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EX-31.1 - CERTIFICATION OF CEO PURSUANT TO RULES 13A-14 AND 15D-14 - AMBAC FINANCIAL GROUP INCdex311.htm
EX-32.2 - CERTIFICATION OF CFO PURSUANT TO 18 U.S.C. SECTION 1350 - AMBAC FINANCIAL GROUP INCdex322.htm
EX-32.1 - CERTIFICATION OF CEO PURSUANT TO 18 U.S.C. SECTION 1350 - AMBAC FINANCIAL GROUP INCdex321.htm
EX-31.2 - CERTIFICATION OF CFO PURSUANT TO RULES 13A-14 AND 15D-14 - AMBAC FINANCIAL GROUP INCdex312.htm
EX-10.21 - AGREEMENT BETWEEN DOUGLAS C. RENFIELD-MILLER AND AMBAC FINANCIAL GROUP - AMBAC FINANCIAL GROUP INCdex1021.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2009

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-10777

 

 

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   13-3621676
(State of incorporation)   (I.R.S. employer identification no.)
One State Street Plaza  
New York, New York   10004
(Address of principal executive offices)   (Zip code)

(212) 668-0340

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act): (Check one):

Large accelerated filer  ¨        Accelerated filer  x        Non-accelerated filer  ¨        Smaller reporting company  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 3, 2009, 287,589,393 shares of Common Stock, par value $0.01 per share, (net of 5,767,286 treasury shares and 1,021,603 restricted nominee shares) of the Registrant were outstanding.

 

 

 


Table of Contents

Ambac Financial Group, Inc. and Subsidiaries

INDEX

 

 

          PAGE
PART I    FINANCIAL INFORMATION   
Item 1.    Financial Statements of Ambac Financial Group, Inc. and Subsidiaries   
   Consolidated Balance Sheets – September 30, 2009 (unaudited) and December 31, 2008    3
   Consolidated Statements of Operations (unaudited) – three and nine months ended September 30, 2009 and 2008    4
   Consolidated Statements of Stockholders’ Equity (unaudited) – nine months ended September 30, 2009 and 2008    5
   Consolidated Statements of Cash Flows (unaudited) – nine months ended September 30, 2009 and 2008    6
   Notes to Unaudited Consolidated Financial Statements    7
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    60
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    109
Item 4.    Controls and Procedures    114
PART II    OTHER INFORMATION   
Item 1.    Legal Proceedings    115
Item 1A.    Risk Factors    118
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds    123
Item 6.    Exhibits    124
SIGNATURES    125
INDEX TO EXHIBITS    126


Table of Contents

PART 1- FINANCIAL INFORMATION

Item 1 – Financial Statements of Ambac Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

 

(Dollars in Thousands)

   September 30,
2009
    December 31,
2008
 
     (unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $8,298,503 in 2009 and $11,080,723 in 2008)

   $ 8,233,730      $ 8,537,676   

Fixed income securities pledged as collateral, at fair value (amortized cost of $241,146 in 2009 and $277,291 in 2008)

     248,829        286,853   

Short-term investments, (amortized cost of $1,344,944 in 2009 and $1,454,229 in 2008)

     1,344,945        1,454,229   

Other (cost of $1,278 in 2009 and $13,956 in 2008)

     1,278        14,059   
                

Total investments

     9,828,782        10,292,817   

Cash and cash equivalents

     149,554        107,811   

Receivable for securities sold

     53,339        15,483   

Investment income due and accrued

     66,899        116,769   

Premium receivables

     4,016,775        28,895   

Reinsurance recoverable on paid and unpaid losses

     68,166        157,627   

Deferred ceded premium

     549,199        292,837   

Subrogation recoverable

     570,133        10,088   

Deferred taxes

     —          2,127,499   

Current income taxes

     —          192,669   

Deferred acquisition costs

     300,127        207,229   

Loans (includes $228,125 at fair value in 2009)

     607,949        798,848   

Derivative assets

     1,187,636        2,187,214   

Other assets

     700,497        723,887   
                

Total assets

   $ 18,099,056      $ 17,259,673   
                

Liabilities and Stockholders’ Equity:

    

Liabilities:

    

Unearned premiums

   $ 6,100,656      $ 2,382,152   

Losses and loss expense reserve

     4,521,807        2,275,948   

Ceded premiums payable

     329,849        15,597   

Obligations under investment and payment agreements

     1,416,142        3,244,098   

Obligations under investment repurchase agreements

     113,527        113,737   

Deferred taxes

     18,856        —     

Current taxes

     50,567        —     

Long-term debt (includes $894,815 at fair value in 2009)

     2,751,625        1,868,690   

Accrued interest payable

     41,948        68,806   

Derivative liabilities

     4,652,390        10,089,895   

Other liabilities

     253,670        279,616   

Payable for securities purchased

     22,560        10,256   
                

Total liabilities

     20,273,597        20,348,795   
                

Stockholders’(deficit) equity:

    

Ambac Financial Group, Inc.:

    

Preferred stock

     —          —     

Common stock

     2,944        2,944   

Additional paid-in capital

     2,171,848        2,030,031   

Accumulated other comprehensive gains (losses)

     6,372        (1,670,198

Retained deficit

     (4,448,113     (3,550,768

Common stock held in treasury at cost

     (561,495     (594,318
                

Total Ambac Financial Group, Inc. stockholders’ deficit

     (2,828,444     (3,782,309

Noncontrolling interest

     653,903        693,187   
                

Total stockholders’ deficit

     (2,174,541     (3,089,122
                

Total liabilities and stockholders’ deficit

   $ 18,099,056      $ 17,259,673   
                

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

3


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

 

(Dollars in Thousands, Except Share Data)

   Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
   2009     2008     2009     2008  

Revenues:

        

Financial Guarantee:

        

Net premiums earned

   $ 238,401      $ 282,326      $ 612,945      $ 794,663   

Net investment income

     134,977        126,757        358,157        381,142   

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     (32,529     (2,548     (1,452,664     (4,920

Portion of loss recognized in other comprehensive income

     —          —          —          —     
                                

Net other-than-temporary impairment losses recognized in earnings

     (32,529     (2,548     (1,452,664     (4,920
                                

Net realized investment gains

     92,279        51,926        106,904        75,383   

Change in fair value of credit derivatives:

        

Realized gains and losses and other settlements

     (732,857     (837,929     (731,287     (805,921

Unrealized gains (losses)

     2,865,761        (1,867,250     4,411,004        (2,630,842
                                

Net change in fair value of credit derivatives

     2,132,904        (2,705,179     3,679,717        (3,436,763

Other income

     309,922        (2,713     350,866        7,797   

Financial Services:

        

Investment income

     18,454        63,810        58,342        205,458   

Derivative products

     (222,450     (17,199     (280,868     (102,057

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     (11,660     (124,280     (283,858     (451,932

Portion of loss recognized in other comprehensive income

     —          —          —          —     
                                

Net other-than-temporary impairment losses recognized in earnings

     (11,660     (124,280     (283,858     (451,932
                                

Net realized investment gains

     28,109        39,289        142,345        55,173   

Net change in fair value of total return swap contracts

     6,902        (28,279     18,573        (72,977

Net mark-to-market (losses) gains on non-trading derivative contracts

     (6,907     (5,230     783        (4,968

Corporate and Other:

        

Other income

     1,109        887        33,325        2,751   

Net realized investment gains

     —          —          33        —     
                                

Total revenues

     2,689,511        (2,320,433     3,344,600        (2,551,250
                                

Expenses:

        

Financial Guarantee:

        

Losses and loss expenses

     459,213        607,702        2,429,890        1,311,169   

Underwriting and operating expenses

     28,039        47,051        133,537        157,909   

Interest expense on variable interest entity notes

     2,658        3,367        7,835        10,303   

Financial Services:

        

Interest from investment and payment agreements

     6,433        50,048        27,533        196,965   

Other expenses

     3,316        3,466        10,808        10,152   

Corporate and Other:

        

Interest

     29,918        29,970        89,601        84,422   

Other expenses

     5,975        10,027        6,659        33,216   
                                

Total expenses

     535,552        751,631        2,705,863        1,804,136   
                                

Pre-tax income (loss) from continuing operations

     2,153,959        (3,072,064     638,737        (4,355,386

(Benefit) provision for income taxes

     (34,284     (640,687     1,211,477        (1,086,877
                                

Net income (loss)

   $ 2,188,243        (2,431,377     ($572,740     ($3,268,509

Less net loss attributable to the noncontrolling interest

     (14     (155     (16     (78
                                

Net income (loss) attributable to Ambac Financial Group, Inc.

   $ 2,188,257        ($2,431,222     ($572,724     ($3,268,431
                                

Net income (loss) per share attributable to Ambac Financial Group, Inc. common shareholders

   $ 7.58        ($8.45     ($1.99     ($13.66

Net income (loss) per diluted share attributable to Ambac Financial Group, Inc. common shareholders

   $ 7.58        ($8.45     ($1.99     ($13.66

Weighted-average number of common shares outstanding:

        

Basic

     288,770,269        287,599,495        287,647,272        239,265,594   

Diluted

     288,770,269        287,599,495        287,647,272        239,265,594   

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

4


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

 

    Total           Ambac Financial Group, Inc.     Noncontrolling
Interest
 
    Comprehensive
Income
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Preferred
Stock
  Common
Stock
  Paid-in
Capital
    Common Stock
Held in
Treasury,
at Cost
   

Balance at January 1, 2009

    ($3,089,122       ($3,550,768     ($1,670,198   $ 0   $ 2,944   $ 2,030,031      ($594,318   $ 693,187   

Sale of subsidiary shares to noncontrolling interest

    100,000                      100,000   

Retirement of shares issued to noncontrolling interest

    (11,178               128,547          (139,725

Comprehensive income:

                 

Net loss

    (572,740     ($572,740     (572,724               (16
                             

Other comprehensive income:

                 

Unrealized gains on performing securities, net of deferred income taxes of $869,680

    1,717,185        1,717,185          1,717,185             

Gain on derivative hedges, net of deferred income taxes of $170

    315        315          315             

Gain on foreign currency translation, net of deferred income taxes of $32,919

    61,592        61,592          61,135                457   
                             

Other comprehensive income

    1,779,092        1,779,092                 
                             

Total comprehensive income

    1,206,352      $ 1,206,352                 
                             

Adjustment to initially apply ASC 944-20-65-1

    (381,716       (381,716            

Adjustment to initially apply ASC 320-10-65-1

    —            102,065        (102,065          

Dividends declared – subsidiary shares to non-controlling interest

    (12,148       (12,148            

Stock-based compensation

    (19,552       (32,822           13,270       

Cost of shares acquired

    (115               (115  

Shares issued under equity plans

    32,938                  32,938     
                                                           

Balance at September 30, 2009

    ($2,174,541       ($4,448,113   $ 6,372      $ 0   $ 2,944   $ 2,171,848      ($561,495   $ 653,903   
                                                           
                 

Balance at January 1, 2008

  $ 2,271,954        $ 2,107,773        ($22,138   $ 0   $ 1,092   $ 839,952      ($646,786     ($7,939

Comprehensive loss:

                 

Net loss

    (3,268,509     ($3,268,509     (3,268,431               (78
                             

Other comprehensive loss:

                 

Unrealized losses on securities, net of deferred income taxes of ($547,903)

    (1,094,955     (1,094,955       (1,094,955          

Gain on derivative hedges, net of deferred income taxes of $7,031

    8,546        8,546          8,546             

Gain on foreign currency translation, net of deferred income taxes of ($4,340)

    (7,884     (7,884       (8,080             196   
                             

Other comprehensive loss

    (1,094,293     (1,094,293              
                             

Total comprehensive loss

    (4,362,802     ($4,362,802              
                             

Adjustment to initially apply ASC Topics 820 and 825, net of deferred income taxes of $10,826

    20,102          20,102               

Dividends declared - common stock

    (12,924       (12,924            

Dividends on restricted stock units

    (33       (33            

Exercise of stock options

    (52,443       (52,443            

Issuance of stock

    1,182,032                1,852     1,180,180       

Stock-based compensation

    21,730                  21,730       

Excess cost related to share-based compensation

    (13,721               (13,721    

Cost of shares acquired

    (1,071               (1,071  

Shares issued under equity plans

    52,443                  52,443     
                                                           

Balance at September 30, 2008

    ($894,733       ($1,205,956     ($1,116,627   $ 0   $ 2,944   $ 2,028,141      ($595,414     ($7,821
                                                           

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

5


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended
September 30,
 

(Dollars in Thousands)

   2009     2008  

Cash flows from operating activities:

    

Net loss attributable to common shareholders

     ($572,724     ($3,268,431

Noncontrolling interest in subsidiaries’ earnings

     (16     (78
                

Net loss

     (572,740     (3,268,509

Adjustments to reconcile net loss to net cash (used in) provided by operating activities:

    

Depreciation and amortization

     2,223        2,415   

Amortization of bond premium and discount

     (143,772     (14,163

Share-based compensation

     13,315        17,443   

Current income taxes

     243,236        (851,658

Deferred income taxes

     1,243,586        (254,488

Deferred acquisition costs

     (100,610     33,851   

Unearned premiums, net

     (436,753     (414,583

Losses and loss expenses, net

     1,483,109        1,011,925   

Ceded premiums payable

     (349,535     (18,976

Investment income due and accrued

     49,870        62,770   

Accrued interest payable

     (57,443     (46,115

Net mark-to-market (gains) losses

     (4,430,360     2,710,009   

Net realized investment gains

     (249,282     (130,556

Other-than-temporary impairment charges

     1,736,522        456,852   

Other, net

     232,895        49,213   
                

Net cash used in operating activities

     (1,335,739     (654,570
                

Cash flows from investing activities:

    

Proceeds from sales of bonds

     3,014,573        4,907,418   

Proceeds from matured bonds

     497,216        1,136,613   

Purchases of bonds

     (1,636,336     (3,118,341

Change in short-term investments

     109,285        (455,227

Loans, net

     404,748        29,551   

Recoveries from impaired investments

     13        1,759   

Change in swap collateral receivable

     445,435        (130,443

Cash acquired in consolidation of variable interest entities

     1,013,260        —     

Other, net

     3,689        2,926   
                

Net cash provided by investing activities

     3,851,883        2,374,256   
                

Cash flows from financing activities:

    

Dividends paid – common stockholders

     —          (12,924

Dividends paid – subsidiary shares to noncontrolling interest

     (12,148     —     

Securities sold under agreements to repurchase

     —          (100,000

Proceeds from issuance of investment and payment agreements

     53,756        39,916   

Payments for investment and payment draws

     (1,643,102     (3,041,662

Proceeds from issuance of long-term debt

     —          228,969   

Proceeds from the issuance of subsidiary shares to noncontrolling interest

     100,000        —     

Retirement of subsidiary shares to noncontrolling interest

     (11,178     —     

Payments for redemption of variable interest entity long-term debt

     (920,845     —     

Capital issuance costs

     (297     (11,462

Net cash collateral received

     (40,587     (21,315

Proceeds from issuance of common stock

     —          1,182,032   

Purchases of treasury stock

     —          (1,072

Excess tax benefit related to share-based compensation

     —          (13,721
                

Net cash used in financing activities

     (2,474,401     (1,751,239
                

Net cash flow

     41,743        (31,553

Cash and cash equivalents at January 1

     107,811        123,933   
                

Cash and cash equivalents at September 30

   $ 149,554      $ 92,380   
                

Supplemental disclosure of cash flow information:

    

Cash paid during the year for:

    

Income taxes

   $ —        $ 32,580   
                

Interest expense on long-term debt

   $ 74,820      $ 79,402   
                

Interest on investment agreements

   $ 38,436      $ 227,805   
                

Supplemental Schedule of Non-cash investing and financing activities:

The Company consolidated certain variable interest entities during the period. In conjunction with the consolidation of these entities, liabilities were assumed as follows

 

Fair value of assets consolidated

   $ 833,848

Cash consolidated

     1,013,260
      

Liabilities consolidated

   $ 1,847,108

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

6


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

(1) Background and Basis of Presentation

Ambac Financial Group, Inc. (“Ambac” or the “Company”) is a holding company incorporated in the state of Delaware. Ambac, through its subsidiaries, provided financial guarantees and financial services to entities in both the public and private sectors around the world. The long-term senior unsecured debt of Ambac is rated CC with a negative outlook by Standard & Poor’s Ratings Service, a Standard & Poor’s Financial Services LLC business (“S&P”), and Ca, with a negative outlook, by Moody’s Investors Services, Inc. (“Moody’s”). Ambac’s principal financial guarantee operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance”), a guarantor of public finance and structured finance obligations, has a CC financial strength rating with a developing outlook by S&P, and a Caa2 financial strength rating with a developing outlook from Moody’s. These ratings reflect multiple downgrades in Ambac Assurance’s financial strength ratings from June 2008 through August 2009.

