Wall Street Greek: Straddle Anyone? Playing Bond Insurers

(Stocks in this article: AMEX: SPY, AMEX: DIA, Nasdaq: QQQQ, AMEX: SDS, AMEX: DOG, AMEX: QLD, NYSE: MBI, NYSE: ABK, NYSE: WMT, NYSE: OMX, NYSE: HNZ, NYSE: HRL, NYSE: CS, NYSE: BCS, NYSE: NWA, NYSE: DAL, NYSE: MHS, NYSE: MDT, Nasdaq: MSFT, Nasdaq: YHOO)

U.S. stocks picked up the baton from Europe and Asia today, as investors returned from the three day layoff energized. With no new catastrophic acronym introduced into the investor lexicon today, the market seems to say, "No news is good news!" The market is growing more battle ready with each passing day, shaking off bad news with increasingly more authority. This is a good sign and reason to believe in technical base-points.

Bond Insurer Countdown

Still, a minefield lay before us this week with the bond insurer issues yet unresolved. We would much rather see MBIA (NYSE: MBI) and Ambac (NYSE: ABK) emerge from current distress with their municipal bond businesses still intact. If these companies are forced to split out the business, and lose their AAA credit ratings (keeping it in the muni-bond portion), they will be severely disabled. What they need is to give up just enough ownership interest, or otherwise create capital, to preserve the rating and get the regulators off their backs. If you have not already seen it, please review our discussion of the topic in "The Greek's Week Ahead."

MBIA resurrected its old CEO, Joseph Brown, to lead it through the fire. Joseph is taking a $4.4 million personal stake in MBIA at a price of $12.15 a share. This seems to offer him incentive to do the right thing for MBIA's stakeholders, but he's also gaining a potential bonus of $2 million and added bonus of $5 million in a year's time, so it's not so clear that he's bearing a cost. Clearly though, he has incentive to create value, but seems to bear less risk than apparent on the surface.

MBIA has taken a strong position against the legal right of the State of New York to force a split of the company's business. The important question to be answered is how confident MBIA's raters are in its ability to meet obligations. MBIA went out and raised $2.5 billion over the last three months and has declared itself more than adequately financed. What matters though, is what S&P, Moody's and Fitch think. The clear resolution to the problem is to get the corporate management teams, rating agencies and regulators in one room at the same time to discuss exactly what capital amount is needed to resolve the issue. There must be no opportunity for miscommunication or confusion, and that risk seems to exist now with two separate lines open to the rating agencies, one from the companies and one from the regulators. Once capital requirements are clear and uniformly understood, MBIA and Ambac can set forth on attaining it, or not.

Ambac looks as if it's been more easily swayed, and seems to be considering the split scenario. Both firms' shares are lower this morning. It's possible we would see no quick direction taken toward resolution in MBI's case. If regulators seek to force the issue and MBI finds legal loophole to argue the case, we believe MBI shares would react to the downside initially. But, the same might be said for ABK's shares, if the company agrees to a split. Remember though, shareholders should gain two separate interests in two separate firms, and those two pieces might equal the current value of the whole, or allow for value creation. The important question to be answered is would a split make capital acquisition easier or harder for these firms.

A Trade to Play It

While volatility is priced into the stocks' options to a degree, a good way to play this situation seems to be by taking long positions on both calls and puts (at the same strike, or same distance from spot price), thus betting on greater volatility than is priced into the options. The technical term for this is a straddle. Simply put, you lose if MBI and ABK shares sit still this week, and that seems unlikely. The hope is to gain more on one side of the bet than the cost of both options. Profit depends on volatility, and enough of it to overcome cost. Also, time is your enemy, as usual.

You could bias your gamble, based on your expectations of which way the situation will go, by simply investing disproportionately in calls or puts. The bet then becomes sort of a semi-hedged one, carrying directional risk as well as that tied to lack of volatility and time decay. The stocks seem to have good catalyst for volatility thanks to Eliot Spitzer's deadline (he said 3-5 days about 4 days ago). Whether he was referring to business days or just days does not change the bet much. How much conviction he has in the deadline, and how close the rating agencies may be to action is very important. NY State Insurance Superintendent Dinallo seemed to indicate some flexibility on timeline.

Economic Data & Analysis

State Street Investor Confidence Index

February's take on investor confidence measured 73.0, compared to January's 68.8. It seems Ben Bernanke's significant action and the government's fiscal stimulus effort have encouraged investors. Stock prices told us that already though by rising off of January's lows.

Oil on the Rise

Despite OPEC's decision to keep production steady, a refinery explosion and threats from Hugo Chavez (though later rescinded) have kept momentum on the bullish side of the table. Recent news that America's President wants to speed the rate of strategic oil reserve filling, Iranian and Venezuelan hopes to cut production in March and mysterious undersea Internet cable disruption (to Iran) have certainly not been overlooked by oil bulls either. Perhaps most important, European economic growth continued in Q4 and the global economy looks more resilient than recently assessed. Find today's important headlines below...