The Hidden Values of Ambac (AMBC)

I started a position in Ambac this week.  While I still have more work to do on the company, I’ve done enough to think its worth a starter position. As usual, it will grow as the stock trends up and if events arise that validate the thesis behind my purchase.  I first got the idea for the stock after having read Christian Herzeca’s blog post that points to the benefit Ambac has accrued from MBIA’s legal trailblazing.

Much like every other company with a ticker the stock ran away from me on Friday and is already a couple of bucks above where I bought it.  Yet despite the move, I don’t think this is a scenario you have to rush into. The catalysts to stock appreciation are all going to take time to play out:

1. A business plan that realizes the benefits of past net operating losses
2. Reversals of their RMBS loss reserves
3. Trial wins and/or settlements that add to shareholder value

About the only possible short-term catalyst I can imagine is if the company finds a merger partner that can take advantage of its NOLs.  And given that the company is fresh out of bankruptcy, I doubt that is going to happen overnight.

I’m still trying to wrap my head around the company.  The financial statements are complicated and the amount of disclosure available is sparse (with a company just recently out of bankruptcy it’s typical to have little information available). I tried, for example, to pull off an adjusted book value estimate for the company (equivalent to the one MBIA provides) but ran into a enough roadblocks along with way that I had to conclude that I failed miserably in the attempt and that the required data either just isn’t there or I still have more to learn before I find it.

Ambac runs  business that is quite similar to MBIA. They have a public insurance business that, in the past, has underwritten bond issues from municipalities, counties, and long-life public projects. And they have a structured finance business that in the past offered financial guarantees on residential mortgage backed securities (RMBS), collateralized debt and loan obligations (CDOs and CLOs) and collateralized student loans.

Much like MBIA, they ran into a lot of trouble in 2008 as they began to experience significant losses on their financial guarantees. However unlike MBIA they were unable to avoid bankruptcy. They emerged from bankruptcy at the start of May.

Exposure to RMBS

Much of the work I’ve done on Ambac has been as a comparison to MBIA. And one of the first things that made Ambac stand out to me was that unlike MBIA, they have virtually no exposure to CMBS and commercial real estate (CRE). I put together the following table of exposures of each company (note that MBIA exposure does not add up to the total gross par of MBIA Corp as I limited the table to items where there was overlap with Ambac).

The primary source of new loss reserves at MBIA has been its structured CMBS Pools and other CRE CDO’s. A big part of the settlement with Bank of America was the commutation of all of the CRE exposure between the two companies.

Ambac, on the other hand, is primarily exposed to RMBS (mid-prime, sub-prime and second lien). And while low grade RMBS securities have been crushed, most of that crushing took place over the last 5 years and is now complete.  Barring another downturn in housing (something that looks much less likely at this point), there should be little more crushing on the horizon.

Indeed the losses on RMBS and elsewhere in Ambac’s portfolio appear to be subsiding and to some extent reversing. In the first quarter Ambac recorded only $4.1 million in new loss reserves, down from $464 million in Q1 2012. They also reversed $129 million in previously recorded losses related to RMBS. In the fourth quarter, while the company did not break out new losses from reverses, the change in the overall loss reserve was a net benefit of $36.7 million, suggesting again that in that quarter revisions outweighed new loss estimates.

A look at Pro-forma Income

The lower levels of reserving are leading to a much improved income statement. I did some work to come up with a pro-forma income statement, ignoring the effect of the mark to market on derivative instruments, one time gains on investments, gains on foreign currency, etc. The company has generated a tidy operating profit in each of the last two quarters.  Note that even without the net benefits from Loss and Loss Expense the company would have been quite profitable.

Keep in mind these are run-off earnings and, absent the company writing new business, they will decline over time.

Net Operating Losses

A second catalyst for the stock is the company’s massive net operating losses. As I mentioned earlier, Ambac went through a tough time in 2007-2012 with the result being that they lost a whole lot of money. The emerged from bankruptcy with most of the tax benefit associated with those losses intact.

