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