October 20, 2005

AMBAC: Katrina loss reserves: "All ... er Nuthin?"

SUMMARY: AMBAC announced a $92 million (before tax) provision on Katrina-related financial guarantees. In other ways, the earnings conference call was uneventful. Is $92 million too little--or too much?!? More importantly--how does management propose to regain its 15+% ROE, that for so long, led the financial guaranty industry? Is it looking at new credit-related businesses--or just hoping that spreads and competition will, somehow, sort themselves out. We watch and wait!

AMBAC (symbol: ABK), announced 3Q2005 earnings results yesterday (10/19/05), which included hurricane Katrina-related loss provisions ($92 million, before tax, $62 million after-tax) related to "public finance" guarantees on some $1.1 billion debt principal amount in the Gulf Coast area. I wish they disclosed more about how they came up with $92 million. Are these solely muni credits? Or do they include other tax-backed, quasi-muni, obligations? How many years debt service do they expect to pay on defaulted bonds, and what about potential recovery efforts? And specifically, tell us about specific provisions by obligors. They were a bit cagey about this during the call. Anyway, you can listen to the recording of the analysts' call.

Aside from this, the 3Q call was uneventful. Revenue pressures continue. New competitors, alternative "financial guaranty" products (e.g. senior-subordinated structures) and narrow credit spreads that persist in virtually all credit markets--all challenge the 15+% ROE the company has until recently been generating for investors. However, anyone who follows the industry knows this.

But what about the adequacy of that $92 million on $1.1 billion notional principal amount??? On one hand, you could say that ABK, known for its relative "transparency", is conservatively provisioning its Katrina exposure.

"Everyone" knows--and the rating agencies support the view, through allocating next-to-zero capital charges to "municipal" debt--that munis don't default, they just restructure. So, "$92 million is conser... ", you get the picture.

Alternatively, ABK could, also conservatively, argue: "we might have to pay some debt service on bonds of a few hard-pressed localities--BUT we will recover in full. Munis HAVE to make us whole--or they will look bad in the capital markets and be precluded from future borrowings, which they can't... etc., etc. Therefore--we're NOT booking ANY Katrina provision".

Yet another alternative--if you don't buy the "munis can't default, so I can't lose" argument, you could say that the entire principal amount -- $1.1 Billion -- is at risk! This is because "contagion" spreads quickly in the financial markets. Borrowers ape behavior of similar borrowers who have "gotten away with it", especially government borrowers.

Recall that a few months ago, Argentina simultaneously "cleared its name" and reneged on $ Billions owed private investors. WSJ: Bondholders await Argentine Payment. Now, you read that in Africa, Zimbabwe says it may have to nationalize investments to compensate for the economic losses of its own making... and then there's Venezuela: WSJ: Chavez Says Venezuela to Cancel All Existing Mining Concessions.

Once you go the route of questioning rating agency muni capital charges and therefore financial guarantor muni exposure, why stop at Katrina exposure? Why stop at AMBAC? Yes, it is scary--I mean, at least half the financial guarantors' $ Trillion+ guaranty portfolios are muni risk.

This wouldn't be the first time rating agency models have not performed as advertised. Remember Asia and emerging markets (1997), Russia (1998), Enron (2001), CDOs (2002... going forward)???

One thing missing from Ambac's 3Q earnings call: Disappointing that Ambac did not address efforts as regards new businesses to generate "15+% ROE" for shareholders. Yes, credit spreads are narrow. But what else is management doing?

The point here is that ABK's $92 million Katrina provision is neither "too little" nor "conservative". It just "is". And for now, it provides a good opportunity to legitimately stockpile earnings reserves, should competitive revenue pressures continue and "15+% ROE" be a thing of the past.

Posted by at 12:57 PM | Comments (6218)