Monday, July 11, 2011

Plan of Unorganization

The lack of acceptance by the Wisconsin OCI may make Ambac's plan of reorganization filed last week a non-starter - but not necessarily.

The disagreement with OCI, which is rehabilitating the Ambac's Segregated Account, stems from the allocation of the tax sharing agreement between AFGI and AAC. Accoriding to OCI:

"The Rehabilitator engaged in discussions for several months with AFGI and its bankruptcy Creditors Committee to see if mutually agreeable terms could be arrived at for equitably allocating net-operating-loss tax attributes and certain other resources between AFGI, Ambac Assurance Corp. and the Segregated Account."

The POR contains three potential Tax Sharing Agreements which could be effected with OCI. If none of those TSA's are implemented, the POR contemplates a deconsolidation by way of gifting or selling 20% of AAC. AFGI would then sue OCI and AAC for the tax refunds of approximately $700M. If AFGI were to then run out of cash, it would liquidate. 

To all of this, OCI says "The Rehabilitator of the Segregated Account of Ambac Assurance Corporation does not believe that the reorganization plan proposed by Ambac Financial Group, Inc. (“AFGI”) is in the best interests of policyholders of the Segregated Account, or for that matter, those of the AFGI creditors."

We can only presume that OCI infers their rejection of the TSA's as they are unlikely to offer a sweeter TSA to AFGI. While the Edgeworth box - the total amount to be gained by all parties by reaching an agreement - is large, the unusually adversarial relationship between holding company and subsidiary/regulator is making middle ground hard to come by.

It appears that OCI is sticking to a reductionist view of minimizing cash outflows to the holding company. Meanwhile AFGI sees more cash as essential to maximizing its value and protecting itself from unintended deconsolidation, a threat arising from pending surplus note issuance. Deconsolidation would throw a wrench in all cost sharing and inter-company payments by making them subject to income tax.

Not being privy to negotiations, its hard to discount which side is acting the greater fool. It shouldn't shock anyone that we think creditors ought to pursue whatever route minimizes the likelihood of a chapter 7 liquidation, whether it be by way of intended or unintended deconsolidation. Meanwhile, much of AAC's subrogation asset is moving closer to realization which could tremendously effect the value of AAC equity in a chapter 7 liquidation or otherwise.

For these reasons, we are predisposed to reject the plan and see what the creditor committee can put together. Even if that plan turns out substantially the same, it would buy more time for uncertainties with the IRS and putbacks to lift. That could make OCI more amenable to discussions and ease threats from chapter 7. Furthermore, the plan is unlikely to be enacted by the judge if she has serious doubts of the reorganized debtor to continue as a going concern. For better or worse, Shirley has called chapter 7 a "Sword of Damocles" in this case.

Accepting the plan would however create an interesting leverage for AFGI at the negotiating table with OCI and AAC. The rules of the game would change such that AFGI would be guaranteed a greater share of benefits of any settlement. OCI would have the ability to select any of the three TSA's or none at all, determined by which it feels is in policyholders best interest. OCI would undoubtedly place any AFGI claims on AAC into the segregated account and have any attempts of outside litigation remanded back to the Wisconsin courts.

While OCI powers in rehabilitation proceedings are broad, they are not omnipotent. This is a real threat to OCI which from a pure "dollars and sense" point of view predispose them to accepting one of the TSA's. But OCI might not have so much sense. Now we think economic theory is great and value maximizing agents are really neat. But the same people that sat on the Casey Anthony jury are market participants. There is nothing strong about the efficient market hypothesis form that applies to OCI. In other words, we think OCI is a threat to itself, primarily due to a reductionist view of sending cash to the holding company. (Or does it just want us to think so in its pursuit of maximum value...)

So there are definitely merits to this strategy, it would probably work, but there is no reason to take the risk of OCI blowing itself and everyone else in the room to Kingdom Come. The onus is on management to change are mind. They might do that by showing "the consensual direction" of settlement terms that OCI contemplates or protecting the only asset that we really care about, AAC equity.

We might start to feel lonely in our focus on this asset. Perhaps were trying too hard to find friends, but after staring at it for hours OCI's statement gave a 'magic eye' effect to the appearance of 'just hang on, it looks like we'll get this bad boy out of rehab.' Some old port and another hour and it adds 'just like Tapley told ya.' 

(Sr. Unsecureds ended the week trading around and pricing in the high 13s with several $1mm+ blocks trading. DISCS are pricing at 1. As such we estimate enterprise value in the $175M area.)

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