Getting Gemütlichkeit with Genworth's LTCI

Genworth has shat the bed! This calls for something special: a complete, unedited, typo-ridden, stream of unconsciousness, celebration of the fallibility of human judgement (...hopefully not my own.)

The company reported over $500M each in reserve charges and goodwill writeoffs in Q3. What's more, the circumstances of the charges indicate a large GAAP active life charge in Q4.

The pending charges are the probable reason that Genworth was at one point down over 50% in two days. My current guess is that this pretax GAAP charge will be greater than "Fitch's current rating expectations assume an additional $500 million to $1 billion of pre-tax GAAP charges." 

Rating agencies took disparate views on the news. Fitch put the company on negative watch while expecting more charges. S&P took the opposite position, downgrading the company and noting "Any additional material reserve strengthening could result in a downgrade." Moody's was least committal, placing the company on rating watch negative while it "will use the review period to evaluate the results of Genworth's review of the margins on its LTC active life reserves."

Moody's also quoted it's SVP, Scott Robinson, who said "Genworth has taken prudent actions to protect its capital position and has the capacity to absorb the announced reserve charge, which was higher than we expected. While we will gain insight into the company's long-term care reserve margins during the review process, we believe the company remains exposed to further, significant deterioration in its legacy block of business."

Indeed. The policies in the active life reserve display much better characteristics than those in the claim reserve (other than not being in claim e.g. tighter underwriting, benefit length, daily max, attained age, etc.). However the active life reserve is split into two buckets for GAAP reserve loss recognition testing (LRT) margin, the older of which is markedly worse than the newer. The GAAP LRT margin on this pre-10/3/1995, "PGAAP" group of policies was only $100M on a $2.5B reserve (both are after tax). The newer "HGAAP" block of policies has a $2.9B GAAP LRT margin on a $13.4B reserve.

The Q3 claim reserve strengthening was roughly 15%. Claim reserves are best estimates, which are used to the active life testing margin process to establish the economic balance sheet margin. That margin is then stress tested to come up with the LRT margin. The bad news is that the actual best estimate of the present value of future claims on the active life book was $37.8B at the end of last year. The good news is that the increase to this number should be substantially less than 15% due to the shorter tail and better risk profile of this book. It is harder for claim severity to increase when duration and daily benefits have tighter caps.

The assumption changes appears to expose PGAAP book to considerable negative margins, while the HGAAP book appears to maintain a decent margin. The increase in PGAAP expected future claims will be higher than for HGAAP. The ratio of expected future claims to active life reserve is certainly higher for PGAAP. We can only guess, but perhaps it is as high as 3.5 versus the aggregate ratio of 2.3. Using a 15% increase on this assumption infers a GAAP charge of roughly $1.3B before any remedial action.

As noted, active life reserves are not just best estimates of future losses, they also also include expected future premiums. Increased loss expectations may increase the companies expected future premium rate increases. This led Genworth to note in its earnings report that "the company is developing related management actions, that it expects will offset much, or possibly most, of the reduction on margins from the claim reserve review." So maybe this pretax GAAP charge number we are playing with gets down to $1B.

But Q4 GAAP troubles could be compounded by additional goodwill writeoff of as much as the remaining $300M. The company noted in a November 6th press release responding to credit rating changes that "These changes in ratings or outlook are expected to reduce sales in some of its products." Lower expected sales was one reason for the Q3 writeoff and there is no indication that the company anticipated the rating and outlook changes.

All this GAAP analysis raises one of the central questions surrounding investment management: "who really gives a shit?" Now that we know the actuarial assessment has changed the economics outlook for the book of business, who cares how the bean counters catch up with reality? For one, we will gain more, albeit incremental insight into the book with every quarter and every review. For another, if we switch to statutory accounting, the bean counting determines dividend capacity and could even require regulators to intervene in the subsidiary's operations. 

There are big differences in GAAP and statutory margin tests. A big one for Genworth is how the book is divided. Rather than PGAAP and HGAAP books, Genworth's statutory tests divide the company between subsidiaries: GLIC, GLICNY, and BLAIC (a Bermuda reinsurance entity for GLIC and GLICNY). GLIC is the largest unit with the coziest margins. GLICNY is smallest and has already established an asset adequacy reserve. This reserve was actually reduced by $40M at the end 2013, but the take away for investors is that this margin is nil. This is where the likely statutory charge will come from in Q4.

Any distinct (non-geographic) characteristics between the books of GLICNY versus GLIC are not immediately clear to your blogger, but it is safe to say that GLICNY book is generally better than the claim reserve book and PGAAP book. GLICNY accounts for less than 10% of total active life reserves and probably accounts for less than $3.8B of the $37.8B aggregate PV of claims and expenses.

Being a New York subsidiary GLICNY follows that state's mandates for margin testing. This includes the unique disallowance of any expected but not yet approved rate increases. This nullifies managements main lever in offsetting increased loss reserves. Still the size of the likely statutory charge in Q4 will be a few hundred million or less. While this could drive unassigned surplus and therefore dividend capacity to or below zero for 2014, management has precluded dividends anyways. 

To put this in perspective, the company would have to post a about a $3B pretax reserve charge to take its RBC ratio down to 200% where the company would be required to submit a plan on how it intends to increase the ratio. $3.6B might get the company to a level at which regulators can take action (principally restricting new business). $4.2B is the level at which regulators have the option to take control of the company and either liquidate or - as is more commonly the case - rehabilitate it. At about a $5B the regulators would be required to take control of the life subsidiaries. 

Needless to say, none of those charges are coming out of the NY sub alone anytime soon. The aggregate book meanwhile would need expected losses to increase at twice the rate of the claim reserve book, with no management action to get to a level where Genworth needs to file an company action plan. Its more likely that the claim book loss expectation increase will be more than twice the rate of active life book loss expectation increase and that the latter will be reduced by management action.



Such reserve charges look increasing unlikely given that two of the large drivers of LTC  mispricing are approaching their limits. When underwritten, the oldest books of business were assumed to lapse at a rate of 6.5% and earn a yield of 6.75%. The lapse rate in the 2013 statutory CFT margin is 0.45%. Genworth uses the actual forward rate curve to predict future investment returns. A final 10 year yield that is 220 bps lower would decrease margins at the company about $2B. A final 10 year yield below 1.5% would be needed to to completely erode the 2013 CFT margin. A ten year of approximately 0.3% is needed to completely erode the 2013 economic balance sheet margin on its own. Given where the forward rate is now, this level of adjustment in interest rates will not be coming this year.

