Ambac Settlement Bigger News for Munis Than Stocks

Hot on the heels of Security Capital's agreement with Merrill Lynch (MER - commentary - Cramer's Take) to unwind eight credit-default swaps (CDS), Ambac (ABK - commentary - Cramer's Take) and Citigroup (C - commentary - Cramer's Take) have reached a similar agreement. The arrangement has Ambac paying Citigroup $850 million to terminate approximately $1.4 billion of a CDS referencing a so-called CDO-squared transaction.

Collateralized Debt Obligations (CDO) with asset-backed securities (ABS) as collateral, a category which includes CDO-squareds, are the primary problem facing monoline insurers. While the monolines face losses beyond their initial expectations on a variety of structured finance transactions, monolines senior position in these transactions are limiting actual losses. ABS CDOs were creating using mezzanine ABS securities, many of which are already suffering massive losses.

These agreements to terminate CDS are a major positive for the monoline insurers, at least in terms of solvency. It turns an unknown into a known. Ambac's loss on the CDS in question was an unknown. Some even believed Ambac would take a total loss on the transaction. Now their loss position is known: $850 million. That's the end of it.

Beyond that is the fact that Ambac had actually written the position down by $1 billion. So the company will be booking a $150 million gain. This proves, with an actual trade, that in at least one case, Ambac was being conservative in its valuation of liabilities. While not proving anything per se, it's fair to interpret this as a significant positive in terms of Ambac's future mark-to-market losses.

Finally, this should improve the capital situation at Ambac Assurance. Not only will the company record a $150 million gain, but it has eliminated a significant source of loss uncertainty.

This is all great news for municipal bond holders. If Ambac and other monolines can stabilize, even at non-AAA ratings, the market will once again see municipal insurance as having some positive value.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.