Assured Guaranty Ltd AGO W
January 18, 2008 - 4:40pm EST by
aviclara181
2008 2009
Price: 17.46 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,350 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

 

AGO is a monoline insurance company that trades at 6x 2008 earnings and 3.5x my estimate for 2009 earnings.  The company has been dragged down along with the other monolines as the market has proverbially "thrown the baby out with the bathwater".  While most of the other monolines have insured a significant amount of subprime RMBS CDOs and CDO-squared, AGO has limited subprime RMBS and no CDO exposure post 2004. As a result, while the other monolines are struggling to find capital to maintain their AAA rating AGO has been reaffirmed AAA by Moody's, S&P and Fitch.  Yesterday, S&P released an updated report on loss estimates for the monolines under a stress scenario.  While many monolines saw their loss estimates increase dramatically, AGO's loss estimate was increased by $500K.

 

December 17 - Stress Test

 

ABK - losses of 1,849 on capital cushion of 1575 - underfunded by 275

MBI - losses of 3,181 on capital cushion of 1775 - underfunded by 1,400

AGO - 31.1mm of losses on capital of 275mm  - overfunded by 245mm

 

 

January 17th  - Stress Test

 

ABK - losses of 2,249 on capital cushion of 1575 - underfunded by 675

MBI - losses of 3,520 on capital cushion of 1775 - underfunded by 1,750

AGO - 31.6mm of losses on capital of 275mm  - overfunded by 245mm

 

My thesis is that AGO emerges out of this subprime catastrophe as one of the dominant players in the monoline industry. They are benefiting from massive improvements in pricing as most other monolines are capital constrained and can not offer new coverage. Earnings will accelerate in the core business as they are writing new business at ROEs in excess of 20% vs. historic sub 10%s. This will lead to EPS growing from 2.65 in 2007 to $5.00+ in 2009. The company recently completed an equity raise which it re-invested in a deal to reinsure municipal bonds underwritten by ABK.  According to management, the ROE on that book of business is 20%+ (including the equity dilution, the deal is 30-35 cents accretive).  I think that AGO is in a prime position to do additional reinsurance deals at these robust ROE levels in the near term as MBI, ABK, SCA, and FGIC are all in the market for more capital. 

 

AGO's provides significant detail on its portfolio and its exposures appear to be manageable.  I have reservations on only  a couple of HELOC deals - one completed in 2007 and a second completed in 2005. The deals are Prime helocs, but I expect that as they mature, AGO will have to take a 50mm charge ( I expect the company to take a 13mm after tax charge for the helocs in the next quarter).  The remainder of the business is in very good shape.  Details on the portfolio can be found on the company's website at www.assuredguaranty.com

 

I believe that the monoline industry looks similar to the property casualty business after hurricanes Rita and Katrina.  Those that had no (or limited) losses, generated business at significant ROEs, while those with massive losses were forced to raise capital at dilutive rates / and or liquidate.  I think this market plays out the same way - Warren Buffet's entrance into the business is a testament to the future profit potential in the industry.  

 
Some investors are worried about a material contraction in the monoline industry.  Although this would have significant ramifications for large participants such as ABK and MBI, AGO only has a 1% market share of the muni market.  Assuming the market contracted by 50% and AGO only secured a 20% future market share, AGO would grow production by 10-fold. With ROE's expanding to 20% over the next few years and with an estimated year end BV of $30 (ex- the mark to market) and $5 of earnings, the stock should trade to 1.7-2x BV, or $50 - $60 a share (180% - 240% upside). 

Catalyst

- Q4/Q1 bookings and the recognition that this company is going to grow earnings and book value at an accelerated pace

- Market share data on municipal market

- Additional large reinurance announcements (probably within the next 60 days)
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    Description

     

    AGO is a monoline insurance company that trades at 6x 2008 earnings and 3.5x my estimate for 2009 earnings.  The company has been dragged down along with the other monolines as the market has proverbially "thrown the baby out with the bathwater".  While most of the other monolines have insured a significant amount of subprime RMBS CDOs and CDO-squared, AGO has limited subprime RMBS and no CDO exposure post 2004. As a result, while the other monolines are struggling to find capital to maintain their AAA rating AGO has been reaffirmed AAA by Moody's, S&P and Fitch.  Yesterday, S&P released an updated report on loss estimates for the monolines under a stress scenario.  While many monolines saw their loss estimates increase dramatically, AGO's loss estimate was increased by $500K.