Based on the holdings of cash, short term investments and bonds of $164,700 as of September 30, 2009, management believes that Ambac will have sufficient liquidity to satisfy its needs through the second quarter of 2011, but no guarantee can be given that Ambac Assurance will be able to dividend amounts sufficient to pay all of Ambac’s operating expenses and debt service obligations in the long-term, or that Ambac will be able to access alternative sources of capital. Ambac Assurance is unable to pay dividends in 2009 and will likely be unable to pay dividends in 2010, absent special approval from the OCI, thus constraining Ambac’s principal source of liquidity. Further, other contingencies (e.g., an unfavorable outcome of the outstanding class action lawsuits against Ambac), could cause additional liquidity strain. While management believes that Ambac will have sufficient liquidity to satisfy its needs through the second quarter of 2011, no guarantee can be given that it will be able to pay all of its operating expenses and debt service obligations thereafter, including maturing principal in the amount of $143,000 in August 2011. In addition, it is possible its liquidity may run out prior to the second quarter of 2011. Ambac is developing strategies to address its liquidity needs; such strategies may include a negotiated restructuring of its debt through a prepackaged bankruptcy proceeding. No assurances can be given that Ambac will be successful in executing any or all of its strategies. If Ambac is unable to execute these strategies, it will consider seeking bankruptcy protection without agreement concerning a plan of reorganization with major creditor groups.

Ambac Assurance has not written a meaningful volume of financial guarantee business since November 2007. As such, Ambac is actively mitigating losses in Ambac Assurance’s insured portfolio and increasing the yield on its investment portfolio in order to maximize the residual value of Ambac Assurance. Further, the Company’s existing investment agreement and derivative product portfolios are in active runoff, which may result in transaction terminations, settlements, restructuring, assignments of and scheduled amortization of contracts. In the course of managing the inherent risks of these portfolios during runoff, the Financial Services segment may enter into new financial instrument transactions for hedging purposes to the extent we are able to do so.

Ambac’s principal business strategy going forward is to (i) grow our business by developing new business initiatives which capitalize on our expertise and relationships in the capital markets and (ii) increase the residual value of our financial guarantee business by mitigating losses on poorly performing transactions. Ambac had intended to reactivate Everspan Financial Guarantee Corp. (“Everspan”) for purposes of writing financial guarantee insurance in the U.S. public finance market; however, market conditions, among other things, hampered the Company’s efforts to raise third party capital. Since Ambac has been unable to raise capital for Everspan, it has postponed indefinitely its efforts to launch Everspan. Contributing factors to this decision are that management believes that Everspan will require substantially more capital, including third-party capital, and at least a AA S&P and A2 Moody’s rating in order to compete in the U.S. public finance market. Further, the Company has not received permission from the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”) to capitalize Everspan at a level enabling it to compete in that market, and it is unlikely that OCI will grant such permission without substantial improvement in Ambac Assurance’s financial position by significant further progress in reducing problem exposures.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

As described above, the financial strength rating downgrades have adversely impacted Ambac’s ability to generate new business and will negatively impact Ambac’s future business, operations and financial results. There can be no assurance that Ambac will be successful in realizing any of the foregoing strategies. If such initiatives are ultimately unsuccessful, Ambac’s activities may resort solely to loss mitigation and eventual run-off of the existing book of business.

On July 15, 2009, Ambac acquired the assets of NSM Capital Management LLC and Structured Credit Solutions LLC, which are now part of Ambac’s subsidiary, RangeMark Financial Services, Inc. (“RangeMark”). RangeMark provides consultative advisory, credit risk management, asset valuation, investment management, and debt capital markets services, all built around a core discipline of quantitative research and analytics to the structured credit and public finance markets. In addition to using their services to augment the management of Ambac’s and its affiliates’ investment portfolios and mortgage-related and other asset-backed financial guarantee liabilities, Ambac intends for RangeMark to continue to provide its suite of services to outside parties and will seek to grow and expand such services.

Regulatory Update:

Ambac Assurance has not yet completed its statutory financial statements for the third quarter of 2009. As a result of significant losses on exposures to residential mortgage backed securities (“RMBS”), including financial guarantee insurance policies and credit default swap contracts on CDO of ABS securities, Ambac Assurance’s statutory capital and surplus had been reduced significantly. Ambac Assurance continues to work to reduce exposures through commutations and other settlements. The third quarter 2009 results and ending statutory surplus will be affected by estimated impairment losses on credit derivatives, realized losses relating to other than temporary impairment losses on Alt-A investments and statutory loss and loss expenses incurred during the quarter and will also include the effects of commutations and other settlements completed prior to the filing of Ambac Assurance’s statutory financial statements, as well as other significant non-recurring third quarter activity such as reinsurance recaptures of $311,000, which has a positive effect on surplus, and the correction of an error in the prior quarter’s estimation of credit derivative impairments of approximately $280,000, which has a negative effect on surplus. Ambac Assurance’s statutory financial statements are scheduled to be filed with the OCI and the regulators in the other jurisdictions in which it is licensed no later than November 16, 2009. Statutory capital and surplus differs from stockholders’ deficit as determined under U. S. GAAP, principally due to statutory accounting rules that treat loss reserves, consolidation of subsidiaries, premiums earned, policy acquisition costs and deferred income taxes differently.

Due to the deterioration of Ambac Assurance’s financial condition, the OCI has increased its oversight of Ambac Assurance and is evaluating Ambac Assurance’s ability to pay all claims in its insured portfolio. While no proceeding is currently pending, following such evaluation and depending on the result of such review, OCI could decide to initiate delinquency proceedings with respect to Ambac Assurance to protect the interests of its policyholders. A number of adverse consequences could result from the initiation of delinquency proceedings, including, without limitation, the occurrence of an event of default with respect to Ambac’s debt, which could result in acceleration of principal of such debt in the amount of $1,642,500; termination of credit default swap contracts which are insured by Ambac Assurance, which could liquidate mark-to-market claims in respect of underlying exposures in the amount of $23,108,905; and the loss of control rights by Ambac Assurance in respect of insured transactions, thus compromising Ambac Assurance’s ability to mitigate loss in its insured portfolio and to fully realize the credit for remediation inherent in its loss reserves.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Ambac Assurance is subject to the insurance laws and regulations of each jurisdiction in which it is licensed, some of which are described below. Failure to comply with applicable insurance laws and regulations (including, without limitation, minimum surplus requirements, aggregate risk limits and single risk limits) could expose Ambac Assurance to fines, the loss of insurance licenses in certain jurisdictions, the imposition of orders by regulators with respect to the conduct of business by Ambac Assurance and/or the inability of Ambac Assurance to dividend monies to Ambac, all of which could have an adverse impact on our business results and prospects. Failure to comply with any of the foregoing items could prompt the initiation of delinquency proceedings with respect to Ambac Assurance which could have the adverse impacts described in the immediately preceding paragraph. Even if delinquency proceedings were not commenced, the OCI could impose additional limitations on our operations and business, which could limit the ability of Ambac Assurance to pay claims under financial guarantee insurance policies, credit default swaps and reinsurance agreements and to pay dividends to Ambac for an unspecified period of time.

Section 3.08 of the Wisconsin Administrative Code prohibits the Company from having total net liability in respect of any one issue of municipal bonds in excess of an amount representing 10% of its qualified statutory capital. Total net liability, as defined by the Wisconsin Administrative Code, means the average annual amount due, net of reinsurance, for principal and interest on the insured amount of any one issue of municipal bonds. Additionally, Section 3.08 of the Wisconsin Administrative Code prohibits the Company from having outstanding cumulative net liability, under inforce policies of municipal bond insurance in an amount which exceeds qualified statutory capital. Cumulative net liability, as defined by the Wisconsin Administrative Code, means one-third of one percent of the insured unpaid principal and insured unpaid interest covered by inforce policies of municipal bond insurance.

The New York financial guarantee insurance law establishes single risk limits applicable to obligations insured by financial guarantee insurers. Additionally, the laws of the states of California, Connecticut and Maryland include single risk limits applicable to financial guarantee insurers which are similar to the corresponding provisions of New York law. The single risk limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits require that the insured net par outstanding and/or average annual debt service, net of reinsurance and collateral, for a single risk not be greater than the insurer’s qualified statutory capital. New York law also establishes aggregate risk limits on the basis of aggregate net liability and policyholders’ surplus requirements. Aggregate net liability is defined as the aggregate of the outstanding insured principal, interest and other payments of guaranteed obligations, net of reinsurance and collateral. Under these limits, qualified statutory capital must at least equal a percentage of aggregate net liability that is equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for municipal bonds to 4.00% for certain non-investment grade obligations. California, Connecticut and Maryland laws also include aggregate risk limits which are similar to the corresponding provisions of New York law.

As a result of the reduction in statutory capital and surplus and qualified statutory capital during 2009, Ambac Assurance is not in compliance with the single and aggregate risk limits. Ambac Assurance submitted a plan to the respective insurance regulators detailing the steps that Ambac Assurance has taken and will seek to take to reduce its exposure to no more than the permitted amounts. Following the submission of such plan, after notice and hearing, the regulators could require Ambac Assurance to cease transacting any new financial guarantee business until its exposure to losses no longer exceeds said limits.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Reclassifications:

Certain reclassifications have been made to prior periods’ amounts to conform to the current period’s presentation.

Codification and references:

In June 2009, the FASB issued ASC Topic 105 Generally Accepted Accounting Principles, which applies to financial statements of nongovernmental entities that are presented in conformity with GAAP. On July 1, 2009, the FASB launched its Accounting Standards Codification (the “Codification”). Pursuant to ASC Topic 105, the Codification will become the sole source of authoritative U.S. GAAP for interim and annual periods ending after September 15, 2009, except for rules and interpretive releases of the SEC, which are sources of authoritative U.S. GAAP for SEC registrants. Ambac adopted the provisions of ASC Topic 105 effective September 30, 2009. The adoption of ASC Topic 105 required Ambac to modify its disclosures within this report related to references to source of authoritative U.S. GAAP applied and did not have any effect on Ambac’s financial condition, results of operations or cash flows.

 

(2) Net income per Share

ASC Paragraph 260-10-65-2 of ASC Topic 260, Earnings Per Share, effective for fiscal years beginning after December 15, 2008, clarified that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method, which Ambac has adopted in 2009. Retrospective application is required. Ambac has participating securities consisting of nonvested common stock with the same voting and dividend rights as our common stock. Basic net income per share is computed by dividing net income available to common stockholders less income allocated to participating securities, by the weighted-average number of common shares outstanding during the period. The amount of income allocated to participating securities amounted to a $0.03 reduction to basic net income per common share outstanding during the three month period ended September 30, 2009. No income was allocated to participating securities during the nine month period ended September 30, 2009. Common shares outstanding includes common stock issued less treasury shares plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding during the period, plus all dilutive potential common shares outstanding during the period. All dilutive potential common shares outstanding consider common stock deliverable pursuant to stock options, nonvested restricted stock units, nonvested common shares, and stock purchase contracts. There were no dilutive effects for the three and nine months ended September 30, 2009 and 2008. The number of additional shares is calculated by assuming that outstanding stock options were exercised or purchased contracts were settled and that the proceeds from such exercises or settlements were used to acquire shares of common stock or retire existing debt as specified in the contract at the average market price during the year.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

(3) Application of the New Financial Guarantee Accounting Standard

In May 2008, the FASB issued standards to clarify existing accounting guidance for financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities (i.e., loss reserves). Ambac adopted ASC Topic 944 on January 1, 2009, except for the disclosures about the insurance enterprise’s risk management activities, which it adopted in the quarter ended September 30, 2008. ASC Topic 944 is required to be applied to financial guarantee insurance contracts inforce upon adoption and to new financial guarantee contracts issued in the future. As a result of adopting ASC Topic 944, a cumulative effect adjustment of ($381,716) was recorded to the opening balance of retained earnings at January 1, 2009. The impact of adopting this guidance on the Ambac’s balance sheet is as follows:

 

     As reported at
December 31,
2008
    As adjusted
for ASC
Topic 944 at
January 1,
2009
   Transition
adjustment
 

Assets:

       

Premiums receivable

   $ 28,895 (1)    $ 4,622,858    $ 4,593,963   

Reinsurance recoverable on ceded losses

     157,627        257,721      100,094   

Deferred ceded premiums (formerly prepaid reinsurance)

     292,837        1,215,996      923,159   

Deferred acquisition costs

     207,229        199,517      (7,712
                       

Total

   $ 686,588      $ 6,296,092    $ 5,609,504   
                       

Liabilities:

       

Unearned premiums

   $ 2,382,152      $ 7,204,206    $ 4,822,054   

Loss and loss expense reserve

     2,275,948        2,716,138      440,190   

Ceded premiums payable

     15,597        679,384      663,787   

Other liabilities

     279,616        344,805      65,189   
                       

Total

   $ 4,953,313      $ 10,944,533    $ 5,991,220   
                       

Reduction to opening retained earnings upon adoption

          ($381,716
             

 

(1) Premiums receivable were reported in Other Assets at December 31, 2008.

A summary of the effects of ASC Topic 944 on the balance sheet amounts above is as follows:

 

   

Premiums receivable and ceded premiums payable increased to reflect the recording of the present value of future installment premiums discounted at a risk-free rate. Ceded premiums payable is reduced for the present value of future ceding commission receivable on reinsured policies. Refer to the “Net Premiums Earned” section below for a detailed discussion.

 

   

Unearned premiums and deferred ceded premiums increased to reflect the recording of the present value of future installment premiums discounted at a risk-free rate, offset by the change in the premium earnings methodology to the level-yield method. Refer to the “Net Premiums Earned” section below for a detailed discussion.

 

   

Loss and loss expense reserves and reinsurance recoverable on ceded losses increased to reflect estimated losses based on probability weighted cash flows discounted at a risk free rate as compared to a best estimate discounted using the after-tax investment yield of the Company’s investment portfolio, which was in accordance with existing guidance prior to the implementation of ASC Topic 944. These increases are offset by the requirement to recognize loss reserves only for the excess of the expected loss over the unearned premium reserve on a transaction by transaction basis. Refer to the “Loss reserves” section below for a detailed discussion.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

   

Deferred acquisition costs decreased to reflect deferral of the present value of net ceding commissions received on future installment premiums and slower amortization of previously deferred costs (caused by the level-yield premium earnings methodology) offset by deferral of the present value of premium taxes payable (included in other liabilities). Refer to the “Deferred Acquisition Costs” section below for a detailed discussion.

The accounting policies for premium earnings, loss reserves and deferred acquisition costs discussed in the remainder of this Note only relate to Ambac’s policies in effect since January 1, 2009 in accordance with ASC Topic 944. As such, certain line items in the financial statements will not be comparable between periods. Please refer to Note 2 in the Notes to Consolidated Financial Statements of Ambac’s December 31, 2008 Form 10-K for a discussion of our policies in effect for periods prior to January 1, 2009.

Net Premiums Earned:

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially established in an amount equal to: i) the present value of future contractual premiums due (the “contractual” method) or, ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable (the “expected” method), the present value of premiums to be collected over the life of the transaction. An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted average risk-free rate and weighted average period of future premiums used to estimate the premium receivable at September 30, 2009 is 2.7% and 11 years, respectively. Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities and consumer auto loans. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk free rate.

