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December 04, 2007




You probably already went through this Structured Finance CDO Ratings Review presentation by Fitch. Fitch is claiming better than expected performance of BB CDOs

In case you haven't the slides are available at


Replay Information:
U.S./Canada: +1-800-642-1687
International: +1-706-645-9291
Replay ID: 25810543


Thanks, I'll have the guys take a look at it. As an aside, Fitch's credibility (& their 2 competitors) is pretty much shot, for they said expected performance for much of this stuff was investment grade about a year or two ago, and look where we are now.


First of all, I want to say that I think you have put together a fantastic blog. It's the best I have seen and I really enjoy reading it. Now to issues related to Ambac and other bond insurers.

Putting aside the question of default losses, a week or so ago I began to think about what it might cost to acquire the types of instruments insured by the bond insurers, particularly Ambac. My (very limited) understanding is that there is not much of a market for these types of instruments, so the analysis is far from clear-cut.

However, taking a stab, I guessed that the type of assets in Ambac's insured portfolio might be acquired for prices in the following approximate ranges relative to the outstanding face amount of the securities: consumer asset-backed ($69.2B) - 80 cents on the dollar; 2nd lien and sub-prime ($18.8B + $8.8B) - 75 cents; ABS CDO >25% MBS - 60 cents; high-yield ABS CDO - 80 cents. This brings up the first question: are these approximate valuations in the ball park? Too high? Too low?

If it were possible to acquire the assets discussed above at these prices, my math suggests that the break-even point for the investment in them (assuming they are held to maturity) occurs at principal and interest losses around $35B, about six times Ambac's equity capital. Principal and interest losses equal to 5% of face value, or roughly $8B, just enough to exhaust Ambac's equity capital + net unearned premium reserve, would imply a windfall on these assets (5% losses versus a 25% discount on face value). This brings up question 2: does your math basically agree with mine?

The general conclusion is that there appears to be a huge disconnect between the risk that is priced into market valuations of asset-backed securities and the valuations of that risk on the bond insurers' balance sheets. Do you agree?

If this is correct, it would seem plausible that certain investors (e.g., hedge funds, perhaps your fund, etc.) could capitalize on this disconnect by simultaneously acquiring the types of assets insured by the bond insurers and shorting the bond insurers' shares.

Naked shorting of the largest bond insurers stikes me as dangerous, for a number of reasons. First, I believe that the Fed can exert a very strong influence on bond insurers' exposure to loss, and that the bond insurers factor into the Fed's delicate attempt to balance the risk of a collapse in asset values against the risk of loosening monetary policy and possibly re-ignited the trend toward extreme financial leverage that has gotten us into the current mess. Ambac and MBIA bankruptcies would, in my view, greatly increase the risk of a collapse in asset values, something that the Fed will attempt to avert at all cost.

Moreover, if one considers the principal and interest losses to US investors in fixed income securities associated with widespread bankruptcies of bond insurers, the numbers become frightening ($500B+ based on my back-of-the-envelope math - do you agree?). Even though some industry analysts (e.g., Goldman Sachs, Deutsche Bank) have projected losses approaching this magnitude, the Fed has in effect endorsed a $150B estimate, and will likely attempt to navigate monetary policy to something around this level, a level the bond insurers could weather.

In addition, it is also in the rating agencies' interests to prop the bond insurers up, as they have so far. If losses are moderate, the rating agencies could affirm AAA ratings, allowing them to write out of the current hole, even though everyone expects ultimate losses to be large enough to more than justify a downgrade (perhaps multiple downgrades).

Now on to a completely separate question that was raised by one respondent (could have bee me). It is my understanding that the UEPR (less deferred acquisition expenses and prepaid reinsurance premiums) translates into additional claim paying ability. If part of this amount were ceded to reinsurers, it would obviously decrease the unearned premium reserve, but the reinsurance would increase the amount available to fund losses by a larger amount. How much additional "capital" the reinsurance provides would depend on the terms of the reinsurance deal.

Somewhat to my surprise, it is my understanding that there is some appetite in the reinsurance industry to at least seriously consider a deal. If I find the time, I may share some information on my limited knowledge of the types of deals floating around (if this piques your interest, e-mail me and let me know). Regardless of the reinsurance market details, thinking about this leads me down a different tangent.

For companies as large as Ambac and MBIA, unless they come up with something extremely creative that does not involve insurance industry capital(not likely in my opinion), they really only have one place to shop, Berkshire. Others that come to mind include Swiss Re -- too conservative and is already in the mess, Munich Re -- too conservative, AIG -- already in the mess, and burned bridges by fighting a guaranteed film finance deal several years back, brokered market -- limited appetite for this magnitude, plus many are partly owned by hedge funds that can take on the risk at much better economics in the capital markets).

