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Catch this bond insurer while it’s on the rebound

When the stock market crashed five years ago, one of the casualties was Ambac Financial Group Inc., a municipal bond insurer that got caught up in the U.S. housing collapse and was forced to file for bankruptcy in 2010.

But after years in the penalty box, Ambac is back. The company exited from insolvency last month, and looks like an intriguing, deep value play.

One way to view the newly emerged Ambac is as a low-priced option on the future prosperity of the U.S. economy and the recovery of the housing market.

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Like most bankruptcies, Ambac restructured its debt, wiped out former shareholders, and recapitalized by issuing new stock to bond holders.

It's those new shares that represent a decent speculation for intrepid investors, one that is not without some risks, but at current prices has a reasonable margin of safety in case things go wrong.

The allure of Ambac is that it is a treasure trove of assets whose potential worth isn't reflected in the current share price. The mispricing isn't unusual because there is usually a stigma attached to bankruptcy, and the value story at Ambac will likely take a few years to become apparent. As well, some bond holders who played the bankruptcy are selling out their stock, depressing its value, now that the shares are listed and have some liquidity.

In common with most deep value plays, Ambac isn't well followed by the Street. Only one analyst – Mark Palmer at New York-based institutional broker BTIG – is pounding the table, arguing it is a compelling buy.

"This is not an earnings story, of course. This is a story about unlocking the value of Ambac's various assets," Mr. Palmer said in an interview.

There isn't much comment about the company on the blogosphere, although Ambac recently received a favourable nod at the Reminiscences of a Stock Blogger site as a value play.

The numbers that outline the undervaluation of Ambac are pretty simple. The company has a market capitalization of $1.1-billion (U.S.), but has three assets that collectively could be worth far more.

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The first is $4-billion in tax-loss carry forwards, which don't expire until 2029-34. The value of a tax loss, of course, is hard to quantify, but Ambac's is of such an enormous size that it will be able to shelter earnings from taxes for the foreseeable future. The company can accelerate its access to this benefit by purchasing a financial firm with earnings, a step Mr. Palmer believes it will take.

A second source of value are recoveries on paid claims that Ambac made against soured residential mortgage-backed securities it insured.

Mr. Palmer estimates Ambac has paid out $2.5-billion to JP Morgan, Bank of America/Countrywide, and Credit Suisse, among other institutions.

But Ambac stands a good chance of recovering some of this money, based on successful challenges by other insurers against banks, alleging that the mortgage securities were flawed.

If Ambac were to recover half of the money, the amount would exceed its total current market capitalization. How likely and sizable are the potential recoveries? Banks have been settling claims very similar to Ambac's with other insurers for about 60 cent to 70 cents on the dollar.

The third potential source of value is Ambac's $6.6-billion loss and expense reserve.

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Many investors believe the company will ultimately pay out only $5-billion on securities it has insured, but Mr. Palmer said the amount may end up being "meaningfully lower" if the U.S. housing market and economy continue to improve.

The way to play Ambac with the most upside, assuming the bullish thesis is correct, is through warrants issued as part of the restructuring. The warrants are long-term options to buy the stock at a strike price of $16.67 a share at any time over the next 10 years. The chief attraction, and danger, of warrants is that they offer leverage, both on the way up and way down.

In Ambac's case, a 100 per cent rise in the stock will lead to a rise of about 140 per cent in the warrants, excluding any remaining option value. Warrants can end up worthless, however, if the shares trade below the strike price on the expiry date.

To be sure, there are risks with Ambac. It has insured municipal bonds, and could be on the hook if hard-pressed cities, such as Detroit, become insolvent. If the housing market weakens further, its loan loss reserves might be too low rather than too high on the mortgage-backed securities it has insured. The economy could slip into a recession, harming its prospects.

But given the multiple sources of value, and the likelihood that the U.S. economy is on the mend rather than on the cusp of a another downturn, patient investors should be rewarded. Mr. Palmer estimates Ambac is worth about $31, a conservative figure that may underestimate Ambac's prospects.

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About the Author
Investment Reporter

Martin Mittelstaedt has had a varied reporting career at the Globe and Mail, covering politics, the environment and business. He opened up the Globe's New York bureau for the Report on Business, and has also been on the banking and capital markets beats. He's written extensively on investing themes. More


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