     

    December 17 - Stress Test

     

    ABK - losses of 1,849 on capital cushion of 1575 - underfunded by 275

    MBI - losses of 3,181 on capital cushion of 1775 - underfunded by 1,400

    AGO - 31.1mm of losses on capital of 275mm  - overfunded by 245mm

     

     

    January 17th  - Stress Test

     

    ABK - losses of 2,249 on capital cushion of 1575 - underfunded by 675

    MBI - losses of 3,520 on capital cushion of 1775 - underfunded by 1,750

    AGO - 31.6mm of losses on capital of 275mm  - overfunded by 245mm

     

    My thesis is that AGO emerges out of this subprime catastrophe as one of the dominant players in the monoline industry. They are benefiting from massive improvements in pricing as most other monolines are capital constrained and can not offer new coverage. Earnings will accelerate in the core business as they are writing new business at ROEs in excess of 20% vs. historic sub 10%s. This will lead to EPS growing from 2.65 in 2007 to $5.00+ in 2009. The company recently completed an equity raise which it re-invested in a deal to reinsure municipal bonds underwritten by ABK.  According to management, the ROE on that book of business is 20%+ (including the equity dilution, the deal is 30-35 cents accretive).  I think that AGO is in a prime position to do additional reinsurance deals at these robust ROE levels in the near term as MBI, ABK, SCA, and FGIC are all in the market for more capital. 

     

    AGO's provides significant detail on its portfolio and its exposures appear to be manageable.  I have reservations on only  a couple of HELOC deals - one completed in 2007 and a second completed in 2005. The deals are Prime helocs, but I expect that as they mature, AGO will have to take a 50mm charge ( I expect the company to take a 13mm after tax charge for the helocs in the next quarter).  The remainder of the business is in very good shape.  Details on the portfolio can be found on the company's website at www.assuredguaranty.com

     

    I believe that the monoline industry looks similar to the property casualty business after hurricanes Rita and Katrina.  Those that had no (or limited) losses, generated business at significant ROEs, while those with massive losses were forced to raise capital at dilutive rates / and or liquidate.  I think this market plays out the same way - Warren Buffet's entrance into the business is a testament to the future profit potential in the industry.  

     
    Some investors are worried about a material contraction in the monoline industry.  Although this would have significant ramifications for large participants such as ABK and MBI, AGO only has a 1% market share of the muni market.  Assuming the market contracted by 50% and AGO only secured a 20% future market share, AGO would grow production by 10-fold. With ROE's expanding to 20% over the next few years and with an estimated year end BV of $30 (ex- the mark to market) and $5 of earnings, the stock should trade to 1.7-2x BV, or $50 - $60 a share (180% - 240% upside). 

    Catalyst

    - Q4/Q1 bookings and the recognition that this company is going to grow earnings and book value at an accelerated pace

    - Market share data on municipal market

    - Additional large reinurance announcements (probably within the next 60 days)

    Messages


    SubjectViability of business model
    Entry01/18/2008 06:05 PM
    Memberrii136
    Thanks for posting this. They definitely do look cheap, if you think bond insurance isn't going the way of the do-do.

    Can you talk more about how you think about the long-term viability of bond insurance? Is this really a viable business long-term if the bond insurers are willing to take on the risk of default for a fraction of the risk premium the market would otherwise apply? What allows AGO to take on the default risk at below market prices and still maintain profitability? Are they better accessors of risk and, if so, how?

    If you believe the popular argument, these businesses only exist because of the ratings discrepancy between corporate and muni (all else being equal, the muni will get a lower rating, usually by one grade). As the credit agencies have become increasingly meaningless, and faith in the insurers has dropped, do you think the value proposition is there long-term?


    thanks,
    rii

    SubjectViability of the business mode
    Entry01/18/2008 07:50 PM
    Memberaviclara181
    two parts to your answer -

    1) AGO trades at a discount to the NPV of its written premiums ($37 per share) - so if you think that they write no new business and you agree that AGO has nominal default risk, this stock should be worth $37.

    2) Bond Insurance - I think they are providing a service - they are underwriting the municipality risk in exchange for a fee - basically they are buying a portfolio of CDS (but with better terms), and an investor is buying the monolines expertise in managing that risk (and the diversification of that risk). This is a business that makes sense. Investors got burned by ABK and MBI because they did not manage risk properly - that got paid to little to take on the CDO and RMBS risk - they were, however, properly paid for taking on the muni risk. the current situation is unique in that AGO is getting paid too well to underwrite muni business because there are no monolines left to write new business - they should not get an ROE of 20% to do this, but they are and will for the forseeable future.

