Wednesday, January 5, 2011

Ambac Sr. Unsecured and ACA/Goldman

Find a chair and sit in it. Some investors find this type of combobulating discombobulating. Anyway:

Consider yourself agnostic on future loss developments (including recoveries) for a moment. Under such a circumstance you would feel that Scenario 1 under the WI Insurance Commissioners rehabilitation plan (see is a balanced forecast. In that scenario, by 2020 statutory surplus net of surplus notes would be roughly 2x the par value of hold co. debt outstanding as of that corporations bankruptcy filing. That multiple goes up if you assume that the $400M of DISC's (similar to TRUP's) is wiped out in reorganization. All the active pari pasu maturities of sr. debentures and notes are quoted and recently trading under 20. With this type of math, you needn't bother unsheathing your HP 12c.

But you really aren't agnostic on loss developments or mortgage-gate, are you? You aren't all jolliness floating down the River Styx like Mark Tapley. That's OK. Here's a big piece of potential upside to lift your spirits.

No financial guarantors are booking benefits for non-putback recoveries. Any recoveries in this area would come from lawsuits under motions relating to breach of contract and negligent misrepresentation. For this class of suit all eyes are on MBIA vs. Merrill. I am still surprised that I still have not seen any commentary relating the ACA/Goldman settlement to this class of suit. IT IS THIS CLASS OF SUIT.

Sure, the SEC was sitting in the FGs seat and with much more leverage, but the circumstances of the case are largely the same. Sure, the suit was resolved by settlement without admission. And sure, one could argue Goldman's motivation was PR, political, or otherwise unrelated to their position in the case. But that does not change the fact that Goldman paid 55% of the initial par value of the deal to put the issue behind them. The FGs don't have subpoena power or public and political ire on their side. They do have a large amount of powerful and incriminating information (think Clayton Holdings. The best summary I have seen on the subject is from John Mauldin toward the end of this article:

Ambac has a lot of losses in this area and hasn't booked any recoveries. If it recovers 25% of par in compensatory damages, then the residual value of sr debt is double Scenario 1 or $2B higher. That implies a 1900% return over 9 years. If recoveries look like 55% or 100% or more, then we can switch from multiples to exponents.

It is also worthwhile to note that 1)litigation is beta neutral and 2)a very low probability of Scenario 1 (no CDO recoveries) or better makes these bonds very interesting.

See the February update on developments and DISCS here.

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