For both upfront and installment premium policies, premium revenues are earned over the life of the financial guarantee contract in proportion to the insured principal amount outstanding at each reporting date (referred to as the level-yield method). For installment paying policies, the premium receivable discount, equating to the difference between the undiscounted future installment premiums and the present value of future installment premiums, is accreted as premiums earned in proportion to the premium receivable balance at each reporting date. Because the premium receivable discount and UPR are being accreted into income using different rates, the total premiums earned as a percentage of insured principal is higher in the earlier years and lower in the later years for an installment premium transaction as compared to an upfront premium transaction.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Below is the premium receivable roll-forward for the period ended September 30, 2009:

 

Premium receivable at December 31, 2008

   $ 28,895   

Impact of adoption of ASC Topic 944

     4,593,963   
        

Premium receivable at January 1, 2009

     4,622,858   

Premium payments received

     (316,826

Adjustments for changes in expected life of homogeneous pools or contractual cash flows

     (457,109

Accretion of premium receivable discount

     85,278   

Other adjustments (including foreign exchange)

     82,574   
        

Premium receivable at September 30, 2009

   $ 4,016,775   
        

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. For premiums paid upfront, a deferred ceded premium asset is established which is initially recorded as the cash amount paid. For installment premiums, a ceded installment premiums payable liability and offsetting deferred ceded premium asset are initially established in an amount equal to: i) the present value of future contractual premiums due or, ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be paid over the life of the transaction. An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies. For both up-front and installment premiums, ceded premiums written are primarily recognized in earnings in proportion to and at the same time the related gross premium revenue is recognized. For premiums paid to reinsurers on an installment basis, Ambac records the present value of future ceding commissions as an offset to ceded premiums payable, using the same assumptions noted above for installment premiums. The ceding commission revenue associated with the ceding premiums payable is deferred (as an offset deferred acquisition cost) and recognized in income in proportion to ceded premiums.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The table below summarizes the future gross premiums corresponding to the related premium receivable on an undiscounted basis and future premiums earned, net of reinsurance at September 30, 2009:

 

     Future premiums
expected to be
collected(1)
   Future expected
premiums earned,
net of reinsurance(1)

Three months ended:

     

December 31, 2009

   $ 99,044    $ 119,077

Twelve months ended:

     

December 31, 2010

     358,933      450,131

December 31, 2011

     339,789      415,976

December 31, 2012

     315,694      379,147

December 31, 2013

     296,448      349,205

Five years ended:

     

December 31, 2018

     1,240,613      1,377,994

December 31, 2023

     983,972      992,734

December 31, 2028

     812,771      732,508

December 31, 2033

     570,564      463,167

December 31, 2038

     237,535      197,203

December 31, 2043

     64,000      57,056

December 31, 2048

     14,411      13,917

December 31, 2053

     2,163      3,259

December 31, 2058

     31      83
             

Total

   $ 5,335,968    $ 5,551,457
             
(1) The future premiums corresponding to the receivable and future net premiums earned disclosed in the above table relate to the premium receivable asset and unearned premium liability recorded on Ambac’s balance sheet. The use of contractual lives for many bond types which do not have homogeneous pools of underlying collateral is required in the calculation of the premium receivable as described above, which results in a higher premium receivable balance than if expected lives were considered. If installment paying policies are retired early as a result of rate step-ups or other early retirement provision incentives for the issuer, premiums reflected in the premium receivable asset and amounts reported in the above table for such policies may not be collected in the future.

When an issue insured by Ambac Assurance has been retired, including those retirements due to refunding or calls, the remaining unrecognized premium is recognized at that time to the extent the financial guarantee contract is legally extinguished. Accelerated premium revenue for retired obligations for the three and nine months ending September 30, 2009 were $90,325 and $165,126, respectively. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow (a pre-refunding). The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date or a specified call date. Ambac has evaluated the provisions in certain financial guarantee insurance policies issued on legally defeased obligations and determined those policies have not been legally extinguished and, therefore, premium revenue recognition has not been accelerated.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The table below shows premiums written on a gross and net basis for the three and nine month periods ended September 30, 2009 and 2008:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
     2009     2008    2009     2008  

Revenues:

         

Financial Guarantee:

         

Gross premiums written

   ($ 231,213   $ 118,645    ($ 388,884   $ 419,132   

Ceded premiums written

     389,679        4,371      577,225        (36,609
                               

Net premiums written

   $ 158,466      $ 123,016    $ 188,341      $ 382,523   
                               

Loss Reserves:

Ambac’s financial guarantee insurance policies generally pay scheduled interest and principal if the issuer of the insured obligation fails to meet its obligation. The loss and loss expense reserve (“loss reserve”) policy for financial guarantee insurance discussed in this footnote relates only to Ambac’s non-derivative insurance business. The policy for derivative contracts is discussed in “Derivative Contracts” below. Under ASC Topic 944 a loss reserve is recorded on the balance sheet on a policy-by-policy basis for the excess of: (a) the present value of expected net cash outflows to be paid under an insurance contract, i.e. the expected loss, over (b) the UPR for that contract. To the extent (a) is less than (b), no loss reserve is recorded. Changes to the loss reserve in subsequent periods are recorded as a loss and loss expense on the income statement. Expected losses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining expected losses is subject to certain estimates and judgments based on our assumptions regarding the probability of default and expected severity of performing credits as well as our active surveillance of the insured book of business and observation of deterioration in the obligor’s credit standing.

Ambac’s loss reserves are based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac’s surveillance group to track credit migration of insured obligations from period to period and update internal classifications and credit ratings for each transaction. Non-adversely classified credits are assigned a Class I or Survey List (“SL”) rating while adversely classified credits are assigned a rating of Class IA through Class V. The criteria for an exposure to be assigned an adversely classified credit rating includes the deterioration of an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), poor performance by the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of an insured securitization transaction is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related issue. For example, a servicer of a mortgage-backed securitization that does not remain current in its collection loss mitigation efforts could cause an increase in the delinquency and potential default of the underlying obligation. Similarly, loss severities increase when a servicer does not effectively handle loss mitigation activities such as (i) the advancing of delinquent principal and interest and of default related expenses which are deemed to be recoverable by the servicer, (ii) pursuit of loan charge-offs which maximize cash flows from the mortgage loan pool, and (iii) foreclosure and real estate owned disposition strategies and timelines. All credits are assigned risk classifications by the Surveillance Group using the following guidelines:

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

CLASS I – “Fully Performing – Meets Ambac Criteria with Remote Probability of Claim”

Credits that demonstrate adequate security and structural protection with a strong capacity to pay interest, repay principal and perform as underwritten. Factors supporting debt service payment and performance are considered unlikely to change and any such change would not have a negative impact upon the fundamental credit quality.

SURVEY LIST (SL) – “Investigation of Specific Condition or Weakness Underway”

Credits that require additional analysis to determine if adverse classification is warranted. These credits may lack information or demonstrate a weakness but further deterioration is not expected.

CLASS IA – “Potential Problem with Risks to be Dimensioned”

Credits that are fully current and monetary default or claims-payment are not anticipated. The payor’s or issuer’s financial condition may be deteriorating or the credits may lack adequate collateral. A structured financing may also evidence weakness in its fundamental credit quality as evidenced by its under-performance relative to its modeled projections at underwriting, issues related to the servicer’s ability to perform, or questions about the structural integrity of the transaction. While these credits may still retain an investment grade rating, they usually have experienced or are vulnerable to a ratings downgrade. Further investigation is required to dimension and correct any deficiencies. A complete legal review of documents may be required. An action plan should be developed with triggers for future classification changes upward or downward.

CLASS II – “Substandard Requiring Intervention”

Credits whose fundamental credit quality has deteriorated to the point that timely payment of debt service may be jeopardized by adversely developing trends of a financial, economic, structural, managerial or political nature. No claim payment is currently foreseen but the probability of loss or claim payment over the life of the transaction is now existent (10% or greater probability). Class II credits may be borderline or below investment grade (BBB- to B). Prompt and sustained action must be taken to execute a comprehensive loss mitigation plan and correct deficiencies.

CLASS III – “Doubtful with Clear Potential for Loss”

Credits whose fundamental credit quality has deteriorated to the point that timely payment of debt service has been or will be jeopardized by adverse trends of a financial, economic, structural, managerial or political nature which, in the absence of positive change or corrective action, are likely to result in a loss. The probability of monetary default or claims paying over the life of the transaction is 50% or greater. Full exercise of all available remedial actions is required to avert or minimize losses. Class III credits will generally be rated below investment grade (B to CCC).

CLASS IV – “Imminent Default or Defaulted”

Monetary default or claims payment has occurred or is expected imminently. Class IV credits are generally rated D.

CLASS V – “Fully Reserved”

The credit has defaulted and payments have occurred. The claim payments are scheduled and known, and reserves have been established to fully cover such claims.

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The population of credits evaluated in Ambac’s loss reserve process are: i) all adversely classified credits (Class IA through V) and ii) non-adversely classified credits (Class I and SL) which had a rating downgrade since the transaction’s inception. One of two approaches is then utilized to estimate expected losses to ultimately determine if a loss reserve should be established. The first approach is a statistical expected loss approach, which considers the likelihood of all possible outcomes. The “ base case” statistical expected loss is the product of: (i) the net par outstanding on the credit; (ii) internally developed historical default information (taking into consideration internal ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) a discount factor. The loss severities and default information are based on rating agency information, are specific to each bond type and are established and approved by Ambac’s Enterprise Risk Management Committee (“ERMC”), which is comprised of Ambac’s senior risk management professionals and other senior management. For certain credit exposures, Ambac’s additional monitoring and loss remediation efforts may provide information relevant to adjust this estimate of “base case” statistical expected losses. As such, ERMC-approved loss severities used in estimating the “base case” statistical expected losses may be adjusted based on the professional judgment of the surveillance analyst monitoring the credit with the approval of senior management. Analysts may accept the “base case” statistical expected loss as the best estimate of expected loss or assign multiple probability weighted severities to determine an adjusted statistical expected loss that better reflects a given transaction’s potential severity.

The second approach entails the use of more precise estimates of expected net cash outflows (future claim payments, net of potential recoveries, expected to be paid to the holder of the insured financial obligation). Ambac’s surveillance group will consider the likelihood of all possible outcomes and develop cash flow scenarios. This approach can include the utilization of market accepted software tools to develop net claim payment estimates. We have utilized such tools for residential mortgage-backed exposures as well as certain other types of exposures. These tools, in conjunction with detailed data of the historical performance of the collateral pools, assist Ambac in the determination of certain assumptions, such as default and voluntary prepayment rates, which are needed in order to estimate expected future net claim payments. In this approach a probability-weighted expected loss estimate is developed based on assigning probabilities to multiple net claim payment scenarios and applying an appropriate discount factor. A loss reserve is recorded for the excess, if any, of estimated expected losses (net cash outflows) using either of these two approaches, over UPR. For certain policies, estimated potential recoveries exceed estimated future claim payments because all or a portion of such recoveries relate to claims previously paid. The expected net cash inflows for these policies are recorded as a subrogation recoverable asset.

The discount factor applied to both of the above described approaches is based on a risk-free discount rate corresponding to the remaining expected weighted-average life of the exposure and the exposure currency. The discount factor is updated for the current risk-free rate each reporting period. The weighted average risk-free rate used to discount the loss reserve at September 30, 2009 was 2.48%.

Additional remediation activities applied to adversely classified credits can include various actions by Ambac. The most common actions include obtaining detailed appraisal information on collateral, more frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. Senior management meets at least quarterly with the surveillance group to review the status of their work to determine the adequacy of Ambac’s loss reserves and make any necessary adjustments.

In an effort to better understand the unprecedented levels of delinquencies, Ambac engaged consultants with significant mortgage lending experience to review the underwriting documentation for mortgage loans underlying certain second-lien insured transactions. Those transactions which have exhibited exceptionally poor performance were chosen for further examination of the underwriting documentation supporting the underlying loans. Factors Ambac believes to be indicative of this poor

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

performance include (i) increased levels of early payment defaults, (ii) the significant number of loan charge-offs and resulting high level of losses and (iii) the rapid elimination of credit protections inherent in the transactions’ structures. Generally, the sponsor of the transaction provides representations and warranties with respect to the securitized loans, including the loan characteristics, the absence of fraud or other misconduct in the origination process, including those attesting to the compliance of home loans with the prevailing underwriting policies. Pursuant to the transaction documents, the sponsor of the transaction is obligated to repurchase, cure or substitute the breaching loan. Substitution is generally limited to two years from the closing of the transaction and the cure remedy is permitted only to the extent cure is possible.

Subsequent to the forensic exercise of examining loan files to ascertain whether the loans conformed to the representations and warranties, we submit nonconforming loans to the sponsor for repurchase. For all of the transactions reviewed by Ambac, the substitution remedy is no longer available. To effect a repurchase the sponsor is generally required to repurchase the loan at the current unpaid principal balance of the loan plus accrued unpaid interest. In cases where loans are repurchased by a sponsor, the effect is typically to increase the over-collateralization of the securitization, depending on the extent of loan repurchases and the structure of the securitization.

While the obligation by sponsors to repurchase loans with material breaches is clear, generally the sponsors have not honored those obligations. Ambac’s approach to resolving these disputes has included negotiating with individual sponsors at the transaction level and in some cases at the individual loan level and has resulted in the repurchase of some loans. Ambac has utilized the results of the above described loan file examinations to make demands for loan repurchases from sponsors or their successors and, in certain instances, as a part of the basis for litigation filings. Ambac has initiated and will continue to initiate lawsuits seeking compliance with the repurchase obligations in the securitization documents. Ambac’s past experience with similar mortgage loan disputes is that it takes approximately three years from the identification of loans with material breaches to resolution with the sponsor. Estimated recoveries will continue to be revised and supplemented as the scrutiny of the mortgage loan pools progresses

We have performed the above-mentioned, detailed examinations on a variety of second lien transactions that have experienced exceptionally poor performance. However, the estimated recoveries we have recorded to date have been limited to only those transactions whose sponsors (or their successors) are subsidiaries of global financial institutions, all of which carry a single-A rating or better from a nationally recognized rating agency. Each of these financial institutions has significant financial resources and an ongoing interest in mortgage finance. Additionally, we are not aware of any provisions that explicitly preclude or limit the successors’ obligations to honor the obligations of the original sponsor. As a result, we did not make any significant adjustments to our estimated subrogation recoveries with respect to the credit risk of these sponsors (or their successors).

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the period ended September 30, 2009:

 

           Year-to-date ended
September 30, 2009
 

Loss reserves at December 31, 2008, net of subrogation recoverable and reinsurance

     $ 2,129,758   

Impact of adopting ASC Topic 944

       339,426   
          

Loss reserves at January 1, 2009, net of subrogation recoverable and net of reinsurance

     $ 2,469,184   

Changes in loss reserves due to:

    

Credits added

   1,764,219     

Credits removed

   (72,199  

Change in existing credits

   1,765,634     

Change in subrogation recoveries

   (1,057,093  

Claim payments, net of subrogation received and reinsurance

   (972,177  
        

Net change in loss reserves

       1,428,384   

Intercompany elimination of VIEs (1)

       (19,310
          

Loss reserves at September 30, 2009

     $ 3,878,258   
          

 

(1) Represents the elimination of intercompany loss reserves relating to Variable Interest Entities consolidated during the year in accordance with ASC Topic 810, Consolidation.

The net change in loss reserves of $1,428,384 for the nine months ended September 30, 2009 is included in loss and loss expenses in the Consolidated Statement of Operations.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The table below summarizes information related to policies currently included in Ambac’s loss reserves at September 30, 2009:

Surveillance Categories

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     17        16        38        57        71        2        201   

Remaining weighted-average contract period (in years)

     22        9        9        9        5        0        9   

Gross insured contractual payments outstanding:

              

Principal

   $ 160,342      $ 1,024,238      $ 5,085,641      $ 10,045,817      $ 11,480,231      $ 772      $ 27,797,041   

Interest

     73,204        42,642        867,705        5,010,814        2,878,671        164        8,873,200   
                                                        

Total

   $ 233,546      $ 1,066,880      $ 5,953,346      $ 15,056,631      $ 14,358,902      $ 936      $ 36,670,241   
                                                        

Gross claim liability

   $ 2,915      $ 203,927      $ 573,541      $ 3,337,160      $ 5,074,006      $ 937      $ 9,192,486   

Less:

              

Gross potential recoveries

     (3     (24,272     (49,742     (1,203,473     (2,339,386     —          (3,616,876

Discount, net

     (480     (19,979     (42,065     (158,532     (985,645     (64     (1,206,765
                                                        

Net loss reserve (excluding reinsurance)

   $ 2,432      $ 159,676      $ 481,734      $ 1,975,155      $ 1,748,975      $ 873      $ 4,368,845   
                                                        

Unearned premiums

   $ 372      $ 5,351      $ 73,720      $ 234,229      $ 131,193      $ —        $ 444,865   
                                                        

Loss reserve reported in the balance sheet (excluding reinsurance)

   $ 2,060      $ 154,325      $ 408,014      $ 1,740,926      $ 1,617,782      $ 873      $ 3,923,980   

Reinsurance recoverables reported in the balance sheet

   $ 37      $ 478      $ 2,969      $ 23,672      $ 41,010      $ —        $ 68,166   

 

* Excludes $17,673 gross of reinsurance and $17,451 net of reinsurance, of loss adjustment expense reserves.

Loss reserves on non-defaulted credits were $2,532,062 at September 30, 2009. These loss reserves were comprised of 132 credits with net par of $16,244,937. Loss reserves on defaulted credits were $1,328,744 at September 30, 2009, comprising 69 credits with net par outstanding of $10,527,630. Loss expense reserves are also established for significant surveillance and mitigation expenses associated with adversely classified credits. Total loss expense reserves were $17,451 and $33,579 at September 30, 2009 and December 31, 2008, respectively.