    SubjectIndustry - after nuclear winte
    Entry01/19/2008 07:38 AM
    Memberaviclara181
    What is so interesting here, and what i should have included in my writeup, is the landscape of the industry post the rating agency downgrades. Before, there were 9 players in the industry - ABK, ACA, AGO, CFIG, FIGC, FSA, MBI, RDN and SCA. Of these, only 3 wrote no/limited toxic business - AGO, FSA and RDN. Based on friday's announcement, ABK is going into run-off - SCA, ACA and FIGC are going to do the same - MBI has a small chance of survival after doing the massive bond deal. The players that i just listed, controlled 70-75% of the muni business. The nice thing is that the remaining participants, including Berkshire, do not have the ability to write more than 40-50% of the market and no one has a gun to their head to write new business. For those few who survived, this is going to be a phenomenal business for the next few years. I know this is controversial - those that were short any name in the monoline space ie.ABK&MBI have a vendetta on bond insurance in general and those that went long the same names have been burned so bad they never want to hear the term monoline ever again. This is an economically insensitive grower that is really cheap and is already becoming a dominant force in its industry with s fantastic management team.

    Subjectrisks
    Entry01/19/2008 11:31 AM
    Memberroc924
    I am attracted to the idea due to the almost certain significant improvement in the competitive environment and general fear in the industry, but can you provide a more detailed assessment of the risks with AGO?

    How do you assess if AGO has accrued appropriate reserves?

    Can you provide an assessment of AGO's credit derivative exposure?

    What does this mean? "The Company's credit derivative exposures are substantially similar to its financial guaranty insurance contracts and provide for credit protection against payment default. They are contracts that are generally held to maturity and principally not subject to collateral calls due to changes in market value. The unrealized gains and losses on derivative financial instruments will amortize to zero as the exposure approaches its maturity date, unless there is a payment default on the exposure."

    Won't AGO have a "payment default on the exposure" in this market? Can you bracket the risk here on their $2.5B in credit derivatives?

    Doesn't this suggest a big earnings hit in 4Q (new disclosure in the Sep07 10-Q)? "Market conditions at September 30, 2007 were such that quoted market prices were generally not available, therefore the Company primarily used a combination of observable market data and valuation models to estimate the fair value of its credit derivatives."

    Does AGO still have the QSPEs off balance sheet? If so, what is the exposure?

    SubjectResponses to ROC
    Entry01/20/2008 10:57 AM
    Memberaviclara181


    How do you assess if AGO has
    accrued appropriate reserves?

    Answer) AGO has accrued 25mm of after tax loss reserves. As I included in my writeup, this compares to S&Ps loss expectations under a stressed scenario of 31.6mm in lossses on all RMBS and CDO exposure. This is up from 31.1mm in december 17th. I have run my own sensitivities, but the ratings agency number will be better informed than my own at this point. The company has 2 HELOC deals that have significant risks associated with them - one 2007 and one 2005 deal - these are both prime RMBS deals, but stressed losses could get to 50mm after taxes under a draconian case (much worse than what S&P, Moodys or Fitch is expecting). I think the company takes a 25mm pre-tax and 13mm after tax charge on this exposure in the quarter (15 cents a share).

    Can you provide an assessment of AGO's credit
    derivative exposure? What does this mean? "The Company's credit derivative
    exposures are substantially similar to its financial guaranty insurance contracts
    and provide for credit protection against payment default. They are contracts that are
    generally held to maturity and principally not subject to collateral calls due to
    changes in market value. The unrealized gains and losses on derivative financial
    instruments will amortize to zero as the exposure approaches its maturity date, unless
    there is a payment default on the exposure."

    2) I am going to combine the response to these two questions - AGO has $61 Billion of bonds insured in a way that would classify as CDS. Of that exposure 59.2B (or 97%) is in AAA rated assets with $8 Billion of that in mortgage related assets (only 1.8B after 2005). The mortgage related assets that are subprime have an average subordination level of 39%! The S&P Stress test for RMBS that was recently done (january 17th), had 19% loss assumptions. So, lots of room for further losses before any writedowns! In addition, it is my belief that the loss estimates moved from 31.1 to 31.6mm is because AGO insured roughly 200mm of 2006 subprime RMBS with subordination of roughly 19%. These deals, in my opinion, led to the 500K increase in losses. The CDS loss is based on spread movements in the ABX for subprime and the JP Morgan CLO AAA index. The company marks the entire portfolio based on those indecies. As AAA rated securities, this does not necessarily mean that defaults have moved higher, it may also mean that spreads had tightened to unrealisticly tight levels and are now expanding. Spread widening on AAA credits have not been impacted by investors expectations on losses - as an example, investors still do not expect GE to default, but GE spreads have widened. Over time, these mark to market losses will move to zero as GE bonds will approach maturity and trade back to par.

