There was an interesting article in this weekend’s edition of Barron’s.  The financial weekly bible is noting that, despite the turmoil and perhaps terminal verdict of bond insurers, there may actually be some significant value left MBIA Inc. (NYSE: MBI). 

Barron’s was very negative on this one even last summer about the exposure to mortgages being overlooked.  Back then MBIA shares traded hands at $65-ish.  But now Barron’s is saying "the market has gotten too bearish on the bond insurer."   Barron’s now summarizes the situation at MBIA as: "MBIA was due for a setback. But at its current price, it’s being punished too severely for bond-industry problems." The entire article is online and you can see the other points there.

This more or less denotes that much more of the woes at MBIA is more in sympathy with Ambac Financial (NYSE: ABK) than to the exact exposure that MBIA has in reality.  This article does not at all indicate that Ambac will escape the storm like MBIA can. It also notes what we observed last week with MBIA’s new $1 billion in capital surplus notes with a 14% yield have fallen down to 75 cents on the dollar.  Its credit protection costs also jumped to previously unheard of levels.

Barron’s also points out that even though large value investors such as M.J. Whitman’s Third Avenue Fund, Davis Select Advisors, and Warburg Pincus are down significantly, they are now key investors in MBIA.  Another Barron’s attribute of this being cheap is that it notes "MBIA remains a profitable entity, but its shares are off nearly 90% from their highs." 

One key issue that Barron’s is hinging much of the contra-mortality of MBIA is that any future claims losses from principal and interest will be dribbled out a the 20-year (or in some cases 50-year) time period; hence "the present value of claims cost dwindles dramatically in relative significance."  This also notes that when Warburg Pincus ran its worst case stress test under "Armageddon-like housing and other economic assumptions" that its annual loss expenses came to no more than around $250 million per year under the most harsh conditions.  This even points to some claims of liquidation value being $30 to $40 per share, although we would caution that others are arguing that the death sentence for all of these has already been determined and the formal verdict just hasn’t been announced.

There are other things at work that could topple all of these companies, even if the original blame lies elsewhere.  The new issue for 2008 is "counterparty risk" and the implications of systematic counterparty failure are disastrous.  This is the new term that bears will use (and are already using) to put pressure on financial and other sector stocks, even if it is not a new term nor a new issue at all.  The reality is that the blowup at ACA would end up looking like a cartoon in comparison.

Frankly, an intervention via a government stimulus package may or may not help, and you can find the criticisms and support all over the place on that issue.  An intervention with a financial stimulus plan for the public may not be enough if there is actual counterparty failure and outright systematic default.  If a stimulus package is presented whereby the government acts as a backstop to prevent the counterparty defaults from being 100%, then this entire issue may be minimized drastically and the fears of a 1929 crash or 1987 crash would effectively be put to rest.  If some of the figures really do pan out the way some of the calculations we have seen, then the expected meltdown of these insurers could literally have dire consequences in the financial markets.  We have even noted the possibility of a 1,000 point drop in the DJIA.

Perhaps the single best tool to use outside of personal opinions derived from all the facts that can be gathered is to look at the trading volume.  The trading volume measured by inflows and outflows of dollars in stocks and sectors will tell you immediately what Wall Street is thinking.  So far that verdict IS that a death sentence is most likely.  The reality is that some firms have yet to implode.  If we start seeing counterparty defaults then we will see more waves of writedowns from major financial institutions.  To make matters worse, many of those institutions may not survive counterparty implosions that leave them on their own. 

We recently pondered a scenario where Warren Buffett and Berkshire Hathaway (NYSE: BRK-A) could save the day.  The reality there is that he would save the day if it ends up looking like a layup, but he won’t come to the rescue just because these need rescuing. This is also just one more piece of the puzzle in what we have deemed as financial mergers becoming mandated rather than preferred.

Right now the situation is deemed as almost entirely up to the ratings agencies like Moody’s and S&P after "negative credit watch" turned this further into another house of cards.  The worst case scenario very well may end up being another Enron situation, with the difference being that the widespread impact of the bond insurers failing having a much broader economic impact on the entire financial system.  It goes without saying that this holiday-shortened week will be more crucial for all the bond insurers.

Jon C. Ogg
January 21, 2008

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