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Idea: Pairs Trade, Long Assured Guaranty (AGO) and Short MBIA (MBI) (NB the caption information above doesn't work for entering pairs trade information for both legs; I have supplied information for the AGO long leg only)
There are two investable municipal bond guarantors (monolines), AGO and MBI, that are in a position to write new municipal finance insurance policies (wraps). (Build America Mutual (BAM) is also in a position to write new wraps but, as a mutual insurer, is not investable).
As discussed below, AGO has a competitive advantage over MBI with respect to various performance metrics including, most prominently, excess capital adequacy. This indicates that AGO is in a far better capital position to either repurchase common stock or purchase legacy monoline books of insured par.
I expect repurchasing common stock (and buying legacy books if at the right price) to be an important basis by which a monoline can grow its adjusted book value over the next 12-24 months (medium term).
Repurchases of common stock will be the catalyst that results in greater shareholder returns for AGO than for MBI. The more conventional business method of increasing adjusted book value, simply writing new wrap business, will not be a significant driver over the medium term, as I don’t believe there will be a substantial amount of new wrap business written. I do not expect that long-term interest rates will appreciate sufficiently to stimulate substantial new wrap business. In any event, AGO is now, and will be able in the future, to offer municipal insurers somewhat greater value than MBI with respect to whatever new wrap business that is done.
Over the medium term, there will be a significant creditor restructuring at Puerto Rico Electric Power Authority (PREPA) that will adversely affect MBI more than AGO, on a relative basis and before taking into account reserves. This restructuring will have a greater effect on the monolines’ share prices as that timing horizon approaches.
Also over the medium term, because of the “Rhodes test” in the Detroit case and the Stockton Ca. confirmed plan of adjustment, both of which I discuss below, any additional municipal bankruptcies and non-bankruptcy creditor restructurings that occur will be resolved on a basis that should be less advantageous to monolines than might otherwise be expected.
Because AGO has a competitive advantage to grow its adjusted book value, as compared to MBI, I expect AGO’s common stock to outperform MBI common stock over the medium term.
The principal risk to this thesis is that MBI’s current share price is at a greater discount to adjusted book value than AGO’s current share price.
If over the medium term there is an industry-wide reduction in the share price discount of adjusted book value generally for monolines, then this pairs trade will lose money.
However, I do not expect such discount reversion to occur since I do not expect a vibrant new business environment arising for monolines over the medium term.
Comparative common stock performance YTD 14
AGO = +10.1%
MBI = -21.3%
A fair question to ask is whether this outperformance year to date will continue in AGO’s favor, or revert to mean in favor of MBI.
My thesis is that looking out over the medium term, the monoline business environment will resemble the business environment year to date, and perhaps become even more challenging for monolines. Because of this, I expect AGO’s outperformance to continue.
Some relevant metrics that indicate AGO’s competitive advantage over MBI:
Non-GAAP net income (eliminating GAAP distortions based on mark to market accounting adjustments)
3rd Q ’14 = $1.08/sh
9 months 14 = $2.89/sh
Dividend Yield = 1.7%
3rd Q ’14 = $.34/sh
9 months 14 = $.12/sh
Dividend Yield = 0
Excess Capital (taken from S&P’s depression stress test analyses as of 12/31/13)
AGO = $1,500MM
MBI = $450MM
Common Stock Buyback Programs
Repurchased $445MM of common stock in 14
Repurchased $224MM of common stock in Q3 14
Announced authorization for $400 million additional repurchases
Repurchased $23MM of common stock in Q3 14. No prior repurchases. Previously, management stated that excess capital would be used to reduce leverage.
Announced authorization for $200 million additional repurchases
Exposure to PREPA
AGO = $912MM
Total gross par insured = $312B
MBI = $1,420MM
Total gross par insured = $277B
Rate differential between AGO wraps and MBI wraps trading in marketplace is 25-50bps in favor of AGO.
See this Barron’s article for source, as well as Citibank’s view that this rate differential may decline in MBI’s favor (with which I disagree)
The monolines business environment will be challenging over the medium term because of recent legal developments and a current and prospective inability to offer municipal issuers a sufficient value proposition, due to the expected long-term interest rate environment:
The legal landscape relating to the priority of claims in municipal bankruptcy has been adversely affected by Judge Rhodes’ discrimination ruling in the Detroit bankruptcy case, in which Judge Rhodes expressly permitted discrimination of pension unsecured claims over other unsecured claims.
