Buyback Blowback at Ambac and MBIA
by Eric Englund
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
Eric Englund [send him mail], who has an MBA from Boise State University, lives in the state of Oregon. He is the publisher of The Hyperinflation Survival Guide by Dr. Gerald Swanson. You are invited to visit his website.
Copyright © 2008 Eric Englund