule interpretation ( I saw the word “rule change” bandied about on the Web a lot – this of course sounds more sinister – but ABK switched to this standard last quarter itself, just didn’t have this bouncing effect before). But what piqued my interest is a statement from their CFO that if the Fair Value mark was done on July 31st  instead of June 30th – there would have been a loss of about $1.5 Billion as opposed to $961 MM odd  gain. I said, WTF? How can there be such volatility on portfolio marks.

 

The answer is embedded in AMBAC’s Derivative Liability portfolio which is about 7+BN – and based on what I could gather consists of Credit Default Swap (CDS) guarantees. The new FAS 157 ( The same Level 1,2,3 asset treatment you see with banks) – which on this credit guarantee require AMBAC to discount the MTM ( Mark-to-Market) Fair Value not just depending on the movement of default risk of the counterparty against which the insurer purchased the protection ( This in essence would increase the value of the Liability, due to the increased risk)  but also use instead of a simple standard Net Present Value discount rate to value the liability risk back ( I saw they have used 4.5% - 5% in the past) additionally ADD the increase in spread of AMBAC's own CDS as traded in the market. Most I am sure know how NPV works –  use a higher discount rate and the present value will diminish in principal. Oh my god! Is this a insurer’s book – or a daily trading hedge fund (Actually, I think the answer is Yes!). But truly this rule is one of the best concocted hedge one can think of – kudos to the people who came up with this one – I am sure with  great intentions, but look at the execution now! Essentially, since AMBAC’s own CDS spreads increased tremendously, and if the counterparty risk they insured not so much – it ends up being a huge positive and thus resulted in a gain.

 

Basically, if for eg I owe money (lets say $500 bucks) to James(TDRH), Michael ( Everyday) and Bill ( Florida) [ Pardon , upfront] but somehow Tastylunch, Dexion think,  I somehow can’t pay these folks because I am a pauper – I can run home to my wife and say that suddenly I have $250 bucks from nowhere – till the point in time Tasty notices the trips we’ve started to make to Target and spreads the word that  I am not penniless any more  and all of a sudden everyone comes to my house to collect. Wonderful scenario!

 

But let me tell you folks – this is the best asymptotic series with a slight divergence bounce signal one could come up with. Everytime it tries to move to zero – it will bounce back slightly because of the gain. I am actually astonished – by the fact that the spread will be evaluated on Quarter end – that’s a big timing risk – and wont be surprised at all – if we see spreads on AMBAC’s go up near a quarter-end – otherwise they have some bitter news coming.

 

This is not all – they whittled down their active credit reserves(ACR)  by half ( from $1,1 BN to 555.5 MM ) and had a huge gain of  $339 MM of Loss Expense ( as a net recovery) due to the improving remediation efforts assumptions – I guess Congress is definitely helping a multitude of borrowers – at least AMBAC has already officially recognized it in its earnings ( Of course “Such recoveries are expected to take several years for ultimate collection” – as per Ambac)

  

Contrast this on the other hand – with a credit impairment of  $1062 MM they recognized on their CDOs and an increase of $170 MM of their CASE BASIS RESERVE ( which is meant for actual defaults – rather than the ACR which is a future provision. Analogous  to LLR ( eqvt of ACR) and Losses/Charge-Offs ( Case Basis) to banks. So Case-Basis goes from  $350 MM to $520 MM (50% increase – and of course like LLR – its netted off from there – so ACR would decrease because of this) – AND SOMEONE TOLD YOU , THERE WERE NO LOSSES, right? Its partially true – because although the event has happened – they have not paid out the CLAIMS yet. ( Net claims was only $67 MM for the quarter) However, the money has to be allocated for.

 

Some simple statistics

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AMBAC in Quarter 1,2008  was holding $1.1 BN in reserves against 52  impaired transactions amounting to $7 BN. Their total CDS outstandings on book was $62 BN.

So net about 9% of the book is impaired. Now with the Citigroup deal done – I guess this will reduce to $61 BN and $6BN impaired. But reserves are $500 MM. So about 10% of impaired book and about 1% of loss coverage. Of course – without any knowledge of delinquency, underlying loss figures ( which they are using to evaluate the reserve adequacy) , its difficult to say whether this is adequate.

Liquidity

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Can they pay for their claims? They say they have enough to cover $16.5 BN in payout. This for a company which had  $1.2 BN in capital last quarter – this quarter of course its increase nicely to $1.9 BN due to the $900 MM earning recognition. They have about $106 MM in Cash and about $1.6 BN in Short-term investments ( Cash and equivalents , I am presuming). And also the $1 BN in total reserves – This is not too bad. Obviously they have about $18 BN in Investment assets – but really liquidating those is only theoretical to a large extent.

 

A lot thus depends on timing – and their entire accounting depends on it – precisely the NPV time component and the discount – they seem to be doing this with every risk evaluation. If for eg.  its like a Hurricane – then basically all the counter-party defaults can happen in a compressed time period – leading to a deluge of claims – and like a bank they will need to have cash. However, if it doesn’t happen – they are in a way better situation, I think.

 

Their ability to generate revenue – though is in true jeopardy – they actually had a great quarter by increased earned premiums by about $105 MM – of which $116 MM increase was due to accelerated ones – due to people refinancing or closing out.

 

Honestly, I see a lot of statements, even here at the fool, that AMBAC is a value. I shudder at the thought – they may survive – but value is where YOU KNOW that the underlying organization has stability. If you are an investor, all the best.