What about reserve increases in future years? This is a more valid concern, but Genworth's life insurance subsidiaries book over $500M of pretax profits annually across all busisness lines. Additionally the present value of future profits on new LTC business accretes to margin analysis as it is booked. Combined these add over $700M to margins annually. Meanwhile the oldest, worst business runs off.

Of course, many believe that it's impossible to make money in longterm care insurance. The most common reasons sited are the information advantage of policyholders, the contradictory incentives of insurer and insured, and the difficulty of necessary forecasting. There may be no other form of insurance that suffers so broadly from all three conditions. 

There may be no business today that suffers from such sparse competition and a negative sentiment. This bodes well for future returns. Genworth has shortened its tail risk, tightened underwriting, and increased prices for expected returns above 20% on new business. So prices for new business have risen not just to reflect more conservative assumptions, but also to make more money per unit of new risk. Meanwhile, Genworth has proven the regulatory appetite to allow for significant price increases on existing business to offset extreme deviations from industry forecasts.

While this is a LTC focused post, there just has to be some comment on valuation. The yield on the jr. subordinated 6.15s of 36 spiked above a 10% ytw from around 7% before the earnings blunder. Genworth has $4.4B of carrying value of outstanding debt (excluding debt at in international MI) with $1.1B of cash at the holding company and $3.3B value of its interest in publicly traded international mortgage insurance affiliates. This shows an impressive faith in management's ability to lose money.

Genworth's US MI unit, GMICO is worth $2.9B if valued at 2/3 (an approximation of relative rate of NIW) the enterprise value of larger MGIC. There are several ways to get to the current enterprise value (with debt at carrying value) from here. One way would value all of Genworth's other businesses at 2x 2013 earnings except for LTC which will need a 0x multiple to get us to the 8.8B EV. 


Taking a different view, management has estimated they can achieve a long term RoE of 9%. If they achieve that target, buying at 1/3 of book value will earn a return on market equity of 27%. Of course, what type of consensus makes for 27% return on your investment?

This may look like child's play to veterans of the mortgage insurance meltdown, but it still is uncertain how the market will react to the Q4 charges. Even though many called for $500M in reserve charges in Q3, the end results still drove many to despair. In the meantime we'll be keeping our pockets open and hoping for GNW to be a penny stock again soon.

Questions for Radian - How to Prove Clayton Buy Is Not Sofa King Stupid

As expected, Radian announced a lights out operating performance that shows they were on a clear path to earning over $400M. Yay! Balloons! Noise makers!

Scratch the record. Kill the music.

Radian announced it will pay $305M for a business that earned $9M last year. Lets me get out my calculator. Yup that is a little higher than the 6-7x normal PE Radian was on its way to. The yield is also lower than the high teens (mgmt estimate) to arguably 20% ROE that Radian is earnings on it's NIW at it's capital starved subsidiary.

But lets not jump to the conclusion that Radian is buying a 3% yield with a cost of fresh capital in the teens. We can pull up financials from when Clayton was a public company to get an idea of their boom time earnings will be. Surely the next boom can't be too far off. Well the companies peak earnings were $15M in 2003 and it's proforma earnings that year were $9M. Wow that is awful close to last year.

Surely past deal makers saw even more potential in Clayton than our trusty Radian leaders. Nope. Back in the heyday of 2006 the Clayton IPOed for a $125M market cap with about $65M in debt. Then Greenfield took them private in April 2008 at a $135M market cap with $25M in debt. So those valuations seem consistent to each other. They are also both 50-63% of what Radian is paying. Radian's presentation does little to justify such a high price which is why I have composed a few questions that management may wish to ponder:

-In your presentation you describe Clayton as a "Non-capital intensive business" which is fantastic, but aren't you spending $305M of freshly raised capital on it? Or was that broccoli you spent? Or are you just trying to tell us that you value this cash flow stream so highly because it does not have a moat of capital around it?

-In your presentation you describe your purchase of Clayton as having a "Future tax benefit from basis step-up". Should I try to negotiate a higher price for a given bond so that I can depreciate a larger premium? Is this Radian's investment strategy?

In your presentation you state "Acquisition is expected to be breakeven from an accretion/dilution standpoint and modestly accretive excluding the non-cash amortization of intangible assets." Is that for 2014? If yes, analyst estimates have 2015 earnings ex-Clayton growing by 50%. Will Clayton earnings keep pace or is the deal dilutive after year 1?


-This deal could only be considered accretive on a normal basis if Clayton earnings growth is substantially faster than MI earnings growth. Furthermore, Clayton earnings would have to attain a far higher than record level, including boom time GAAP and pro-forma earnings. Radian has also said that they do not know when or how final housing finance reform will shakeout. So, what special insight does Radian have that allows it the vision of such high profits at Clayton?

-Simply, how does Radian see twice as much value as a boom time valuation?

-Given the different lines of business and locations, how much expense reduction can Radian achieve with synergies? How does a cross sell function between deal/servicer products and private mortgage insurance (what are the revenue synergy opportunities)?

-Radian has bought diversification across the mortgage market. An investor can buy the S&P 500 and get diversification across all markets for less than half the cost. That one is not a question.

Well this turned out to be more of a rant (OK a temper tantrum) than a list of questions for management. Maybe this post should have been called "Seeing Red with Radian."

Radian management made some graceful moves in the downturn. They managed the bust better than any other company. But now it seems management is doing anything but a favor for shareholders. Managers use your money to buy things for all types of reasons. It may behoove them to diversify their business so that they have a more steady job. Managing a bigger company surely necessitates paying managers more. Sometimes managers acquiesce to large shareholders who may have their own agenda, like buying more stock in a secondary. Many times experts become so overconfident that they actually become worse at their expertise than lay people.

Even if 1) Radian had no other way to utilize it's tax benefit, 2) we think record profits are sustainable and can grow as fast as PMI profits, 3) we add back a $10M amortization, the current yield on the Radian's Clayton investment would be less than 7.5%. It falls at 6.6% without fudging around for taxes. Radian's average analysts estimate (which this quarter was beat by at least 50% anyway you slice or dice operating earnings) for 2014 is 0.95 and for 2015 of 1.45 per share. If you take the most generous current yield on the Clayton investment and the analyst estimates (which were just beaten). then you have something that looks consistent with management's comment on accretion only applying to 2014. Thereafter it would be sharply dilutive.

