WASHINGTON, May 14, 2013 – A tiny pocket of strength has developing, almost unnoticed, in the area of the financial stocks. When we speak of “financials,” that’s usually understood to mean stocks including major and regional banks, insurance companies large and small, and perhaps a smattering of venture capital firms and other companies that service those companies already named.
While the financial stocks in general have been recovering over the past several months, with the exception of last week’s setbacks, the action in another minority flavor of the financials has been quite positive, although it’s been occurring off the charts of many investors. The area we’re referring to? Those companies that, back in the day, used to be known as muni bond insurers.
Again, back in the day, when states and municipalities wished to absolutely minimize the interest rates offered on their bonds, they needed to do two things.
First, they needed to shore up their state, local, or project balance sheets to get the best bond rating possible. While muni bonds still remain mostly Federal tax exempt, thus allowing the muni issuers to lower the interest rates offered on new issues below corporate bonds of equal value, municipalities always strive to get the lowest rate possible commensurate with current return. That’s in order to get a good deal for the taxpayers who ultimately have to foot the interest rate bill.
Second of all, muni issuers have also been able to insure their issues against default by purchasing long-term guarantee policies from specialized insurance companies that agree to underwrite a portion of that default risk. Until fairly recently, these muni bond insurers—primarily Ambac, MBIA, and Radian—were among the safest and most boring of stocks in which to invest if capital preservation and an occasional capital gain happened to be your investment goal.
However, in the lead up to the financial Big Bang otherwise known popularly as The Great Recession (or, as the Prudent Man would have it, Great Depression II), the muni bond insurers, hungry like the big bankers for outsized profits, capital gains, and bonuses that might make even Bill Gates blush, branched out wildly into other insurance directions. Most notably, they overreached by getting into the business of insuring mass quantities of the kind of collateralized debt securities (CDS), particularly in the real estate finance market, that sent our bubble-housing economy crashing to the ground circa 2007-2009. Ambac (now AMBC), MBIA (MBI), and Radian (RDN) crashed along with it, each in its own special way.
Most professional investors at the time figured that one or more of these companies would vanish without a trace. And indeed it certainly looked that way for a while, particularly in the cases of Ambac and MBIA. But now, quietly, and nearly unnoticed until recently, save by a lucky cadre of bargain hunters, these crippled bond insurers have been slowly coming back.
The first noticeable sign of this phenomenon occurred as news of the increasingly improving balance sheet of Radian (RDN) began to hit the Street late in 2012. With its stock once almost disappearing into single digit limbo, Radian has been relentlessly dealing with its once massive losses, and is predicted to be getting close to the breakeven point this quarter. The stock has been buoyant of late, and is currently perched at roughly $13.50 a share and rising, although day-to-day action remains volatile.
We’ve traded RDN here a few times with great success and are considering re-entering the trade again, though we don’t want to chase it.
Another big surprise was the huge jump taken last week by another crippled bond insurer, MBIA (MBI). In the doldrums for years, the company’s fortunes have also been improving in recent quarters as it has been working its way back to solvency while dealing with numerous lawsuits by and against major banking institutions, stemming from its radical decision, a few years back, to split into a “good MBIA” and a “bad MBIA,” effectively putting a major portion of its bad business off the balance sheet. That infuriated their big banking clients and creating gainful employment for a phalanx of overpaid attorneys in the process.
Last week’s jump was the direct result of the company’s improving fortunes, signaled in a major way when S&P’s ratings service removed MBIA’s bonds from pure junk status (CCC) to B, a considerable improvement that will give a boost to the company’s bottom line by reducing future borrowing costs. The rating must have been noticing that MBIA has been winning its court cases with some regularity, thus removing potential hurdles for the company’s continued viability.
MBIA stock currently sits around the $15 dollar level after last week’s jump, and it now has actual earnings. This, combined with the S&P ratings change, has gotten investors interested in MBIA.
We don’t own MBIA, but bought a small amount of its bonds at the bottom for roughly fifty cents on the dollar. The bonds, which mature in 2025, boast a 7% coupon and have now nearly achieved par (100% of face value or, in bond parlance, $1 per bond). That gives us a nearly 100% return on investment, something that rarely happens in bond investing.
The road has been rockier for Ambac Financial Group (current symbol, AMBC). This bond insurer was finally forced into Chapter 11 bankruptcy roughly three years ago, its situation complicated by the usual big bank problems as well as a protracted and costly wrangle with the IRS involving millions of dollars of actual or alleged taxes.