I have a hard time imagining that Berkshire would touch this exposure except with extremely onerous terms. Even though there is a slight chance (not very likely) that Ajit Jain (who runs reinsurance at Berkshire) might have be interested, Berkshire's more likely gameplan would be to purchase a bond insurer with a solid management team and minimal exposure (e.g., FSA), capitalize on the perceived risk in MBIA and Ambac's portfolios in the short term, and if the time comes that Ambac and/or MBIA are downgraded, take the their entire books (excluding the crap).

Not only does this seem more like Berkshire's style, but I also believe that it is much more in Berkshire's interest. Rather than risking $2B (or more) for a chance to make say $600M on a reinsurance deal plus a little more if Berkshire gets a cut of the going forward business, this would allow Berkshire to create a behemoth bond insurer with a creme de la creme portfolio that benefits from greatly reduced competition and greatly increased credit spreads viz higher premiums. Would it be unrealistic to conjecture that this franchise would be worth in excess of $10B if Ambac and MBIA are downgraded? If you want to talk about bling, there's your bling!


Looks like Moody's must read your blog :)

MBIA Shares Drop After Moody's Says Capital in Doubt



@ JQ
I wonder if they just started reading it a weak and a half ago:-)

You get the award for the longest blog post comment I have ever seen. You bring up some damn good points, though. I will have to address this later in order to give it a legitimate reply since it is 3:41 am and I have had a long night. I find it hard to believe you know little about the business though.



You are not one to complain about long posts. Only kidding, this is great stuff so I hope you keep it coming. I can't believe you put up two additional posts last night. After Googling your name last night and watching the video, I am also now aware that you are able to slam dunk over people:)

It was probably evident, but the ideas thrown out toward the end of the post were shots from the hip, and were not meticulously reasoned. It might not be practical for Berkshire to acquire FSA from Dexia (though a significant investment seems very plausible). Nevertheless, Berkshire, hedge funds, etc. are likely pump money into the bond insurance business (either by investing in the "winners," starting a new entity, or both) if MBIA and/or Ambac are downgraded.

It would be great to hear your response to some of the comments I posted if you get the chance to provide them.


@ mark
Read the latest Pershing report below. You may be closer to the mark than you think on the acquisition trail:


Thanks for the link. 145 slides with no fluff is a lot to get through. A handful of comments follow.

It is nothing short of insane to apply a AAA rating to the insurance subs of these companies. In addition, the amount of debt on MBIA's balance sheet makes the idea of investing in MBIA even crazier.

The title is a bit misleading because it does not outline much of a solution -- the presentation suggests that the entire industry is about to implode. "Spectacular explosions at MBIA and Ambac lead to doom for the bond insurance industry" might be a better title.

The analysis appears to ignore a number of exposures (including stinky stuff like consumer asset backed for Ambac). Is this correct or am I missing something? If these would be additive then it obviously makes things look uglier.

The loss calculations in the presentation rely heavily on market valuations, which can be a very poor barometer. Does it make sense to rely on market valuations as the market runs like hell from the same crap they lined up to buy in the first place?


I'll be honest with you. I didn't get past slide 55 yet. So much to do, so little. Time. As for market valuations... honestly, at the end of the day, it is the marktet that is the sole indicator of an asset's value. You can have your opinions and models all you want, but someday you may have to sell your asset, and that is when the reality starts to sink in. You know the old saying, "The market can remain irrational longer than you can remain solvent".


In a previous post, I threw out some wild guesstimates for the cost to purchase assets similar to those in Ambac's portfolio. Were these prices even remotely realistic? Here they are: consumer asset-backed - 80 cents on the dollar; 2nd lien and sub-prime - 75 cents; ABS CDO >25% MBS - 60 cents [probably too low]; high-yield ABS CDO - 80 cents.

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I have limited bandwidth to return emails. I do not want the lack of answers to email questions to appear as if I am avoiding them, it is just that after a certain level of volume it distracts me from my day job.

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I do have company in these loss estimates.

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This again highlights that we have been conservative in our assumptions over default rates and potential losses that Ambac could incur. For an anecdotal example of the implications of foreclosure recovery rates in housing markets like CA and FL, see my last post. My findings are actually on par with that guy that writes the well followed Accrued Interest credit blog (very smart guy who came to almost the exact level of losses I did), Bill Ackman from Pershing Capital (prescient guy who got me started following these companies and also believes them to be insolvent soon), and UBS.

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My primary occupation is investing, not blogging. I disseminate my research and opinions to provoke discussion and I love to blog on these topics, but I have limited bandwidth to return emails.

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