Loss reserves ceded to reinsurers are calculated in a similar manner to those noted above for gross loss reserves. Loss reserves ceded to reinsurers at September 30, 2009 were $68,166. Amounts are included in reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet.

The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

to be adequate for losses inherent in the non-derivative financial guarantee insurance portfolio. Ambac’s management believes that the reserves for losses and loss expenses and UPR are adequate to cover the ultimate net cost of claims, but the reserves are based on estimates and there can be no assurance that the ultimate liability for losses will not exceed such estimates.

Deferred Acquisition Costs:

Financial guarantee insurance costs that vary with and are primarily related to the production of business have been deferred. Ambac periodically conducts a study to determine the amount of operating costs that vary with and primarily relate to the acquisition of business and qualify for deferral. These costs include compensation of certain employees, premium taxes, ceding commissions payable on assumed business and certain other underwriting expenses, net of ceding commissions receivable on ceded business. Certain future costs associated with installment premium contracts, such as premium taxes and ceding commissions, are estimated and present valued using the same assumptions used to estimate the related premiums receivable described in the “Net Premiums Earned” section above. Given the negligible amount of new business underwritten during 2008 and 2009, the amount of acquisition costs eligible for deferral has decreased significantly from prior years. Premium taxes and reinsurance commissions are deferred in their entirety. Costs associated with credit derivatives are expensed as incurred. Deferred acquisition costs are expensed in proportion to premium revenue recognized. Amortization of deferred acquisition costs is adjusted to reflect acceleration of premium revenue due to refunding or calls and to reflect changes in the estimated lives of certain obligations. As a result of changes to the premium revenue recognition model under ASC Topic 944, as described in the Net Premiums Earned section above, deferred acquisition costs were evaluated under the new standard and ultimately impacted the cumulative effect adjustment made to retained earnings at January 1, 2009, as noted above.

 

(4) Derivative Contracts

ASC Topic 815, Derivatives and Hedging, establishes accounting and reporting standards for derivative instruments. All derivatives, whether designated for hedging relationships or not, are required to be recorded on the Consolidated Balance Sheets at fair value. Methodologies used to determine fair value of derivative contracts, including model inputs and assumptions where applicable, are described further in Note 10, Fair Value Measurements. Effective beginning with the quarter ended March 31, 2009, ASC Topic 815 requires enhanced qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The enhanced disclosures have been included in the discussion below.

The Company has entered into derivative contracts both for trading purposes and to hedge certain economic risks inherent in its financial asset and liability portfolios. Derivatives for trading include credit derivatives issued as a form of financial guarantee, total return swaps, certain interest rate and currency swaps and futures contracts. Credit derivatives have also been purchased to mitigate portions of the risks assumed under written credit derivative contracts. See “Derivative Contracts Classified as Held for Trading Purposes” below for further discussion of these products. Interest rate and currency swaps are also used to manage the risk of changes in fair value or cash flows caused by variations in interest rates and foreign currency exchange rates. Certain of these transactions are designated as fair value hedges or cash flow hedges under ASC Topic 815. See “Derivative Contracts used for Non-Trading and Hedging Purposes” below for further discussion of derivatives used for risk management purposes.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

All derivative contracts are recorded on the Consolidated Balance Sheets at fair value on a gross basis; assets and liabilities are netted by customer only when a legal right of offset exists. Ambac elects to not offset fair value amounts recognized for the right to reclaim cash collateral or futures margin or the obligation to return cash collateral against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement. The amounts representing the right to reclaim cash collateral and posted margin, recorded in “Other assets” were $245,813 and $618,784 as of September 30, 2009 and December 31, 2008, respectively. The amounts representing the obligation to return cash collateral, recorded in “Other liabilities” were $90,011 and $130,381 as of September 30, 2009 and December 31, 2008, respectively. The following table summarizes the location and fair values of individual derivative instruments reported in the Consolidated Balance Sheet as of September 30, 2009. Amounts are presented gross of the effect of offsetting balances even where a legal right of offset exists:

Fair Values of Derivative Instruments

 

   

Derivative Asset

 

Derivative Liability

   

Balance Sheet
Location

  Fair Value  

Balance Sheet
Location

  Fair value

Derivatives held for trading

       

Credit derivatives

  Derivative assets   $ 272,878   Derivative liabilities   $ 4,094,030

Interest rate swaps

  Derivative assets     445,433   Derivative liabilities     515,712
  Derivative liabilities     150,141   Derivative assets     14,290

Currency swaps

  Derivative assets     370,699   Derivative liabilities     182,712

Futures contracts

  Derivative assets     —     Derivative liabilities     9,573

Other contracts

  Derivative assets     —     Derivative liabilities     263
               

Total derivatives held for trading

      1,239,151       4,816,580
               

Derivatives designated as hedging instruments under ASC Topic 815

       

Interest rate swaps

  Derivative assets     —     Derivative liabilities     —  
  Derivative liabilities     53   Derivative assets     —  
               

Total derivatives designated as hedging instruments under ASC Topic 815

      53       —  
               

Non-trading derivatives not designated as hedging instruments under ASC Topic 815

       

Interest rate swaps

  Derivative assets     112,916   Derivative liabilities     295
  Derivative liabilities     —     Derivative assets     —  
               

Total non-trading derivatives not designated as hedging instruments under ASC Topic 815

      112,916       295
               

Total derivatives

    $ 1,352,120     $ 4,816,875
               

Derivative Contracts Classified as Held for Trading Purposes:

Financial Guarantee Credit Derivatives:

Until the third quarter of 2007, Ambac sold credit protection by entering into credit derivatives, primarily in the form of credit default swap contracts (“CDS contracts”), with various financial institutions. In a limited number of contracts, the Company purchased credit protection on a portion of the risk written, from reinsurance companies or other financial companies. Credit derivative assets included in the Consolidated Balance Sheets as of September 30, 2009 arose from such purchased credit default swaps.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

These credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation. Upon a credit event, Ambac Credit Products (“ACP”) is generally required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. The majority of our credit derivatives are written on a “pay-as-you-go” basis. Similar to an insurance policy execution, pay-as-you-go provides that Ambac pays interest shortfalls on the referenced transaction as they are incurred on each scheduled payment date, but only pays principal shortfalls upon the earlier of (i) the date on which the assets designated to fund the referenced obligation have been disposed of and (ii) the legal final maturity date of the referenced obligation.

In a small number of transactions, ACP is required to (i) make a payment equal to the difference between the par value and market value of the underlying obligation or (ii) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation. There are less than 25 transactions, which are not “pay-as-you-go”, with a combined notional of approximately $2,900,000 and a net liability fair value of $69,000 as of September 30, 2009. All except one deal carry an internal rating of A or better. These transactions are primarily in the form of CLOs written between 2002 and 2005.

Substantially all of ACP’s credit derivative contracts relate to structured finance transactions. Credit derivatives issued by ACP are insured by Ambac Assurance. None of our outstanding credit derivative transactions at September 30, 2009 include ratings based collateral-posting triggers or otherwise require Ambac to post collateral regardless of Ambac’s ratings or the size of the mark to market exposure to Ambac. However, in connection with a negotiated amendment of one credit derivative in July 2009, Ambac has posted $90,000 of collateral to the counterparty.

Ambac maintains internal credit ratings on its guaranteed obligations, including credit derivative contracts, solely to indicate management’s view of the underlying credit quality of the guaranteed obligations. Independent rating agencies may have assigned different ratings on the credits in Ambac’s portfolio than Ambac’s internal ratings. Ambac’s BBB internal rating reflects bonds which are of medium grade credit quality with adequate capacity to pay interest and repay principal. Certain protective elements and margins may weaken under adverse economic conditions and changing circumstances. These bonds are more likely than higher rated bonds to exhibit unreliable protection levels over all cycles. Ambac’s below investment grade (“BIG”) internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions.

The following table summarizes the net par outstanding for CDS contracts, by Ambac rating, for each major category as of September 30, 2009:

 

Ambac Rating

   CDO of ABS    CDO of CDO    CLO    Other    Total

AAA

   $ —      $ —      $ 5,346,112    $ 4,496,657    $ 9,842,769

AA

     —        —        9,568,142      2,833,714      12,401,856

A

     —        —        2,055,069      945,066      3,000,135

BBB

     —        —        941,301      718,417      1,659,718

Below investment grade

     22,587,982      65,172      417,474      100,000      23,170,628
                                  
   $ 22,587,982    $ 65,172    $ 18,328,098    $ 9,093,854    $ 50,075,106

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The table below summarizes information by major category as of September 30, 2009:

 

     CDO of ABS    CDO of CDO    CLO    Other    Total

Number of CDS transactions

     22      1      76      37      136

Remaining expected weighted-average life of obligations (in years)

     18.4      8.1      4.4      5.0      10.8

Gross principal notional outstanding

   $ 23,042,982    $ 65,172    $ 18,328,098    $ 9,093,854    $ 50,530,106

Hedge principal notional outstanding

   $ 455,000    $ —      $ —      $ —      $ 455,000

Net derivative liabilities (at fair value)

   $ 2,842,580    $ 13,470    $ 498,564    $ 466,538    $ 3,821,152

The maximum potential amount of future payments under Ambac’s credit derivative contracts written on a “pay-as-you-go” basis is generally the gross principal notional outstanding amount included in the above table plus future interest payments payable by the derivative reference obligations. For contracts that are not written with pay-as-you-go terms, the maximum potential future payment is represented by the principal notional only. Since Ambac’s credit derivatives typically reference obligations of or assets held by SPEs that meet the definition of a VIE, the amount of maximum potential future payments for credit derivatives is included in the table in Note 7, Special Purpose Entities and Variable Interest Entities.

Amounts paid under our written credit derivative contracts may be recoverable as a result of future payments of previously missed principal or interest payments by the reference obligation payor or purchased credit derivatives that hedge Ambac’s gross exposure to a written contract or future recoveries from reference obligation collateral acquired in connection with credit derivative settlements. Such collateral typically comprises securities and/or loans owned or referenced in the securitization structure on which Ambac provided senior credit protection. The fair value of purchased credit derivatives included in net fair value of credit derivatives was $272,878 and $321,007 at September 30, 2009 and December 31, 2008, respectively.

Ambac’s credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under ASC Topic 815. Changes in fair value are recorded in “Net change in fair value of credit derivatives” on the Consolidated Statements of Operations. The “Realized gains and losses and other settlements” component of this income statement line includes (i) premiums received and accrued on written credit derivative contracts, (ii) premiums paid and accrued on purchased credit derivative contracts, (iii) losses paid and payable on written credit derivative contracts and (iv) paid losses recovered and recoverable on purchased credit derivative contracts for the appropriate accounting period. Losses paid and payable and losses recovered and recoverable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under the contract terms has occurred or in connection with a negotiated termination of a contract. Paid losses included in realized gains and losses and other settlements were $745,672 and $769,456 for the three and nine months ended September 30, 2009, respectively, and $853,270 and $854,945 for the three and nine months ended September 30, 2008, respectively. The “Unrealized gains (losses)” component of this income statement line includes all other changes in fair value, including reductions in the fair value of liabilities as they are paid or settled.

Although CDS contracts are accounted for at fair value in accordance with ASC Topic 815, they are surveilled similar to non-derivative financial guarantee contracts. As with financial guarantee insurance policies, Ambac’s surveillance group tracks credit migration of CDS contracts’ reference

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

obligations from period to period. Adversely classified credits are assigned risk classifications by the surveillance group using the guidelines described above in Note 3. The table below summarizes information related to CDS contracts currently on Ambac’s adversely classified credit listing:

 

     Surveillance Categories
     IA    II    III    IV    Total

Number of CDS transactions

     7      5      14      4      30

Remaining expected weighted-average life of obligations (in years)

     4.6      8.8      21.4      15.8      17.4

Net principal notional outstanding

   $ 1,705,759    $ 3,867,909    $ 15,340,632    $ 3,544,613    $ 24,458,913

Net derivative liabilities (at fair value)

   $ 160,851    $ 285,940    $ 1,923,604    $ 667,824    $ 3,038,219

Financial Services Derivative Products:

Ambac, through its subsidiary Ambac Financial Services, provided interest rate and currency swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. The interest rate swaps provided typically require Ambac Financial Services to receive a fixed rate and pay either a tax-exempt index rate or an issue-specific bond rate on a variable-rate bond. Ambac Financial Services manages its interest rate swaps business with the goal of being market neutral to changes in benchmark interest rates while retaining some basis risk. Within the trading derivatives portfolio, Ambac Financial Services enters into interest rate and currency swaps with professional counterparties and uses exchange traded U.S. Treasury futures with the objective of managing overall exposure to benchmark interest rates and currency risk exposure. Basis risk in the portfolio arises primarily from (i) variability in the ratio of benchmark tax-exempt to taxable interest rates, (ii) potential changes in the counterparty bond issuers’ bond-specific variable rates relative to taxable interest rates, (iii) variability between Treasury and swap rates, and (iv) changes in inflation expectations and nominal swap rates in the United Kingdom. If actual or projected benchmark tax-exempt interest rates increase or decrease in a parallel shift by 1% in relation to taxable interest rates, Ambac will experience a mark-to-market gain or loss of $90 and $140 at September 30, 2009 and December 31, 2008, respectively. Ambac has economically hedged the risk of interest rate increases through Ambac Financial Service’s trading derivatives portfolio to mitigate floating rate obligations elsewhere in the company, including in the credit derivative portfolio. As of September 30, 2009, the notional amounts of Ambac Financial Services’ trading derivative products are as follows:

 

Type of derivative

   Notional

Interest rate swaps—receive-fixed/pay-variable

   $ 2,878,954

Interest rate swaps—pay-fixed/receive-variable

     3,114,126

Interest rate swaps—basis swaps

     3,613,816

Currency swaps

     2,086,320

Futures contracts

     568,700

Other contracts

     242,486

Ambac, through its subsidiary Ambac Capital Services, entered into total return swap contracts with professional counterparties. These contracts required Ambac Capital Services to pay a specified spread in excess of LIBOR in exchange for receiving the total return of an underlying fixed income obligation over a specified period of time. The referenced fixed income obligations met Ambac Assurance’s financial guarantee credit underwriting criteria at the time of the transactions. During the three months ended September 30, 2009, all remaining total return swaps were terminated and settled.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The following table summarizes the location and amount of gains and losses of derivative contracts held for trading purposes in the Consolidated Statement of Operations for the three and nine months ended of September 30, 2009:

 

          Amount of Gain or (Loss) Recognized in
Consolidated Statement of Operations
 
    

Location of Gain or (Loss)

Recognized in Consolidated

Statement of Operations

   Three months ended
September 30, 2009
    Nine months ended
September 30, 2009
 

Financial Guarantee

       

Credit derivatives

   Net change in fair value of credit derivatives    $ 2,132,904      $ 3,679,717   

Financial Services derivatives products

       

Interest rate swaps

   Derivative products      (188,817     (251,887

Currency swaps

   Derivative products      (8,294     (13,132

Total return swaps

   Net change in fair value of total return swap contracts      6,902        18,573   

Futures contracts

   Derivative products      (25,635     (17,175

Other derivatives

   Derivative products      274        953   
                   

Total Financial Services derivative products

        (215,570     (262,668
                   

Total derivative contracts held for trading purposes

      $ 1,917,334      $ 3,417,049   
                   

Derivative Contracts used for Non-Trading and Hedging Purposes:

Interest rate and currency swaps are used to manage the risk of changes in fair value or cash flows caused by variations in interest rates and foreign currency exchange rates. These risks exist within the investment agreement business primarily related to differences in coupon interest terms between investment agreement contracts and invested assets that support those contracts. In order to qualify for hedge accounting, a derivative must be considered highly effective at reducing the risk associated with the exposure being hedged. Each derivative must be designated as a hedge, with documentation of the risk management objective and strategy, including identification of the hedging instrument, the hedged item, the risk exposure, and how effectiveness will be assessed prospectively and retrospectively. The extent to which a hedging instrument is effective at achieving offsetting changes in fair values or cash flows must be assessed at least quarterly. Any ineffectiveness must be reported in net income. Derivatives may be used for non-trading and hedging purposes, even if they do not meet the technical requirements for hedge accounting under ASC Topic 815.

