Wednesday, September 5, 2012

Ambac Analysis: Looking Through a Glass of Milk

FASB 163 and FASB 46 has created a lot of opportunity for accountants to charge higher fees. These pronouncements are what one ought to expect of putting accountants in charge of what investors see. For bond insurers in particular these two accounting rules have made financial statements less relevant by distancing them from economic value. This is not to mention making accounting more costly for reporting companies.

Throw in a healthy portion of financial distress and a bankruptcy, and statutory statements look more intuitive then GAAP.

With that in mind, we have created this spreadsheet examining Ambac by adjusting the operating subsidiary's (AAC) financials in a similar way to how we have looked at Syncora. In Ambac's case, we have the added adjustment for the de facto AAC liabilities in the segregated account.

Ambac's financial statements are the murkiest of any large public company we have ever seen. By looking at the statutory statements we simplify the valuation process. We first adjust present value numbers presented on the balance sheet by 1) senior claims on the residual value of AAC, namely surplus notes, claims in the segregated account, and AAC auction market preferred shares (ARPS); and 2) the present value of future installment premiums.

Dividing this sum by the par of senior hold co debt gives us an adjusted book value per bond (ABV) which expressed as a percent of par equals 104. This tells us that if future investment income covers future costs, the value of a sr. debt will acrete from 104 by the aggregate discount factor (different values are discounted by different rates, we have not calculated the aggregate but at most it would equal the yield on Ambac's investment portfolio or 6.02%).

We can then adjust for our view on future loss and recovery developments. Syncora's recent settlement with Countrywide include a cash payment that was over twice Syncora's reserve. Assured Guaranty's settlement with Countrywide covered about 80% of losses. Both of these settlements suggest a 50% increase in Ambac's repurchase benefit could prove conservative (it would make total recoveries $3.5B below Q2 2012 expected future claims payments not including the RMBS portion of the $3,653M of claims presented and unpaid at quarter end). It also leaves plenty of room for things to go wrong in other areas (like with the IRS). Round it down to $1,500M, add it to our ABV calculation and your looking at 211. The bonds currently trade at 30.

This of course ignores the effect of DISCs on diluting value to sr. debt, but there is little in the way of guidance on how  warrants recovered by these creditors might be structured. The DISCS will also receive a slice of common. These very well may prove the most rewarding investment in Ambac. This assumes deconsolidation is avoided. We think this is a very good bet, though the risk is apparent.

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