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by Eric Englund
Ambac
and MBIA
are world leaders in providing financial guarantees and credit
enhancements for bond issuers (e.g., municipalities), asset
managers, financial institutions, and insurance companies.
Both companies are traded on the New York Stock Exchange.
Holders of bonds and securities, "insured" by Ambac
and MBIA, are provided irrevocable guarantees of timely payment
of interest and principal should there be a default or other
triggering event. Between the two companies, they
guarantee more than $1 trillion in municipal, corporate,
and mortgage debt. A critical aspect of such guarantees pertains
to the fact that Ambac’s and MBIA’s triple-A credit ratings
are bestowed upon the bonds and securities they are insuring.
This highest credit rating, correspondingly, signals to the
market that such insured bonds and securities are of the highest
quality and safety. Underpinning this uppermost credit rating,
enjoyed by both Ambac and MBIA, is each company’s capital
strength. Consequently, it would be reasonable to assume that
directors and officers, of both companies, would view financial
strength as sacrosanct. The dirty-little-secret, you won’t
hear from Wall Street analysts, is that Ambac’s and MBIA’s
top managements were knowingly weakening their respective
company’s balance sheets just as they were aggressively expanding
into structured finance. It is a fundamental tenet for insurers,
sureties, and financial guarantors to put the interests of
policyowners, beneficiaries, and obligees (i.e., customers)
before shareholders. At Ambac and MBIA, this tenet was grossly
violated.
These
previously obscure companies are dominating the financial
headlines as their names are now forever linked to the subprime-mortgage
meltdown. These once staid municipal bond insurers aggressively
expanded into guaranteeing collateralized debt obligations
(CDOs),
which repackage assets such as mortgage bonds and buyout loans
into new securities with varying risk. For these specialists,
in risk assessment, to bestow triple-A ratings on what has
turned out to be toxic junk simply defies all credit-underwriting
principles. When the mortgage-lending industry was openly
flaunting "liars loans," low-doc loans, Alt-A loans,
etc., how couldn’t it have been clear, to the executives at
Ambac and MBIA, that mortgage underwriting standards had gone
into the gutter? To turn around and place triple-A ratings
on this financial debris is nothing short of financial alchemy;
in which these two companies believed they had discovered
a means of turning lead into gold. To be so cavalier indicates
corporate cultures imbued with arrogance and selfishness.
Standard
& Poor’s is reviewing
$534 billion worth of subprime-mortgage securities and CDOs
for possible ratings downgrades. This is a staggering figure.
For Ambac, MBIA, and other mono-line insurers to be so wildly
off the mark is mind-numbing. Of course, this begs the question
as to why anyone would ever again trust a triple-A-rated security
insured by Ambac or MBIA? When a financial guarantor proves
to be untrustworthy, it loses its franchise and cannot remain
a viable business concern.
To date,
both Ambac and MBIA have experienced horrific financial results
in structured finance. For fiscal-year 2007, Ambac suffered
a net loss of a little over $3.2 billion while MBIA suffered
a net loss of slightly over $1.9 billion. When combining enormous
losses with significant stock buybacks, in fiscal-year 2007,
Ambac’s net worth declined by a whopping 63% (down to $2,275,826,000)
while MBIA’s declined by 49% (down to $3,649,305,000). Thus,
it is no wonder that Standard & Poor’s and Moody’s are
reviewing these weakened companies for possible ratings downgrades.
Fitch Ratings has already dropped
Ambac to double-A and may do the same to MBIA.
To be
sure, there are those who will argue that the aforementioned
financial losses were not foreseeable. No management team
willfully makes such flagrant strategic errors. In turn, the
financial losses suffered by both companies most certainly
should get the attention of shareholders but should not translate
to a loss of trust in the marketplace. I have little doubt
that Ambac’s and MBIA’s top executives are saying just that.
Perhaps there is a smidgen of legitimacy to this argument.
When
it comes to a breach of trust, however, both Ambac’s and MBIA’s
executives have been caught red-handed. First let’s discuss
the sacrosanct nature of protecting an insurer’s/financial
guarantor’s capital strength. Here is what A.M.
Best Company – the world leader in providing financial-strength
ratings for insurance companies – has to say
about capital strength:
The
company’s capital and surplus are measured by the difference
between its assets minus its liabilities. This value protects
the interests of the company’s policyowners in the event
it develops financial problems; the policyowners’ benefits
are thus protected by the insurance company’s capital. Shareholders’
interest is second to that of policyowners.
Beyond
a shadow of a doubt, Ambac’s and MBIA’s executives subordinated
the interests of the beneficiaries – who depend upon each
respective company’s financial guarantees – to those of the
shareholders. This is an outright breach of trust, a dereliction
of duty, and here’s how they did it.
From
fiscal-year 2001 through the third quarter of 2007, Ambac
and MBIA have been engaged in what can only be described now
as reckless stock-buyback programs. Over this period of time,
Ambac has repurchased $1,015,036,000 worth of its common stock
while MBIA has repurchased $1,843,044,000 of its common stock.
Wall Street, of course, always cheers on a stock buyback because
it reduces the number of shares outstanding; which analysts
foolishly believe enhances shareholder value (as explained
here).
The opposite, in fact, is true. A stock buyback weakens a
company’s balance sheet and I have never understood why a
weaker financial condition is better for a company and its
shareholders.
So let’s
put this into context for Ambac and MBIA. When a publicly-held
company buys back its stock, such transactions can be easily
tracked in the company’s financial statement. The first place
to look, in the financial statement, is in the statement
of cash flows. There you will see it as a use of cash
categorized as a purchase of treasury stock. The next
place to look is in the statement of changes in shareholders’
equity. There you will see treasury stock recorded
as causing a decrease in total shareholders’ equity.
So, in the name of enhancing shareholder value, Ambac and
MBIA respectively spent $1,015,036,000 and $1,843,044,000
worth of cash for stock buybacks (over the past seven years).
But, and now you know this, such cash expenditures reduced
liquidity and net worth by those exact amounts. How can this
be deemed responsible behavior when both companies are expressly
in the business of insuring bonds and providing financial
guarantees?
To add
some more fuel to the fire, let’s fantasize for a moment and
assume that both companies had responsible management teams
who never would engage in stock buybacks. Well, Ambac’s net
worth would be fully 44% higher than it is today while MBIA’s
would be fully 50% higher. Accordingly, both companies would
stand a better chance, of surviving the subprime meltdown,
had their top executives been prudent financial managers.
Shareholders, moreover, would certainly sleep better at night
had such additional financial cushions existed in order to
help their companies ride out these rough times.
And now,
the New York state insurance superintendent is begging money-center
banks to rescue
these two train-wrecked companies. In a separate article,
it is stated that "A group of eight banks is already
considering a plan to inject capital into Ambac, which needs
at least $1bn. Several banks are also believed to be talking
to MBIA, which needs at least $500m."What a mess.
Ambac
and MBIA, to say the least, are sorely missing the cash they
used to repurchase their own shares. Indeed, this is the blowback
management didn’t foresee when they put shareholders ahead
of "policyowners." Such negligent behavior most
certainly has opened the door for municipalities, regulators,
and shareholders to file civil lawsuits against the directors
and officers of Ambac and MBIA.
Hence,
we have the ultimate irony here. You can bet that Ambac’s
and MBIA’s directors and officers are praying that their directors
& officers liability insurance carriers have been
prudently managed so as to put policyowners ahead of shareholders.
What a novel idea.
February
6, 2008
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