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January 1, 2016
We believe the equity of Ambac is mispriced due to several factors such as 1) being a post re-org equity, 2) crossover ownership from distressed credit funds who are forced sellers due to redemptions in their funds, 3) being a run-off business, 4) difficult to interpret financial statements; and, 5) valuation dependent on litigation. We also believe there are near-term catalysts that will help unlock value.
Background of Ambac
Ambac Financial Group, Inc. (AMBC) is a holding company headquartered in New York, NY. Ambac’s main subsidiary is Ambac Assurance Corporation (AAC), a provider of finance guarantee insurance and related services in the public finance and structured finance market segments. AAC owns Ambac Assurance UK Limited (Ambac UK), a provider of financial guarantee services in Europe. AAC is domiciled in the State of Wisconsin and is regulated by the Office of the Commissioner of Insurance for the State of Wisconsin (OCI). Ambac UK is regulated and supervised in the United Kingdom by the Prudential Regulation Authority (PRA).
AAC historically provided financial guarantee insurance (or municipal bond insurance) for public and structured finance obligations. Its principal business now consists of mitigating losses through the pursuit of recoveries in respect of paid claims, litigation to recover losses or mitigate future losses, commutations of policies, purchases of Ambac-insured obligations and repurchases of surplus notes issued by Ambac Assurance or the Segregated Account and maximizing the return on its investment portfolio.
AAC also provided investment agreements, funding conduits and interest rate swaps, principally to the clients of its financial guarantee business. AAC insured all of the obligations of its financial services subsidiaries. The interest rate swap and investment agreement businesses are in active runoff.
Ambac was formed in 1971 to insure municipal bonds. The business was stable and profitable for three decades, but as the municipal bond insurance market became saturated in the late-1990s, Ambac ventured into adjacent areas of financial guarantee insurance. The two main areas of diversification were providing insurance wraps to RMBS transactions and wrapping AAA-rated tranches of CDOs. By 2007 Q3, Ambac started reporting heavy losses.
In March 2010, AAC established a Segregated Account, under the control of the OCI as Rehabilitator, to facilitate an orderly run-off and/or settlement of certain liabilities, including policies relating to credit default swaps, residential mortgage-backed securities (RMBS), student loans, and other policy obligations with substantial projected impairments or transactions with contractual triggers based upon AAC’s financial condition or the commencement of rehabilitation. The Segregated Account was capitalized with a $2.0 billion secured note from AAC and an excess of loss reinsurance agreement with AAC’s general account subject to AAC maintaining a minimum surplus of at least $100 million.
Essentially, the Segregated Account is structured such that AAC is responsible for ensuring that the Segregated Account services its policies subject to AAC maintaining a $100 million surplus. However, pressure on the insured portfolio continued to mount, restricting dividends from AAC to AMBC, leading the parent to declare bankruptcy in November 2010. The Company emerged in May 2013, cancelling all existing common shares and issuing 45.0 million of new common shares to prepetition claimholders, as well as 5.0 million warrants with a $16.67 strike price and an April 2023 expiration.
Ambac Investment Thesis
We believe there is an exceptional opportunity to take a position in Ambac equity. Here is our investment thesis:
