One of the wonderful things about investing is that ultimately you will find out if you are right or if you are wrong. There really isn’t ambiguity over the long term, as the results will speak for themselves. Over the short term, things can be much murkier, as the voting machine of Mr. Market can take precedent over the weighing machine, in the terms of Benjamin Graham. Currently, voters are saying Assured Guaranty (AGO) is worth far less than any reasonable proxy of liquidation value, despite a track record of exceptional performance. I disagree with this assessment based on an examination of the facts. For long-term investors, this might be one of the great opportunities in today’s market, which I’ll attempt to describe in this article.
It seems sensible to start the discussion with a breakdown of past performance. As you can discern from the slide above, book value per share and adjusted book value per share have risen from $18.73 and $24.51 at the time of its IPO in 2004, respectively, to $58.32 and $74.78 in the most recent quarter. This growth has occurred despite the Great Recession, which annihilated most of Assured’s financial guaranty competitors. It has occurred despite the defaults of Detroit, Jefferson County, Stockton, etc. Lastly, it has occurred despite the train wreck that is Puerto Rico.
There seems to always be at least one or two troubled municipalities that dominate the headlines, but it is important to look at the complete picture. The economy has seen steady growth since the Great Recession and growth seems to be accelerating due to a more positive regulatory environment, in addition to the potential for tax reform. Municipalities have taken advantage of historically low interest rates, but there are certainly cities such as Chicago and Hartford that are showing some structural weaknesses. One of the key things to understand though is that Assured Guaranty has seen major amortization of its insured portfolio over the last 8 years, as net par outstanding has declined by 57%. The more capital-intensive structured finance insured exposure has declined by 91% over the same period, from $142.2 billion to $13.1 billion. Meanwhile, AGO’s claims-paying resources has stayed constant at around $12 billion. Assured has never been in a stronger financial situation than it is right now.
CEO Dominic Frederico has done a stellar job in managing the company. One of the best testaments to AGO’s efficiency is the fact that its annual investment income, net of interest and operating expenses, provides a steady and profitable earnings stream. For 2017, this cushion should be around $90MM, which means that 100% of the earned premium can be used to offset any loss developments in the insured portfolio or to generate profits. The other ways that Assured creates value is through buying runoff financial guaranty companies, commutating previously ceded business or reinsuring other portfolios. Major acquisitions have been FSA, CIFG, Radian Assurance, and MBIA’s UK business. AGO has been commutating previously ceded business as it recently did with FGIC, for example, where it takes on the risk but gets back the unearned premium reserve and a premium based on the risk of the portfolio. There are still some very big potential deals out there where AGO can create value.
The biggest opportunity in my opinion is an acquisition of MBIA’s (MBI) National insurance division. This deal would be exceptionally sensible for both parties in that National has a large insured portfolio in runoff, so its priority is really on freeing up capital to its holding company where it can invest long-term to monetize NOLs, while of course making sure the insured portfolio is protected. Assured should be able to buy the subsidiary at a reasonable discount to book value and consolidate it with its operations, in a deal that would bring massive synergies. I think you’d see both stocks rally aggressively if such a deal were to occur. The biggest concern for this type of deal would be MBI’s Puerto Rico exposure of around $3.5 billion, which AGO might not want to add to its existing exposure given the uncertainty on the island. We should get a great deal more clarity in 2018, making the deal path easier. The other option would be for AGO to take the rest of National except for Puerto Rico and maybe Chicago, via a reinsurance transaction. This would really come down to price and what level of capital could be freed up in such a transaction. Another exciting option for purchase would be Ambac’s (AMBC) insured portfolio once it completes the rehabilitation of the Segregated account. Ambac really has the same goals as MBI and the company has done an excellent job in reducing its Puerto Rico risk via buying back large parts of its insured exposures at a discount.
The clear majority of Assured’s insured portfolio will generate no losses whatsoever. As of the 3rd quarter, $13.226 billion of the $275.8 billion of net par exposure is categorized as below investment grade or 4.8%. $5.2 billion of that shows sufficient deterioration to make future losses possible but for which none are currently expected. Nearly $3 billion of the claims, which are expected to or already have generated losses, are in structured finance with much of it covered by R&W agreements. The biggest concern is the nearly $5 billion in net par related to Puerto Rico.
Municipal bonds are generally very safe investments and are usually split into GOs and revenue bonds. They have strong protections, which is why defaults are infrequent and severities are low. Over the last decade, we have seen defaults in Vallejo, Stockton, Detroit, and Jefferson County, etc. These municipalities were in terrible financial condition with dismal prospects for short-term improvement. Puerto Rico’s debt-to-GDP ratios at the time of its bankruptcy put it in a stronger position than many of these other defaults. Since Hurricane Maria, however, Puerto Rico bonds have been devastated with prices reflecting unheard of severities.
I’d argue that we are in the period of peak uncertainty as it relates to Puerto Rico. The Oversight Board and government of PR have done everything they can to hide the actual finances of the Commonwealth. On December 18th, it was revealed that they have discovered 8000 bank accounts holding $6.8 billion in cash, although $1.7 billion is restricted by bankruptcy proceedings. This was after the governor said that they would have no money by December. I discussed the pathetic track the Oversight Board has taken things down in my recent article; Puerto Rico’s Oversight Board is Failing At Its Duties.