13 Comments – Post Your Own

#1) On August 07, 2008 at 7:42 PM, DemonDoug (32.21) wrote:

I responded to the abk "earnings" on my pitch part for ABK.

I'm going to be blunt.  I don't believe a word of what ABK is saying.  My belief is that their assets are far smaller than their liabilities, and that they have been insolvent for some time, and btw, did you see the part where their net premiums written were down 95%?

Once someone sues ABK for claims to be paid, it will be a domino effect and everyone will be done, this is what Mellon has just done with BAC regarding the CFC deal.

I couldn't read your full analysis though but I skimmed enough of it to know that you did a good job, fact is I just flat out don't believe these liars and the numbers they are making up.

BTW RDN actually might survive this mess and do well.  MBI and ABK are toast.

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#2) On August 07, 2008 at 8:15 PM, EverydayInvestor (< 20) wrote:

So when are ya goin' ta' pay me, anchak? I could use 500 quid (actually 250 quid, but hey, who's counting?). Nice analysis. I don't even bother to look at these companies because they are so much of a black box. Standard property/casualty/health insurers, I love, though. Presidential Life (PLFE) is the last CAPS--ratable company I looked at, and they were trading below a solid book value then (and now).

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#3) On August 07, 2008 at 10:24 PM, anchak (99.86) wrote:

Doug.... Replied to your pitch...points are bang on - I seriously think this company has a chance of stopping all new thru-the-door business - no doubt they want this Connie Lee or Daisy Dee whatever that is - so that you can conn some unsuspecting fool - especially internationally.

THE RDN Comment is very very very interesting - more work, ie 10q reading. The issue is I dont think I still have all the facets of the business model figured out - you need that to make a value call.

Michael....I knew you would take it in your stride. Drinks are on me whenever. Thanks again for the tip. I think as another leg of the bear starts - time has come to at least prepare a list of potential value buys - S&P clearly will breach 1200, possibly 1150 this time. I am trying to make an assessment on the regionals banks.

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#4) On August 08, 2008 at 1:34 PM, dwot (45.58) wrote:

Congrats to you for going through that mess.  I've taken the time to look at stocks and post on them and I do find it is enormously time consuming.  Certainly it seems that they do a good job of hiding the elephant...

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#5) On August 08, 2008 at 1:36 PM, dwot (45.58) wrote:

Also, I spent a lot of time justifying a loser is a loser.  Never did I find anything that changed my mind after a quick look.  I decided there are simply better places to put your time so I don't do it nearly as often anymore.

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#6) On August 09, 2008 at 12:49 PM, anchak (99.86) wrote:

dwot....Thanks ma'am...I was away for a day ..hence the delay in the response....Looks like MBIA had the same bounce...it would be interesting to see what the future holds for these companies

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#7) On August 10, 2008 at 4:38 PM, dexion10 (27.86) wrote:

Here;s the way I see it regarding ABK.

Best case scenario they make about $1 per share in GAAP earnings next year. Throw a 5x multiple on that (like you would with most re-insurers) and that gives you $5 per share max earnings.

Now ABK may have a run-off value much higher than that - but that's debatable depending on who all their CDO liabilities play out.

That's my two cents - I probably won't play ABK long or short in CAPS again as these re-insurers destroyed my score a year ago and I obviously don't get them - I lost money going short and going long them.

In real life however I had gone long ABK calls ahead of earnings for a 120% gains and I am currently shorting ABK via  $2.50  puts (if there is a crisis between now and Sept those could be 5-10 baggers).

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#8) On August 10, 2008 at 10:31 PM, dexion10 (27.86) wrote:

Anchak I saw your post on my blog regarding the refiners and I replied here:

 

FYI the insiders at Holly Corp (HOC) - a good sour crude refiner - continued to sell heavily in July so I really don't expect this rally to last.

At some point the market will realize that refining is a horrible business that has only periodic moments in the sun. 

 

... that said I still believe that through the cycle (as weak capacity is shook out) FTO, VLO, MRO will benefit will perform better than peers. 

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#9) On August 13, 2008 at 11:20 AM, Tastylunch (29.41) wrote:

somehow it  is always Tastylunch , one never knows why they owe him money or how he knows they actually have cash, but somehow it always Tastylunch :-)

Nice analysis on Ambac Anchak. To be honest I dn't understand their business very well, but when I see that much accounting trickery going on it's an instant red flag. I don't think many of the blogghing community on CPAS is fooled by the monoliners shenangians but certainly there are a lot of "sheeple" regular players (as TMFBENT likes to call them)  who are.

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#10) On August 14, 2008 at 10:29 PM, dexion10 (27.86) wrote:

Anchak - First of all Thanks for your comments on my blog...

I responded to your question regarding variable costs at energy companies.  

Please check and recommend my latest blog on valuing energy stocks - I am very proud of it (I think it's my best post ever) and I'd like it to be one of the weeks most popular.

Thanks!

here's my blog  Report this comment
#11) On August 26, 2008 at 10:58 PM, dexion10 (27.86) wrote:

anchack - I replied to your comments in my pitches (CALM) and I also replied to gold miners post here .

Nice buy and sell at CALM buy the way... it'd be a short here if there were any shares left to borrow... but you can never borrow the good ones lol ;-)  !!! 

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#12) On August 28, 2008 at 10:50 AM, GS751 (27.55) wrote:

Great post.  Very interesting how they do that.

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#13) On December 29, 2008 at 11:28 PM, dexion10 (27.86) wrote:

NICE 300 POINT DAY FOR ANCHAK!

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