The good news for shareholders is that this deal is quite small at approximately 10% of Radian's enterprise value. Far worse is having a management team willing or inept enough to destroy shareholder value. Has noted earlier, Radian reported a lights out earnings performance so these are crosscurrents in the market for RDN stock. The only surprise for this shareholder is management's mistakes.

Genworth and Friends Announce Radian Likely to Surprise

Genworth announced earnings on Tuesday night, slightly beating consensus with strong performance in US MI and Long Term Care making up for poor life insurance mortality.

The US MI unit reported a quarterly loss provision of $63M, the lowest since Q2 2007. This is particularly relevant to Radian because of the similar size and reserves of legacy portfolios and defaults.

Radian ended the first quarter with 53,119 loans in default having had 12,113 new delinquencies and 13,645 cures. Genworth ended with 45,861 loans in default having had 12,100 new delinquencies and 13,678 cures. In a normal quarter, new delinquencies are the main drivers of loss provisioning.

MGIC provisioned about $5.3m for every new delinquency in the quarter compared to Genworth's $5.2m.  

The other big swing factors in operating earnings are mostly determined by actuarial assumptions. While books of business vary, Genworth and MGIC all have a primary reserve per delinquency with a $26m handle (Q4 for AIG had a $25m handle, but they haven't reported Q1 yet.) (Genworth and AIG report the components and not the actual figure. Genworth: 1,197mm reserve, 45,861 defaults. AIG: 1,220mm reserve, 47,518. This is not to be confused with "Flow Reserve per Delinquency.") Radian's Q4 reserve per default stands at $26.7m.

Consider also that Old Republic reported a $22.9M Q1 loss provision in its MI unit with an ending delinquent inventory of 35,042 loans, a lower provision to inventory ratio than Genworth. This looks like the result of beneficial developments in expected roll rates, principal actuarial assumptions. While Old Republic does not report report new delinquencies, its provision per delinquency was certainly less than MGIC and Genworth.

So what's the punch line? Radian Guaranty (the MI unit) will probably put up a loss number within the $65-75M area if actuarial adjustments are neutral. Core revenues (earned premiums + investment income) for the MI unit look like they will be in $220M area and $250M for Radian overall. Mgmt guided other operating expense excluding charges associated with stock price changes at down 10-15% for 2014. That implies quarterly core expenses (Other Op Ex - Stock Px Ex + Policy Acquisition Ex + Interest Cost) of less than $83M. Knowing of no deterioration in Radian Asset's book and the expected recovery of TRUPs losses, a $10M loss provision seems conservative, though this number can be volatile. This all adds up to what I'll call a conservative economic earnings number likely to be north of $60M and comfortably above consensus EPS of $0.21.

There are plenty of chances for this number to be muddled in a single quarter. For instance, we already know that the stock px rose slightly in the quarter so there will be a pretax charge of, oh, say  $10Mish. Maybe there will be a random actuarial provision, a legal charge, a single premium business revenue charge.

Still if you twist my arm,  I might tell you that I really think the economic earnings number will be above $75M. I really don't think it matters though. The only real message that investors need to take away from this report is the same one that has been broadcasted since the start of 2013: the foundation has been poured for a long term earnings renaissance.

Radian's core revenues will pass $1B this year before continuing higher despite today's puny origination market. The investment portfolio will continue to compound tax free for many years. Core op ex looks to level off around $350M. The loss ratio of new business is peaking in the high 20% range. Radian is positioned to be earning $400M in 2015 without a growing mortgage market or housing finance reform, both of which currently look more likely to help or greatly help the MI industry.

Sawadee Kraup JPM Settlement

A few updates on thoughts on Syncora on areas that I've been emailed on.

Banks including JPM persistently acted like they were (or are) in the land of smiles on their exposure to monoline put backs, right up to settling in the realm of 100% of liabilities in the case of JPM/Syncora.  In fact as far as I can tell, JPM has now settled for over 100% of Syncora's gross economic (net of remediation) losses in the relevant deals (JPMF 2007HE1, SACO I Trust 2007-1, and BSSP 2007-r5). Syncora likely had extra leverage given that losses attributable to uninsured CF notes are likely only going to have a shot of recovery through Syncora litigation. All in, as they say in the land of smiles, kapun kraup Mr. Diamond.

I'm not privy to how the 2010 remediation and subsequent deals contracted recovery claims. Without that knowledge I can't say it is impossible that uninsured CF holders won't make a valid claim on part of this settlement. I'm not expecting that though. 

Elephants aren't only disappearing in Thailand. I am expecting Syncora will ultimately get another bump in surplus of 250M-400M above current (very low, maybe 25-50M) recovery estimates on their Lehman Greenpoint claim (JPMF 2006 HE1 ax). But that is the only big boy source of upside to Syncora's insured book, which I think has the more problem credits relative to capital than Assured, MBIA, Ambac, Radian Asset, or American Overseas. 

In the past, I have described ABV without new biz as analogous to maturity value of a zero coupon, if installment premiums are not included and roughly offset op ex. So that ABV is basically net assets - net ultimate losses which you can get too via adjusting a securities-only BS or working off the statutory statements. This is just one way to think about it and it is not a conservative one because (among other things) the yield on liabilities exceeds the yield on assets.  Such an ABV number per share for Syncora is very likely closer to (including under) ten than 20 with a higher risk of being 0 than say Ambac's risk of being worth less than 16.67 in 2023. But there is definitely a wider distribution of possible outcomes both ways for Syncora. Combine that with low liquidity and you've got one spicy dish for sure. 

To say the same thing in a new way Syncora could end happier, but Ambac is the better bet for a happy ending.

G'day Bond Insurers

There's nothing surprising in Syncora's announcement of a settlement with JP Morgan. The only "new new" to us is the timing, and while that was highly uncertain it can't be called a surprise. As predicted, the stocks are better indicators of news than headlines. Ambac's stock is telling us that JPM's most recent dose of reality in it's litigation reserves may filter through to the their settlement discussions as well.

Syncora is an easier settlement for the banks than some other FGs because of its size, other trouble spots in its portfolio, and the 2009 MTA restructuring which resulted in about half SYCRF common and all of newly created preference shares being issued to structured finance counterparties. In many cases these were the same banks that were across the table in R&W litigation talks. These all provide opportunities to disguise the actual value of the R&W settlement.