In certain situations, monoline claims will be classified as unsecured by a proposed adjustment plan, even though they are indeed secured. This was the case with respect to monoline insured unlimited tax general obligation (UTGO) bonds in Detroit.
This will require costly bankruptcy litigation and may result in settlements that are less favorable than one might have thought for secured claims.
In other situations, monoline claims will indeed be unsecured (for reasons discussed below).
This subjects monoline claims to adverse discrimination as compared to pension claims under the “Rhodes test”, which I expect to become an important precedent for future municipal bankruptcies.
Stockton Ca.’s exercise of business judgment not to reject its pension funding contract with CalPERS and to honor CalPERS claims in full indicates the “home town” preference that municipalities will exhibit to honor unsecured pension claims over unsecured financial debt claims.
Monolines are able to offer a greater value proposition to municipal issuers only if long term interest rates are higher than they are currently. When long term interest rates are low, the incremental cost savings that may be derived by an A-rated (or below) issuer from obtaining a AA-rated wrap is smaller than if long term rates are high; there is a lower slope to the yield curve and a lesser risk premium differential between A (or below) and AA rated wrapped securities.
Wrapped bonds constituted over 50% of municipal bond issuances in the late 1990s and early 2000s, dropping to 4% in 2012, and ticking up to 6% in 2014. Long term interest rates would have to increase some 300bps in order to replicate the issuing environment that previously existed.
Long term interest rates rise when there are increased expectations of inflation. Long term TIPS indicate no inflationary expectations, and the recent decline in oil and other commodity prices seems to be a short term confirmation of this long term prognosis.
Discussion as to “Rhodes test” and Stockton Debt Adjustment Plan
You may think that the i) monolines recovery of 74% on their UTGO wraps in the Detroit debt adjustment confirmation plan, and ii) ruling in the Stockton municipal bankruptcy that Stockton’s pension obligations were subject to impairment notwithstanding their protection set forth in the State of California constitution, were favorable to monolines.
I believe that upon closer examination, these cases afford monolines no comfort and reason for concern.
In connection with Judge Rhodes’ decision to confirm Detroit’s bankruptcy plan of adjustment, Judge Rhodes issued an oral opinion, which is to be supplemented with a formal written opinion. There hasn’t been much focus on the short-form opinion that he read from the bench, but I believe it is highly adverse to the interests of monolines if the test set forth therein (Rhodes test) is followed in future municipal bankruptcies. If the Rhodes test becomes an influential precedent (and I expect it will be, as Judge Rhodes is a highly respected bankruptcy judge), the Detroit debt adjustment plan will serve as a troublesome roadmap for monolines in future municipal bankruptcies.
After the monolines and various other classes of creditors settled with the City of Detroit, the only remaining dissenting class of claims in the Detroit debt adjustment confirmation hearing were rejected contract and lease claimants and involuntary claimants such as tort and other plaintiffs whose litigation against Detroit was stayed by Detroit’s bankruptcy (collectively, IC). The ICs viewed their unsecured claims to be parri passu with Detroit’s unsecured pension obligations. The ICs argued that the Detroit plan of adjustment improperly discriminated in favor of the pension claimants.
The Rhodes test approved the adjustment plan’s discrimination in favor of the pension claimants and set forth a remarkably strong endorsement of a plan that discriminates in favor of pension claims as an unsecured claim that is “first among equals”.
The best (and really only) analysis of the Rhodes test to date has been made by Prof. Melissa Jacoby at Credit Slips. I will quote her discussion since it sets up the issue squarely:
“In the absence of further guidance from Congress in the statute, Judge Rhodes said, the test of whether discrimination is unfair turns on "matters of conscience," informed by factors such as the purpose of municipal bankruptcy and the judge's "experience, education and sense of morality." With respect to pension claimants, the judge concluded that the City "demonstrated a substantial mission-related justification," namely preserving relationships with employees and enhancing their motivation. Judge Rhodes observed no similar dynamic with respect to the dissenting classes. Judge Rhodes also sought to recognize the judgment of the people of Michigan to give constitutional protection to pensions even though that would not prevent impairment in bankruptcy. The court considered the reasonable expectation of parties; other unsecured creditors, Judge Rhodes said, should have been on notice that they lacked the same level of protection as public pensions.”