    Won't AGO have a "payment
    default on the exposure" in this market? Can you bracket the risk here on their $2.5B in
    credit derivatives?

    No - there is no payment default on assets that do not default. They will not make a payment on GE despite the fact that they may have a loss because spreads have widened.

    Doesn't this suggest a big earnings hit in 4Q (new
    disclosure in the Sep07 10-Q)? "Market conditions at September 30, 2007 were such that
    quoted market prices were generally not available, therefore the Company primarily
    used a combination of observable market data and valuation models to estimate the
    fair value of its credit derivatives."

    They already disclosed a loss - mark to market of 220mm as of november 30th when they did their secondary in december. The ABX did not move much in the month of december, but the JPM CLO index did move a bit - i would guess that the mark to market loss will increase to the 275mm level in the quarter. I really dont know why investors focus on this number at all - these guys underwrite risk, not market movements on AAA spreads. If they had a credit that got downgraded, they would be forced to take a reserve. Absent case reserves, this mark to market is meaningless.


    Hope this helps....

    Subjectquestions
    Entry01/20/2008 01:42 PM
    Membercarbone959
    I also agree that surviving/new books of business likely have a nice future here. Questions:
    1) This deal to reinsure some of Ambac's portfolio - how does that factor into your thesis?
    2) You say that the rating agencies' stress tests at this point are better than yours. I also trust that they've gotten a reality check but they might not show these cards for political reasons. The rating agencies have to manage their public image and market image, their entire earnings power is based on perception. They are still conflicted by this. Therefore, can you elaborate on your stress tests? What kind of house price declines, what assumption about about municipal and other debt? What about student loans and auto loans? What if, for example, the U.S. experiences some sort of stagflation and we have to raise short term rates back over 6%, this might sharply drive down asset prices and ability/willingness to lend through the system. It's not inconceivable that that this scenario takes places and causes home prices to decline 40%+ peek-to-trough during the next few years, as opposed to the currently commonly accepted 10-25% type figures.
    3) To what extent is XL a player in the industry? Ackman says it's a bust too, so I'm surprised it's not even in your list of 9.
    4) Radian: you said they did not do any toxic stuff??? Weren't they sort of terrible in mortgages? C-Bass? Fieldstone?
    thanks.

    SubjectComments
    Entry01/20/2008 03:09 PM
    Memberdavid101
    I think the irony that AGO turns out to be a survivor is that it is because they were NOT AAA-rated from all the for-profit rating agencies until recently. It kept them out of harm's way. Perverse.

    I think bond insurance survives. There are too many hands in the pot to let it die, even if it means some of the players may change.

    As for the difference between CDS on insurance on bonds, they are actually very similar. The biggest difference is how the accounting flows through the financials. Credit derivatives involve mark-to-market (M-T-M) while insurance involves reserves. Given the recent experience, I believe the FG's will probably lean to structuring more deals as inusrance again as M-T-M can greatly distort things.

    David

    SubjectCarbone Response
    Entry01/20/2008 03:38 PM
    Memberaviclara181
    1) the ABK deal was to reinsure a high grade muni book at 20%+ ROE. It was a great deal. If they can write additional business in lump form from the likes of MBI, ABK, SCA, FGIC etc, it will get them to $5 in eps faster than 2008.

    2)S&P increased loss assumptions by 4% on 2006 vintages - if you go the the assured guaranty site, they posted the S&P press release. You can see all the revised stress assumptions and their impact on all financial guarantors. Because of the subordination levels averaging 39% and no CDO-squared (post 2003), you would have to see a doubling of the loss assumptions used by S&P before AGO would have to take sizable losses. Also, AGO has limited exposure to subprime RMBS written 2006 and beyond. I dont if they were smart or just lucky, but they have avoided the toxic stuff. An example, if 50% of subprime borrowers default at a severity of 50%, that is a portfolio loss of 25%. Their average subordination is again 39%.

    3) XL's insurer is called SCA and it is a public company. It was spun out from XL in 2006, i believe.

    4) Radian has a seperate subsidiary that acted as a financial guarantor. That subsidiary is well capitalized and wrote a good book of business. They have not done as well on the mortgage insurance side of the business.

