|Shares Out. (in M):||157||P/E||n/a||4x|
|Market Cap (in $M):||3,392||P/FCF||n/a||n/a|
|Net Debt (in $M):||0||EBIT||0||0|
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Ticker L / S Price Date Name Sector
AGO Long $21.66 11/16/09 Assured Guaranty Muni Bond Insurance
FY + 1
FY + 2
Fully Diluted Shrs M
P / E
Stated GAAP BVPS
Stated GAAP Tang BVPS
Q309 run rate implies $7.20 in EPS in "no loss" muni environment
BVPS EX MTM, including full reserve for likely losses
Adj BVPS (adding Unearned Premium - Def Acq Costs)
Quick Pitch: Target: $50. AGO had it's last major downside taken away Friday 11/13/09 as Moody's said it would keep the insurer "AA" if it completed a set of reasonably achievable capital plans. AGO equity will revalue upwards from the probabilistic pricing in of "soft run off" liquidation value (which would have been driven by a Moody's downgrade) to a reasonable multiple on EPS power. In a normalized loss reserving environment (which should be approaching by Q110), AGO should have an operating earnings run rate of $7.20 annually and is currently the only primary muni bond insurer. It's massive earnings power (due to a very accretive Q309 acquisition of FSA) has not yet been evaluated by the street. The severe threat of a Moody's downgrade has kept analysts away from the stock. AGO is now able to pick and choose their muni wraps, raise prices, and add a tremendous amount of long-lived muni bond insurance to their book of business. Visibility towards $7 in persistent operating EPS should help move the stock to $50, which will still be a discount to adjusted book value per share.
1) 11/10/09 pre-release of Q309 EPS indicated a $7.20 operating EPS run rate.
2) Visibility to the end of reserving for structured product losses is now here.
3) FSA acquisition is massively accretive, closed in Q309 and not yet evaluated by the street.
4) Moody's downgrade risk was divergently negative relative to S&P and Fitch and was a major source of distraction / frustration for the management team.
5) Several near term catalysts.
1) 11/10/09 pre-release of Q309 EPS indicated a $7.20 operating EPS run rate.
Q309 Op Income Adjusted for Merger, 1x Expenses
Financial Guaranty Contacts Loss Reserving
Credit Derivative Loss Reserving
Total Op Income in Normalized Loss Environment
Q309 Normalized Op Income Per Share
Although the "zero loss" underwriting business model of muni bond insurance is challenged by some noted investors (when it benefits them to do so), it is a business model that existed well through the 70's, 80's, 90's and has existed through the financial crisis. Their have been minimal losses on muni wraps through history, and many defaults often result in a full recovery from a new, tax-backed issue. Jefferson County was one recent loss. Losses have generally been confined to small, speculative muni issues that go uninsured. Muni wrappers function as "real" rating agencies - they actually do granular work on their rated issues and approve only "zero loss" issues.
2) Visibility to the end of reserving for structured product losses is here
The vast majority of the reserve building of AGO & FSA has been from their structured RMBS exposure. Here's what the combined company will look like on insured par exposure:
|$B Net Par Outstanding|
|Total Insured Par||US Public Finance||US Structured Fin||International|
|Assured Guaranty Corp.||128||49||60||19|
|Assured Guaranty Re||119||76||21||21|
|Total Proforma AGO||663||412||165||86|
AGO / FSA have been building their structured loss reserves for several quarters. They update realistic economic / default assumptions each quarter and add to their reserves based on assumed losses over the life of each contract. At this point we have seen the "hockey stick" growth of 30-60 day defaults in RMBS deals move to a "plateau" as the burn out of speculative mortgage borrowers has occurred. High unemployment will keep defaults persistently high, but more predictable.
In terms of buckets generating the most loss reserves, it has generally been the $24B of remaining RMBS net par across both companies, and the worst ~15% of those deals (the ones with the low subordination levels). Up through Q209, the combined companies had taken $2.7B of reserving charges. In addition to this, AGO's acquisition of FSA was for $800M, or less than 1/3 of it's $2.8B of book value at the time of the deal (that already included $2.3B of reserving through Q209). (More on this later).