We owned these bonds, too. Unfortunately, unlike the MBIA bonds, which have continued to pay us interest, the Ambac bonds went flat and ceased paying interest after the bankruptcy petition was filed—normal procedure, but one that didn’t help our bottom line. Further, the bonds became illiquid, since nobody wanted them, so we simply sat and watched them for years.
This spring, however, the litigation, including the IRS situation, was finally resolved in the courts, and last week, Ambac emerged from bankruptcy to trade once again on the exchanges. Ambac’s emergence occurred in the “regular way,” as opposed to the travesty that occurred for bondholders during the GM bankruptcy proceedings. In the GM case, the government unilaterally (and probably illegally) wiped out the bondholders in a payoff to this administration’s union supporters.
Normally, however, bondholders are first in the queue to get whatever proceeds or settlements occur when a Chapter 11 filing is resolved. The bankruptcy court observed the pecking order in the Ambac settlement. In emerging from bankruptcy, Ambac first (as permitted by the courts) wiped out all its old stock. I.e., stockholders of old Ambac stock received precisely zero for their holdings since common stock is last in the queue.
Here’s the transaction as briefly described by Briefing.com (no current link):
“Co [Ambac] announced the effectiveness of its Second Modified Fifth Amended Plan of Reorganization, which marks the completion of its financial restructuring and Ambac’s emergence from Chapter 11 bankruptcy protection.
“Under the terms of the restructuring, all allowed claims of Ambac’s former creditors were discharged and such creditors received new common stock, and in certain instances, new warrants, issued by the reorganized co. All common stock of the co in existence prior to Ambac’s emergence from bankruptcy has been cancelled. Holders of such existing stock have not, and will not, receive distributions under the Plan.
“Co traded on the OTC markets under ABKFQ since going into bankruptcy in 2010.”
Bondholders, as we see here, are first in the queue either in a Chapter 11 emergence or, as is sometimes the case, when the bankruptcy court dissolves the company in question and allows creditors to pick the corpse as it were.
Thus, while they were not made whole, Ambac bondholders were given, in exchange for the old bonds, X shares of Ambac’s new common stock in compensation. The Maven was thus delightfully surprised when one morning last week, he looked in his general account and saw his small Ambac bond holding gone and, in its place, shares of new Ambac stock, which promptly jumped before settling down somewhat yesterday and today to a price near $23 per share.
This gives us, computed from what we paid for the bonds, a roughly 300 per cent return on this mess, and we couldn’t be happier. Remember: when a company is able to successfully emerge from bankruptcy, it emerges with a pristine balance sheet and no old debt.
Given its potential for continued solvency and growth, and with its legal problems behind it, a formerly bankrupt company that’s just emerged from Chapter 11 can often be among the best investments you can make over time since it gets a new change to come out the gate without any of its former encumbrances.
And that’s what you’re looking at with Ambac’s new stock. There are no guarantees to anything, of course. But, on the face of it, with all its litigation behind it, at least with regard to its past business, and with a promising future of new business ahead, AMBC could eventually prove to be the best bet of all these three troubled companies.
That’s why we’re holding our AMBC for the longer term, and will probably get back into RDN, and perhaps take a crack at MBI in the weeks to come if market conditions warrant.
On an optimistic note, the successful emergence of Ambac from Chapter 11, along with the improving health of MBIA and Radian, is perhaps another reason why the financial tone of this market is improving. With these three primarily bond insurers on the mend, and with litigation for the banks (except perhaps for Bank of America [BAC]) slowly settling down, perhaps financial institutions as a whole will finally start getting back to the business they’re supposed to be in: making small business and real estate loans available again for the average working stiff who’d like to get back to having a life after spending some five or six years lost in the desert of financial stasis.
Note: While we are cautiously favorable toward the common stock of the insurers mentioned in this article, their outstanding bonds, in light of current developments, are no longer anywhere near the deal they were when those bonds and others bottomed at historic lows in March 2009. We got into small bond positions in MBIA and AMBC at the time, frankly, as a crapshoot. Fortunately, after being patient for four years, we’ve now been lucky enough to get rewarded.
March 2009 was the kind of once-in-a-lifetime Warren Buffett-style, blood-running-in-the-streets moment when you can make bets like this. Hopefully, none of us will ever see the likes of that horrible month again during our lifetimes.
Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.
Positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.
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Read more of Terry’s news and reviews at Curtain Up! in the Entertain Us neighborhood of the Washington Times Communities. For Terry’s investing and political insights, visit his Communities columns, The Prudent Man and Morning Market Maven, in Business.
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