As a legal matter, this ruling is indefensible. It endorses a judge’s experience, education and sense of morality as a standard for analyzing a crucial bankruptcy plan confirmation standard, discrimination between parri passu claims. This is a standard-less standard. Judge Rhodes’ advice to future bankruptcy judges in municipal bankruptcies: “Hey, just you be you and all is good”.
This ruling also seems to place unsecured pension claims above unsecured financial claims because of a protection (state constitutional protection) that is unenforceable in federal bankruptcy court.
In essence, Judge Rhodes just made enforceable something that is unenforceable under federal bankruptcy law, and he used the reasonable expectation of the parties as a justification, where the reasonable expectation of the parties, one would have thought, was that the bankruptcy judge would have enforced the law.
Moreover, who is to say that non-impairment of pension claims is a “mission-related justification” for a municipality whereas non-impairment of financial debt claims is not? Doesn’t a municipality need both a workforce and capital?
In summary, pension obligations are usually protected in state constitutions from reduction by state legislatures, but pensions are also unsecured future promises to pay. In a municipal bankruptcy, pension obligations and all other unsecured obligations rank at the same level of priority in terms of security, but the municipality may wish to give preferred treatment to pension obligations in the plan of adjustment in terms of impairment, for obvious political “main street v. wall street” considerations. The Rhodes test gives future bankruptcy plans explicit permission to do just that!
Now, you may think the Rhodes test does not affect the treatment of secured obligations, in which case you would be right. You may also think that monoline wraps are secured obligations in municipal bankruptcy, in which case you may or may not be right, depending upon the security involved.
UTGO wraps are secured for purposes of bankruptcy law only in lien states (such as California), while other monoline wraps may be secured for purposes of municipal bankruptcy only by special revenues. See the online debate at the Public Sector Inc. website for more discussion of the security status of UTGO and special revenues bonds.
You might recall that Detroit plan of adjustment classified the UTGO bonds that AGO and MBI wrapped as unsecured obligations even though they were secured by a pledge of special revenues, so that they were secured for purposes of bankruptcy law. AGO and MBI had to litigate the issue and eventually settled for a 74% recovery, which is substantially less than the recovery that should have been accorded secured obligations. One can expect this adversarial position to be taken in future chapter 9 bankruptcies where there are large unsecured pension claims that otherwise would be subject to higher priority secured financial debt claims. Why? It worked for Detroit.
In the case of unsecured UTGO bonds in non-lien states and other wrapped securities that are not secured by a pledge of special revenues, the Rhodes test is directly applicable, and municipalities can be expected to use it to cramdown classes of unsecured financial claims.
In the Stockton bankruptcy case, while bankruptcy Judge Christopher Klein ruled that CalPERS was an unsecured creditor with no special status protecting pension obligations from impairment, notwithstanding state constitutional protection, Stockton’s debt adjustment plan was still confirmed with no impairment of pension obligation owed to CalPERS and an impairment cramdown of the Franklin bond fund that was the principal unsecured financial creditor. See Stockton Plan of Adjustment Confirmation Transcript (Judge Klein: “…on October 1st I made an oral ruling regarding the status of the CalPERS pension -- or the CalPERS contract, and I ruled that the contract can be rejected under 11 USC Section 365 by the City. And the City has declined to reject the contract, saying it exercises its business judgment to conclude that the pension contract -- that CalPERS is, in effect, the low cost provider of the City's pensions, and that it would, under any theory, cost more to use some other pension provider, and pensions themselves might also produce less.” See also Judge Klein’s discussion on the effect on Stockton employees of any termination of the CalPERS funding contract at pps.19-28).
So, in summary, when you review carefully the results of the Detroit and Stockton cases, your scorecard will read: Main Street 2, Wall Street 0.
Now, this may not be of consequence if there are no municipal bankruptcies over the medium term of this thesis, but this legal landscape ought to be taken into account by monolines in the pricing of their insurance. If it is, this will only reduce the value proposition perceived by issuers contemplating insurance.
Continuation of business and legal environment existing year to date for monolines over the medium term, under which AGO has a competitive advantage over MBI in an industry where they are the only two viable investable names.
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