AGO’s Puerto Rico credits are generally quite adequately protected. $1.419 billion of the exposure is to GO bonds. As you can see from the graphic that was included in Manal Mehta’s terrific MBI article, debt service on GOs is supposed to come before all other expenses. While current prices don’t reflect that reality, I do believe that in court the constitutions on the United States and Puerto Rico will indeed matter!
$853MM of net par relates to PREPA where creditors have a perpetual lien on the net revenues of the utility. Similar protections are involved with the $373MM PRASA exposure. Probably the most worrisome credits are the $1.377 billion of exposure to the Puerto Rico Highway and Transportation Authority. This is another revenue bond that wouldn’t worry me except for the “clawback” feature. This feature says that if there is not enough revenue to cover the debt service on the GOs, revenue can be diverted from these bonds only to pay GOs. Obviously, those aren’t being paid either, which is just another blatantly illegal act perpetrated by the government of Puerto Rico and the Oversight Board. Ultimately, these issues will be worked out in court or via a settlement. Remember that much of the interest and principal payments on Puerto Rico debt is 15-30 years out. This means that you must present value of the actual losses to get a real feel for how significant of a hit it would be to the company. Any increases in interest rates that bolster investment income would go a long way to mitigating losses.
Assured easily has the financial capacity to fight it out as long as it needs to via appeals, etc. The company generates enough investment income to cover its annual Puerto Rico payments, so it isn’t like Puerto Rico alone is enough to put the company in any financial duress or that there will even be a sniff of a liquidity problem. In past bankruptcies, AGO has assisted the defaulted municipality with obtaining access to capital markets via its insurance. There is the potential debt for equity swaps and a whole swath of options, which should reduce projected severities. As the situation clears up, I believe it will be very manageable, in direct contrast with what the current market is pricing in. I believe a big reason for the disconnect is that the likelihood of news getting worse in the short term is higher than it getting good, just by the nature of the bankruptcy process and the political environment we are in. As facts come into focus, the long-term potential undeniably outweighs the bad.
While it is impossible to tell you exactly what AGO has reserved for Puerto Rico, the net expected loss to be paid in U.S. public finance is now $1.046 billion and obviously most of that relates to PR. The balance sheet has a $1.326 billion loss and LAE reserve. RMBS and structured losses have been more favorable than expected due to home price appreciation, so AGO’s reserves have thus far proven to be conservative. On the asset side, there is a $497MM salvage and subrogation recoverable, which will probably keep going up in the short term, but AGO will eventually get a lot of this money it is paying to cover Puerto Rico debt service back once the restructuring is finalized. Lastly, the largest liability on the balance sheet is a $3.597 billion unearned premium reserve. This money is already on the balance sheet and is being invested to generate income, which ultimately can be used to pay any claims.
Currently, AGO trades around $33.62, a 52-week low despite stellar year-to-date financial results. Non-GAAP operating shareholders’ equity per share is $55.87 and adjusted book value per share is $74.78. That means that AGO is trading at a 40% and 55% discount to these metrics, respectively. Based on 118 MM shares outstanding and using a 21% tax rate, a staggeringly large and unlikely $2 billion increase to losses would result in a $13.38 loss per share. This would put operating book value per share and adjusted book value per share at $42.49 and $61.40, respectively, in this extreme scenario. Keep in mind that AGO has been generating roughly $200MM a quarter in operating income despite reserving aggressively for PR, so the actual losses would be far more gradual. I believe the company should trade around operating book value, given that its new business production is accelerating and its path to continue creating value.
AGO has been buying around $500MM in stock per year over the last few years and that is its stated goal. If the company were to buy $500MM in stock at $33.62, it would reduce shares outstanding by 14.87MM, so that would reduce the share count to 103.13. The adjusted book value of $8.820 billion would be reduced by the cash amount to $8.320 billion. The new adjusted book value per share would be $80.67 per share and operating book value per share would be $57.07. As an AGO bull, I don’t mind the decline in the stock as it allows the company to materially increase intrinsic value because it is in a strong position to buy back stock. Also, I’m able to add to my position for my clients and I, which I assure you I’ve been doing.
Recent stock and bond pressure relating to Puerto Rico reflects maximum panic. The OB and government of PR have been doing everything in their power to make things look as bad as can be for the Commonwealth, to enhance their negotiating leverage with creditors. As more data comes out and as we get to court, creditors will be able to utilize the leverage on their strong legal protections and the calculus is going to change materially. In Detroit’s bankruptcy, the initial offer for UTGO bonds was 20 cents and then later that was reduced to 10 cents. Ultimately, it settled for 74 cents. There is nothing inherent to PR that makes its situation that much worse than previously struggling municipalities. No matter what happens, AGO is prepared and should see at least 50% stock returns over the next 3 years in my estimation, and would still not be overvalued.
Disclosure: I am/we are long AGO, MBI, AMBC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.