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AGO - Assured Guarantee - Impact of Puerto Rico Default


persistentone
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I want to start a discussion around whether any of the muni bond insurers might become a good investment after Puerto Rico defaults.  The two largest exposures are to MBI and AGO.  My first look at MBI suggests there is no margin of safety.  There is a high probability that its regulator will forbid payments to cover interest on the PR bonds, and there is a real Chapter 11 risk.  I want to review AGO superficially and I can turn that into a post in Investment Ideas once I get better facts.

 

AGO looks more interesting than MBI.  The following table shows AGO's par value coverage of PR debt:

 

http://static.cdn-seekingalpha.com/uploads/2015/6/1096303_14346538539628_8_thumb.jpg

 

Some questions to address:

 

1) How much of par value will the bonds lose?

 

Even if we assume that there will be a 70% wipeout of par value on all of these bonds, that still isn't enough to wipe out AGO's equity. 

 

Note that I didn't make reference here to any special negotiated terms that AGO may have on specific bonds that would limit their losses.  For example, is AGO only covering losses after the first X% are taken directly by investors?  Or does AGO have reinsurance on some of the bonds that would establish a maximum cap on losses?

 

If I had to guess, I would say that the actual workout will be better than a 70% of par loss on the government bonds, particularly since Puerto Rico has authority to raise taxes and recently passed a higher sales tax.  It's worth noting however that I track at least one PR government bond that is trading at 40% of par, and this is before the default.  So apparently there is a risk for a large wipeout.

 

The PREPA utility bonds are much more problematic.  The utility for Puerto Rico needs billions to improve its infrastructure, and the worst part is their main customer - the Puerto Rican government - never pays them.  I think a huge wipeout on these bonds should be factored in as more likely than not.

 

2) How much is the present value of the interest payments on the bonds that AGO needs to insure?

 

I don't have this calculation, but I assume this number is manageable since it is probably two years or less of the full interest payment, followed by many years of payments that only bridge the difference between the workout amount on the bonds.  AGO appears to have enough liquidity to make the interest rate payments that they will need to cover on these bonds.

 

Does AGO have a published number for this present value interest rate payments value?

 

A clue regarding AGO's solvency:

 

* Watch the three AGO preferreds B, E, and F and look for a break below $20 (part $25).  I won't be surprised to see these trade to $10 to $14 during peak of a selloff.

 

* Monitor the two AGO bonds CUSIPs 04621WAA8 and 04621WAC4.  So far both trade above par.

 

* Monitor the difference between insured and uninsured bonds with the same maturity at PREPA (which I view as the place they will take the biggest hit).  A PREPA insured bond is CUSIP 74526QNT5 and trades near par.  An uninsured bond is 74526QKV3 and trades around 50% of par.  If the market perceived a risk of non payment by AGO, that should show up in the price for the insured bonds.

 

How I think this all plays out:

 

1) PREPA will miss its huge July 1 payment.  PR government defaults will follow.

 

2) MBI will announce that its regulator is blocking its payment to cover the missed PR payments, and things from that point become a liquidity crisis for MBI.  They may be forbidden from writing new business.  They may elect to go Chapter 11. 

 

3) If MBI fails to make its payments, further panic will ensue on PR bonds, sending those even lower.

 

4) AGO is likely to sell way down based on the above events, and I think there is a strong risk of institutional panic selling.

 

I want to have a pretty good calculation of the worst case adjusted book value for AGO, and if during the panic they sell for maybe 50% of that adjusted book, it's a go for an investment.

 

Can anyone add good facts to the above discussion, or maybe point to writeups that attempt some of these calculations?  I have seen some articles on Seeking Alpha that claim the haircuts will only be 30% of par, but I think this is a view through rose colored glasses.  If you look at enough bonds and their actual trading history, it is clear that the market expects a 50% haircut or worse.  Then the question becomes how many of these bonds have reinsurance or other features that can limit AGO's losses.

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A few things to think about:

 

1. Puerto Rico can't declare bankruptcy - it is illegal (unless they change the law)

2. The constitution of Puerto Rico puts debt payment above other payments including pensions, etc.  Many of these bonds will have saftey features in them reflecting this that will be hard to overturn.

3. AGO has worked through many of the recent major problems like Detroit, Stockton, Alabama with relatively minor hits to earnings and equity.  Management is quite good about managing risk levels - the only loss they've had was in 2007 and it was not large compared to their earnings.

