Why MBIA is Different Than Ambac

COMPANY ANALYSIS: 29 NOV 2010, 12:06 AM ET

The Monoline That Kicked the Hornet's Nest

We compare the legacy portfolios of Ambac and MBIA and the contributing factors which led

Ambac to both bankruptcy and regulatory intervention, while MBIA avoided both.

Ambac's failure is largely attributable to several factors including: not raising sufficient capital,

not splitting its public and structured finance businesses, and different regulatory regimes.

Additionally, Ambac insured more ABS CDOs and subprime RMBS in the troubled vintage years.

In our opinion MBIA's solvency is not in question in the near term.

New York state law does not allow for the creation of a segregated account like AAC's thus we do

not believe it is possible for MBIA to replicate AAC's segregated account.

Why MBIA is Different than Ambac

In this note, we review the primary reasons why we believe Ambac is now facing regulatory intervention at the operating company level (Ambac Assurance Corporation or AAC) and has been forced to file for bankruptcy at the holding company level (Ambac Financial Group or Ambac) while MBIA has thus far avoided both. Prior to the meltdown of the sector that began in 2007, Ambac and MBIA had dominated the bond insurance sector with a combined market share of more than 50%. Both insurers' books of business were similar in terms of size and composition. Anecdotally, many investors we have spoken with over the years had considered Ambac the more sophisticated of the two companies. We believe the premature failure of Ambac relative to MBIA can be largely attributable to its inability to execute a split of its book of business and failure to raise sufficient additional capital before the markets shut down. Conversely, MBIA, which has avoided both a holding company failure and insurance subsidiary regulatory intervention, was able to execute these two measures. Other key differences between Ambac and MBIA are their different regulatory regimes and the underlying composition of their structured books of business. Below, we explore the subject in greater detail.

Ambac Background

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Understanding the corporate structure of Ambac is a prerequisite to understanding its ultimate demise. Ambac is a holding company with distinct characteristics from a regulated insurance operating company. As an insurance holding company, Ambac's activities are largely restricted to capital markets issuance and debt service. Insurance operations are conducted through AAC. While AAC is a wholly owned subsidiary of Ambac, insurance operating companies are regulated at the state level (AAC in Wisconsin) and are required to be capitalized separately from the holding company. Moreover, a holding company is prohibited by state insurance regulators from taking assets from their insurance operating subsidiaries. While regulators do permit holding companies to take up to a 10% dividend annually from their operating subsidiaries, AAC has been prohibited from upstreaming dividends for a few years now.

Ambac recently filed for Chapter 11 bankruptcy in New York, reporting liabilities of $1.68 billion as of June 30 on an unconsolidated basis. In a statement, Ambac said senior creditors did not agree to a proposed prepackaged plan and that it could not raise capital as an alternative. Creditors did agree to a non-binding term sheet that is expected to serve as a basis for further negotiations.

Mechanics of Regulatory Scheme

The flow chart below displays the restructuring mechanics which occurred at AAC. In March 2010, AAC established a segregated account for certain of its liabilities, primarily policies related to credit derivatives, RMBS, and other structured finance transactions. In addition, ABK reached a non-binding agreement on the terms of a proposed settlement agreement with several counterparties to commute substantially all of its remaining CDOs of ABS. Currently, claims payments arising from segregated account policies are being delayed until the plan is approved by the courts.



To capitalize the segregated account, AAC will issue a $2 billion secured note to the account. AAC agrees to provide the segregated account the principal amount of $2 billion and to pay interest on the outstanding principal amount of 4.5% per annum. Claim payment liabilities due and payable under the segregated account will be paid directly by the segregated account in the form of cash or in surplus notes which have been indicated at a 25%/75% split. The surplus notes have a maturity date of ten years from the closing date with interest on the notes paid annually at a rate of 5.1%. All payments of principal and interest on shall be subject to the prior approval of OCI. The account will also benefit from an aggregate excess of loss reinsurance agreement with AAC once the secured note is fully depleted. AAC will have no obligation to make any payment such that its policyholders' surplus is below $100 million or to the extent that such a payment would result in a surplus amount lower than $100 million. Recent dealer runs show Ambac's 5.1% surplus notes due 2020 quoted at $10/$20.

Why Did Ambac Fail While MBIA Has Not (Yet)?

Ambac Raised Insufficient Capital

Before the capital markets were shut off, Ambac raised a total of $1.5 billion capital in the form of equity and equity units. MBIA was more aggressive in its capital markets activity raising a total of $2.9 billion including $1 billion of surplus notes. We believe that it is highly likely that Ambac would have been able to raise a likewise amount of surplus notes, as evidenced by the investor appetite for the MBIA issue and given that this form of capital would not have diluted equity holders.