Being a smaller insurer also made it easier to compile the deal level loss data on Syncora. I think I've published this before but regardless you can check it out here. Syncora ought to have targeted full recovery of actual and expected paid claims and we would be surprised if they took anything less than 85%. Not counting losses neutralized by previous restructuring, these loses were definitely over 210M and very likely over 225M. (Note this excludes the BSSP 2007 R5 deal because it's been a while since we've reviewed the indenture in this more exotic securitization trust.) Given the size of Syncora's current R&W recovery benefit and it's claims against Greenpoint, Syncora's economic benefit from settlement is very very likely more than 75M above accounting benefit marks and probably closer to double that.

Whether or not this will be clear in Syncora's financial statements will be determined by the structure of the settlement. For example the full cash value that JPM paid could have been reduced by, trading  Syncora corporate securities or insured securities that JPM likely carried far below market value and farther below par. JPM could also have indemnified Syncora on other exposures.

Ambac continues to be a harder pill to swallow for its R&W counterparties, mostly because of the dolars involved. However, the results and methods we used in this spreadsheet (originally published in this Sept 2012 post) have been confirmed by Bank of America's new disclosure of "over $2.5B" in R&W of Ambac loss compensation claims. Any overestimation of claims in the spreadsheet are most likely compensated for in there being no accounting for other lawsuits and non-litigious recoveries. Furthermore given Ambac's stated intent and position of strength in its breach of contract cases and preliminary success in its fraud cases, the company will likely experience greater than 100% recoveries if only due to interest and legal cost recoveries and not punitive damages for fraud. 

The legacy securities of the DISCs that we recommended buying (and bought) at a rounding error from zero are now at the equivalent of a DISC at 40. And while it's a fair time for a victory lap, Ambac common and especially the warrants still seems like a compelling long-term investment. The warrants offer similar upside to an economic book value as Syncora common, with a higher quality portfolio, better disclosures, and management seemingly more intent on full recoveries of R&W (and maybe even fraud) claims. Both are compelling.

As an aside it's worth noting that while the surplus notes are now trading near par, the perpetual preferred are now trading at 33 by way of Alliance Semiconductor common stock (ALSC, thank you Stephen Pendergast). The Surplus notes are a senior claim and will eventually have cumulative fixed interest (versus non-cumulative non-fixed). I can't figure out if this is a screaming bargain or a trap. Consider for instance that American Overseas (formerly RamRe) is playing hardball with preferred security holders, placing $3 million in a trust to redeem par value of many times that of preferred securities at maturity in 2066. When in doubt, stay without.

That's all for now.

Quick Thoughts on Syncora and Ambac

As expected, Syncora reported its worst quarter since the 2009 MTA last quarter (as measured by change in the Dragon's ABV metric.) If you lightened up in the mid 60s as we suggested, getting back in today at the .52 offer will lock in a good trade. While that trade has been working out, Puerto Rico isn't about to default and JP Morgan is confronting RMBS litigation reality (among other issues) in its litigation reserves. If you made the same trade on Ambac, banking profits there might be wise too. The patient investor will buy and snooze. No need to check headlines, the stocks will tell you when a deal is wrapped up.

Thoughts from the Back Row

1. Radian's delinquent inventory is now less than half it's peak level. And there are clandestine cures in the current number. Recently we've been thinking a lot about the rescission and denials that never were: the claims that were never reported because the loan files were never found, never delivered to the servicer, and never compiled at all. Eventually, the banks realized robosigning wasn't going to work for them.

At the same time, Radian is writing business at a pace that will likely add close to half a billion in value over the life of the business. In a year, today's headlines about the effect of future capital requirements on Radian will prove to be a fart in the wind. However, a correction would be healthy and could be imminent.

2. Syncora should be reporting it's worst quarter since reorganization. There seems to be a hard bid in the 0.6s. It may be wise to lighten up before an ugly quarter, but we wonder if the bid is JP Morgan or Greenpoint and if it cares how much money the company loses. Meanwhile, Syncora wrapped Detroit COPs trade near 48 for a current yield (variable) of 1% or less. If the paper were 20, 60% of the loss is gone on any repurchased paper. It seems pretty clear where that bid is coming from.

3. If you wiggle the numbers around (student loan losses were higher but surplus note repurchases more than offset that), the most recent report on the rehabilitation of Ambac's segregated account looks better than Scenario One. Scenario One was a projection of Ambac's performance under a base case scenario which was made at the commencement of rehabilitation. Surplus was projected to exceed outstanding notes by $4B in 2020, with another $1.2B in qualified statutory capital. That now looks more likely to happen has soon as the company wraps up its R&W claims, especially considering that reserves on repurchased wrapped paper are not released, and there is a lot of it.

4. Obama's support for the principles of the Corker-Warner bill makes a fall or winter vote a real possibility. It won't rally the house republicans around those principles, but it will pin them into being the only opposition to a bill that rids the nation of the ugly legacy of Fannie and Freddie. That's a brand that neither Hensarling nor Boehner is shooting for.

Detroit, Now What?

Detroit will miss a payment on it's pension obligation certificates, setting in motion a slow mechanism to raise taxes "without limit as to rate or amount."

Missing payment on this obligation is interesting for several reasons. Traditional unlimited tax GOs are normally paid by taxes that are levied above and beyond statutory limits in good times and bad. These POCs are not. This means that once the unlimited tax mechanism is implemented mandating payment of vested pension obligations of the retirement system and therefore the POCs that have a acquired those rights, the city's budget will be unaffected because the payments will be covered by new revenues.

Things will get messy in the meantime. Normal unlimited tax general obligation securities would be enforceable by Mandamus and these will be too. But if the city or other parties wish to put up a fight, the unusual nature of the pledge may result in a lengthier implementation of the remedy. The ultimate outcome is more certain than the timing, the Michigan Supreme Court has determined that pension funding payments are constitutionally mandated and that a court can compel a municipality to make them by raising taxes or levies without limit.

Syncora may opt to novate the exposure from SCA to SGI under this scenario and implement a claims moratorium, though we are not sure they would want or are able to implement either of these alternatives. The company was confident enough to increase it's SCA exposure to this credit in the first quarter by buying a $25M chunk of the FGIC-insured bonds for about 67% or par.

The secondary news sources we have seen indicate that Detroit also plans to default on it's ULT and LT GO bonds. ULT GO debt payments may be made by money that would not otherwise be available to the city, so defaulting on these makes no financial sense. The calculus of politics and public relations never makes sense, so we won't dwell on it. Assured Guaranty, NPFG, Syncora and any other guarantors of this debt will face the smoothest process of compelling the city to caugh it up.