4. Part of a write-off for Puerto Rico has already been taken, although they won't disclose how much for obvious reasons

5. If Puerto Rico did declare bankruptcy, it's not like they can keep all their assets and pay none of their debts.  I'm sure debt holders would have claims on assets from PREPA, etc.  The write down of 30% you talk about may be reasonable

6. AGO is not only responsible for interest and principal payments missed, so any hit to earnings will be spread out over 20 years.

7. BTIG, which seems to be the investment company with the best handle on AGO, issued a report on Friday saying that there could be upside for AGO (target $41) and MBIA if PREPA made the July 1st payment.  They then reduced them to hold on Monday after the President's address saying they were "uninvestable" and would range trade +/- 15% for the next year until this is resolved.  WEll, we are at the -15% level now and there is still upside to $41 (almost a double) if this gets resolved with no or small haircuts.

 

For more details of AGO's debt, take a look at http://assuredguaranty.com/uploads/PDFs/AGM_1Q15_Supplement.pdf where they show the amounts at risk by year.  You could take these numbers, assume a percent loss on each one and then do a present value calc to the overall hit to the company if you want.

 

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FRom Mark Palmer at BTIG:

 

Assured Guaranty Ltd.

Downgrading to Neutral (from Buy) as Puerto Rico

Governor to Seek Deferral of Debt Payments

We are downgrading Assured Guaranty (AGO) to Neutral (from Buy)

and removing our price target after Puerto Rico Governor Alejandro

Garcia Padilla in an interview with The New York Times published last night

stated that the Commonwealth would not be able to pay its debts,

claiming that "there is no other option." The governor had previously

rejected the possibility of a default, noting in his State of the

Commonwealth address on April 30 that much of Puerto Rico's debt was

held by locals. A spokesperson for the governor stated that he would seek

to defer payments on the Commonwealth's debt while negotiating with

creditors.

 AGO has $6.04bn of gross insured exposure and $4.94bn of net

insured exposure to Puerto Rico's debt. While it is not yet clear what

impact Governor Garcia Padilla's new tack will ultimately have on the

bond insurers insofar as the Commonwealth's constitution clearly

states that debt payments must be made before other obligations are

addressed, we believe the uncertainty created by the reversal of his

stance makes the bond insurer stocks unbuyable until clarity around

the situation develops and the magnitude of the losses the insurers

stand to realize becomes more apparent.

 Rep. Jennifer Gonzalez of the New Progressive Party, the party in

opposition to Governor Garcia Padilla's Popular Democratic Party,

noted to the Times that a move to miss debt payments would require

a referendum and an amendment to Puerto Rico's constitution. We

believe it is quite possible that the governor will propose such actions

when he meets with the Commonwealth's legislature later today prior

to a televised address.

 Valuation: Our Neutral rating on AGO is based on our view that the

increased risk premium associated with the situation in Puerto Rico

likely will cause the stock to trade within +/- 15% from current levels

over the next 12 months. BTIG does not assign price targets to

Neutral-rated stocks.

 

We note that Standard and Poor's has stated that AGO has sufficient

capital cushion to withstand a stressed scenario with regard to Puerto

Rico's debt while retaining its current credit ratings of 'AA.' However,

we also believe that the governor's change in approach will delay

indefinitely the company's intention to ask its regulators to allow their

operating subsidiaries to make a special dividend to its holding

company, which would have facilitated capital return.

 It is also unclear what impact, if any, the governor's remarks will have

on negotiations between the Puerto Rico Electric Power Authority

(PREPA) and creditors including AGO whether they will have any

bearing on whether the utility will make the $416mm debt-service

payment due July 1.

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 AGO has $6.04bn of gross insured exposure and $4.94bn of net

insured exposure to Puerto Rico's debt. While it is not yet clear what

 

Look at page 21 of the URL you supplied:

http://assuredguaranty.com/uploads/PDFs/AGM_1Q15_Supplement.pdf

 

The table at the bottom of page 21 says the net par exposure of $4.0 Gross is only $2.2B.  Unfortunately, the table at the top gives a calculation of "Gross Debt Service Outstanding".  They do NOT define this term in their glossary.  Nor do they supply a calculation based on net exposure.  Really very frustrating.

 

What is AGO's Net Exposure (who cares about gross?) including costs to service interest payments?  There has to be a present value calculation for that 20 year stream of interest rate payments, otherwise how do you estimate an impairment of book value?

 

I agree there are reasons to believe that there will not be a 60% wipeout of par value.  But even if there is, AGO appears to be able to survive that.  I just want to know where a safe number would be to draw a line in the sand, and I want that number to absorb a 60% wipeout for par, and added to that the present value of the net interest payment exposure.