1. Valuation is compelling – We believe Ambac is worth >$60 per share or 4x from the current stock price.
Since Ambac is in run-off, we believe we should begin to value the company with adjusted book value and then layer in some assumptions about potential changes. Ambac presents its own measure of adjusted book value at $17.81 as of 2015 Q3. We suggest several adjustments to the company’s calculation. As a starting point here is the company’s calculation of adjusted book value:
September 30, 2015
($ in millions, other than per share amounts) $ Amount Per Share
Total Ambac Financial Group, Inc. stockholders' equity $1,355.0 $30.10
Non-credit impairment fair value losses on credit derivatives 16.3 0.36
Effect of consolidating financial guarantee VIE (327.0) (7.26)
Insurance intangible asset (1,279.4) (28.42)
Goodwill — —
Ambac CVA on derivative product liabilities (84.0) (1.86)
Net unearned premiums and fees in excess of expected losses 1,208.5 26.84
Net unrealized investment (gains) losses in AOCI (87.8) (1.95)
Adjusted Book Value $801.6 $17.81
Shares outstanding (in millions) 45.0
Here are adjustments that we make to the company’s calculation of adjusted book value:
Mark Purchased DPOs to Par 188.7 4.19
NPV of Installment Premiums 347.1 7.71
Mark Surplus Notes to Par (243.4) (5.41)
Mark Preferred Stock to Par (386.0) (8.58)
Modified Calculation of Adjusted Book Value $708 $15.73
Then, we adjust for Ambac’s outstanding warrants:
Assume warrant exercised 69.5 16.67
Fully diluted shares 49.5
Gator’s Calculation of Adjusted Book Value 777.5 $15.70
We then make other adjustments based on our view of various assets and liabilities (we explain each of adjustments and our rationale below):
Expected Improvement in RMBS credit $600 12.12
Ambac wrapped RMBS held on balance sheet $340 6.87
Additional Excess Spread Recoveries $320 6.46
Gator’s Target Price for Ambac $2,037.5 $41.16
In this valuation, we give no credit to the significant NOLs Ambac owns. Instead we address NOLs in #9 below. We also do not include an upside to litigation recoveries, but discuss the possibility in #8 below.
a. Improvement in RMBS credit – With steadily rising home prices, Ambac’s estimates of future losses on Residential Mortgage Backed securities is consistently declining. Here’s the recent history of expected RMBS loss payments versus RMBS outstanding:
Expected Future, RMBS, Reserve
RMBS Claims, Outstanding, Percentage
2012 Q4 3,141 19,117 16.4%
2013 Q1 2,863 18,267 15.7%
2013 Q2 2,685 17,447 . 15.4%
2013 Q3 2,400 16,667 14.4%
2013 Q4 2,202 16,026 13.7%
2014 Q1 2,031 15,452 13.1%
2014 Q2 1,895 14,876 12.7%
2014 Q3 1,801 14,295 12.6%
2014 Q4 1,588 13,686 11.6%
2015 Q1 1,539 13,107 11.7%
2015 Q2 1,468 12,588 11.7%
2015 Q3 1,258 12,009 10.5%
As you can see, the Estimated Future RMBS Claims has steadily dropped over the past three years. We believe there will be continued improvement and estimate that Future RMBS Claims will only be 50% of the current estimate.
b. Ambac-wrapped RMBS held on-balance sheet – Ambac holds repurchase Ambac-wrapped RMBS on its balance sheet at market value. We think this is too conservative because the discount to par reflect potential credit losses, but since Ambac has already reserved for these credit losses, it is double counting losses.
c. Additional Excess Spread Recoveries – Ambac has been receiving a high amount of excess spread from securitization where the company has already paid losses. These excess spread recoveries have been paid, but the company has not been lowering its estimate of future excess spread. We estimate that Ambac will receive approximately one more year of excess spread recoveries than management’s current estimate.
2. Downside protection with holding company assets
In a downside scenario where the litigation recoveries do not come in as the company expects, we believe Ambac Financial, the holding company, still has value of $11.
Valuation of Ambac Financial:
Investment portfolio at AFG $250 $5.00 Value of NOLs at AFG $200 $4.00 Equity in Surplus Note Securitization $80 $1.60 NOL Tolling Payments from AAC $100 $1.00 Total $630 $10.60
3. Three potential near-term catalysts – We believe there are three near-term catalysts that could drive Ambac higher:
a. Recently appointed the Interim CEO as CEO on a permanent basis
b. A settlement with either JP Morgan or Bank of America regarding R&W claims
c. A settlement with holders of Surplus Notes and Deferred Payment Obligations to restructure their holdings to enable AAC to exit Rehabilitation
4. Additional value creation from continuing to repurchase own liabilities at a discount – Management has been repurchasing Ambac’s own securities in the secondary market. Purchases have been concentrated on Ambac-wrapped RMBS and Surplus Notes. These transactions are value creating for the company. For example, Ambac surplus notes trade at 80 cents on the dollar and accrue interest at 5.1%.