LT GO holders and guarantors such as Ambac are sadly screwed unless they have an additional security interest such as state aid. Otherwise their only hope for timely payments of principal and interest is state intervention. Even with a default, actually expunging any of LT GOs for good still seems unlikely without a bankruptcy filing or creditor agreement.

In sum, Detroit is on track to follow the Vallejo model: crushing weak securities while having no choice but to make strong ones whole or near whole. Look for LT GOs to be slashed along with OPEB and non-vested employee benefit liabilities.

Prospects for Detroit's Unusual Bond Pledges

Despite the emergency financial manager protestations to the contrary, Kevyn Orr is almost certainly going to recommend a Ch. 9 filing for Detroit. The governor's approval is a significant hurdle to that recommendation becoming reality, especially considering that the emergency manager law stipulates that the city plan and budget to repay debt service in full. Orr's recent comments suggests he does not seek to abide by that statute.

Of course, Orr's attempt to reduce debt service may be inspired by public relations more than bona fide expense reduction. OPEB liabilities are generally written in graphite, not ink, even before considering the special powers vested in the emergency manager. Detroit's $6B liability can go as low as Orr needs it to go, but attacking malicious Wall Streeters will give him and his supporters cover to take actions with less legal hurdles.

Imposing losses on debt holders and insurers will take a bankruptcy filing, and even then, only limited tax general obligation bonds would be in serious danger. These LT GOs are an emperor with no clothes: while they are called general obligations, they are not the unlimited tax GOs that are the pinnacle of legal security in muniland. The LT GOs must be paid for out of available sources in the general fund, and as such their credit has more in common with traditional Certificates of Participation and lease revenue bonds than ULT GOs. COPs and lease revs traditionally are secured by a leased asset while LT GOs are basically just an unsecured credit of the general fund. Based solely on the pledge behind the bond, Detroit LT GOs could fair worse than Vallejo's golf course COPs. Lobbying by the cult of GOs would be the best hope for these bonds should a Ch. 9 filing occur. Detroit has uninsured and Ambac-insured LT GOs outstanding.

Pension Obligation bonds traditionally have LT GO pledges, but Detroit bucks the trend here too. The city's Pension Ob structure is technically a lease revenue, but has all the strength of an unlimited tax general obligation. More specifically, the credit has all the strength of vested benefits of a pension plan including an unlimited taxing authority should the city miss a payment, legally transferred to it with that transfer receiving the blessing of a court. Detroit's Pension Obligation Certificates are insured by FGIC and Syncora. NPFG/MBIA and Assured Guaranty insure some true ULT GOs.

Like Vallejo, Detroit's essential service revenue bonds will likely remain unaffected by any emergency manager debt haircut initiatives or bankruptcy filing.

JeffCo Addendum for Syncora

Within the Plan Support Agreements alone, Syncora looks to be taking a loss of $60M-90M for a net reserve release of $40M-$70M based on our read of the deal. This seems like a reasonable settlement as it would be better than the terms of Syncora's 2010 commutation of JeffCo exposure, and rightfully so since this agreement releases J.P. Morgan from all related litigation. 

Still there is an outside chance of there being an agreement outside of the PSAs, but we don't think so. On the upside this would mean further compensation for releasing JPM from litigation. On the downside it would mean having recently commuted exposure for a substantial sum prior to this deal. 

Indeed, we had previously thought that the April commutation contained Jefferson County exposure as commutation payments are typically the sum of net unearned premiums and loss reserves. About $10M of the $91.5M April payment is unearned premiums and only Jeff Co reserves could account for that type of payment. It now seems to us more likely that this $80M excess over unearned premiums was in compensation for some insured or underlying asset. This means most of the bump to surplus from this deal is coming from contingency reserves. Contingency reserves would be considered cookie jar accounting shenanigans under GAAP, so the April commutation appears to us to be a non-event.

So there it is. The deal leads to $40M-$70M reserve release unless we are wrong on there being an additional agreement.

Fun Facts on the JeffCo Agreeement

While less interesting than the Red Wedding, there is plenty of entertaining tidbits in the 336 page finale to the Jefferson County debacle. Here is what stood out to us:

1) Insurers will essentially pay no further claims. Assured will be compensated for all payments it makes and the vast majority of all other insured warrant holders must commute their exposure, or else there is no deal. With $2.4B of warrant holders contractually obligated to support the deal, the commutations will or should happen. We don't know if the plan will force all non-Assured warrants to commute though it seems that it will. Ambac did force a commutation settlement of all its Las Vegas Monorail exposure several years ago. It is also possible that all FGIC ($1.4B) and Syncora ($700M) wrapped paper is embedded in that $2.4B. But for other warrant holders, the commutation election is independent of voting for the plan of reorganization.

2) The 20% haircut to warrant holders is well within the opportunity and legal costs of duking it out with the county, so this does not diminish the standing of the rate covenant or net revenue pledge. Most warrant holders are earning only two times LIBOR on a junk credit, the 20% they are losing out on can be earned back elsewhere in four or five years.

3) The $165M payment to insurers is not enough to make them whole in settlement of $335M of certain warrants that they own (non-2013 warrants). Pay close attention: the payment is made to the insurers collectively and not simply 49% of each warrant. It makes the most sense for this payment to be divvied up not based on the warrants owned, but for the losses on these warrants to be in proportion to each insurers total exposure. This would fit intuitively with industry commutation practices. For example, if each insurer took a 5% loss on total exposure that would work out to losses on direct exposure of: Assured - $10M; Syncora: $50M; FGIC - $75M. Golly, it looks like the losses were just north of 5%, and in exchange the insurers will no longer incur significant legal costs. This is well within even FGIC's reserves, which we believe are the lowest (for example, lower dollars reserved than Syncora despite having more net exposure.)

4) The language in the agreement does not seem to absolutely disallow additional outside agreements between the parties, but this is our lowest confidence read. An outside agreement would allow councilmen to campaign on having made all of Wall St. bend the knee when perhaps all the payments are ultimately coming from JP Morgan's pocket.

Old Republic Read Through - MI Profits on the Way

Old Republic's earnings announcement on Thursday showed that the company's  mortgage insurance business was essentially break even in the first quarter despite having been in run-off since August 31, 2011. It's safe to say that should the company have continued writing business at a decent clip, the unit would have been profitable. Likewise, extrapolating the results to Radian and Genworth shows that those companies should be profitable in the first quarter, while MGIC could be close. Radian and Genworth have the most new (post-2008) profitable business and strongest reserves, respectively.