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 AGO has $6.04bn of gross insured exposure and $4.94bn of net

insured exposure to Puerto Rico's debt. While it is not yet clear what

 

Look at page 21 of the URL you supplied:

http://assuredguaranty.com/uploads/PDFs/AGM_1Q15_Supplement.pdf

 

The table at the bottom of page 21 says the net par exposure of $4.0 Gross is only $2.2B.  Unfortunately, the table at the top gives a calculation of "Gross Debt Service Outstanding".  They do NOT define this term in their glossary.  Nor do they supply a calculation based on net exposure.  Really very frustrating.

 

What is AGO's Net Exposure (who cares about gross?) including costs to service interest payments?  There has to be a present value calculation for that 20 year stream of interest rate payments, otherwise how do you estimate an impairment of book value?

 

I agree there are reasons to believe that there will not be a 60% wipeout of par value.  But even if there is, AGO appears to be able to survive that.  I just want to know where a safe number would be to draw a line in the sand, and I want that number to absorb a 60% wipeout for par, and added to that the present value of the net interest payment exposure.

 

Pg. 23 of that same url provides an amortization schedule showing $3.7 billion total net debt service.

 

However, that link is only for Assured Guaranty Municipal. $4.94 billion is the consolidated net par of all the subs & parent. The total net debt service exposure is $8.3 billion. This is presented on pg 127-128 of the 10q.

 

http://www.sec.gov/Archives/edgar/data/1273813/000127381315000019/gaapago-03x31x2015x10q.htm#s70292AA5063AA576264DCBEE3D8605D3

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Pg. 23 of that same url provides an amortization schedule showing $3.7 billion total net debt service.

 

However, that link is only for Assured Guaranty Municipal. $4.94 billion is the consolidated net par of all the subs & parent. The total net debt service exposure is $8.3 billion. This is presented on pg 127-128 of the 10q.

 

http://www.sec.gov/Archives/edgar/data/1273813/000127381315000019/gaapago-03x31x2015x10q.htm#s70292AA5063AA576264DCBEE3D8605D3

 

Great, thank you.

 

Are the column totals in those tables already discounted to present value using their discount rate of 6%?

 

There is enough exposure there that I guess we have to dig in and understand better how they structure their exposure.  Are they not responsible for the first X% of losses?  How is their reinsurance structured?    Does AGO do these things in similar ways across all of its obligations, or is it likely to be very different for each class of bond?

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The other thing to consider is that AGO has been a well run company, profitable and has been able to manage big claims without major hits to earnings or book value.  If we assume they continue to do this and that Puerto Rico can be managed (which I do), the hits to earnings should be small.

 

On the balance sheet, the Net Loss Expense and LAE Reserve is now $787 million with a Net Reserve (after taking out Salvage and Subrogation Recoverable) of $582 million.  This is already a liability on this balance sheet and out of shareholder equity, sio will not hit the earnings or book value.  They do not break this out, so we don't know how much of this is for Puerto Rico, but say "U.S. Public Finance Economic Loss Development: The net par outstanding for U.S. public finance obligations rated BIG by the Company was $7.9 billion as of March 31, 2015 compared with $7.9 billion as of December 31, 2014. The Company projects that its total net expected loss across its troubled U.S. public finance credits as of March 31, 2015 will be $310 million, compared with $303 million as of December 31, 2014. Economic loss development in First Quarter 2015 was approximately $9 million, which was primarily attributable to certain Puerto Rico exposures. "

 

I would think most of this $310 million is for Puerto Rico as all the other big trouble spots have been taken care of, but it would be nice if they did tell us, but don't to avoid influencing negotiations.

 

The Net Expected Loss to be Paid was $1,154 million and the Net Expected Loss to be Expensed was $315 million, with this loss spread out over many years with a max loss of $25 million in a single year.

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Does anyone have CUSIPs for *uninsured* bonds with lots of liquidity, so we can establish a fair market price every day?  Many of these bonds trade too infrequently.  The two classes of bonds I want to track:

 

* Puerto Rican General Obligation

* PR Electric Power Authority

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Does anyone have CUSIPs for *uninsured* bonds with lots of liquidity, so we can establish a fair market price every day?  Many of these bonds trade too infrequently.  The two classes of bonds I want to track:

 

* Puerto Rican General Obligation

* PR Electric Power Authority

 

I found two decent tracker bonds:

 

PUERTO RICO COMWLTH General Obligation 8.0% 7/1/2035 CUSIP 74514LE86

PUERTO RICO ELEC PWR AUTH 5.25% 7/1/2040 CUSIP 74526QVX7

 

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Does anyone have CUSIPs for *uninsured* bonds with lots of liquidity, so we can establish a fair market price every day?  Many of these bonds trade too infrequently.  The two classes of bonds I want to track:

 

* Puerto Rican General Obligation

* PR Electric Power Authority

 

 

http://puertorico.municipalbonds.com/bonds/recent#srt=Trade.yield&direction=desc

 

I use this website to track the prices.