    SubjectCompass responses
    Entry01/21/2008 07:24 PM
    Memberaviclara181
    1) yes
    2) my bear case scenario would involve AGO having to post 100mm in capital against the remaining RMBS (ex-heloc) portfolio and 100mm against the HELOC portfolio. This would bring excess capital down to 75-125mm (including the additional $50mm of capital raised the in the recent equity deal that has yet to be deployed). The problem with this scenario is that on an ongoing basis (after these charges)AGO would not earn more than $3-3.50. I think this scenario has less than a 10% chance of occuring, but it is still a possibility. Another possibility, which i would place at less than 1% is the muni market falling apart - if this happened we would not just be in a recession, we would be in a depression.

    Subjectrii -- viability of business m
    Entry01/21/2008 11:21 PM
    Membermax318
    This is an interesting question. As Berkshire's entry into the business points out, the business makes sense at a certain level of premium pricing (as pointed out already on this board).

    Aviclara points out later in this thread that certain risks were obviously underpriced.

    But there's another point to be brought up here. The point brought up by RII has been mentioned by Buffett and Ackman: how can a bond insurer accept 20 bp of premium for what the market would assess with a 60 bp spread over the RFR? How can you expect the bond insurers to make money if they are undercutting the credit risk premium that would otherwise be required by the market?


    Something to keep in mind is that debt and insurance are two different things. The bond insurer gets the premium upfront and gets to invest it. The market demand for extra muni spread would also be driven by 1) illiquidity 2) MTM and downgrade risk

    These are some reasons why the market's demanded spread would be higher than the premium demanded by a bond insurer.

    Subjectre: viability + spreads
    Entry01/21/2008 11:55 PM
    Membercarbone959
    max,
    You mention Buffett and the two risks that might justify a high spread in the market: 1) illiquidity 2) MTM and downgrade risk.
    So while we're mentioning Mr. Buffett, I think he'd be the first to say that excessive leverage and unconservative accounting are two undesirable characteristics of any asset manager and that in the absence of these two, your points (1) and (2) are much less relevant.
    Regarding viability of the model, I've so far understood from this credit crisis that any quantifiable risk is worth insuring at some price X, just as any stock that can be properly valued is worth buying at some price X. This is the difference between a municipal bond and a CDO^2. The history behind municipal debt insurance is, I am guessing, long enough to tell us that this biz is viable. However, maybe some segments of it are not. For example, maybe insuring a AA municipality into AAA is a pretty crappy idea, but insuring a BBB into AA is nice.

    Subject$5+ in 09
    Entry01/22/2008 07:31 PM
    Membercompass868
    Can u provide a little more granularity about how you get to the way above consensus number of $5+. Is it just more reinsurance deals, better pricing on muni biz, or some combination? aside from debate on future of muni biz, what about state structured fin biz? i have to imagine strucured fin new production is extremely weak now given all going on in the world. that said stands to reason they take share there as well. wondering what ur factoring in on that front for your estimates. anyway a quick walk thru to the $5+ would be much appreciated. thanks.

    Subjectre: viability
    Entry01/22/2008 08:59 PM
    Memberrii136
    Max,

    Thanks for the comments and more specifically addressing my questions. A few thoughts, in reverse order:

    1) You make good point on the distinction between insurance and debt, particularly with getting the premium up front. That said, the logic becomes a bit circular, as this premium is then re-invested back into the business. So unless the core operation of taking on default risk at a fraction of the market is a good investment of capital, then the bond insurers are not benefiting from the premium investment, and are even compounding their problem. Also, as for MTM risk, this is actually something that the bond insurers do take on. ABK and MBI actually haven't had any big payouts yet--all their losses have been MTM, which has impaired their capital base and destroyed their credibility. So, in sum, I still don't get how this business is sustainable long-term ASSUMING the market correctly prices risk. That's a big if, as I will get to in a moment. You could also make the argument that AGO is better at assessing risk than the market, but I'd need some evidence of that to get comfortable with that.

    2) As Ackman has pointed out, muni bond insurance makes sense because of the way the ratings companies rate muni vs. corporate debt. Muni ratings are usually one grade lower than their corporate equivalent, despite their vastly superior default profiles. So basically, from what I can tell, muni insurance is a good business because yields are largely depending on the credit rating assigned by the ratings companies who are screwing muni's out of millions of dollars a year, and giving their bond insurer friends the proceeds. But now that the rating agencies have lost credibility, is this still the case? So my concern was, and still is, if the ratings companies lose their credibility (they have), and the market begins to assess default risk independently, the arbitrage should go away. This doesn't lead to a blow-up, but it eliminates new business. If all these bond insurers have been writing credit protection on a bond class that has had something like 5 basis points of default (I believe that was the number quoted on MBI's book), why does the market continue to demand a larger risk premium? Either the market is incorrect in its assessment, or insurers are taking on tail risk, which means this business will work until, one day, it doesn't.

