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Saturday, December 29, 2007

Assured Guaranty Ltd. (Report # 441299001)

Assured Guaranty Ltd. (Ticker: AGO, $26.01 as of 12/28/07 close)

Author: Accrued Interest

Position: Long

Submitted: December 29, 2007 (Saturday) on the author's website

You're wrong, Assured Guaranty. You have that power too.

Berkshire Hathaway is starting its own municipal bond insurer, Berkshire Hathaway Assurance Corp. There are three questions. First, what impact will this have on the muni market? Second, what impact will this have on other monoline insurers? And third, what will muni guys call the new insurer? BHAC? (Pronounced like Be Hock? Maybe the old Oracle should have thought about that a bit more).

The answer to the first question is that its great news. See below.

The answer to the second question is that its great news for some and terrible news for others. Remember that it was often speculated that Berkshire could be a source of capital for the likes of AMBAC, MBIA or FGIC. I myself wrote the following in November:

Berkshire Hathaway has expressed interest in the muni insurance business. I'm sure that if Berkshire put, say, $1 billion into AMBAC, then AMBAC could subsequently do a couple preferred offerings. They'd be expensive, but with Warren Buffett already on board, I think they could get it sold.

Now Buffet won't be on board, so you can forget all that. Its possible BHAC sells some reinsurance to existing muni bond insurers, but that won't inspire confidence in the overall concern like a direct investment would have. I'd therefore put the odds of an eventual downgrade of FGIC as very high, AMBAC and MBIA as moderate. S&P and Moody's are currently satisfied with both MBIA and AMBAC's capital position, which means that any downgrade of these two is likely 6-12 months away if it happens. I believe both MBIA and AMBAC will need more capital, so the moderate odds of a downgrade is based on the odds of them raising more capital. FGIC on the other hand needs capital pronto and I don't know where its going to come from.

I'm skeptical that any of these three can remain a going concern without a AAA rating. I'd suspect they go into runoff. MBIA stock was down nearly 16% today, AMBAC down nearly 14%.

Meanwhile, Assured Guaranty was also lower today by about 4%. The market is reading the Buffett news all wrong by punishing AGO. See, AGO is kind of like the C3-PO of bond insurance. Not especially better than the next protocol droid, but happened to get stolen by the right Jawas at the right time. Now AGO is right in the middle of saving the entire galaxy from the Evil CDO Empire! I guess Buffett is kind of like Luke in this metaphor? Or maybe Obi Wan? I digress.

AGO has benefited from a ton of free press in the last 6 months. As problems with the larger, more established MBIA, FGIC, and AMBAC became apparent, both the ratings agencies and Street firms starting publishing regular reports on all bond insurers. This thrust little Assured into the mainstream consciousness. Suddenly the "reputation" barrier to entry in the municipal insurance business had been smashed into who knows what.

The only risk AGO stock holders face is the possibility that municipal bond insurance declines as a concept. That bond buyers are no longer willing to pay for extra protection on AA-rated school districts and A-rated sewer systems. The fact is that the history of defaults on these types of credits is slim indeed, which is exactly why the municipal insurance business is so profitable. Classically, muni buyers liked insurance because it prevented them from having to do any credit research. So the question is, will investor laziness trump the fear created by current insurer troubles?

I believe the entry of Buffet's firm solidifies the laziness argument. Now municipal buyers can say that we have three solid insurers without any significant structured finance holdings: FSA, AGO, and now BHAC. That's enough insurers to diversify a portfolio reasonably. We can also dismiss FGIC and whomever else winds up going down as insurers who made bad decisions. Not that insurance is a bad business or a bad concept.

I've been around the muni market long enough to know that these people like the status quo. Even more so that other markets. They want to believe in insurance. They want to keep buying insured bonds without thinking about it. They won't need a lot of convincing that throwing FSA and AGO out with the FGIC bathwater is a bad idea. Its what they want to believe anyway.

So back to AGO stock. Its really the best pure-play muni insurer going. Current its trading around 1.1x book. MBIA and AMBAC had been trading more like 1.3x prior to the credit crunch. But that's not the real reason to own AGO. Assured is going to rapidly rise from also-ran to major player in municipal bond insurance. Municipal issuance is going through a bit of a lull here, but after the new year, we're going to see muni issuance ramp back up. Issuers are going to be looking for insurance, and they ain't going to be calling MBIA. Assured, FSA and Berkshire are going to dominate municipal insurance in 2008. This should allow Assured to grow their book value just as fast as they can get capital to grow it. This will also create improved pricing power, which is the reason Buffett gave for making an entry into the muni market. So you may argue that AGO should trade at a higher multiple of book value than MBI or ABK did in years past.

AGO's stock may be rocky, especially if any of the problem 3 wind up in run-off in 2008. But still, as a long-term investor, I'd be happy to ride that out. AGO has a great model and a great opportunity. In time, they will learn to use this power. And I want to be in on the ride.

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