As of September 30, 2009, the notional amounts of Ambac’s derivative contracts used for non-trading and hedging purposes are as follows:

 

     Notional

Derivatives designated as hedging instruments under ASC Topic 815:

  

Interest rate swaps

   $ 972

Derivatives not designated or qualifying as hedging instruments under ASC Topic 815:

  

Interest rate swaps

     469,665

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Interest rate and currency swaps are utilized to hedge exposure to changes in fair value of assets or liabilities resulting from changes in interest rates and foreign exchange rates, respectively. These interest rate and currency swap hedges are referred to as “fair value” hedges. If the provisions of the derivative contract meet the technical requirements for fair value hedge accounting under ASC Topic 815, the change in fair value of the derivative contract, excluding accrued interest, is recorded as a component of “Net mark-to-market gains (losses) on non-trading derivative contracts” in the Consolidated Statements of Operations. The change in fair value of the hedged asset or liability attributable to the hedged risk adjusts the carrying amount of the hedged item and is recorded as a component of “Net mark-to-market gains (losses) on non-trading derivative contracts.” Changes in the accrued interest component of the derivative contract are recorded as an offset to changes in the accrued interest component of the hedged item.

The following table summarizes the location and amount of gains and losses of fair value hedges and related hedge item reported in the Consolidated Statement of Operations for the three and nine months ended September 30, 2009:

 

Derivatives in ASC Topic 815
Fair Value Hedging
Relationships

  

Location of Gain or (Loss)
Recognized in Consolidated
Statement of Operations

   Amount of Gain or
(Loss) Recognized
on Derivatives
    Amount of Gain or
(Loss) Recognized on
Hedged Item
    Net Gain or (Loss)
Recognized in Income
Related to Hedge
Terminations and
Ineffectiveness
 

Three months ended September 30, 2009:

         

Interest rate swaps

   Net mark-to-market gains (losses) on non-trading derivative contracts    $ (1,280   $ 1,062      $ (218
   Financial Services: Interest from investment and payment agreements      1,423        (2,849     (1,426

Currency swaps

   Net mark-to-market gains (losses) on non-trading derivative contracts      —          —          —     
   Financial Services: Interest from investment and payment agreements      —          —          —     
                           

Total

      $ 143      $ (1,787   $ (1,644
                           

Nine months ended September 30, 2009:

         

Interest rate swaps

   Net mark-to-market gains (losses) on non-trading derivative contracts    $ (65,375   $ 66,011      $ 636   
   Financial Services: Interest from investment and payment agreements      6,691        (8,403     (1,712

Currency swaps

   Net mark-to-market gains (losses) on non-trading derivative contracts      (94     92        (2
   Financial Services: Interest from investment and payment agreements      35        (54     (19
                           

Total

      $ (58,743   $ 57,646      $ (1,097
                           

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Interest rate swaps are also utilized to hedge the exposure to changes in cash flows caused by variable interest rates of assets or liabilities. These interest rate swap hedges are referred to as “cash flow” hedges. The effective portion of the gains and losses on interest rate swaps that meet the technical requirements for cash flow hedge accounting under ASC Topic 815 is reported in “Accumulated Other Comprehensive Losses” in Stockholders’ Equity. If the cumulative change in fair value of the derivative contract exceeds the cumulative change in fair value of the hedged item, ineffectiveness is required to be recorded in net income. As of September 30, 2009, $758 of pre-tax deferred gains on derivative instruments reported in Accumulated Other Comprehensive Income are expected to be reclassified to net income during the next twelve months. Transactions and events expected to occur over the next twelve months that will necessitate reclassifying these derivative gains include the repricing of variable-rate assets.

The following table summarizes the location and amount of gains and losses of cash flow hedges reported in the consolidated financial statements for the three and nine months ended of September 30, 2009:

 

Derivatives in ASC
Topic 815 Cash Flow
Hedge Relationships

  Amount of Gain
(Loss)
Recognized in
OCI on
Derivatives
(Effective
Portion)
   

Location of Gain (Loss) Reclassified
from AOCI
into Income (Effective
Portion)

  Amount of Gain
(Loss)
Reclassified from
AOCI into
Income (Effective
Portion)
 

Location of Gain or
(Loss) Recognized
in Income (Ineffective
Portion)

  Amount of Gain
(Loss)
Recognized in
Income
(Ineffective
Portion)

Three months ended September 30, 2009:

         

Interest rate swaps

  $ (370   Financial Services: Investment income   $ 481   Net mark-to-market gains (losses) on non-trading derivative contracts   $ 19
                       

Total

  $ (370     $ 481     $ 19
                       

Nine months ended September 30, 2009:

         

Interest rate swaps

  $ (1,427   Financial Services: Investment income   $ 2,196   Net mark-to-market gains (losses) on non-trading derivative contracts   $ 75
                       

Total

  $ (1,427     $ 2,196     $ 75
                       

Ambac discontinues hedge accounting prospectively when it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative or hedged item expires or is sold or the hedge relationship is re-designated. When hedge accounting is discontinued because the derivative no longer qualifies as an effective fair value hedge, Ambac continues to carry the derivative on the balance sheet at its fair value. The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as other components of the carrying amount of that asset or liability. The net derivative gain or loss related to a discontinued cash flow hedge (recognized during the period of hedge effectiveness) will continue to be reported in “Accumulated Other Comprehensive Income” and amortized into net income as a yield adjustment to the previously designated asset or liability. If the previously designated asset or liability is sold or matures, the net derivative gain or loss related to a discontinued cash flow hedge reported in “Accumulated Other Comprehensive Income” will be reclassified into net income immediately. All subsequent changes in fair values of derivatives

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

previously designated as cash flow hedges will be recognized in net income. In connection with the significant terminations within Ambac’s investment agreement portfolio during 2008 and the first nine months of 2009, many hedge accounting relationships have been discontinued.

Ambac enters into non-trading derivative contracts for the purpose of economically hedging exposures to fair value or cash flow changes caused by fluctuations in interest rates and foreign currency rates. Such contracts include derivatives that do not meet the technical requirements for hedging under ASC Topic 815. Net gains (losses) recognized on such contracts recognized as part of net mark-to-market gains (losses) on non-trading derivative contracts were $365 and $7,147 for the three and nine months ended September 30, 2009, respectively.

Contingent Features in Derivatives Related to Ambac Credit Risk:

Ambac’s interest rate swaps and currency swaps with professional swap-dealer counterparties and certain front-end counterparties are generally executed under standardized derivative documents including collateral support and master netting agreements. Under these agreements, Ambac could be required to post collateral in the event net unrealized losses exceed predetermined threshold levels associated with the credit ratings assigned to Ambac Assurance by designated rating agencies. Additionally, credit rating downgrades below defined levels generally provide counterparties the right to terminate the swap positions.

As of September 30, 2009, the aggregate fair value of all derivative instruments with contingent features linked to Ambac’s own credit risk that are in a net liability position after considering legal rights of offset was $227,867 related to which Ambac had posted assets as collateral with a fair value of $371,569. All such ratings-based contingent features have been triggered as of September 30, 2009, requiring maximum collateral levels to be posted by Ambac and allowing counterparties to elect to terminate the contracts. Assuming all contracts terminated on September 30, 2009, settlement of collateral balances and net derivative liabilities would result in a net receipt of cash and/or securities by Ambac. If counterparties elect to exercise their right to terminate, the actual termination payment amounts will be determined in accordance with derivative contract terms, which may result in amounts that differ from market values as reported in Ambac’s financial statements.

 

(5) Income Taxes

Ambac files a consolidated Federal income tax return with its subsidiaries. Ambac and its subsidiaries also file separate or combined income tax returns in various states, local and foreign jurisdictions. The following are the major jurisdictions in which Ambac and its affiliates operate and the earliest tax years subject to examination:

 

Jurisdiction

   Tax Year

United States

   2005

New York State

   2005

New York City

   2000

United Kingdom

   2005

As of September 30, 2009 and December 31, 2008, the liability for unrecognized tax benefits is approximately $50,980 and $83,200, respectively. Included in these balances at September 30, 2009 and December 31, 2008 are $50,567 and $83,200, respectively, of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

As a result of the availability of net operating loss carrybacks, during the three months and nine months ended September 30, 2009, Ambac released $35,375 from its liability for unrecognized tax benefits related to tax years 2006 and 2007, as any IRS assessment would be fully covered by the loss carryback.

Ambac accrues interest and penalties related to unrecognized tax benefits in the provision for income taxes. During the three and nine months ended September 30, 2009, Ambac recognized interest of approximately $1,025 and $3,075, respectively, compared to approximately $1,025 and $3,075 in the three and nine months ended September 30, 2008. Ambac had approximately $12,075 and $9,000 for the payment of interest accrued at September 30, 2009 and December 31, 2008, respectively.

As a result of the development of additional losses and the related impact on the Company’s cash flows, management believes it is more likely than not that the Company will not generate sufficient taxable income to recover the deferred tax operating asset. A full valuation allowance of $2,788,609 has been established against the operating portion of its deferred tax asset.

The capital loss portion of its deferred tax asset is comprised of $442,458 relating to securities that Ambac has the intent to sell and $21,184 relating to securities for which management has the intent and ability to hold such securities to maturity. It is more likely than not that Ambac will not have sufficient capital gains in the three year carry back and five year carry forward period to fully validate the deferred tax asset related to the securities that Ambac intends to sell and has set up a full valuation allowance against this portion. No valuation allowance is needed on the portion of the deferred tax asset related to securities that Ambac has both the intent and ability to hold these securities until recovery. It is reasonably possible that the intent and ability to hold such securities may be changed if unanticipated changes in the Company occur, which would result in the Company recording a valuation allowance against this portion of the deferred tax asset.

The Company has a deferred tax liability of $40,040, which is comprised of deferred tax liabilities resulting from foreign currency translation and various fair value amounts. The timing of the reversal of these items is indeterminable. These liabilities have been netted against the deferred tax asset for securities held to maturity, resulting in an overall deferred tax liability of $18,856.

 

(6) Investments

Effective April 1, 2009, Ambac adopted ASC Paragraph 320-10-65-1, of ASC Topic 320, Investments – Debt and Equity Securities. ASC Paragraph 320-10-65-1 amends existing GAAP guidance for recognition of other-than-temporary impairments of debt securities and presentation and disclosure of other-than-temporary impairments of debt and equity securities. Under the new guidance, if an entity assesses that it either (i) has the intent to sell its investment in a debt security or (ii) more likely than not will be required to sell the debt security before its anticipated recovery of the amortized cost basis, then an other-than-temporary impairment charge must be recognized in earnings, with the amortized cost of the security being written-down to fair value. If these conditions are not met, but it is determined that a credit loss exists, the impairment is separated into the amount related to the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income. The cumulative effect of adopting ASC Paragraph 320-10-65-1 is recognized as a $102,065 adjustment to increase retained earnings with an offsetting adjustment to accumulated other comprehensive income. The adoption adjustment represents the after-tax difference between (i) the April 1, 2009 amortized cost of debt securities for which an other-than-temporary impairment was previously recognized and which management does not intend to sell and it is not more likely than not that the company will be required to sell before recovery of the amortized cost basis and (ii) the present value of cash flows expected to be collected on such securities.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Effective April 1, 2009, Ambac also adopted ASC Paragraph 820-10-65-4, which provides additional guidance for estimating fair value in accordance with ASC Topic 820, Fair Value Measurements and Disclosures, when the volume and level of activity for the asset or liability have significantly decreased. The adoption of ASC Paragraph 820-10-65-4 did not have a significant impact on Ambac’s financial statements.

The amortized cost and estimated fair value of investments at September 30, 2009 and December 31, 2008 were as follows:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair
Value

September 30, 2009

           

Fixed income securities:

           

Municipal obligations

   $ 3,148,404    $ 175,412    $ 8,940    $ 3,314,876

Corporate obligations

     902,648      18,732      45,759      875,621

Foreign obligations

     182,514      11,369      985      192,898

U.S. government obligations

     210,274      4,870      —        215,144

U.S. agency obligations

     164,303      10,681      61      174,923

Residential mortgage-backed securities

     1,973,070      206,482      156,839      2,022,713

Collateralized debt obligations

     80,395      22      20,837      59,580

Other asset-backed securities

     1,636,895      7      258,927      1,377,975

Short-term

     1,344,944      1      —        1,344,945

Other

     1,278      —        —        1,278
                           
     9,644,725      427,576      492,348      9,579,953
                           

Fixed income securities pledged as collateral:

           

U.S. government obligations

     143,418      2,689      125      145,982

U.S. agency obligations

     25,401      1,755      —        27,156

Residential mortgage-backed securities

     72,327      3,364      —        75,691
                           

Total collateralized investments

     241,146      7,808      125      248,829
                           

Total investments

   $ 9,885,871    $ 435,384    $ 492,473    $ 9,828,782
                           

December 31, 2008

           

Fixed income securities:

           

Municipal obligations

   $ 4,421,331    $ 41,963    $ 202,751    $ 4,260,543

Corporate obligations

     443,804      7,448      69,688      381,564

Foreign obligations

     143,328      8,669      1,628      150,369

U.S. government obligations

     172,838      10,988      —        183,826

U.S. agency obligations

     483,751      75,533      —        559,284

Residential mortgage-backed securities

     3,788,822      19,131      1,946,981      1,860,972

Asset-backed securities

     1,626,849      2,768      488,499      1,141,118

Short-term

     1,454,229      —        —        1,454,229

Other

     13,956      232      129      14,059
                           
     12,548,908      166,732      2,709,676      10,005,964
                           

Fixed income securities pledged as collateral:

           

U.S. government obligations

     125,068      4,626      —        129,694

U.S. agency obligations

     29,735      2,222      —        31,957

Mortgage-backed securities

     122,488      2,714      —        125,202
                           

Total collateralized investments

     277,291      9,562      —        286,853
                           

Total investments

   $ 12,826,199    $ 176,294    $ 2,709,676    $ 10,292,817
                           

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Foreign obligations consist primarily of government issued securities which are denominated in Pounds Sterling, Euros or Australian dollars.

The amortized cost and estimated fair value of investments at September 30, 2009, by contractual maturity, were as follows:

 

     Amortized
Cost
   Estimated
Fair Value

Due in one year or less

   $ 1,471,879    $ 1,475,947

Due after one year through five years

     840,456      855,939

Due after five years through ten years

     922,895      932,166

Due after ten years

     2,887,954      3,028,771
             
     6,123,184      6,292,823

Residential mortgage-backed securities

     2,045,397      2,098,404

Collateralized debt obligations

     80,395      59,580

Other asset-backed securities

     1,636,895      1,377,975
             
   $ 9,885,871    $ 9,828,782
             

Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

Unrealized Losses:

The following table shows gross unrealized losses and fair values of Ambac’s investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at September 30, 2009 and December 31, 2008:

 

     Less Than 12 Months    12 Months or More    Total
      Fair Value    Gross
Unrealized
Loss
   Fair Value    Gross
Unrealized
Loss
   Fair Value    Gross
Unrealized
Loss

September 30, 2009:

                 

Fixed income securities:

                 

Municipal obligations

   $ 70,559    $ 7,851    $ 50,808    $ 1,089    $ 121,367    $ 8,940

Corporate obligations

     116,729      14,100      135,991      31,659      252,720      45,759

Foreign obligations

     9,586      239      4,935      746      14,521      985

U.S. government obligations

     19,680      125      —        —        19,680      125

U.S. agency obligations

     6,204      61      —        —        6,204      61

Residential mortgage-backed securities

     175,597      70,620      145,719      86,219      321,316      156,839

Collateralized debt obligations

     8,593      214      50,965      20,623      59,558      20,837

Other asset-backed securities

     790,020      170,534      339,468      88,393      1,129,488      258,927
                                         

Total temporarily impaired securities

   $ 1,196,968    $ 263,744    $ 727,886    $ 228,729    $ 1,924,854    $ 492,473
                                         

December 31, 2008:

                 

Fixed income securities:

                 

Municipal obligations

   $ 2,420,553    $ 150,494    $ 524,667    $ 52,257    $ 2,945,220    $ 202,751

Corporate obligations

     133,118      12,868      148,322      56,820      281,440      69,688

Foreign obligations

     18,270      1,628      —        —        18,270      1,628

Residential mortgage-backed securities

     225,612      40,549      651,680      1,906,432      877,292      1,946,981

Asset-backed securities

     638,170      212,501      339,612      275,998      977,782      488,499

Short-term and other

     1,494      108      59      21      1,553      129
                                         

Total temporarily impaired securities

   $ 3,437,217    $ 418,148    $ 1,664,340    $ 2,291,528    $ 5,101,557    $ 2,709,676
                                         

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Ambac has a formal impairment review process for all securities in its investment portfolio. Ambac conducts a review each quarter to identify and evaluate investments that have indications of possible other than temporary impairment, including substantial or continuous declines in fair value below amortized cost or declines in external credit ratings from the time the securities were purchased. Management has determined that the unrealized losses reflected in the table above are temporary in nature as of September 30, 2009 and December 31, 2008 based upon (i) no principal and interest payment defaults on these securities; (ii) analysis of the creditworthiness of the issuer and financial guarantor, as applicable, and analysis of projected defaults on the underlying collateral; (iii) management has no intent to sell these investments in debt securities; and (iv) it is not more likely than not Ambac will be required to sell these debt securities before the anticipated recovery of its amortized cost basis. The assessment under (iv) is based on a comparison of future available liquidity from the fixed income investment portfolio against the projected net cash outflow from operating activities and debt service. For purposes of this assessment, available liquidity from the fixed income investment portfolio is comprised of the fair value of securities for which management has asserted its intent to sell plus the scheduled maturities and interest payments from the remaining securities in the portfolio. As of September 30, 2009, management had the intent to sell securities with a total fair value of $3,800,000, which is considered to be immediately available for liquidity needs in our analysis. To the extent that securities that management intends to sell are in an unrealized loss position, they would have already been considered other-than-temporarily impaired with the amortized cost written down to fair value. Because the above-described assessment indicates that future available liquidity exceeds projected net cash outflow, it is not more likely than not we would be required to sell additional securities, other than those already identified for sale, before the recovery of their amortized cost basis. In the liquidity assessment described above, principal payments on securities pledged as collateral are not considered to be available for other liquidity needs until the collateralized positions are projected to be settled. Projected interest receipts on securities pledged as collateral generally belong to Ambac and are considered to be sources of available liquidity from the investment portfolio. As of September 30, 2009, for securities that have indications of possible other than temporary impairment but which management does not intend to sell and will not more likely than not be required to sell, management compared the present value of cash flows expected to be collected to the amortized cost basis of the securities to assess whether the amortized cost will be recovered. Cash flows were discounted at the effective interest rate implicit in the security at the date of acquisition. For floating rate securities, future cash flows and the discount rate used were both adjusted to reflect changes in the index rate applicable to each security as of the evaluation date.

