Attached files

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EX-99.1 - INTERIM ORDER PURSUANT TO SECTIONS 105(A), 362, AND 541 - AMBAC FINANCIAL GROUP INCdex991.htm
EX-10.1 - SETTLEMENT AGREEMENT, DATED AS OF JUNE 7, 2010 - AMBAC FINANCIAL GROUP INCdex101.htm
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 302 - AMBAC FINANCIAL GROUP INCdex311.htm
EX-32.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 906 - AMBAC FINANCIAL GROUP INCdex321.htm
EX-99.2 - INTERIM ORDER PURSUANT TO SECTIONS 105(A), 362, 363, AND 364 - AMBAC FINANCIAL GROUP INCdex992.htm
EX-32.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 906 - AMBAC FINANCIAL GROUP INCdex322.htm
EX-31.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 302 - AMBAC FINANCIAL GROUP INCdex312.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, 2010

 

¨ 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.

(Debtor-in-possession as of November 8, 2010)

(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 12, 2010, 302,112,225 shares of Common Stock, par value $0.01 per share, (net of 5,904,539 treasury 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, 2010 (unaudited) and December 31, 2009      3   
   Consolidated Statements of Operations (unaudited) – three and nine months ended September 30, 2010 and 2009      4   
   Consolidated Statements of Stockholders’ Equity (unaudited) – nine months ended September 30, 2010 and 2009      5   
   Consolidated Statements of Cash Flows (unaudited) – nine months ended September 30, 2010 and 2009      6   
   Notes to Unaudited Consolidated Financial Statements      7   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      86   
Item 3.    Quantitative and Qualitative Disclosures About Market Risk      135   
Item 4.    Controls and Procedures      139   
PART II OTHER INFORMATION   
Item 1.    Legal Proceedings      140   
Item 1A.    Risk Factors      147   
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds      155   
Item 6.    Exhibits      156   

SIGNATURES

     157   

INDEX TO EXHIBITS

     158   


Table of Contents

 

PART 1 – FINANCIAL INFORMATION

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

Ambac Financial Group Inc. and Subsidiaries

Consolidated Balance Sheets

 

(Dollars in Thousands)

   September 30,
2010
    December 31,
2009
 
     (unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $5,599,075 in 2010 and $7,605,565 in 2009)

   $ 5,968,020      $ 7,572,570   

Fixed income securities pledged as collateral, at fair value (amortized cost of $190,453 in 2010 and $164,356 in 2009)

     194,387        167,366   

Short-term investments, (amortized cost of $617,748 in 2010 and $962,007 in 2009)

     617,748        962,007   

Other (cost of $100 in 2010 and $1,278 in 2009)

     100        1,278   
                

Total investments

     6,780,255        8,703,221   

Cash and cash equivalents

     69,673        112,079   

Receivable for securities sold

     22,578        3,106   

Investment income due and accrued

     37,346        73,062   

Premium receivables

     2,802,811        3,718,158   

Reinsurance recoverable on paid and unpaid losses

     126,458        78,115   

Deferred ceded premium

     318,616        500,804   

Subrogation recoverable

     1,222,216        902,612   

Deferred taxes

     —          11,250   

Current taxes

     —          421,438   

Deferred acquisition costs

     251,971        279,704   

Loans

     20,999        80,410   

Derivative assets

     298,757        496,494   

Other assets

     216,644        229,299   

Variable interest entity assets:

    

Fixed income securities, at fair value

     1,939,492        525,947   

Restricted cash

     1,952        1,151   

Investment income due and accrued

     1,230        4,133   

Loans (includes $17,007,648 and $2,428,352 at fair value)

     17,201,665        2,635,961   

Derivative assets

     4,362        109,411   

Other assets

     11,214        12   
                

Total assets

   $ 31,328,239      $ 18,886,367   
                

Liabilities and Stockholders’ Deficit:

    

Liabilities:

    

Unearned premiums

   $ 4,442,271      $ 5,687,114   

Losses and loss expense reserve

     5,510,541        4,771,684   

Ceded premiums payable

     182,725        291,843   

Obligations under investment and payment agreements

     814,389        1,177,406   

Obligations under investment repurchase agreements

     101,807        113,527   

Current taxes

     22,449        —     

Long-term debt

     1,823,327        1,631,556   

Accrued interest payable

     90,975        47,125   

Derivative liabilities

     486,878        3,536,858   

Other liabilities

     138,301        248,655   

Payable for securities purchased

     2,486        2,074   

Variable interest entity liabilities:

    

Accrued interest payable

     651        3,482   

Long-term debt (includes $17,130,379 and $2,789,556 at fair value)

     17,335,034        3,008,628   

Derivative liabilities

     1,581,681        —     

Other liabilities

     12,304        60   
                

Total liabilities

     32,545,819        20,520,012   
                

Stockholders’ deficit:

    

Ambac Financial Group, Inc.:

    

Preferred stock

     —          —     

Common stock

     3,080        2,944   

Additional paid-in capital

     2,186,372        2,172,656   

Accumulated other comprehensive income (loss)

     347,738        (24,827

Accumulated deficit

     (3,978,701     (3,878,015

Common stock held in treasury at cost

     (430,600     (560,543
                

Total Ambac Financial Group, Inc. stockholders’ deficit

     (1,872,111     (2,287,785

Noncontrolling interest

     654,531        654,140   
                

Total stockholders’ deficit

     (1,217,580     (1,633,645
                

Total liabilities and stockholders’ deficit

   $ 31,328,239      $ 18,886,367   
                

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

3


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

 

      Three Months Ended
September 30,
    Nine Months Ended
September 30,
 

(Dollars in Thousands, Except Share Data)

   2010     2009     2010     2009  

Revenues:

        

Financial Guarantee:

        

Net premiums earned

   $ 143,085      $ 238,401      $ 435,321      $ 612,945   

Net investment income

     69,840        137,645        256,438        364,026   

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     (8,461     (32,529     (49,706     (1,452,664

Portion of loss recognized in other comprehensive income

     1,877        —          4,286        —     
                                

Net other-than-temporary impairment losses recognized in earnings

     (6,584     (32,529     (45,420     (1,452,664
                                

Net realized investment gains

     2,053        86,916        75,473        93,075   

Change in fair value of credit derivatives:

        

Realized gains (losses) and other settlements

     4,862        (732,857     (2,762,509     (731,287

Unrealized gains

     4,550        2,865,761        2,806,963        4,411,004   
                                

Net change in fair value of credit derivatives

     9,412        2,132,904        44,454        3,679,717   

Other income

     186,859        268,836        100,713        309,780   

Income (loss) on variable interest entities

     26,377        41,096        (504,873     41,140   

Financial Services:

        

Investment income

     8,425        18,454        26,554        58,342   

Derivative products

     (78,368     (222,450     (207,552     (280,868

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     —          (11,660     (3,079     (283,858

Portion of loss recognized in other comprehensive income

     —          —          —          —     
                                

Net other-than-temporary impairment losses recognized in earnings

     —          (11,660     (3,079     (283,858
                                

Net realized investment gains

     464        28,109        67,706        142,345   

Net change in fair value of total return swap contracts

     —          6,902        —          18,573   

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

     —          (6,907     (14,295     783   

Corporate and Other:

        

Other income

     114        1,109        1,575        33,325   

Net realized (losses) gains

     (521     —          10,172        33   
                                

Total revenues

     361,156        2,686,826        243,187        3,336,694   
                                

Expenses:

        

Financial Guarantee:

        

Losses and loss expenses

     165,396        459,213        577,874        2,429,890   

Underwriting and operating expenses

     41,200        28,012        150,627        133,466   

Interest expense

     27,492        —          34,378        —     

Financial Services:

        

Interest from investment and payment agreements

     3,951        6,433        13,742        27,533   

Other expenses

     3,460        3,316        10,211        10,808   

Corporate and Other:

        

Interest

     29,878        29,918        89,634        89,601   

Other expenses

     13,695        5,975        38,288        6,659   
                                

Total expenses

     285,072        532,867        914,754        2,697,957   
                                

Pre-tax income (loss) from continuing operations

     76,084        2,153,959        (671,567     638,737   

Provision (benefit) for income taxes

     65        (34,284     50        1,211,477   
                                

Net income (loss)

   $ 76,019      $ 2,188,243      $ (671,617   $ (572,740

Less: net income (loss) attributable to the noncontrolling interest

     13        (14     (13     (16
                                
        

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

   $ 76,006      $ 2,188,257      $ (671,604   $ (572,724
                                

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

   $ 0.25      $ 7.58      $ (2.29   $ (1.99

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

   $ 0.25      $ 7.58      $ (2.29   $ (1.99

Weighted-average number of common shares outstanding:

        

Basic

     302,177,506        288,770,269        293,542,268        287,647,272   

Diluted

     302,177,506        288,770,269        293,542,268        287,647,272   

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

4


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

 

     Total     Comprehensive
(Loss) Income
    Ambac Financial Group, Inc.        
       Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income
    Preferred
Stock
     Common
Stock
     Paid-in
Capital
     Common
Stock Held in
Treasury, at

Cost
    Noncontrolling
Interest
 

Balance at January 1, 2010

   $ (1,633,645     $ (3,878,015   $ (24,827   $ —         $ 2,944       $ 2,172,656       $ (560,543   $ 654,140   

Comprehensive loss:

                     

Net loss

     (671,617   $ (671,617     (671,604                  (13
                                 

Other comprehensive loss:

                     