The following are all excerpts from the first quarter 10-Q:

As of March 31, 2013 Ambac has an ordinary U. S. federal net operating tax carryforward of approximately $7,107,171, which if not utilized, will begin expiring in 2029 and will fully expire in 2034

…Ambac has relinquished its claim to all net operating loss carry-forwards resulting from losses on credit default swap contracts arising on or before December 31, 2010 to the extent such net operating loss carry-forwards exceed $3,400,000. The exact amount of the loss carry-forward relinquishment is $1,059,988.

…Upon emergence from bankcruptcy, approximately $816,380 of the NOL will be reduced for cancellation of indebtedness income and reduction of interest expense pursuant to IRC Section 382 (l)(5).

…As a result of the development of additional losses and the related impact on the Company’s cash flows, management believes it is more likely than not that the Company will not generate sufficient taxable income to recover the deferred tax operating asset. As of March 31, 2013, the company had a valuation allowance of $3,134,054.

When put together these statements suggest to me that Ambac is carrying around $3 billion of NOL’s, and in addition that they have another $3.1 billion of NOL’s that are not being recognized simply because the company can’t envision a scenario whereby they would earn enough money to offset them before they expire.

Now NOL’s are a precarious catalyst, because if Ambac cannot find a way of becoming profitable then they are essentially worthless. And while I am not super familiar with the accounting of NOL’s during I takeover, I have heard it can be difficult to carry them over in such a case, so they may or may not represent a significant asset to an interested party. Nevertheless, they pose an interesting chip that could be played by a creative management. Ambac is after all involved in an industry that currently has a dearth of players; with a proper capital infusion they could perhaps venture back into public insurance or expand back into structured insurance now that we are seeing a resurgence of structured vehicles. And how about a plain vanilla mono-line business, where they would compete for the 20% ROE’s that MGIC and Radian have been bragging about.

Putback Recoverables

The final catalyst for Ambac is to take advantage of the inroads made by MBIA on putback litigation and maximize the recoveries of their putbacks.  Of the company’s $14 billion in RMBS gross par and $6 billion in gross loss reserve, they have booked $2. billion in what is called subrogation recoveries.  From the 10-K:

Subrogation recoveries are really just a fancy way of saying that this is money they expect to get back in one way or another for breaches of representations and warranties.  The subrogation recoverable listed in the table above refers to only those loans to which Ambac contracted a third party to investigate and quantify the breaches.  On the other $2.5 billion of loans, Ambac has booked a further, relatively smaller estimate of what they expect to get back.  While I’ve had a bit of trouble trying to understand what that number is, I’m pretty sure the number is somewher between $500 million (provided in Note 3 of the Surveillance Categories table on Page 127 of the 10-K) and $750 million (which comes directly from the table itself).  Below I’ve reproduced an abridged version of the table showing only the RMBS data, as well as the Note 3 subrogation recoverable.

Note 3:

The point here is that Ambac is likely being conservative on its recovery assumption for the other $2.5 billion.  For the RMBS that the company has investigated thoroughly they are expecting a recovery of about 70%, yet for all other RMBS they are only booking about 20% recovery.  If all RMBS see equal recoveries of 70%, Ambac stands to gain another $1.25 billion in recoverables.  This is a not insubstantial $28 per share of additional book value.

Now of course there are a lot of if’s in this analysis and, as we know from MBIA, these things can take a very long time to be realized.  But it remains another potential catalyst that, when added to the others, makes the shares attractive to me.

Conclusion

The way that I’m looking at Ambac is that they have been dealt a few interesting cards, they are out of bankruptcy and ready to play another hand, so let’s see what kind of interesting things they can do to make the most of what they are dealt. If nine months from now they are in the same position they are now I probably am going to begin to lose interest.  What I am hoping is that between now and then management comes up with some creative means for realizing the locked up value that I have described.  We’ll just have to see how it plays out.