    This is a fascinating situation. If the business is viable, and the portfolio is relatively solid, then this stock should do incredibly well as basically all of their competitors are now out of play. I just can't get comfortable with the underlying contradictions.

    rii

    Subjectre: spreads and default risk
    Entry01/22/2008 09:22 PM
    Memberrii136
    Carbone,

    To your point:

    "Regarding viability of the model, I've so far understood from this credit crisis that any quantifiable risk is worth insuring at some price X, just as any stock that can be properly valued is worth buying at some price X."

    I agree in most cases but disagree in the case of bond insurance. Insurance as a business in many cases makes sense. Individuals are risk adverse and afraid of tail risk in medical, auto, etc. Large insurers can diversify that risk. That business makes sense.

    Investors sometimes want to make a certain bet but to hedge out specific risks. You may invest in a large company whose main customer is on the verge of bankruptcy, but hedge out that customers bankruptcy risk by buying credit protection. This allows you to isolate the bet you want to make. This sort of insurance also makes sense, provided it is given at the prevailing market rate.

    When you buy a bond, you are paid a risk premium in exchange for taking on the risk of default and MTM losses. When you insure a bond, you are protecting against default and, to a large degree, MTM losses (note that many banks have avoided large MTM losses on a variety of junk because of the bond insurers). So somehow you are able to take on, say, a 100bps risk premium for these risks, turn around and pay 30bps to insure against the exact same risks you were compensated to take, and book 70bps of theoretically "riskless" profit going forward. This just does not make any sense long term as being possible, unless you wrongly assessed the risk of default in the first place, or if there is, in fact, risk of your insurer defaulting. There is no value added by this transaction with the exception of the AAA brand, which does not mean nearly as much as it used to. You are just transferring your risk to another party who is willing to take on that same risk for less money.

    What is totally perverse about bond insurance is that both parties book a profit on this transaction. The bond insurer, who in the above scenario has just accepted market risk 70bps below the market, is able to, through creative accounting, book this as a profit. And what gets really perverse is that when they incur MTM losses, they only would book 3/10ths of the loss, because that is the original ratio at which they took on the risk. If bond insurers booked MTM losses on each transaction, they would show losses on every single transaction, because they systematically are willing to take on below market risk. There is a great quote floating around somewhere by MBI or ABK where they basically say just as much.

    Perhaps I'm missing something. This is still all very new to me. But I it just doesn't make sense.

    rii

    Subject5+ in EPS
    Entry01/23/2008 08:17 AM
    Memberaviclara181
    There are a few ways to get there, but i will use a simplistic bridge.

    2007 Net Income - 184mm
    ABK reinsurance - 30mm (use of 150mm of capital - mgmt guided to 20% ROE on this deal - it may be 250 and 50mm, but i am being conservative).

    Remaining Capital surplus - beginning - 250mm
    Capital From Equity Raise - 150mm
    Capital Generated from operations 08 - 240mm
    Total Excess Capital to be deployed 640mm
    ROE % 20%
    Net Income Potential 128mm

    Additional Wrapping of existing business - They have been providing re-wraps on muni deals done by the agencies that are on the verge of downgrade - these deals require virtually no capital and they are doing them for 20bps. I assume that over the next 12 months they underwrite 10B of re-wrapping
    Additional Wrap - 10,000
    Basis points 20
    Tax Rate 20%
    Additional net Income 16mm

    Run-off - every year, a portion of the business will roll of that had ROEs in the high single digits and will be replaced with 20% ROEs - I assume 12 year life of the portfolio, so this adds 6mm of net income.

    Total Net Income run-rate year end 2008 - 365mm or $4.57 per share.

    I expect the company will do at least 1 sidecar reinsurance deal for one of the struggling monolines (i believe they have had conversations with FGIC, SCA, ABK, and MBI)- these will require very little capital from AGO in the short term - i expect 200mm of side car deals, with 4% management fees and 20% ROEs - 16mm in net income or .20 per share.

    Hybrid security - i believe the company has 100mm of capacity for a hybrid security. this will allow for a further 20 cents of eps at 20% ROEs.