Reserves per default are set to spike at all of the MI companies. Our darling, Radian is set to see the primary reserve per default increase by as much as $2m to $3m depending on the level of provisioning. That will bring the total above $30m.

The level of profits at these companies will not result in P/E levels that justify the current stock price. But that's not what this earnings season is all about. This season should be when the industry's financial trajectory becomes clear to the guru watchers and serious "home gamers" rather than just the obsessed industry-following clowns.

More and more capital is recognizing that the fix is in financially (Post 11/6/12 rebuttal to Barron's). There is plenty of room to run on that path as normalized profits begin in 2015 with record profits possible for some shortly thereafter. After that, the next leg of the run would come from housing finance reform, but that's a whole other story.

Reasons to Expect a Larger Share for PMI Industry

The role of private mortgage insurance (PMI) is set to grow. Independent initiatives by Congress, the administration, FHA, FHFA, and other government agencies have created and/or seek to create a housing finance system that would expand the role of PMI. Meanwhile, the return to normal household formation levels and pent up demand bode well for home purchase volumes. Money has flowed back into the industry: market insider Old Republic bought a minority stake in MGIC, Arch Capital bought the MI operating assets of bankrupt PMI Group Inc., and market leader Radian Group broke above $1B in market capitalization for the first time in two years. The following articles highlight major opportunities for market participants.

http://www.corelogic.com/downloadable-docs/MarketPulse_2013-February.pdf
CoreLogic's recent Market Pulse newsletter said that rather than the 20% down payment baseline under the 2011 QRM proposal, "it is anticipated that the QRM rule, to be released by the end of Q2 2013, will impose a minimum down payment restriction of 10 percent." The study also shows the size of a 5% or lower down payments segment of the market, but not the 20% or lower segment. "Meanwhile, a bipartisan group of senators who drafted the language requiring the QRM rule in the 2010 Dodd-Frank Act wrote a letter to regulators yesterday urging them to drop a strict down-payment requirement."
http://www.bloomberg.com/news/2013-02-13/housing-industry-pins-hopes-on-obama-to-soften-down-payment-rule.html
This article sites broad-based support from the administration to Congress for aligning QRM with QM. Interestingly the article concludes with this: "Not everyone in the housing industry favors merging the two rules. Private mortgage insurers, which protect lenders against defaults on loans with down payments below 20 percent, stand to gain if the QRM rule allows its down-payment limit to be waived in some cases when the borrowers buy their coverage." Out loud, the PMI industry has been crying loudest for a reduction in the down payment requirement, becoming the only low down payment means of complying with the rules would create a boon the industry has never seen before. 

http://financialservices.house.gov/calendar/?EventTypeID=309
House Financial Services two early February hearings on FHA and Mortgage Insurance garnered broad, if not unanimous, bipartisan committee support for further curtailment of FHA and expansion of private mortgage insurance. In the hearing focusing primarily on FHA's health, Carol J. Galante, Commissioner and Assistant Secretary for Housing at FHA, testified that FHA is currently working to reduce it's underwriting share of the mortgage insurance market. Talk has grown around the idea of FHA-PMI risk sharing arrangements may create a new opportunity for PMI companies.


http://www.fhfa.gov/Default.aspx?Page=30
In his latest speech on December 8, 2012 Edward DeMarco, Acting Director of the FHFA, overseer of Fannie and Freddie, said "Also part of any transition are steps that FHFA is taking to contract the Enterprises’ operations – whether it is increasing guarantee fees or pursuing risk sharing alternatives. These initiatives have the potential to transfer some credit risk to the private sector, a goal that most policymakers seem to agree with." This followed comments on November 28th "As we seek to reduce the Enterprises’ long-term risk exposure and place them in a more stable financial condition, we are examining various methods of risk sharing, including the expanded use of mortgage insurance and securities structures that allow for private sharing of risk."

The House that S.A. Built

We called a bottom to the MI stock rout on 8/25/11 here. Since that time the worst performer, Genworth, beat the S&P by 4% returning 41%. Radian returned 200% after answering The Dragon's Capital Question by implementing precisely the commutation solution that we had suggested. We reasserted our view of Radian in response to Barron's November 6th article asserting Radian was "A House of Cards."

Now we will justify why market prices of Radian and MGIC diverged in 2012 and what that means for investments now. While we have hardly mentioned MGIC on these pages before, we did and do consider the company solvent in the sense that there exists value in equity if liquidity does not get in the way. But liquidity does look likely to get in the way.

MGIC will have a holding company cash position of $187M in Q4 after accounting for $200M in contribution commitments to its operating subsidiary and $13M in non-deferable interest payments on Sr. Notes. The company has $100M of Sr. Notes maturing on 11/1/15 and will need to make $26M in interests payments for each of the next three years. This means that without any other sources or uses of cash, MGIC will have approximately $9M at the holding company at year end 2015.  Without a large downward revision to its expected claim rate on its legacy book, MGIC will likely still exceed a 25:1 risk-to-capital ratio at that time.

The future of the company then, is dependent on access to capital markets. The Dragon guesses that they will have it, but price is wildly uncertain. For that reason, the best place in the capital structure looks to be the subordinated debenture 9% of 2063 recently trading around 46 with substantial deferred interest. (The securities are 144a meaning only qualified institutional buyers may purchase them, thanks for looking out for the little guy big brother). We see this trade returning 40% annualized through 2016 if a liquidity solution is realized. The odds are good, but we think we can do better. Playing the market access game has never been our favorite bet.

We claim no exceptional forecasting power in forcasting market access, a clear hurdle to committing capital here. There is an attractiveness to this trade in so far as it is robust to long term perceived uncertainty of the role of PMI. However, the Dragon  believes that role is more certain than the market suspects. Old Republic, a market insider, and newcomer Arch Capital are betting that way. Old Republic acquired a minority stake in MGIC common stock and Arch announced the acquisition of PMI Group, Inc assets.

For the PMI industry's future, the big question on everybody's mind is QRM and housing finance reform. Whether the initial QRM proposal is revised or not, PMI on qualified mortgages is going to be the main show for low down payment mortgages. Retaining a 5% interest might increase cost, but hardly makes the product unworkable. QRM implementation would also likely come after a QM-like exemption while the GSEs remain in conservatorship. Meanwhile FHFA Acting Director Edward DeMarco has voiced support for an expanded role of PMI. DeMarco faces hostility from Senate Democrats over his resistance to principal reduction, but such an idea would fit with any FHFA director's duty to fulfill a mandate to "foster liquid, efficient, competitive, and resilient national housing finance markets (including activities relating to mortgages on housing for low- and moderate-income families involving a resonable economic return that may be less than the return earned on other activities)."