Ambac capital raise: Ambac raised capital in early 2008. In mid-March, the company closed its $1.155 billion public offering of common stock and a $95 million common stock private placement with two financial institutions. In addition, Ambac completed a $250 million public offering of 5 million equity units. Ambac contributed most of the net proceeds from these offerings to AAC in order to increase its capital position with about $100 million retained at the holding company to provide incremental liquidity.

MBIA capital raises: In late 2007, MBIA entered into an agreement with Warburg Pincus with



the private equity firm making an initial investment by purchasing $500 million of common stock in January 2008. The company's second substantial capital management activity occurred when MBIA Insurance Corp. (MBIA Corp.) sold $1.0 billion in surplus notes in mid-January 2008. About a month later, in February of 2008, the company issued an additional $1.1 billion in common stock, of which Warburg Pincus bought another $300 million. Lastly MBIA Corp. had an agreement in place through a put option to sell to the Trusts the preferred stock of MBIA Corp. in exchange for proceeds of $400 million. In November 2008, MBIA Corp. exercised the put option to sell to the Trusts the perpetual preferred stock issued by MBIA Corp.

Everspan Strategy Fails

In late February 2009, Ambac said that it was in the final stages of launching a new public finance-only bond insurer. The company planned to use its dormant Connie Lee subsidiary, which it renamed Everspan Financial Guaranty Corp., to make the transition. At the time, Ambac expected to have final credit ratings by the end of the first quarter of 2009. Although Everspan was going to be a subsidiary of AAC, the company said that it will be clearly insulated from the entity with segregated capital, separate risk management, and a separate board of directors. The company said that there were no plans for Everspan to assume any of AAC's legacy public finance or other exposures which stands in contrast to how MBIA structured its new municipal subsidiary. In mid-June 2009, Ambac Financial announced that it has postponed its efforts to launch Everspan. Douglas Renfield-Miller, CEO of Everspan and EVP of Ambac and AAC, announced his retirement.

Ambac's Underlying Structured Portfolio Riskier

In our opinion, Ambac's legacy structured finance portfolio was riskier than MBIA's. While we believe its book of business was weaker based on our evaluation of credit quality and the ultimate relative deterioration of each company's respective books, Ambac also had a larger nominal amount. As of YE07, Ambac had almost twice as much direct RMBS subprime than MBIA with $8.6 billion. Additionally, Ambac originated $22.0 billion of ABS subprime CDOs in the troubled vintage years of 2006 and 2007 compared to MBIA's $11.1 billion.



Published in:

US Morning Comment [November 29]

European Morning Comment [November 29]

Segregated Account Not Possible Under New York Insurance Law

In March 2010, AAC established a segregated account for certain of its toxic exposures at the direction of the Wisconsin Office of the Commissioner of Insurance (OCI). The OCI commenced rehabilitation proceedings with respect to liabilities contained in the segregated account, resulting in a Bankruptcy credit event for AAC-referenced CDS but not a cross default for the holding company unsecured bonds. Wisconsin Statute 611.24 lays out the details of optional segregated accounts, stating that "With the approval of the commissioner, a corporation may establish a segregated account for any part of its business. The commissioner shall approve unless he or she finds that the segregated account would be contrary to the law or to the interests of any class of insureds." It is important to note that New York state law does not have a similar statute that would enable a domiciled insurer to create a segregated account like AAC's. As such, we do not believe it is possible for MBIA to replicate AAC's segregated account.

Related Research

MBIA 3Q10: Channel-ing More Surplus/Liquidity Ambac: Dammed If They Do, Dammed If They Don't MBIA Surplus Notes: Debt with Equity Risk/Return MBIA: Holding Company Hypotheticals MBIA Updated Stress Test: Put-Back to Life? Ambac: Sorting Out the Confusion Ambac: Structured Book Amputation Ambac Financial: Restructuring Decision Tree Monoline Outlook 2010: It's A Wrap! The Monoline Endgame Ambac: Exchange Offer Pro Forma Impact Examined MBIA: Restructuring Painful but Necessary Ambac Financial 4Q08 - Everspan Can? Ambac and MBIA: Can the Subsidiary Strategy Work?

Rob Haines [email protected]

Craig Guttenplan, CFA [email protected]

Joseph Di Carlo, CFA [email protected]

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Why MBIA is Different Than Ambac

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