Ambac: Another Triple A To Bite The Dust

As the global financial authorities wrestle with the incredible mess known as the world economy, credit rating agencies Standard & Poors, Moody's and Fitch have come increasingly under fire.  Of particular interest is the sheer volume of over-rated issuers who have subsequently defaulted  http://markostake.blogspot.com/2010/05/bond-rating-agencies-yield-junky.html.

Now, we're NOT talking about junk-rated paper.  Investors, who made the mistake of paying attention to ratings,  have been stung by buying Triple A-rated paper which then was either downgraded to junk status or defaulted, resulting in massive capital losses.

To re-iterate, the Triple A designation means that the issuer has an infinitesimal probability of default for the forseeable future.  Only 4 U.S.-based corporate issuers carry that rating:  Johnson & Johnson (JNJ), Microsoft (MSFT), Automatic Data Processing (ADP) and ExxonMobil (XOM).  Even Uncle Sam, who owns a printing press, is in danger of losing this elite status.

ABK was itself rated Triple A until 2008.  The company is now facing bankruptcy, according to a recent filing with the Securities and Exchange Commission (SEC).

Ambac (ABK), however, takes this ratings lunacy to an entirely different level.  At issue is MUCH more than ABK's own $1.2 billion in outstanding debt.  The company, known as a "mono-line insurer", provides credit insurance for hundreds of billions of outstanding bonds.  ABK, along with rival MBIA (MBI), are the two key companies providing this "service". 

Issuers, who would NOT qualify for a Triple A, but would wish to carry that rating, pay a premium to the mono-line insurers to provide a guarantee to establish the soundness of their debt.  In effect, ABK and MBI act as additional security to prospective investors who insist on purchasing only the very safest of bonds.

If the mono-line insurers default, their insurance becomes worthless and affects huge swaths of debt, including municipalities and mortgage-backed, collateralized obligations.  If this insurance becomes unavailable, or is perceived to have no value, many prospective issuers will have to access the capital markets at a complete disadvantage.  Not to mention the fact that the outstanding issues already insured will become far less liquid, resulting in extreme price pressure.

To be fair, the affairs of the operating company will be separated from that of its insurance unit, Ambac Assurance.  However, a bankruptcy of a mono-line insurer would be un-precedented and, at the very least, throw its customers into disarray during what may be a highly contested process.

The big three rating agencies, whose self-serving methods have been completely exposed as fraudulent, continue to maintain that their business models are viable.  What's wrong with having issuers shop for a rating that is to their satisfaction?  Everything! 

What investors are learning from the credit fiasco of the last 3 years is that the rating agencies provide ZERO information.  In so doing, they have sown the seeds of their own demise.  As investors learn to place no value on a credit rating, issuers will stop paying for these ratings and the problem will take care of itself.  Any financial regulatory policy will be purely window dressing for public consumption and to curry political favor.

Washington, where WERE you?  Oh, yes.  Our friends at the SEC were too busy preventing the Bernie Madoff scam from duping investors.  Or, preventing the investment banks from creating misleading derivatives, that led to massive financial system dislocations. 

The irony of the financial meltdown is that there are so many villians, that each of them can easily point the finger at someone else.  It was the investment banks' fault.  It was the credit rating agencies' fault.  It was the regulators' fault.  It was the Senate Finance Committee's fault.  It was the Federal Reserve's fault.  It was George Bush's fault.  On and on.

Systemic financial crises are not created without the participation of MULTIPLE parties, each of which is acting in their own interest.  The only common thread is that, while all the villains cashed in, the investment world lost.  America lost.  The global financial community lost.  At least the villians got their bonuses!

Marko's Take

Other links we like:  http://www.lemetropolecafe.com/, http://www.shadowstats.com/, http://www.goldpennystocks.com/, http://harveyorgan.blogspot.com/ and http://www.youtube.com/markostaketv.

What Exactly Is A Junk Bond?

"Junk" bonds are defined as those which carry a credit rating of BA+ and below by Moody's, or BB+ and below by Standard & Poors.   This definition is somewhat arbitrary and both of these rating agencies have been tarnished in the last couple of years.  Both gave out AAA ratings, the highest possible, to a number of issuers only to have them default.

The list of idiotic ratings includes many Collateralized Bond Obligations (CBOs), which were insured by "mono-line" insurers AMBAC and MBIA - all of which either defaulted or underwent significant restructurings.

Having traded junk bonds in a former lifetime, I used to bristle at the term junk for several reasons.  One, the term is quite perjorative and tars the entire group with the same brush.  Second, junk status does NOT speak to VALUE.  A very low rated company could be a steal, while a high rated company could be tremendously overvalued, as holders of AMBAC and MBIA debt found out in 2008.

Junk bonds are merely part of a continuum of risk in the entire arena of corporate bonds, all of which should be viewed on the basis of risk and return.  At the "high quality" end of the risk spectrum are "investment grade" bonds - those which carry a credit rating of BBB- and above by Standard & Poor's, or BAA- and above by Moody's.  An investment grade rating is incredibly difficult to get - less than HALF of the Fortune 1000 would qualify!

Valuation of any corporate bond is viewed by comparing its "spread over treasuries" to its risk.  The spread is measured as the difference between the yield on the corporate bond and the yield on treasuries corresponding to the same maturity.  A high spread is indicative of attractive potential returns, while a low spread indicates the opposite.

For most investors, buying individual junk bonds, or any corporate bonds for that matter, is very difficult.  Corporate bonds are typically sold in lots of $1 million face value, therefore, one needs at least $20 million to properly diversify that asset class alone!

An interesting Exchange Traded Fund (ETF) exists to allow smaller investors to take a postion in junk bonds.  The ticker is JNK and it's comprised of approximately 100 issuers carrying a combined yield of just over 11%.  It's impossible to assess it's value based on this information alone, since we'd have to analyze the entire basket as to risk and return. 

Concerns about the credit worthiness of the "PIGS" countries (http://markostake.blogspot.com/2010/02/sovereign-debt-crisis-threatens-to-take.html) has weighed heavily on all segments of the corporate bond market, especially junk.  Year-to-date, junk bonds have returned MINUS 1.58%.

Prospectively, given the massive economic problems that lie directly ahead, I would, for the time being AVOID this sector.  Once the economic damage has been done and yields shoot higher, this sector might be worth a look. 

Junk bonds are a very poorly understood asset class, so it made sense to do a little primer of just what makes them tick. 

If you have any questions or comments feel free to TAKE ME ON!

Marko's Take