With that in mind, we would rather continue to focus capital on the greatest franchise in the industry. Radian's handling of the housing collapse was nothing short of a masterstroke. The firm aggressively expanded sales efforts just as pricing firmed and competitors retreated from attractive business. Peripheral businesses were sold (or commuted) when capital was needed but after valuable income had been earned and saleability improved. The maturity of the financial guarantee book coincides with debt maturities at the holding company. The company has shifted to more monthly (versus upfront) premium business in anticipation of higher interest rates and longer persistency. Interest cost reimbursement agreements with subsidiaries and the opportunistic repurchase and extension of debts has ensures holding company liquidity until 2017. By that time, dividend capacity and operating earnings will likely be at a record.

Even with S.A. Ibrahim at the helm, Radian will probably lose share within the PMI industry as new entrants and re-entrants fight for a piece of the pie. Meanwhile, refinancing activity will decrease. But the overall PMI market will grow with household formation and home purchases (even in the current low interest rate environment refinancing accounted for only 38% of Radian's NIW in the first 9 months of 2012). All in, Radian's levels of NIW are sustainable. Almost as important, slow moving prices and rising interest rates will keep persistency high on a book of business that is focused on monthly premiums.

Radian publicly says that it expects every $10B of NIW to generate $75M net present value. This appears to be consistent with 70% persistency and a 50% combined ratio. A persistency of 80% would be the lowest in since 2007. The expense ratio has been under 25% four of the last five years (2008 was 29%). Finally, the 2010 book of business is performing at a loss ratio under 10% YTD in it's second full year, a time period normally associated with close to peak losses. From this seat, a persistency at 80% and a combined ratio of 35%, the NPV of $10B looks more like $125M. If so, Radian added value of half a billion dollars, or 2/3 of it's market capitalization, in 2012 alone. But NIW in 2013 has the momentum to be even higher.

That is why we won't settle for an expected 40% per year for 4 years on jr. subordinated MGIC paper.

In the short term for Radian, CFO Bob Quint's expectation as of the Q3 call for "a larger MI operating loss as the negative impact of seasonality on both new defaults and cures is expected to result in significantly higher incurred losses for the {4th} quarter." However both defaults and cures were slightly better while claims paid were about 1% higher.

We never invest based on market witchcraft: technical analysis and chartism. Stoicism has served us better than fast-money market timing. However, watching the telltale signs of this sorcery fascinates us. Two things speak to us from the charts: the fast money is in, but for the real money looking to enter, the pain trade is higher.

The Fix is in at Radian

We've been wanting to revisit our enduring love of Radian for sometime now. Over the weekend Barron's wrote an article "Is Radian a House of Cards?", so we just can't put this off any longer.

Experienced money managers put millions of dollars to work without having the facts straight, so we weren't surprised when a young blogger made several factual errors in a Seeking Alpha Blog Post some weeks ago. In that context it also shouldn't be surprising that a well regarded publication makes the same mistakes in their effort to create this week's 50 inches of text.

It's curious though that both made the mistake of saying Radian was increasing upfront premium business in an attempt to hoard cash at any cost. The number unequivocally say otherwise. So does S.A. Ibrahim on the last two conference calls when he has explained that the shift to monthly premium business is the result of pricing and sales incentive changes that reflect Radian management's view that interest rates and refinancing may have finally bottomed.

The Seeking Alpha Blog took the time to explain how denials will be overturned in waves once an initial 12 month waiting period runs out. This is the opposite of reality in which denials can typically only be overturned within 12 months. Barron's is not quite as egregious, noting that "[Denials] represent claims on which paperwork was missing. They are typically reinstated months later and then approved." Oh missing paperwork. Let's just go back to the file and get it.

WRONG!

Have we forgotten how all of these loans were underwritten? Have we forgotten how to spell MERS? If you think Radian is going to accept robo-signed paperwork dated four years after a loan was underwitten, you had better pass whatever you are smoking over here. And as for typically being reinstated and approved months later, Radian published it's denial reinstatement rate going back to 1Q07. A total of five (5) had reinstatement rates over 50%. What's typical about that?

Speaking of vocabulary, Barron's describes Radian Asset as "double-pledged" against it's own policies and those of Radian Guaranty. This is actually known as stacked subsidiaries in corporate finance and it is not illegal for banks to own subsidiaries, in fact it is common. Under this definition in fact any Bank Holding Company (or any holding company) debt or TRUPS would be backed by the "double-pledged" assets that also back operating company deposits.

Listen to Barron's: Radian can deny claims based off missing paperwork that never existed. The fix is in, Radian is solvent. The bigger question for the company now is housing finance reform, including QRM.

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.

Assured's Other Subsidiary

The likely consummation of AORe's (formerly, RAM Re) commutation with FGIC will leave the Bermuda-based reinsurer with almost no exposure ceded from companies other than Assured Guaranty.

The only other client listed in AORe's annual report is Syncora Guaranty, but the evidence suggests that this is a very small amount. AORe documents show the company with total insured par outstanding ex-FGIC of $11.1B. Meanwhile figures derived from Assured Guaranty documents suggest approximately $11.5B ceded to AORe. While rounding and loss reserves likely cover this discrepancy, those adjustments leave little room for much business ceded from Syncora.

Just because Syncora's piece of the pie is small doesn't mean it's insignificant. If a cherry pie has one sliver of crap in it, most people won't eat any of it. When AORe and Syncora parted ways on most of their business over three years ago, they may have kept an uncertain credit or two on the books. Jefferson County Sewer comes to mind.

Assured itself likely has ceded JeffCo Swr exposure to AORe. That, along with ceded RMBS, should not stop Assured from reassuming business from AORe - either through acquisition or commutation - because Assured  receives no rating agency capital relief from the unrated reinsurer.

As the only survivor of the financial crisis to continue writing new business, Assured must see the rating agency models as key to its current prospects. With a rating of Aa3 with a negative outlook from Moody's, a downgrade would put the company into the credit rating range of its target market. Due to the current focus on ratings, Assured must look to reduce single risk limits, especially of poor credits, which are especially detrimental in this post-apocalypse ratings world. But if the rating agency's don't recognize the a portion of the risk as ceded, there is no rating agency reason for Assured to reassume the business. Indeed, reassuming the ceded risk would essentially amount to an increase in capital to the tune of the net unearned premium and loss reserves taken as payment for a commutation.

