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I don't know whether he coined the phrase, but value investor Mohnish Pabrai can hardly open his mouth without mentioning something like, "Heads, I win; tails, I don't lose that much!"
The idea is simple: Investment outcomes should be broken up by the odds of different scenarios playing out. When the "worst case" scenario means you lose little or nothing, and the "best case" scenario means hitting it out of the park, you likely have a winner on your hands.
With that thought in mind, let's take a look at Ambac Financial (NYSE: ABK), which might be a perfect example of the exact opposite type of investment. Think of it as "Heads, I'll lose a lot; tails, I'll lose everything in short order."
The long downward journey
Ambac, along with rivals MBIA (NYSE: MBI), Assured Guaranty (NYSE: AGO) and The PMI Group (NYSE: PMI) made buckets of money over the past decade insuring bonds. Much like the insurance policy on your car, the odds of a bond defaulting can be leveraged against an insurance premium paid to an insurer like Ambac.
Provided the bond market keeps its act together, this model works wonders. And it did. Ambac shareholders were mightily rewarded -- up until last year, when the market for anything attached to debt disintegrated. Long story short, Ambac's days of lucrative profits could be a thing of the past, and that's the best-case scenario. Even under that rosy outcome, there's still little reason to hold Ambac.
Scenario A: Bad
Could Ambac go bankrupt? Possibly, but that doesn't seem likely anytime soon. The prevailing thought on bond insurers tends to be that actual losses will end up being less than perceived losses, once the bond market stops having a temper tantrum.
There will be claims on the mountains of CDO products Ambac insured, of course. One problem is, nobody has a clue how much those losses will be. $1 billion? $10 billion? Your guess is as good as any. Few seem to know what lies inside the CDOs Ambac insured, let alone exactly how many will self-destruct. In the worst-case scenario, the miserable state of the bond market never recovers, bonds default on a grand scale, and Ambac is pummeled with loads of claims it can't afford.
Scenario B: Good, but still bad
Bullish on Ambac? Your theory likely goes something like this: The stars align, the storm clouds part, and the CDOs Ambac insures stage a dramatic comeback. To investors' delight, Ambac announces its books are in tip-top shape, and there's little to worry about. What happens then?
First, the business of insuring CDOs is toast, one way or another. Investors now realize that insuring a black box of surprises probably wasn't a good idea to begin with. The market for insuring municipal bonds, however, still holds some merit -- and that's probably what bullish investors are holding on to.
Unfortunately, that market has changed a lot over the past year. Moody's (NYSE: MCO) already announced plans to change how it rates municipal bonds, which would drastically reduce their need for insurance. Anything left over in the municipal market will likely be scooped up by more reputable companies like Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), which joined the bond-insurance crowd late last year to capitalize on the turmoil.
Few sane investors are likely to choose Ambac over a company like Berkshire, especially now that both Ambac and MBIA have been stripped of their AAA credit status. In a recent taste of possible things to come, Ambac and some rivals were sued by the city of Los Angeles for "unnecessary" bond insurance, after the city essentially questioned whether it needed insurance on municipal bonds at all. That kind of attitude hardly suggests that a rebound is right around the corner.
Even if Ambac survives, how much business would be left over? Good question. In the best case, it's left with a "Great, now what?" predicament. Business as it knew it could either disappear or move to more reputable insurers. Think of it like surviving a disaster, only to wake up to a world with no food, no water, and no people.
Your turn
Our 110,000-strong CAPS community currently gives Ambac a token one-star rating. Head over to CAPS to vote "underperform" on Ambac, or defy the crowd with a bullish take on its future.
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