Of the securities that were in a gross unrealized loss position at September 30, 2009, $290,805 of the total fair value and $90,636 of the unrealized loss related to below investment grade securities and non-rated securities. These included residential mortgage-backed securities that were rated below investment grade which had a total fair value of $166,546 and unrealized loss balance of $70,678. Of the securities that were in a gross unrealized loss position at December 31, 2008, $56,553 of the total fair value and $129,741 of the unrealized loss related to below investment grade securities and non-rated securities. These included residential mortgage-backed securities that were rated below investment grade which had a total fair value of $54,534 and unrealized loss balance of $129,468.

Residential mortgage-backed securities:

The gross unrealized loss on mortgage-backed securities as of September 30, 2009 is primarily related to Alt-A residential mortgage backed securities. Of the $86,219 of unrealized losses on mortgage-backed securities for greater than 12 months, $78,606, or 91%, is attributable to 17 individual Alt-A securities. These individual securities have been in an unrealized loss position for 21 months. Each of these Alt-A securities have very similar characteristics such as vintage of the underlying collateral (2006-2007) and placement in the structure (generally class-A tranche rated triple-A at issuance). The significant declines in fair value relate to the actual and potential effects of declining U.S. housing prices

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

and the current recession in general on the performance of collateral underlying residential mortgage backed securities. This has been reflected in decreased liquidity for RMBS securities and increased risk premiums demanded by investors resulting in a required return on investment that is significantly higher than historically experienced.

As part of the quarterly impairment review process, management has analyzed the cash flows of all Alt-A RMBS securities held based on the default, prepayment and severity loss assumptions specific to each security’s underlying collateral. Ambac’s model estimates cash flows from the underlying mortgage loans and distributes those cash flows to various tranches of securities, considering the transaction structure and any subordination and credit enhancements that exist in that structure. The cash flow model incorporates actual cash flows on the mortgage-backed securities through the current period, and then projects remaining cash flows using a number of loan-specific assumptions, including default rates, prepayment rates, and recovery rates. Management considered this analysis in making our determination that non-receipt of contractual cash flows is not probable on these transactions.

Other asset-backed securities:

The decrease in gross unrealized losses on other asset-backed securities during the nine months ended September 30, 2009 reflects improved market liquidity for certain higher quality, shorter term consumer asset-backed securities. Of the $88,393 of unrealized losses on other asset-backed securities greater than 12 months, 8 student loan positions comprise $59,102 of the total. These individual securities have been in an unrealized loss position for between 20-21 months. As part of the quarterly impairment review process, management monitors each deal’s performance metrics and other available qualitative and fundamental information in developing an analytical opinion. Ambac determined that there is sufficient credit enhancement to mitigate recent market stresses. Management does not have any credit concerns with these transactions and therefore believes that the timely receipt of all principal and interest from asset-backed securities is probable.

Realized Gains and Losses and Other-Than-Temporary Impairments:

The following table details amounts included in net realized gains (losses) and other-than-temporary impairments included in earnings for the three and nine month periods ended September 30, 2009 and 2008:

 

     Three-months ended
September 30,
    Nine-months ended
September 30,
 
     2009     2008     2009     2008  

Gross realized gains on securities

   $ 121,447      $ 87,646      $ 178,026      $ 131,071   

Gross realized losses on securities

     (1,201     (21,568     (52,964     (33,991

NCFE recoveries

     —          —          13        1,759   

Net gain on investment agreement terminations

     96        24,899        120,911        24,899   

Foreign exchange (losses) gains

     46        238        3,263        6,818   
                                

Net realized gains/losses, excluding other-than-temporary impairments

     120,388        91,215        249,249        130,556   

Net other-than-temporary impairments (a)

     44,189        126,828        1,736,522        456,852   
                                

Total net realized gains (losses) and other-than-temporary impairments included in earnings

   $ 76,199      $ (35,613   $ (1,487,273   $ (326,296
                                

 

(a) Other-than-temporary impairments since April 1, 2009 exclude impairment amounts recorded in other comprehensive income under ASC Paragraph 320-10-65-1, which comprise non-credit related amounts on securities that are credit impaired but which management does not intend to sell and it is not more likely than not that the company will be required to sell before recovery of the amortized cost basis. There were no other-than-temporary impairments recognized in other comprehensive income for the three or nine months ended September 30, 2009.

Other than temporary impairments for the nine months ended September 30, 2009 included charges of $906,264 to write-down the amortized cost basis of tax-exempt municipal bonds and most

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

residential mortgage-backed securities to fair value at September 30, 2009 as a result of management’s intention to sell securities in connection with plans to reposition the investment portfolio and to meet general liquidity needs. Other than temporary impairment charges were $126,828 and $456,852 in the three and nine month periods ended September 30, 2008, respectively. Charges in 2008 included $75,119 and $269,920 for the three and nine months ended September 30, 2008, respectively, related to write-downs of certain securities that were believed to be credit impaired and $51,709 and $186,932 for the three and nine months ended September 30, 2008, respectively, related to securities that management had the intent to sell primarily to meet financial services liquidity needs at that time.

Collateral and Deposits with Regulators:

Ambac routinely pledges and receives collateral related to certain business lines and/or transactions. The following is a description of those arrangements by collateral source:

 

  (1) Cash and securities held in Ambac’s investment portfolio – Ambac pledges assets it holds in its investment portfolio to (a) investment and payment agreement counterparties; (b) derivative counterparties; and (c) a non-U.S. domiciled insurance company which has ceded insurance risks to Ambac. The assets pledged to a non-U.S. domiciled insurance company are being returned to Ambac in November 2009 as a result of the termination of the reinsurance agreement. Securities pledged to investment and payment agreement counterparties as well as non-U.S. domiciled insurers may not then be re-pledged to another entity. Ambac has also sold securities in its Financial Services investment portfolio under agreements to repurchase (“repurchase agreements”). Ambac’s counterparties under derivative agreements and repurchase agreements have the right to pledge or rehypothecate the securities and as such, pledged securities are separately classified on the Consolidated Balance Sheets as “Fixed income securities pledged as collateral, at fair value”.

 

  (2) Cash and securities pledged to Ambac under derivative agreements – Ambac may repledge securities it holds from certain derivative counterparties to other derivative counterparties in accordance with its rights and obligations under those agreements.

The following table presents (i) the sources of collateral either received from various counterparties where Ambac is permitted to sell or re-pledge or directly held in the investment portfolio and (ii) how that collateral was pledged to various investment and payment agreement, derivative and repurchase agreement counterparties and non-U.S. domiciled insurers at September 30, 2009 and December 31, 2008:

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

     Collateral Pledged
     Fair Value
of Cash and
Underlying
Securities
   Fair Value of
Securities
Pledged to
Investment and
Payment
Agreement
Counterparties
   Fair Value of
Cash and
Securities
Pledged to
Derivative
Counterparties
   Fair Value of
Cash and
Securities
Pledged to
non-U.S.
domiciled
insurers
   Fair value of
securities sold
under
agreements
to repurchase

September 30, 2009:

              

Sources of Collateral:

              

Cash and securities pledged directly from the investment portfolio

   $ 1,620,796    $ 1,199,007    $ 404,631    $ 17,158    $ —  

Cash and securities pledged from its derivative counterparties

     90,011      —        90,011      —        —  

December 31, 2008:

              

Sources of Collateral:

              

Cash and securities pledged directly from the investment portfolio

   $ 3,195,550    $ 2,404,591    $ 775,256    $ 15,703    $ —  

Cash and securities pledged from its derivative counterparties

     229,382      —        227,313      —        —  

Securities carried at $7,141 and $6,999 at September 30, 2009 and December 31, 2008, respectively, were deposited by Ambac and Everspan with governmental authorities or designated custodian banks as required by laws affecting insurance companies.

 

(7) Special Purpose Entities and Variable Interest Entities

Ambac has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac has provided financial guarantee insurance, including credit derivative contracts for various debt obligations issued by various entities, including VIEs. Ambac has also sponsored two special purpose entities that issue medium-term notes to fund the purchase of certain financial assets; these special purpose entities are considered Qualifying Special Purpose Entities (“QSPEs”). Finally, Ambac is an investor in mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE.

Financial Guarantees:

Ambac has provided financial guarantees in respect of assets held or debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the debt obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the debt obligations that have been guaranteed by Ambac Assurance. In the case of first loss, the financial guarantee insurance policy only covers a senior layer of losses on assets held or debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the securitized assets contributed to special purpose entities,

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt; such excess cash flow is applied to redeem debt, thus creating over-collateralization.

ASC Topic 810 requires a variable interest holder (e.g., an investor in the entity or a financial guarantor) to consolidate that VIE if that holder will absorb a majority of the expected losses of the VIE, receive a majority of the residual returns of the VIE, or both upon the inception of that holder’s involvement in the VIE. ASC Topic 810 also requires the primary beneficiary or a holder of a variable interest that is not the primary beneficiary or the primary beneficiary’s related parties to reconsider its initial decision to consolidate a variable interest entity upon occurrence of certain specified events in a subsequent reporting period. Ambac evaluates the existence of a VIE upon entering into a transaction that involves a special purpose entity. For all entities determined to be VIEs, Ambac determines whether it is the primary beneficiary of a VIE both at inception and when reconsideration events occur. This is determined by first performing a qualitative analysis of the VIE that includes, among other factors, its capital structure, contractual terms, which variable interests create or absorb variability, related party relationships and the design of the VIE. When qualitative analysis is not conclusive, Ambac performs a quantitative analysis. Generally, Ambac does not absorb the majority of the expected losses and is not the primary beneficiary as the result of its guarantee of insured obligations issued by VIEs due the financial protection available to Ambac in the structure as noted above. Ambac generally considers its guarantee of principal and interest payments of insured obligations, given nonperformance by a nonconsolidated VIE, to be a significant variable interest.

Consolidated VIE

As of September 30, 2009, consolidated VIE assets and liabilities were $1,128,103 and $1,122,684, respectively. As of December 31, 2008, consolidated VIE assets and liabilities were $241,607 and $248,420, respectively. Ambac determined that it is the primary beneficiary of the aforementioned VIEs based on its assessment of potential exposure to expected losses from insured obligations issued by or insured assets held by the VIEs and from holding any additional variable interests issued by the VIEs. Ambac is not primarily liable for the debt obligations issued by the VIEs. Ambac would only be required to make payments on these debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of the VIEs.

At September 30, 2009, five VIEs are being consolidated, which had debt obligations and/or assets insured by Ambac. One VIE had previously been consolidated by Ambac since the inception of the transaction due to the lack of any credit enhancement subordinate to the notes insured by Ambac. Four additional VIEs are consolidated as of June 30, 2009 as a result of Ambac terminating certain reinsurance contracts with a reinsurer. Because the reinsurance contracts are considered implicit variable interests in the respective VIEs being reinsured, the termination of those contracts triggered a reconsideration event under ASC Topic 810. Consequently, Ambac was required to reevaluate its variable interests in these VIEs and concluded it was the primary beneficiary and thus required to consolidate the entities. There are 15 VIEs related to RMBS securitizations that Ambac was required to consolidate under ASC Topic 810 upon reconsideration in relation to the termination of reinsurance contracts and purchases of Ambac guaranteed securities. However, Ambac evaluated these VIEs under FAS 167 “Amendments to FASB Interpretation No. 46(R)” and determined that Ambac may not have to consolidate these same VIEs upon the adoption of FAS 167 on January 1, 2010. Consequently, Ambac will not consolidate these VIEs since the consolidation requirement (i) is temporary in nature, (ii) results in amounts that would have been consolidated under the current rules are not material to our financial statements, and (iii) might cause confusion to users of our financial statements. Ambac’s exposures in these VIEs are adequately reflected on our Consolidated Balance Sheets and Statements of Operations in accordance with ASC Topic 944.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The consolidation of these 15 VIEs would increase Ambac’s assets and liabilities by approximately $1,258,000 and $1,199,000, respectively. The income statement effect related to consolidation of these 15 VIEs would be a gain of approximately $19,374 and $58,750 for the three month and nine month periods ended September 30, 2009, respectively. These consolidation effects would be eliminated on January 1, 2010 upon adoption of FAS 167.

The financial reports of one VIE are prepared by an outside trustee and are not available within the time constraints Ambac requires to ensure the financial accuracy of the operating results. As such, the financial results of this VIE are consolidated on a one quarter lag.

Total variable interest entity notes outstanding was $1,596,814 and $244,500 as of September 30, 2009 and December 31, 2008, respectively. The range of final maturity dates of the variable interest entity notes outstanding is January 2019 to December 2047 as of September 30, 2009. As of September 30, 2009, the interest rates on the variable interest entity notes ranged from 0.32% to 8.06%. Ambac is subject to potential consolidation of an additional $612,960 of assets and liabilities in connection with future utilization of one of the VIEs

The following table provides supplemental information about the combined assets and liabilities associated with the VIEs discussed above. The assets and liabilities of the VIEs are consolidated into the respective Balance Sheet captions.

 

     At September 30,
2009
   At December 31,
2008
 

Assets:

     

Fixed income securities, at fair value

   $ 544,620    $ —     

Cash

     1,018      1,049   

Investment income due and accrued

     1,365      4,599   

Loans (includes $228,125 at fair value in 2009)

     443,310      231,603   

Derivative assets

     112,915      —     

Other assets

     24,875      4,356   
               

Total assets

   $ 1,128,103    $ 241,607   
               

Liabilities:

     

Accrued interest payable

   $ 722    $ 3,841   

Long-term debt (includes $894,815 at fair value in 2009)

     1,121,908      244,500   

Other liabilities

     54      79   
               

Total liabilities

     1,122,684      248,420   
               

Stockholders’ equity:

     

Noncontrolling interest

     5,419      (6,813
               

Total liabilities and stockholders’ equity

   $ 1,128,103    $ 241,607   
               

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Significant Variable Interests in Non-consolidated VIEs

The following table displays the carrying amount of the assets, liabilities and maximum exposure to loss of Ambac’s significant variable interests in non-consolidated VIEs resulting from financial guarantee and credit derivative contracts by major underlying asset classes as of September 30, 2009:

 

     Carrying Value of Assets and Liabilities
     Maximum
Exposure To
Loss(1)
   Premium
Receivable
   Insurance
Liabilities(2)
   Derivative
Liabilities(3)

Global Structured Finance:

           

Collateralized debt obligations

   $ 66,228,128    $ 144,775    $ 198,738    $ 3,976,189

Mortgage-backed - residential

     44,823,588      326,324      2,960,473      8,003

Mortgage-backed - commercial

     1,563,836      4,533      29,443      32,132

Other consumer asset-backed

     12,394,424      81,918      81,837      9,207

Other commercial asset-backed

     45,025,366      1,614,712      2,111,208      25,157

Other

     18,612,202      269,096      671,742      24,302
                           

Total Global Structured Finance

     188,647,544      2,441,358      6,053,441      4,074,990

Global Public Finance

     50,207,575      794,628      964,177      9,388
                           

Total

   $ 238,855,119    $ 3,235,986    $ 7,017,618    $ 4,084,378
                           

 

(1) Maximum exposure to loss represents the gross maximum future payments of principal and interest on insured obligations and credit derivative contracts. Ambac’s maximum exposure to loss does not include the benefit of any financial instruments (such as reinsurance or hedge contracts) that Ambac may utilize to mitigate the risks associated with these variable interests.
(2) Insurance liabilities represents the amount recorded in “Losses and loss expense reserve” and “Unearned premiums” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets. Refer to Note 3 for further information related to the accounting for financial guarantee insurance contracts.
(3)

Derivative liabilities represents the fair value recognized on credit derivative contracts on Ambac’s Consolidated Balance Sheets. Refer to Note 4 “Derivative Contracts” for further information related to the accounting for credit derivative contracts.