    Total EPS - roughly $5

    Other stuff -
    Operating leverage - the company has been undersized so they have not been able to leverage their fixed cost base - this could contribute meaningfully to further ROE expansion

    There is plenty of business for AGO - they are so small relative to the depressed size of the existing market - it is just a question of them deploying the capital in a manner that generates the highest ROEs with the lowest capital requirements.


    Subjectquestions
    Entry01/23/2008 02:42 PM
    Memberskyhawk887
    Interesting write-up. I met with these guys on the IPO road show a few years ago. They were a black box to me.

    It's interesting to note that AGO is based in Bermuda, the hub of the reinsurance business. How likely is it that some of these reinsurers hire executives from ABK and MBIA to build out new muni-bond insurance divisions. How serious are the barriers to entry?

    Second, do you have any data describing how much muni bonds are dependent on property taxes? Is there a risk here that muni defaults could increase substantially?

    SubjectInteresting development
    Entry01/23/2008 05:18 PM
    Memberdavid101
    Seems that the NYSID was not looking forward to working out bond insurers.

    David
    -------------------------------------

    Ambac surges 72% at close; MBIA up 33% on bailout report

    By Alistair Barr
    Last update: 4:16 p.m. EST Jan. 23, 2008Print RSS Disable Live Quotes

    SAN FRANCISCO (MarketWatch) -- Ambac Financial surged 72% and MBIA Inc. jumped 33% on Wednesday afternoon after the Financial Times reported that New York insurance regulators have asked the bond insurers' major counterparties to pump $15 billion of fresh capital into the struggling industry. Eric Dinallo, New York insurance superintendent, has met executives at the banks and has strongly urged them to provide $5 billion in immediate capital to support the bond insurers and to ultimately commit up to $15 billion, the newspaper said, citing unidentified people familiar with the situation.

    Subjectlotsa questions
    Entry01/23/2008 11:18 PM
    Membercarbone959
    I like this idea but have more questions:

    1)You say this industry has been a typical/healthy/benign insurance industry with acceptable returns. Can you walk us muni newbies through the structure of a typical bond insurance deal and, with that example, address the concerns raised by rii136? (that this has been a business of “charging 30bps for 100bps risk”)
    2)There’s also the complete opposite bear case: That municipal insurance actually is profitable but is a rip-off that many municipal customers don’t need. What do you think of all that? Where is this industry going?
    3)How does your thesis change if credit rating agencies lose the market’s respect?
    4)Is it possible that municipal bond insurance has gone through four years of soft market like most other credit-related markets? Assuming a serious recession could losses in AGO’s municipal book make a big dent?
    5)What is the sensitivity around the 20% ROE figure for ABK and similar reinsurance deals?
    6)For the rest of the business, why are you assuming 20%? I understand we’re headed into a hard market but if we want to safe shouldn’t we assume 15%?
    7)You said there’s a small risk of “muni market falling apart”. What exactly do you mean by that and what would happen to AGO under such a scenario?
    8)Management – also a question for david101 – are they still a black box or have you guys learned something new about them? Might the new opportunity make them too greedy? How about too careful?
    Thanks

    SubjectToday's release
    Entry01/24/2008 01:35 PM
    Memberaviclara181
    i will try to respond to the other questions i recieved later on -

    Today's release was very positive. I expected a 25mm reserve and they took 18 - the market to market was in line with what i expected (irrelevent but people seem to focus on it). CITI wrote a note a couple of days a go speculating that the mark would be $1B. The amount of new business was excellent. 156mm of direct PVP and 320 of reinsurance PVP - really outstanding. This should provide significant comfort that earnings will be at least at street expectations for 2008. If this rate of new business continues, eps should be a good bit higher. This is very high ROE business. The company provided a significant amount of disclosure on their book of business. If anyone has any questions, fire away and i will try and answer

    SubjectRE: lotsa questions
    Entry02/09/2008 05:32 PM
    Memberjon64
    I understand from your comments that they can write new business at a 20% ROE, which is good number, but I was curious how quickly they can "reprice" the existing book to get there. Will they actually be able to get 100% of the Book working at these rates by 2009 or will this only apply to new business? I'm not familiar with how this works, but it strikes me that the historical book may only roll off as the bonds reflected in in roll off and that could take 10 years...