5. Rapidly reducing financial guarantee exposures – Ambac’s financial guarantee obligations are rapidly declining at 8% to 10% per quarter. We expect this accelerated pace to continue through the end of 2017 as policies were last issued in 2007.
6. Special situation has no natural support from buy-side – There are many aspects to an investment in Ambac that turn-off investors immediately, but we believe this has created the extraordinary opportunity.
a. Post re-org equity – Ambac Financial emerged from bankruptcy on May 1, 2013. As you know, post re-org equities use fresh start accounting for the financial statements which have their own quirks.
b. Crossover ownership from Distressed Credit funds – When Ambac emerged from bankruptcy, the former senior debt holders received shares of the company, so owners at the emergence were primarily distressed credit funds. In 2015, the distressed debt fund community has been under pressure due to redemptions from their investors from losses on early energy investments and Puerto Rico. To the extent these funds also owned AMBC common, it has been an overhang on the stock.
c. Run-off business – Investors shy away from companies with no ongoing business. Ambac is not writing new financial guarantee business, so it is a liquidating pile of financial assets and liabilities. The catch is there are $5.8 billion of financial assets plus another $2.5 billion in potential payments from litigation plus a large pile of NOLs.
d. Difficult to understand business – Ambac has many parts that are difficult to understand.
e. Business model – Financial guarantee businesses are difficult to understand when they are healthy going concerns.
f. Upside valuation dependent on litigation resolution – Many investors avoid businesses where the value is dependent on litigation because legal cases can take unexpected turns.
g. Only boutique Sell-side firms cover the stock – Only four analysts publish research on Ambac. They work at the boutique firms Odeon, BTIG, R.W. Pressprich, and MKM Partners, so their work does not get wide distribution. Only Odeon has a positive recommendation on the stock.
7. Upside from R&W Litigation Recoveries – We believe there is potential upside to our base case if Ambac can recover $1.2 billion more than they’ve reserved for lawsuits due to R&W litigation. Ambac has reserved $2.5 billion in subrogation recoverables for these lawsuits, so we think Ambac will recover $3.7 billion. There are three main counterparties in Ambac’s litigation: Bank of America, JP Morgan, and Nomura. Here are some details of the various cases with each counterparty:
Bank of America – We believe Ambac could settle with BofA for $2.5 billion. We believe Bank of America’s legal department is again overplaying its hand in a potential settlement with Ambac. The Ambac/B of A lawsuit is in the same court that the MBIA/BofA case was settled in MBIA’s favor. The judge has said the same issues are appearing in the Ambac case as appeared in the MBIA case.
JP Morgan Chase – We believe Ambac could settle with JP Morgan for $1 billion. During a particularly tough hearing for J.P. Morgan last July, the judge urged both sides to mediate a settlement.
Nomura – We believe Ambac will settle with Nomura for $200 million. We believe the Normura loans that they had Ambac wrap were some of the worst loans securitized during the financial crisis.
8. Additional value in NOLs – Ambac has $4.6 billion of US Federal net operating loss carry-forwards ("NOLs"), including $1.4 billion at Ambac and $3.2 billion at Ambac Assurance. Since we believe it is unlikely that Ambac will restart writing financial guarantees, management has stated in the past that it would be interested in acquiring a business to help monetize the value of its NOLs.
We believe the risks to Ambac common present themselves quite quickly when first analyzing the stock. We believe the discounted price of the stock compensates us for taking these risks. Below are the largest risks to Ambac.
1. Puerto Rico – While Puerto Rico presents some headline risk, we believe Ambac has set aside $250 million in reserves to deal with potential losses. We think this approximates the what the ultimate losses will be. We believe Ambac could reinsure all of its Puerto Rico exposure and completely eliminate this risk today for $600 million. If Ambac were to go down the route of reducing its Puerto Rico risk, it would cost $7 per share, which is entirely manageable given our $40 valuation.
2. Disappointing settlement in R&W cases – with any litigation there is always legal risk that the outcome will below expectation, but we have gained confidence in the R&W cases as time has passed.
3. Latent Financial Guarantee risk – Chicago, Student Loans and Military Housing may present long term losses to Ambac, but these will take time to develop.
Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.