Qualified Special Purpose Entities:

A subsidiary of Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These entities meet the characteristics of QSPEs in accordance with ASC Topic 860, Transfers and Servicing. QSPEs are not subject to the requirements of ASC Topic 810 and, accordingly, are not consolidated in Ambac’s financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.

As of September 30, 2009, there have been 15 individual transactions with the QSPEs, of which 9 are outstanding. In each case, Ambac sold fixed income debt obligations to the QSPEs. The fixed income debt obligations are composed of asset-backed securities and utility obligations with a weighted average

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

rating of A- and weighted average life of 5.8 years at September 30, 2009. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. Additionally, Ambac’s creditors do not have any rights with regard to the assets of the QSPEs. The purchase by the QSPE is financed through the issuance of medium-term notes (“MTNs”), which are collateralized by the purchased assets. The MTNs have the same weighted average life as the purchased assets. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued and/or the related derivative contracts. As of September 30, 2009, Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the QSPEs.

Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred on such insurance policies are included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

There were no assets sold to the QSPEs during the nine months ended September 30, 2009 and the year ended December 31, 2008. Ambac Assurance received premiums for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $3,828 and $4,261 for the nine months ended September 30, 2009 and 2008, respectively. Ambac paid claims to the QSPEs of $42,588 and $0 for the nine months ended September 30, 2009 and 2008, respectively, under these financial guarantee contracts. Ambac also received fees for providing other services amounting to $154 and $159 for the nine months ended September 30, 2009 and 2008, respectively.

Derivative contracts are provided by Ambac Financial Services. Consistent with other non-hedging derivatives, Ambac Financial Services account for these contracts on a trade date basis at fair value. The change in fair value of interest rate and currency swaps are reflected in “Derivative products revenues” on Ambac’s Consolidated Statements of Operations. Ambac Financial Services paid $12,248 and received $12,295 for the nine months ended September 30, 2009 and 2008, respectively, under these derivative contracts. Methodologies used to determine fair value of derivative contracts, including model inputs and assumptions where applicable, are described further in Note 10 Fair Value Measurements.

Ambac has elected to account for its equity interest in the QSPEs at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments, effective January 1, 2008. Ambac previously accounted for its equity interest in the QSPEs using the equity method of accounting in accordance with ASC Topic 323, Investments – Equity Method in Joint Ventures. We believe that the fair value of these investments in these QSPEs provides for greater transparency for recording profit or loss as compared to the equity method. Ambac reported a $7,020 cumulative-effect adjustment benefit to the opening balance of retained earnings at January 1, 2008 as a result of the re-measurement to fair value. At September 30, 2009 the fair value of the QSPEs is $13,795 and is reported within Other Assets within the Consolidated Balance Sheets. The change in fair value of the QSPEs for the three and nine months ended September 30, 2009 is $408 and ($495), respectively, and is included within Other Income on the Consolidated Statements of Operations.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

(8) Stockholders’ Equity

Effective January 1, 2009, ASC Topic 810 requires that the carrying value of noncontrolling interests (previously referred to as minority interests) be removed from liability or mezzanine sections of the balance sheet and reclassified as equity; and consolidated net income (loss) to be recast to include net income attributable to the noncontrolling interest, retrospectively for all periods presented. As a result of this adoption, Ambac reclassified noncontrolling interests in the amount of $693,187 into the equity section of the December 31, 2008 consolidated balance sheets. Non-controlling interests includes primarily the preferred stock of Ambac Assurance. In the first nine months of 2009, Ambac Assurance sold an additional $100,000 of preferred stock, bringing the total to $800,000 (32,000 shares of preferred stock). Also, through September 2009, Ambac Assurance retired 5,589 shares of preferred stock for $11,178; 4,686 of these shares were acquired in connection with a CDO commutation in July 2009. The retirement of the preferred stock resulted in an increase in equity attributed to Ambac Financial Group, Inc. of $128,547.

The following schedule presents the effects of changes in Ambac Financial Group, Inc.’s ownership interest in Ambac Assurance on the equity attributable to Ambac Financial Group, Inc.:

Net Income Attributable to Ambac Financial Group, Inc.

Transfers (to) from the noncontrolling interest

As of September 30, 2009

 

Net income attributable to Ambac Financial Group, Inc.

   $ (572,724

Transfers (to) from the noncontrolling interest:

  

Increase in Ambac Financial Group, Inc’s paid-in-capital

  

From retirement of 5,589 shares of preferred stock

     128,547   
        

Change from net income attributable to Ambac Financial Group, Inc. and transfers (to) from noncontrolling interest

   $ (444,177
        

 

(9) Segment Information

Ambac has two reportable segments, as follows: (1) Financial Guarantee, which provides financial guarantees (including credit derivatives) for public finance, structured finance and other obligations; and (2) Financial Services, which provided investment agreements, funding conduits, interest rate, total return and currency swaps, principally to clients of the financial guarantee business, which includes municipalities and other public entities, health care organizations, investor-owned utilities and asset-backed issuers. Ambac’s reportable segments were strategic business units that offer different products and services. They are managed separately because each business required different marketing strategies, personnel skill sets and technology.

Ambac Assurance guarantees the swap and investment agreement obligations of its Financial Services subsidiaries. Additionally, Ambac Assurance provides secured and unsecured borrowings to the Financial Services businesses. Inter-segment revenues include the premiums and investment income

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

earned under those agreements and dividends received from its Financial Services subsidiaries. Such premiums are determined as if they were premiums paid by third parties, that is, at current market prices.

Information provided below for “Corporate and Other” relates to (i) investment advisory, consulting and research services to the structured credit markets and (ii) corporate activities, including interest expense on debentures. Corporate and other revenue from unaffiliated customers consists primarily of interest income. Inter-segment revenues consist of dividends received.

The following table is a summary of financial information by reportable segment of and for the three and nine month periods ended September 30, 2009 and 2008:

 

Three months ended September 30,

   Financial
Guarantee
    Financial
Services
    Corporate
and Other
    Inter-segment
Eliminations
    Consolidated  

2009:

          

Revenues:

          

Unaffiliated customers

   $ 2,875,954        ($187,552   $ 1,109      $ —        $ 2,689,511   

Inter-segment

     (64,775     64,605        —          170        —     
                                        

Total revenues

   $ 2,811,179        ($122,947   $ 1,109        $170      $ 2,689,511   
                                        

Income before income taxes:

          

Unaffiliated customers

   $ 2,386,044        ($197,301     ($34,784   $ —        $ 2,153,959   

Inter-segment

     (69,644     69,119        (301     826        —     
                                        

Total income before income taxes

   $ 2,316,400        ($128,182     ($35,085   $ 826      $ 2,153,959   
                                        

Total assets

   $ 15,191,745      $ 2,707,116      $ 200,195      $ —        $ 18,099,056   
                                        

2008:

          

Revenues:

          

Unaffiliated customers

     ($2,249,431     ($71,889   $ 887      $ —          ($2,320,433

Inter-segment

     4,864        (4,357     55,154        (55,661     —     
                                        

Total revenues

     ($2,244,567     ($76,246   $ 56,041        ($55,661     ($2,320,433
                                        

Income before income taxes:

          

Unaffiliated customers

     ($2,907,551     ($125,403     ($39,110   $ —          ($3,072,064

Inter-segment

     8,012        (5,514     51,229        (53,727     —     
                                        

Total income before income taxes

     ($2,899,539     ($130,917   $ 12,119        ($53,727     ($3,072,064
                                        

Total assets

   $ 14,223,419      $ 5,965,633      $ 257,123      $ —        $ 20,446,175   
                                        

Nine months ended September 30,

   Financial
Guarantee
    Financial
Services
    Corporate
and Other
    Inter-segment
Eliminations
    Consolidated  

2009:

          

Revenues:

          

Unaffiliated customers

   $ 3,655,925        ($344,683   $ 33,358      $ —        $ 3,344,600   

Inter-segment

     (49,340     50,034        359        (1,053     —     
                                        

Total revenues

   $ 3,606,585        ($294,649   $ 33,717        ($1,053   $ 3,344,600   
                                        

Income before income taxes:

          

Unaffiliated customers

   $ 1,084,663        ($383,024     ($62,902   $ —        $ 638,737   

Inter-segment

     (54,210     54,152        58        —          —     
                                        

Total income before income taxes

   $ 1,030,453        ($328,872     ($62,844   $ —        $ 638,737   
                                        

Total assets

   $ 15,191,745      $ 2,707,116      $ 200,195      $ —        $ 18,099,056   
                                        

2008:

          

Revenues:

          

Unaffiliated customers

     ($2,182,698     ($371,303   $ 2,751      $ —          ($2,551,250

Inter-segment

     12,040        (11,365     164,598        (165,273     —     
                                        

Total revenues

     ($2,170,658     ($382,668   $ 167,349        ($165,273     ($2,551,250
                                        

Income before income taxes:

          

Unaffiliated customers

     ($3,662,079     ($578,420     ($114,887   $ —          ($4,355,386

Inter-segment

     22,464        (16,388     158,942        (165,018     —     
                                        

Total income before income taxes

     ($3,639,615     ($594,808   $ 44,055        ($165,018     ($4,355,386
                                        

Total assets

   $ 14,223,419      $ 5,965,633      $ 257,123      $ —        $ 20,446,175   
                                        

 

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Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The following table summarizes gross premiums written, net premiums earned and the net change in fair value of credit derivatives included in the Financial Guarantee segment by location of risk for the three and nine months ended September 30, 2009 and 2008:

 

     Three Months Ended September 30, 2009    Three Months Ended September 30, 2008  
     Gross
Premiums
Written
    Net Premiums
Earned
   Net Change in
Fair Value of
Credit
Derivatives
   Gross
Premiums
Written
   Net Premiums
Earned
   Net Change
in Fair Value of
Credit
Derivatives
 

United States

   ($85,001   $ 143,741    $ 1,943,189    $ 74,232    $ 238,643    ($2,578,637

United Kingdom

   (45,988     71,912      13,628      17,236      17,410    (7,721

Other international

   (100,224     22,748      176,087      27,177      26,273    (118,821
                                        

Total

   ($231,213   $ 238,401    $ 2,132,904    $ 118,645    $ 282,326    ($2,705,179
                                        
     Nine Months Ended September 30, 2009    Nine Months Ended September 30, 2008  
     Gross
Premiums
Written
    Net Premiums
Earned
   Net Change in
Fair Value of
Credit
Derivatives
   Gross
Premiums
Written
   Net Premiums
Earned
   Net Change
in Fair Value of
Credit
Derivatives
 

United States

   ($198,321   $ 427,305    $ 3,372,566    $ 254,852    $ 656,696    ($3,218,855

United Kingdom

   (29,744     111,720      8,271      68,172      52,639    (9,160

Other international

   (160,819     73,920      298,880      96,108      85,328    (208,748
                                        

Total

   ($388,884   $ 612,945    $ 3,679,717    $ 419,132    $ 794,663    ($3,436,763
                                        

 

(10) Fair Value Measurements

On January 1, 2008, Ambac adopted the provisions of ASC Topic 820, Fair Value Measurements and Disclosures. ASC Topic 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement applies to amounts measured at fair value under other accounting pronouncements that require or permit fair value measurements. The transition adjustment to beginning retained earnings was an after-tax gain of $13,031. As described in Note 6, effective April 1, 2009, Ambac adopted ASC Paragraph 820-10-65-4 which provides additional guidance for estimating fair value in accordance with ASC Topic 820 when the volume and level of activity for the asset or liability have significantly decreased. The adoption of ASC Paragraph 820-10-65-4 did not have a significant impact on Ambac’s financial statements.

We reflect Ambac’s own creditworthiness in the fair value of financial instruments by changing the discount rate used by observable credit spreads on Ambac Assurance.

 

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Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

The carrying amount and estimated fair value of financial instruments are presented below:

 

     September 30, 2009    December 31, 2008
     Carrying
Amount
   Estimated
Fair Value
   Carrying
Amount
   Estimated
Fair Value

Financial assets:

           

Fixed income securities(1) 

   $ 8,233,730    $ 8,233,730    $ 8,537,676    $ 8,537,676

Fixed income securities pledged as collateral(1) 

     248,829      248,829      286,853      286,853

Short-term investments

     1,344,945      1,344,945      1,454,229      1,454,229

Other investments

     1,278      1,278      14,059      14,059

Cash

     149,554      149,554      107,811      107,811

Loans

     607,949      610,214      798,848      971,795

Derivative assets

     1,187,636      1,187,636      2,187,214      2,187,214

Other assets

     13,795      13,795      14,290      14,290

Financial liabilities:

           

Obligations under investment, repurchase and payment agreements

     1,529,669      1,430,539      3,357,835      3,377,318

Long-term debt

     2,751,625      1,548,889      1,868,690      626,301

Derivative liabilities

     4,652,390      4,652,390      10,089,895      10,089,895

Liability for net financial guarantees written

     5,872,054      2,308,307      4,270,758      4,489,014

 

(1) See breakout of fixed income securities in Note 6.

Fair value Hierarchy:

ASC Topic 820 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based market assumptions. In accordance with ASC Topic 820, the fair value hierarchy prioritizes model inputs into three broad levels as follows:

 

•  Level 1    –    Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US Treasury securities, exchange traded futures contracts, money market funds and mutual funds.
•  Level 2    –    Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Assets and liabilities classified as Level 2 generally include fixed income securities representing municipal, asset-backed and corporate obligations, most interest rate and currency swap derivatives, total return swaps, certain credit derivative contracts and long-term debt of certain variable interest entities consolidated under ASC Topic 810.
•  Level 3    –    Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. This hierarchy requires the use of observable market data when available. Assets and liabilities classified as Level 3 include most credit derivative contracts written as part of the financial guarantee business, certain interest rate swaps contracts which are not referenced to commonly quoted interest rates, the Company’s equity interest in QSPEs, loan receivables of certain variable interest entities consolidated under ASC Topic 810, investments in certain fixed income securities and long-term debt of certain variable interest entities consolidated under ASC Topic 810 for which quoted prices are not available and valuation models require significant Company based assumptions.

 

44


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Determination of Fair Value:

When available, the Company generally uses quoted market prices to determine fair value, and classifies such items within Level 1. Because many fixed income securities do not trade on a daily basis, pricing sources apply available information through processes such as matrix pricing to calculate fair value. In those cases the items are classified within Level 2. If quoted market prices are not available, fair value is based upon models that use, where possible, current market-based or independently-sourced market parameters. Items valued using valuation models are classified according to the lowest level input or value driver that is significant to the valuation. Thus, an item may be classified in Level 3 even though there may be significant inputs that are readily observable.

The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. The current market disruptions make valuation even more difficult and subjective. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. We believe the potential for differences in third-party pricing levels is particularly significant with respect to residential mortgage backed and certain other asset-backed securities held in our investment portfolio and referenced in our credit derivative portfolio, due to the very low levels of recent trading activity for such securities. In addition, the use of internal valuation models for certain highly structured instruments such as credit default swaps, require assumptions about markets in which there has been a negligible amount of trading activity for over one year. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position by Ambac, may be significantly different from its recorded fair value.

Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, derivative, instruments, loans receivable by and debt instruments issued by variable interest entities consolidated under ASC Topic 810 and equity interests in QSPEs.

Fixed Income Securities:

The fair values of fixed income investment securities are based primarily on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and yield curves for asset-type and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. At September 30, 2009, approximately 8%, 75% and 3% of the investment portfolio was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency, and internal valuation models, respectively. Approximately 14% of the investment portfolio, which represents short-term money market funds, was valued based on amortized cost.