 

I am still holding on to my High way bonds. I think if a debt restructuring is needed, it will not cut to as deep as my cost basis of 36 cents on the dollar. Since other munis sell around 3.5% coupon, both the coupon rate of 5% and the principle has room to be cut.

 

Assuming a restructure that changes coupon rate from 5% to 3.5% and a principle cut from 100 to 70, that will bring tremendous debt relief to PR and should be able to jump start the economy. Everything should be alive again and that's still a double for me.

 

If I were the creditor on the table, I would give them a 5 year 0% payment deal with principle cut from 100 to 90 and ask for local sales tax DECREASE to jump start the economy. However, I would also ask for a GDP linked call option to recover my losses as well as a local sales tax INCREASE if the economy later improves to a good condition.

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Does anyone have CUSIPs for *uninsured* bonds with lots of liquidity, so we can establish a fair market price every day?  Many of these bonds trade too infrequently.  The two classes of bonds I want to track:

 

* Puerto Rican General Obligation

* PR Electric Power Authority

 

I am still holding on to my High way bonds. I think if a debt restructuring is needed, it will not cut to as deep as my cost basis of 36 cents on the dollar. Since other munis sell around 3.5% coupon, both the coupon rate of 5% and the principle has room to be cut.

 

Are your highway bonds secured or unsecured?

 

Can someone talk to the issue of muni bond workouts:  how often do unsecured government bonds get left with zero recovery in a workout?  In corporate bankruptcies, it is of course quite common for unsecured bonds to be left with no recovery.

 

If you got a muni bond secured by a particular tax at 36% of par that sounds like a good position.

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Does anyone have CUSIPs for *uninsured* bonds with lots of liquidity, so we can establish a fair market price every day?  Many of these bonds trade too infrequently.  The two classes of bonds I want to track:

 

* Puerto Rican General Obligation

* PR Electric Power Authority

 

I am still holding on to my High way bonds. I think if a debt restructuring is needed, it will not cut to as deep as my cost basis of 36 cents on the dollar. Since other munis sell around 3.5% coupon, both the coupon rate of 5% and the principle has room to be cut.

 

Are your highway bonds secured or unsecured?

 

Can someone talk to the issue of muni bond workouts:  how often do unsecured government bonds get left with zero recovery in a workout?  In corporate bankruptcies, it is of course quite common for unsecured bonds to be left with no recovery.

 

If you got a muni bond secured by a particular tax at 36% of par that sounds like a good position.

 

Secured. And the highway company has 100 Million free cash flow per year. Its situation is much better than the electric company.

However, PR constitution says if the state runs out of resource to pay the GO bonds, then it can divert the resources from the utility companies to pay the GO bonds first.

The constitution also explicitly says paying muni debt is the first priority, above all other things, like pension and wages.

 

With that said, if there is no cash, there has to be some kind of restructuring. But I don't think it will be a huge cut.

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Does anyone have CUSIPs for *uninsured* bonds with lots of liquidity, so we can establish a fair market price every day?  Many of these bonds trade too infrequently.  The two classes of bonds I want to track:

 

* Puerto Rican General Obligation

* PR Electric Power Authority

 

I am still holding on to my High way bonds. I think if a debt restructuring is needed, it will not cut to as deep as my cost basis of 36 cents on the dollar. Since other munis sell around 3.5% coupon, both the coupon rate of 5% and the principle has room to be cut.

 

Are your highway bonds secured or unsecured?

 

Can someone talk to the issue of muni bond workouts:  how often do unsecured government bonds get left with zero recovery in a workout?  In corporate bankruptcies, it is of course quite common for unsecured bonds to be left with no recovery.

 

If you got a muni bond secured by a particular tax at 36% of par that sounds like a good position.

 

Secured. And the highway company has 100 Million free cash flow per year. Its situation is much better than the electric company.

However, PR constitution says if the state runs out of resource to pay the GO bonds, then it can divert the resources from the utility companies to pay the GO bonds first.

The constitution also explicitly says paying muni debt is the first priority, above all other things, like pension and wages.

 

With that said, if there is no cash, there has to be some kind of restructuring. But I don't think it will be a huge cut.

 

Which CUSIPs are you in?

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