Here are the details on AGO's & FSA's reserving through Q209, given each problematic bucket of exposure. (Note that FSA's table doesn't include it's full public finance exposure):
|FSA Structured Exposures & Reserving|
|Total Net Par||Q209 Incurred||H209||Net Loss and||Reserves|
|$M||Outstanding||Losses||Incurred Losses||LAE Reserves||% of Par|
|Alt-A first lien||1,474.0||61.8||102.6||222.4||15%|
|Alt-A option ARMs||2,438.0||93.7||177.8||490.5||20%|
|Total U.S. RMBS||11,523.0||74.1||390.8||1,340.3||12%|
|Other structure finance||18,399.0||6.1||5.7||22.3||0%|
|Total non-derivative financial guaranty||97,776.0||77.2||230.4||1,554.8||2%|
|Credit Impairment on Credit|
|Derivatives in the Insured Portfolio||505.0||43.4||66.1||147.6||29%|
|AGO Structured Exposures & Reserving|
|Total Net Par||Q209 Incurred||H209||Net Loss and|
|$M||Outstanding||Losses||Incurred Losses||LAE Reserves|
|Prime first lien||729.0||-0.1|
|Prime closed end seconds||314.0||20.4||27.9||36.0||11%|
|Alt-A first lien||4,430.0||18.9||17.6||43.4||1%|
|Alt-A option ARMs||1,215.0||15.2||24.8||45.6||4%|
|Subprime first lien||5,015.0||5.3||11.6||26.7||1%|
|Total U.S. RMBS||12,471.0||67.2||91.5||160.6||1%|
|Other structured finance||49,736.0||-1.6||-11.9||34.5||0%|
|Total Financial Guaranty||127,698.0||72.5||95.0||217.6||0%|
|Proforma AGO/FSA Approx Total Reserve Level||1,920.0|
3) FSA acquisition is massively accretive, closed in Q309 and not evaluated by the street yet.
The AGO acquisition of FSA, closed on July 1, will create a massively accretive effect on AGO's reported EPS. AGO paid $800M, an almost $2B discount to FSA's book value at the time (which had already been hit with $2.3B+ of reserving).
This is resulting in a massive $1.6B unearned premium reserve being booked (instead of negative goodwill) to decrease the purchase price of FSA to the market transaction price. This is a massive cookie jar to AGO's earnings, and we can start to see the effect in Q309. Basically, the FSA half of AGO will have to work through that UPR and amortize it into earnings before any additional reserving gets done on FSA's book. Preliminary indications from AGO indicate that there will few one time boosts to Q309 earnings and the operating rate shown above in point # 1 is sustainable.
The Q309 earnings prerelease of Nov 10th indicated ~$275M reserving done in Q309 - that by definition must be mostly on the AGO book. This appears to be a "kitchen sink" reserve to create the last messy quarter. Now they can go forward with the FSA deal closed. It makes sense that AGO's reserve levels end up being smaller than FSA's, because we know from AGO's detailed disclosures that FSA had far more problematic, low subordination RMBS deals wrapped.
4) Moody's downgrade risk was divergently negative relative to S&P & Fitch and was a major focus and source of distraction / frustration for the management team.
If you've spent the last few months talking to AGO and participating in street presentations and conference calls, you know that the discussion was so focused on Moody's that AGO management had little time to discuss the positive effects of the FSA deal.
AGO has been valued at a "semi-run off" value -- trading at a discount to book value + NPV of unearned premium. The total NPV in a run off is $50.69. This is even as it was growing its muni business in Q309 at a very strong pace, as the last man standing to underwrite primary muni bond insurance. During 2009, AGO has been wrapping close to 20% of the U.S. market that would be eligible for wraps while dramatically increasing its underwriting standards and making some increases to prices.
The main reason AGO had this discount valuation is because of severe concerns that MCO would downgrade AGO to a "A" level from "AA", thereby severely impairing AGO's ability to wrap new muni issues (which are usually "A" themselves).
As of Thursday Nov 12th after the close, that fear has largely been lifted. MCO announced they would expect to confirm "AA" at Assured Guaranty Corp (the main subsid underwriting new muni business at AGO) if AGO accomplishes reasonable capital raise plans. From the Moody's press release:
"However, Moody's stated that capital strengthening initiatives under consideration by the group could result in a conclusion of the rating review with a confirmation at the Aa3 rating level, negative outlook, if fully implemented. Absent such initiatives, Moody's would expect to lower AGC's rating into the single-A range."
AGO put out a press release last night detailing their capital raise plans. I have spent about 2 hours on the phone with the lead MCO analyst on AGO (Arlene Isaacs-Lowe) in October. This may not appear to be a final resolution on the downgrade risk, but it is. I spent a good amount of time discussing capital initiatives and possible equity raises with MCO - this is very favorable conclusion to their review.
There was a fear that the capital raise would be $1.5B - $2.5B, severely diluting the stock. Management has said to me they would rather go into "soft runoff" and not raise that amount. Instead the raise was detailed at $300M. ~10% dilution at these levels (but AGO has indicated they may be able to do a less dilutive raise than even that).
By all indications, MCO did not have a detailed, deal level model in its capital estimates for AGO (whereas S&P and Fitch did and are relatively positive on the company). MCO was ignoring the positive benefits of the extremely high levels of subordination in AGO's optically ugly structured exposures.
5) Several near term catalysts.
Nov 17th earnings and perhaps a discussion of how they will complete the capital plans to satisfy Moody's. Dec 1st analyst day in NYC. Between Nov 17th and Dec 1st, AGO has indicated that it will be working on a "re-education plan" with street analysts to adjust for the FSA deal. Street analysts are largely neutral on the stock, valuing it off of sub $20 per share stated GAAP book value and earnings estimates for 2003 below $3 per share. It is likely there will be strong upward revisions to 2010 estimates in the next few weeks.
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