Derivative Instruments:

Ambac’s exposure to derivative instruments is created through interest rate, currency, total return and credit default swaps and exchange traded futures contracts. Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads and ratings on underlying referenced obligations, yield curves

 

45


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

and tax-exempt interest ratios. Under ASC Topic 820, Ambac is required to consider its own credit risk when measuring the fair value of derivative and other liabilities. As Ambac Assurance’s credit spreads widen, the fair value of our credit derivative portfolio liabilities will be reduced. The fair value of net credit derivative liabilities was reduced by $16,045,222 and $10,246,697 at September 30, 2009 and December 31, 2008, respectively, as a result of incorporating Ambac Assurance credit spreads into the valuation model for these transactions.

As described further below, certain valuation models also require inputs that are not readily observable in the market. The selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in the instrument as well as the availability of pricing information in the market. For derivatives that are less complex and trade in liquid markets or may be valued primarily by reference to interest rates and yield curves that are observable and regularly quoted, such as interest rate and currency swaps, we utilize vendor-developed models. For derivatives that do not trade, or trade in less liquid markets such as credit derivatives on collateralized debt obligations, a proprietary model is used because such instruments tend to be unique, contain complex or heavily modified and negotiated terms, and pricing information is not readily available in the market. These models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques. Ambac has not made significant changes to its modeling techniques for the periods presented.

Credit Derivatives:

Fair value of Ambac’s CDS is determined using internal valuation models and represents the net present value of the difference between the fees Ambac originally charged for the credit protection and our estimate of what a financial guarantor of comparable credit worthiness would hypothetically charge to provide the same protection at the balance sheet date. Ambac competes in the financial guarantee market, which differs from the credit markets where Ambac-insured obligations may trade. As a financial guarantor, Ambac assumes only credit risk; we do not assume liquidity risk or other risks and costs inherent in direct ownership of the underlying reference securities. Additionally, as a result of obtaining the investor’s control rights, financial guarantors generally have the ability to actively remediate the credit, potentially reducing the loss given a default. Financial guarantee contracts, including CDS, issued by Ambac and its competitors are typically priced to capture some portion of the spread that would be observed in the capital markets for the underlying (insured) obligation, with minimum pricing constrained by objective estimates of expected loss and financial guarantor required rates of return. Such pricing is well established by historical financial guarantee fees relative to capital market spreads as observed and executed in competitive markets, including in financial guarantee reinsurance and secondary market transactions. Because of this relationship and in the absence of severe credit deterioration, changes in the fair value of our credit default swaps (both unrealized gains and losses) will generally be less than changes in the fair value of the underlying reference obligations.

Key variables used in our valuation of substantially all of our credit derivatives include the balance of unpaid notional, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads and Ambac Assurance’s credit spread. Notional balances, expected remaining term and reference obligation credit ratings are monitored and determined by Ambac’s Surveillance Group. Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance spreads and quoted values for similar transactions. Implicit in the fair values we obtain on the underlying reference obligations are the market’s assumptions about default probabilities, default timing, correlation, recovery rates and collateral values.

 

46


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Broker quotes on the reference obligations named in our CDS contracts represent an input to determine the estimated fair value of the CDS contract. Broker quotes are indicative values for the reference obligation and generally do not represent a bid or doing-business quote for the reference instrument. Regulations require that such quotes follow methodologies that are generally consistent with those used to value similar assets on the quote providers’ own books. Methodologies may differ among brokers but are understood to reflect observable trading activity (when available) and modeling that relies on empirical data and reasonable assumptions. For certain CDS contracts referencing unsecuritized pools of assets, we will obtain counterparty quotes on the credit derivative itself. Such quotes are adjusted to reflect Ambac’s own credit risk when determining the fair value of credit derivative liabilities. Third party quotes were used in the determination of CDS fair values related to transactions representing 68% of CDS net par outstanding and 50% of the CDS derivative liability as of September 30, 2009.

When broker quotes for reference obligations are not available, reference obligation prices used in the valuation model are estimated internally based on averages of the quoted prices for other transactions of the same bond type and Ambac rating as well as changes in published credit spreads for securities with similar collateral and ratings characteristics. When price quotes of a similar bond type vary significantly or the number of similar transactions is small, as has been observed with CDO of ABS transactions, management will consider additional factors, such as specific collateral composition and performance and contractual subordination, to identify similar transactions. Internally estimated prices for CDO of ABS used in the valuation model also consider the discounted value of future cash flows of the reference obligations. Reference obligation prices derived internally as described above were used in the determination of CDS fair values related to transactions representing 32% of CDS net par outstanding and 50% of the CDS derivative liability as of September 30, 2009.

Ambac’s CDS fair value calculations are adjusted for increases in our estimates of expected loss on the reference obligations and observable changes in financial guarantee market pricing. If no adjustment is considered necessary, Ambac maintains the same percentage of the credit spread (over LIBOR) demanded in the market for the reference obligation as existed at the inception of the CDS. Therefore, absent changes in expected loss on the reference obligations or financial guarantee CDS market pricing, the financial guarantee CDS fee used for a particular contract in Ambac’s fair value calculations represent a consistent percentage, period to period, of the credit spread determinable from the reference obligation value at the balance sheet date. This results in a CDS fair value balance that fluctuates in proportion with the reference obligation value.

The amount of expected loss on a reference obligation is a function of the probability that the obligation will default and severity of loss in the event of default. Ambac’s CDS transactions were all originally underwritten with extremely low expected losses. Both the reference obligation spreads and Ambac’s CDS fees at the inception of these transactions reflect these low expected losses. When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and, therefore, an increase in expected loss. The effects of credit deterioration on financial guarantee CDS fees cannot be observed in the market through new transactions, secondary market transactions or by other means as there have been no such transactions. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread (over LIBOR) which would be captured as a CDS fee (relative change ratio) at the valuation date, resulting in a higher mark-to-market loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. For example, if the credit spread of an underlying reference obligation was 80 basis points at the inception of a transaction and Ambac received a 20 basis

 

47


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

point fee for issuing a CDS on that obligation, the “relative change ratio”, which represents the CDS fee to cash market spread Ambac would utilize in its valuation calculation, would be 25%. If the reference obligation spread increased to 100 basis points in the current reporting period, absent any observable changes in financial guarantee CDS market pricing or credit deterioration, Ambac’s current period CDS fee would be computed by multiplying the current reference obligation spread of 100 basis points by the relative change ratio of 25%, resulting in a 25 basis point fee. Thus, the model indicates we would need to receive an additional 5 basis points (25 basis points currently less the 20 basis points we received at inception) for issuing a CDS in the current reporting period for this reference obligation. We would then discount the product of the notional amount of the CDS and the 5 basis point hypothetical CDS fee increase, over the weighted average life of the reference obligation to compute the current period mark-to-market loss. Using the same example, if the reference obligation spread increased to 100 basis points and there was credit deterioration as evidenced by an internal rating downgrade which increased the relative change ratio from 25% to 35%, we would estimate a 15 basis point hypothetical CDS fee increase in our model (35% of 100 basis points reference obligation spread, or 35 basis points currently, less the 20 basis points contractually received). Therefore, we would record a higher mark-to-market loss based on the computations described above absent any observable changes in financial guarantee CDS market pricing.

We do not adjust the relative change ratio until an actual internal rating downgrade has occurred unless we observe new pricing on financial guarantee CDS contracts. However, because we have active surveillance procedures in place for our entire CDS portfolio, particularly for transactions at or near a below investment grade threshold, we believe it is unlikely that an internal downgrade would lag the actual credit deterioration of a transaction for any meaningful time period. The factors used to increase the percentage of reference obligation spread captured in the CDS fee (or relative change ratio) are based on rating agency probability of default percentages determined by management to be appropriate for the relevant bond type. That is, the probability of default associated with the respective tenor and internal rating of each CDS transaction is utilized in the computation of the relative change ratio in our CDS valuation model. The new relative change ratio in the event of an internal downgrade of the reference obligation is calculated as the weighted average of: (i) a given transaction’s inception relative change ratio and (ii) a ratio of 100%. The weight given to the inception relative change ratio is 100% minus the probability of default (i.e. the probability of non-default) and the weight given to using a 100% relative change ratio is the probability of default. For example, assume a transaction having an inception relative change ratio of 33% is downgraded to B- during the period, at which time it has an estimated remaining life of 8 years. If the estimated probability of default for an 8 year, B- rated credit of this type is 60% then the revised relative change ratio will be 73.2%. The revised relative change ratio can be calculated as 33% x (100%-60%) + 100% x 60% = 73.2%.

As noted above, reference obligation spreads incorporate market perceptions of default probability and loss severity, as well as liquidity risk and other factors. Loss severities are generally correlated to default probabilities during periods of economic stress. By increasing the relative change ratio in our calculations proportionally to default probabilities, Ambac incorporates into its CDS fair value the higher expected loss on the reference obligation (probability of default x loss severity), by increasing the portion of reference obligation spread that should be paid to the CDS provider.

The discount rate used for the present value calculations described above is LIBOR plus Ambac’s current credit spread as observed from quotes of the cost to purchase credit protection on Ambac Assurance. The discount rate used to value purchased credit derivative protection is LIBOR plus the current credit spread of the protection provider. The widening of Ambac’s own credit spread cannot result in our recognition of an asset on a CDS contract. Under our methodology, determination of the CDS fair value requires estimating hypothetical financial guarantee CDS fees for a given credit at the valuation date and estimating the present value of those fees. Our approach begins with pricing in the risk

 

48


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

of default of the reference obligation using that obligation’s credit spread. The widening of the reference obligation spread results in a mark-to-market loss to Ambac, as the credit protection seller, and a gain to the credit protection buyer because the cost of credit protection on the reference obligation (ignoring CDS counterparty credit risk) will be greater than the amount of the actual contractual CDS fees. To factor in the risk of Ambac’s non-performance as viewed by the market, we adjust the discount rate used to calculate the present value of hypothetical future CDS fees by adding the cost of credit default swap protection on Ambac Assurance to the LIBOR curve as of the valuation date. By incorporating the market cost of credit protection on Ambac into the discount rate, the fair value of Ambac’s liability (or the asset from the perspective of the credit protection buyer) will be decreased by an amount that reflects the market’s pricing of the risk that Ambac will not have the ability to pay. In instances where narrower reference obligation spreads result in a CDS asset to Ambac, or when Ambac has a CDS asset arising from reinsured CDS exposure, those hypothetical future CDS fees are discounted at a rate which does not incorporate Ambac’s own spread but rather incorporates our counterparty’s credit spread.

In addition, when there are sufficient numbers of new observable transactions to indicate a general change in market pricing trends for CDS on a given bond type, management will adjust its assumptions about the percentage of reference obligation spreads captured as CDS fees to match the current market. No such adjustments were made in the nine months ended September 30, 2009 and 2008. Ambac is not transacting CDS business currently, other guarantors have stated they have exited this product, and it is possible insurance regulators will prohibit Ambac Assurance and its competitors from transacting this product going forward.

Key variables which impact the “Realized gains and losses and other settlements” component of “Net change in fair value of credit derivatives” in the Consolidated Statements of Operations are the most readily observable variables since they are based solely on the CDS contractual terms and cash settlements. Those variables include (i) premiums received and accrued on written CDS contracts, (ii) premiums paid or accrued on purchased contracts, (iii) losses paid and payable on written credit derivative contracts and (iv) paid losses recovered and recoverable on purchased credit derivative contracts for the appropriate accounting period. The remaining key variables described above impact the “Unrealized gains (losses)” component of “Net change in fair value of credit derivatives.” The net notional outstanding of Ambac’s CDS contracts is $50,075,106 and $56,801,198 at September 30, 2009 and December 31, 2008, respectively. Refer to Note 4 to the Unaudited Consolidated Financial Statements for additional disclosures about Ambac’s credit derivative positions and results.

Financial Guarantees:

Fair value of net financial guarantees written represents our estimate of the cost to Ambac to completely transfer its insurance obligation to another financial guarantor of comparable credit worthiness. In theory, this amount should be the same amount that another financial guarantor of comparable credit worthiness would hypothetically charge in the market place, on a present value basis, to provide the same protection as of the balance sheet date.

This fair value estimate of financial guarantees is presented in the table immediately following the first paragraph of this Note 10 on a net basis and includes direct and assumed contracts written, which represent our liability, net of ceded reinsurance contracts, which represent our asset. The fair value estimate of direct and assumed contracts written is based on the sum of the present values of (i) unearned premium reserves; and (ii) loss and loss expense reserves. The fair value estimate of ceded reinsurance contracts is based on the sum of the present values of (i) prepaid reinsurance, net of ceding commissions; and (ii) reinsurance recoverables on losses.

 

49


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

Under our current financial guarantee model, the key variables are par amounts outstanding (including future periods for the calculation of future installment premiums), expected term, discount rate, and expected net loss and loss expense payments. Net par outstanding is monitored by Ambac’s Surveillance Group. With respect to the discount rate, ASC Topic 820 requires that the nonperformance risk of a financial liability be included in the estimation of fair value. This nonperformance risk would include considering Ambac’s own credit risk in the fair value of financial guarantees we have issued, thus the estimated fair value for direct contracts written was discounted at LIBOR plus Ambac’s current credit spread. The credit spread used to estimate the nonperformance risk component of the fair value of financial guarantees as of September 30, 2009 and December 31, 2008 was 4,262 and 1,687 basis points, respectively. Refer to Note 3, Loss and Loss Expenses, for additional information on factors which influence our estimate of loss and loss expenses. The estimated fair value of ceded reinsurance contracts factors in any adjustments related to the counterparty credit risk we have with reinsurers.

There are a number of factors that limit our ability to accurately estimate the fair value of our financial guarantees. The first limitation is the lack of observable pricing data points as a result of the current disruption in the credit markets and recent rating agency actions, both of which have significantly limited the amount of new financial guarantee business written by Ambac. Additionally, the fair value cost to completely transfer its obligation to another party of comparable credit worthiness. However, our primary insurance obligation is irrevocable and thus there is no established active market for transferring such obligations. Finally, as a result of the breadth, volume and geographic diversification of our financial guarantee exposures, we may need to enhance our model to more accurately incorporate other key variables that may influence the fair value estimate. Variables which are not incorporated in our current fair value estimate of financial guarantees include the credit spreads of the underlying insured obligations, the underlying ratings of those insured obligations and assumptions about current financial guarantee premium levels relative to the underlying insured obligations’ credit spreads.

Long-term Debt:

The fair value of debentures classified as long-term debt is based on quoted market prices. Debt instruments issued by variable interest entities that Ambac consolidates as required by ASC Topic 810 are included in long-term debt on the balance sheet and reported at fair value. The fair values of VIE debt instruments are based on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. For those VIE debt instruments where quotes were not available, the debt instrument fair values are based primarily on estimates of the fair values of financial assets available to fund the debt service, including amounts due under financial guarantee policies provided by Ambac Assurance.

Other Financial Assets and Liabilities:

The fair values of Ambac’s equity interest in QSPEs (included in Other assets), Loans and Obligations under investment, repurchase and payment agreements are estimated based upon internal valuation models that discount expected cash flows using a discount rates consistent with the credit quality of the obligor after considering collateralization.

The following table sets forth Ambac’s financial assets and liabilities that were accounted for at fair value as of September 30, 2009 and December 31, 2008 by level within the fair value hierarchy. As required by ASC Topic 820, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

50


Table of Contents

Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

 

     Level 1    Level 2    Level 3    Total

September 30, 2009

           

Financial assets:

           

Fixed income securities

   $ 215,144    $ 7,675,464    $ 343,122    $ 8,233,730

Fixed income securities, pledged as collateral

     145,982      102,847      —        248,829

Short-term investments

     1,344,945      —        —        1,344,945

Other investments

     —        1,178      —        1,178

Cash

     149,554      —        —        149,554

Loans

     —        —        228,125      228,125

Derivative assets

     —        821,689      365,947      1,187,636

Other assets

     —        —        13,795      13,795

Total financial assets

     1,855,625      8,601,178      950,989      11,407,792

Financial liabilities:

           

Derivative liabilities

     9,573      548,787      4,094,030      4,652,390

Long-term debt

     —        499,873      394,942      894,815

Total financial liabilities

     9,573      1,048,660      4,488,972      5,547,205
     Level 1    Level 2    Level 3    Total

December 31, 2008

           

Financial assets:

           

Fixed income securities

   $ 183,826    $ 8,270,397    $ 83,453    $ 8,537,676

Fixed income securities, pled