    SubjectRE: RE: lotsa questions
    Entry02/11/2008 11:51 AM
    Memberaviclara181
    they have a 12 year book of business on the reinsurance side, which will take a while to reprice, but the direct business is a relatively new business that has a 3-5 year life. I assume very little of the old business getting repriced to get to my eps number - if you look at some of my past responses, i gave a buildout of getting $4-$5 a share in eps.

    SubjectDeployable Capital
    Entry02/29/2008 10:57 AM
    Membercarbone959
    In your $5 EPS post you said they have 640mm of excess capital and that you expect 200mm of sidecar deals, and we know re-wraps don't consume too much capital. Wilbur Ross talks about side car deals as the main reason behind his deal. Does this mean that he sees much more than $200mm in side car potential? Does it mean that the 640mm was too high?
    I fully trust AGO to be able to go in and re-wrap and do side-car deals at very attractive terms, but how at what scale? Will they generate 20% on the 1.5B of excess capital that we might be talking about here? (if his additional 750mm goes through)
    One of the big reasons why I view this an important is I'm assuming zero new muni business, either in the event of collapse of respect for rating agencies and/or if the business turns out to be unviable and municipalities don't request insurance anymore. Do you think this assumption is too aggressive?

    thanks

    SubjectBad news?
    Entry03/12/2008 09:04 AM
    Memberengrm842
    http://biz.yahoo.com/ap/080312/municipal_bonds_ahead_of_the_bell.html?.v=

    SubjectQuestion for jriz
    Entry07/08/2008 11:05 PM
    Membercanuck272
    Sounds like you have done the dissecting work here. What are you assuming for the losses on the 2005-2007 Alt-A ($7.1 billion exposure), subprime first lien ($6.2 billion) and prime HELOC ($1.5 billion)? I was reading a report this week (not on AGO, but a general update on loss estimates) estimating ultimate losses on these vintages and classes in the 20-35% range, depending on a lot of different variables. Depending on the subordination, that could poke a big whole in book value. Please share your analysis. Thanks in advance for your reply.

    SubjectRE: Just to jump in here...
    Entry07/14/2008 07:51 AM
    Memberaviclara181
    I agree - i am using draconian loss assumptions and i get $5 worth of losses on book. With adjusted BV (ex mark to markets) of over $20 a share and with new business ROEs currently in excess of 20%...this makes no sense. If i took a one time hit for the worst case, these guys will have a blended book (old business and new business) with 15%+ ROEs. So a worst case valuation should be 1.0x BV ($26 less $5 of losses (which i dont believe) = $21 x 1.0 = $21. A base case would be $26 - $2 in losses = $24 x 1.5 BV (15% ROE) = $36. A best case scenario would be no incremental losses, ROEs that blend to high teens (18%), so 26 x 1.8 = $47. PP are shorting the stock because it is an insurer, not because it has a bad book of business.

    SubjectTo Aviclara
    Entry07/14/2008 12:04 PM
    Membercanuck272
    What are your draconian loss assumptions? 20% losses on Alt-A, subprime first and prime HELOC is roughly $3 billion, which would more than wipe out all the equity and presumably bankrupt the company. isn't that the worst case?

    SubjectRE: To Aviclara
    Entry07/14/2008 07:59 PM
    Memberaviclara181
    they have subordination in their deals - as an example, the subprime book has 39% subordination which would mean that 80% of all subprime borrowers would have to default with a 50% loss rate. That would be beyond depression levels and at that level, AGO would take no losses. The same example holds true for the Alt A and the Alt A book is performing really well (7.5% 60 day DQ's) - these are first lien Alt A with 19% subordination (these are Prime first liens, so there will be a recovery - assuming a 40% default rate and a 50% severity of loss, total losses, pre-tax would be around 100mm. The HELOCs have multiple protections including rapid amortization triggers, excess interest spread, and reborrowing subordination. The HELOCs currently have 1.5b of par outstanding (after repayments). Taking the worst case Wall Street estimate for 35% Prime HELOC losses, would be a loss of aprox. 250mm pre-tax. There is no bankruptcy risk here...AGO stock has gone down because investors are shooting and then asking questions later...not because there is material risk to the portfolio

    SubjectRE: Any thoughts on today`
    Entry07/22/2008 06:37 PM
    Memberaviclara181
    It made no sense. No problem with capital, earnings were below the street but solid. HELOC losses appear to be behind them. What Moody's did, to put them on watch because they are a bond insurer, was just horrible judgement.

    SubjectRE: Author Exit Recommendation
    Entry09/14/2010 06:31 PM
    Membermm202
    Thanks for the heads up on the exit. Just curious to know why you closed the position.
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