Has Wilbur Ross lost his mind?
Reports that Ross will invest in the battered bond insurer Ambac have soothed investors. But the deal makes no sense, argues Roddy Boyd.
NEW YORK (Fortune) -- "What on earth is Wilbur Ross thinking?"
That's the question analysts and traders are pondering today as they digest the news - first reported in London's Evening Standard - that billionaire vulture investor Wilbur Ross is considering an investment into deeply-distressed monoline insurer Ambac (ABK). The talks, according to sources the Standard didn't name, were said to be well-advanced.
Ross didn't return a call from Fortune seeking comment, but was quoted over the past few days as saying that financial guaranty companies have "a valid business model" rating municipal bonds, but had gone horribly astray with a massive push into insuring hundreds of billions of dollars worth of collateralized securities.
At least some investors are taking the report at face value; Ambac's shares shot up 7 percent to $12.15 on the news of Ross' interest. And the cost of purchasing insurance on Ambac's debt, known as credit default swaps, backed off at least temporarily on the news. To insure $10 million of the company's allegedly AAA-rated debt now costs $375,000 for one year, down from $425,000 earlier in the week.
Others, however, cannot see a clear path to Ross actually salvaging Ambac's troubled business - or even aiding its shareholders. Ambac's recent quarterly earnings release showed a company in free-fall. On a GAAP basis, its loss of $3.3 billion, or $31.85 per share, make it one of the biggest victims of the implosion of the market for collaterlized debt obligations (CDOs). Standard & Poor's announced last Friday that it had placed Ambac Assurance's financial strength, credit enhancement and issuer credit rating on review for possible downgrade. This came on the heels of Fitch Ratings two-notch downgrade, making Ambac the first monoline insurer to lose its triple-A rating.
Here's why Ross's involvement - if it's real - seems unlikely to help. The company's stock is issued is by a holding company; it is virtually impossible that Ross would inject capital here, because "the parent" can only receive cash when its insurance or portfolio management subsidiaries send it dividends. In short, it does no real business. More likely, Ross would invest in or purchase Ambac's regulated insurance subsidiaries, because those are the only parts of Ambac's business that seem likely to generate earning any time soon, if ever.
If Ross were to purchase Ambac in an "as-is" arrangement, he would be buying an enterprise with a staggering $67 billion in CDO exposure, of which $29.1 billion consists of asset-backed CDO's of increasingly dubious credit quality. The company also has $8.4 billion in sub-prime mortgage paper in its portfolio. All told, Ambac's financials show that the insurer has $14.5 billion of claims-paying resources to support a $524 billion guarantee portfolio, figures so unbalanced that the company's attempt to raise $1 billion or more in emergency capital via an equity or convertible offering had to be scrapped last week. (Ironically, Ambac's closest competitor, MBIA (MBI), with credit exposure and insurance guarantees that are even larger, concluded a $1 billion debt offering only two weeks ago, before news leaked out about Ambac's deteriorating condition.)
Looked at another way, Sean Egan of independent ratings shop Egan-Jones told The Times of London yesterday that the big insurers needed a total of around $200 billion to maintain their triple-A ratings.
Yes, Ross has made a reputation as a turnaround king for distressed industries. But a potential investment in Ambac is qualitatively different from Ross' previous successful investments in battered steel, mining and textile companies. Those companies had some combination of legacy pension concerns, depressed markets and cash-flow issues. With union concessions, pension protections, rebounds in commodity prices and the global economic boom, his bets became classic turnaround plays.
With Ambac, Ross is looking at a company with very different problems, and no easy solutions. The first issue is that Ambac as a corporation appears to have an extraordinarily "fat tail," in the jargon of risk analysis. Put simply, its obligations and commitments are likely to expand sharply beyond what even the most bearish forecasters have anticipated.
For Ross, this means that whatever he pays is almost certainly too high, given that his payout obligations are likely only to grow. Ambac's traditional business of insuring municipal securities, which accounts for 50 percent of its insurance premiums collected, is both a profitable and relatively safe business; if Ambac's clients - primarily municipalities - have the ability to raise taxes and fees to meet its obligations.
But there is a very big rub. Issuers large and small in the municipal markets are increasingly forgoing insurance on their principal and interest payments, accepting instead slightly higher interest rates so they can save on insurance fees that sometimes amount to a half point of interest. This is awful news for both Ambac and MBIA, which represent over 40 percent of the municipal insurance market's $1.99 billion in insurance premiums collected over the last five years, according to Bloomberg. And, needless to say, its higher margin and once fast-growing securitized product insurance business is dead, almost certain to never return.