The Ambac (ABK) Bail-Out May Not Work

February 24, 2008 by Douglas A. McIntyre

Ambac (NYSE: ABK), the down-on-its-luck muni-bond insurance company may get rescued by several large banks. If the reports are to be believed, Citigroup (NYSE: C), UBS (NYSE: UBS), and Wachovia (NYSE: WB) will put up as much as $3 billion to help Ambac which insures over $500 billion in bonds, many of them for municipalities

In addition to muni-bonds, Ambac has a huge book of consumer debt and mortgage-backed financial instruments which it has insured with it "AAA" rating, and this part of its book is falling apart as those markets fail. Banks own much of this paper and if the "AAA" goes away at Ambac, so does some the value of the bonds it insures.

Banks like Citi have a good reason to step in with money. The bank’s 10-K indicates that it has $4 billion in exposure to the bond insurers.

Analysts from Oppenheimer recently estimated that the total exposure which banks have with the bond insurance companies is $70 billion. If that number is accurate, it would be fair to ask how a $3 billion bail-out of Ambac and similar deals with MBIA (NYSE: MBI) and one or two other of the insurers would solve a problem which has a much broader financial magnitude.

The investment in Ambac is part of a great race, one which the banks may lose. As the Fed drops rates, mortgages and other consumer debt should reset lower making payments easier to bear. If so, the value of the debt underlying the financial  instruments insured by Ambac should recover, assuming that consumers are helped by the prospects of lower monthly payments.

The economy could still go into a recession deep enough to drive up unemployment. If a large number of Americans are thrown out of work in a short time, lower interest rates will not help them at all. Mortgage and consumer loan defaults will spike up. And, the $3 billion Ambac is getting will be a drop in the bucket.

Banks could lose every dime they put into Ambac and then take loses on their insured debt-instrument portfolios as well.

Douglas A. McIntyre