Thursday, October 18, 2012

Ambac Vacation Notice

I'm not going anywhere. Nor is Ambac. Nor is the IRS. Or are they? The answer to that question will determine whether Ambac's Plan of Reorganization goes on vacation in turn.

Max Webber told you that a federal bureaucracy would take this long. The innards of this federal behemoth have churned for months without acting on Ambac's settlement offer. Our lawyer friend recently pointed out the interesting consequences of this inaction.

Under U.S. law, a confirmed plan of reorganization under Chapter 11 can only be reversed in the case of fraud and even then only within a few months of confirmation. The court confirmed Ambac's plan 7 months ago. Ambac had so many moving parts, it required an intricate plan with several contingencies, not least of which was a time limit for consummation of the plan. If the plan was not consummated within six months of confirmation, the debtor would - and does now - have the right to vacate the plan. If the plan is not consummated within a year, then it shall automatically be vacated.

This consummation thing is more than standard language for a marital prenup. Consummation of the plan entails Ambac actually exiting bankruptcy, something that cannot occur if an IRS settlement does not close.

Let's say this one last way. Ambac has the right to vacate the confirmed plan of reorganization at this moment, and it will automatically vacate the plan if a massive federal bureaucracy doesn't agree to a settlement by March 14, 2013.

It's time for a discount double check.

We hope you already bought DISCS when we published this. We did, and after learning about this predicament we sold our Sr. Unsecured (38-40) and put about half the proceeds into more DISCS (4-5.5). It turns out that this is a compelling trade whether the POR is implemented (still our base case) or not.

Let's look at valuation under the POR first. With 1.5% of the common and 10% undiluted of the company at a strike price of $750M, the DISC to Sr. Debt price relationship is severely disjointed given the extreme set of possible outcomes. Sr. Debt with a price of 40 currently values the holding company at $500M. This translates into a value of about 1.875 for the common equity portion of the DISCS. To justify the implied value of the warrants with their decade-long life, a black-scholes model produces an implied volatility of 23%, less than twice today's VIX. The smartest investors know that physics equations are too heavily relied upon in finance and economics today. With that in mind, scenario analyses can provide greater insight.

A peak at our adjusted statutory book value translates into a residual value of AFGI (the Hold Co) of $1.5B. That would translate into a value for the DISC's warrant rights of 18.75 and common equity rights of 3.75 for a total value of 22.5 per bond (4.5x current price). Meanwhile the Sr. Unsecured would be valued at about 110 per bond (2.5x current).

The above analysis takes loss reserves at face value. We have discussed the strength of the financial guarantor position in their legal battles over mortgage repurchases. We stand with Jay Brown in his view that the repurchase remedy can, should, and will (if the guarantors see it through) cover 100% of losses as long as the deal sponsor is still solvent. If we assume an 80% recovery rate on Ambac's lawsuits against solvent banks, residual value of AFGI moves to $3.5B; DISCS to 80 (16 x current); Sr Debt to 244 (6x current).

Given that our bear case scenarios (which we view as unlikely) of failure in R&W litigation or liquidation of the hold co would leave both Sr. Debt and DISCs close to or actually worthless, we view the leveraged return potential of the DISCs as highly attractive.

That is all good and well if the IRS hive mind approves the settlement offer by spring. This could all be settled tomorrow, but that is anything but a safe bet to an outsider. So what happens to Ambac and the DISCS if the POR goes up in smoke?

Our debtor would not be liquidated. Rather, another plan would need to be crafted. This presents the threat of a new POR that gives Sr. Debt more or all interests in the reorganized debtor and less or none for the DISCS. This is most likely if the underlying enterprise value of Ambac is less than at the confirmation of the current POR. An equal and opposite force exists: if the enterprise value is higher, then a new POR would more likely give DISCS greater recovery.

Given current market prices of Ambac debt and the ripening of repurchase litigation for harvest, the risk seems to the upside. For DISCS holders, vacation is still a nice treat.

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