If (read: when) Assured decides to retake this business, AORe would exist as an investment portfolio of $225M with approximately $105M in liquidation value of preferred stock. That would net out to about $45 per share, or the true Operating Book Value when preferred stock is properly accounted for.

Assured is currently trading at a discount to book value, which means the AORe opportunity presents access to the cheapest possible capital. While it is not a very large source of capital, it is accretive to shareholders and all or almost all benefits to rating agency models. 

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.

And They're Off!

Sometimes a man has to try not to shit himself. Normally looking at numbers doesn't make that so hard. Anyway, let's look at Syncora's big quarter...

Surplus increase from Q1: $321M
Liquidation Value of Sr. Interests Acquired: ~$115M ($105M par)
Gain to be recognized next quarter: $10M
Total benefit to Hold Co common: $445M





Now lets plug the quarter's numbers into a calculation of Adjusted Book Value. This has not been a positive number in the past:
(SGI Surplus) + (SGI & SCA Contingency Reserves) + (SGI & SCA Unearned Premium) - (Surplus Notes at Liquidation Value) - (Preferred Stock at Par) =
$514M + (100+234M=) 334M + (233M+332M=) $565M - $640M - $390M +$10M = $393M



We believe this quarters numbers include the full excess of the cash portion of the countrywide settlements above booked recoveries. This "Type I - Subesquent Event" does not appear to have influenced expected recoveries on non-BofA repurchase requests. As evidence we point out the reduction in outstanding repurchase requests from $1.6B to $0.9B - presumably from the countrywide settlement - while the booked reserve adjustments fell to a piddly $95.5M. In fact, the reserve adjustments fell from $233M or 59% compared to the 44% fall in outstanding requests.

These remaining outstanding requests are now primarily with GreenPoint (Capital One) and EMC (JP Morgan). We believe there to be significant upside to these reserves, though probably not in the same recovery-to-request ratio as the BofA deal (which would imply a final cash recovery of $482M.)

But lets get back to the numbers that were published. ABV means nothing if a company loses it all before it is accessible to shareholders. To that end, we note combined SGI and SCA statutory income statement numbers:

Q2 2012 YTD investment income minus non-loss expenses = $8.5M or $17M annualized
Surplus note accretion will be about $36M in 2012 if all remain outstanding.
Combined SGI & SCA 2012 installment premiums will be roughly $50M.
Pre loss earnings without unearned premium release or accretion would then be $17M-$36M+50M= $31M.


This tells us that our ABV number would grow by $31M per year before considering loss developments and extraordinary items. This is without considering the effect of increasing invested assets by $375M (and thereby investment income). Better yet, this could translate into an increase in invested assets of $200M and retiring the short term surplus notes at outstanding liquidation value and accreted interest. There may of course be the opportunity to tender the notes below that value. This is no stretch of the imagination considering that the NYDFS apparently allowed Syncora to trade some asset for surplus notes, preferred stock, and even Hold Co common.

In prior quarters, we described Syncora common stock as a an at the money or near the money call option. It now looks solidly in the money. Said in terms of loss provisions, there is now value to common that can be lost rather than recoveries necessary for value to be realized. Meanwhile, Syncora's loss cycle has turned. We believe that there are significant recoveries to be realized from not just GreenPoint and EMC but also Jeff Co sewer. The basis for that is the ultimate strength of the rate covenant and net revenue pledge - upholding either one would be enough for full (FULL) recovery; Q2 Jeff Co loss reserves were $132M. The real threats to that recovery are Syncora's ability to see it through rather than the security of the credit. There is (a lot) more to that story and that is for another time (... in part on this page and this page (but not really this page.))

Ah Yes, Syncora

Many particulars and more importantly the entire statutory financial impact of Syncora's settlement with BofA should be evident in the next week when the company reports statutory results for Syncora Guaranty (SGI).

Based on recent RMBS recoveries at SGI, we expect that the announced $325M cash portion of the deal will result in more than $280M ending up with SGI while the rest flows to reinsurers and uninsured certificate holders. This number may overestimate the amount going to certificate holders due to the asset exchange, the still largely undisclosed portion of the deal.

Regardless, the cash numbers are impressive on their own and fall at the top of our previous range discussed here. We have continued to play with our spreadsheets for our own investments even while we were uninspired to write. Syncora's numbers haven't been changed for Q1 2012 but you can still get an idea of what is going on here.

All in, our rough estimate is for the cash portion of the deal to raise statutory surplus by $125M to $175M. Expected put-back recoveries from other counterparties may increase as well. There is no way to gauge the effects of the other remediation mentioned in Syncora's July 17th press release.

We speculate that the asset exchange portion of the deal will have a partially offsetting effect on surplus as surplus supporting assets were exchanged for interests that never reduced surplus. Syncora likely exchanged substantially all of their BofA insurance cash flow certificate and BofA uninsured cash flow certificates for some or all of BofA's interests in Syncora companies. This is what would really make this an earth-shattering, immediate-decimal-place-shifting event for the stock.

At the time of the 2009 MTA agreements, Bank of America and Countrywide would have been small to absent counterparties in the agreements on their own. The 2009 MTA agreements focused on CDS which largely was underwritten on CDOs, not the RMBS securities that the present settlement focuses on. However, BofA had already acquired the big player in CDOs, Merrill Lynch, whose salesmen crisscrossed the country in 2007 getting insurers to "derisk" their CDO warehouses.

Ken Lewis and John Thain shook hands in the fall of 2008, only to learn that two rocks tied together still sink. But BofA's acquisition of ML may be what brings Syncora to the surface in 2012. Based solely on historic market share, ML could easily be the holder of 1/4 or more of the roughly $900M (liquidation value - doesn't include common stock) of previously outstanding 2009 MTA securities.

While none of the securities involved in the asset exchange have any effect on statutory surplus and all are subordinate to claims payments, we view it as positive that per the press release Hold Co securities were included in the asset exchange. This could only be common stock, 40% of which was included in the 2009 MTA. We find it unlikely that Hold Co securities would have been included if all SGI securities were not also included.

This asset exchange portion of the settlement also has positive implication for Ambac debt holders as the establishment of its segregated account has a similar legacy as Syncora's 2009 MTA.

Next week's statutory statement should bring a pretty good idea of the impacts of the asset exchange. In the meantime, there were about 200k shares offered at 0.34 late Friday. We might chip away at those next week.