Unrealized gains on securities, net of deferred income taxes of $10,495

     389,362        389,362          389,362                

Loss on derivative hedges, net of deferred income taxes of $755

     (1,881     (1,881       (1,881             

Loss on foreign currency translation, net of deferred income taxes of $1,529

     (17,310     (17,310       (17,714                404   
                                 

Other comprehensive gain

     370,171        370,171                    
                                 

Total comprehensive loss

   $ (301,446   $ (301,446                 
                                 

Adjustment to initially apply ASU 2009-17

     705,046          702,042        3,004                

Dividends declared – subsidiary shares to non-controlling interest

     (817       (817               

Issuance of stock

     9,618                 136         9,482        

Stock-based compensation

     (126,279       (130,307     (206           4,234        

Cost of shares acquired

     (341                    (341  

Shares issued under equity plans

     130,284                       130,284     
                                                                     

Balance at September 30, 2010

   $ (1,217,580     $ (3,978,701   $ 347,738      $ —         $ 3,080       $ 2,186,372       $ (430,600   $ 654,531   
                                                                     

Balance at January 1, 2009

   $ (3,089,122     $ (3,550,768   $ (1,670,198   $ —         $ 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 loss:

                     

Net loss

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

Other comprehensive loss:

                     

Unrealized gains on 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 loss

     1,779,092        1,779,092                    
                                 

Total comprehensive gain

   $ 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      $ —         $ 2,944       $ 2,171,848       $ (561,495   $ 653,903   
                                                                     

See accompanying Notes to Unaudited Consolidated 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)

   2010     2009  
    

Cash flows from operating activities:

    

Net loss attributable to common shareholders

   $ (671,604   $ (572,724

Noncontrolling interest in subsidiaries’ earnings

     (13     (16
                

Net loss

   $ (671,617   $ (572,740

Adjustments to reconcile net loss to net cash used in operating activities:

    

Depreciation and amortization

     2,686        2,223   

Amortization of bond premium and discount

     (103,445     (143,772

Share-based compensation

     4,250        13,315   

Current income taxes

     443,887        243,236   

Deferred income taxes

     —          1,243,586   

Deferred acquisition costs

     27,733        (100,610

Unearned premiums, net

     (1,062,655     (436,753

Loss and loss expense, net

     370,910        1,435,179   

Ceded premiums payable

     (109,118     (349,535

Investment income due and accrued

     35,716        46,636   

Premium receivables

     915,347        606,083   

Accrued interest payable

     43,850        (23,739

Net mark-to-market (gains) losses

     (2,792,668     (4,430,360

Net realized investment gains

     (153,351     (235,453

Other-than-temporary impairment charges

     48,499        1,736,522   

Variable interest entity activities

     504,873        41,140   

Other, net

     330,273        (345,082
                

Net cash used in operating activities

     (2,164,830     (1,270,124
                

Cash flows from investing activities:

    

Proceeds from sales of bonds

     2,349,427        3,014,573   

Proceeds from matured bonds

     584,365        497,216   

Purchases of bonds

     (880,863     (1,576,127

Change in short-term investments

     344,259        109,285   

Loans, net

     59,412        385,199   

Change in swap collateral receivable

     24,248        445,435   

Other, net

     12,324        (10,127
                

Net cash provided by investing activities

     2,493,172        2,865,454   
                

Cash flows from financing activities:

    

Dividends paid – subsidiary shares to noncontrolling interest

     (817     (12,148

Proceeds from issuance of investment and payment agreements

     1,337        53,756   

Payments for investment and payment draws

     (290,699     (1,643,102

Proceeds from the issuance of subsidiary shares to noncontrolling interest

     —          100,000   

Retirement of subsidiary shares to noncontrolling interest

     —          (11,178

Capital issuance costs

     —          (297

Net cash collateral paid/received

     (80,569     (40,587
                

Net cash used in financing activities

     (370,748     (1,553,556
                

Net cash flow

     (42,406     41,774   

Cash and cash equivalents at January 1

     112,079        106,762   
                

Cash and cash equivalents at September 30

   $ 69,673      $ 148,536   
                

Supplemental disclosure of cash flow information:

    

Cash paid during the year for:

    

Income taxes

   $ —        $ —     

Interest expense on long-term debt

   $ 61,568      $ 74,820   

Interest on investment agreements

   $ 17,175      $ 38,436   

Supplemental disclosure of noncash financing activities:

The company issued common stock upon the extinguishment of $20,311 in long-term debt. In addition, Ambac Assurance issued surplus notes in connection with settlement of credit derivative liabilities as part of the CDS commutation Settlement Agreement and the Segregated Account of Ambac Assurance issued surplus notes as discussed in “Recent Developments” in Note 1 to the Unaudited Consolidated Financial Statements.

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

6


Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(1) Background and Basis of Presentation

Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose affiliates provided financial guarantees and financial services to clients in both the public and private sectors around the world. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). The Company will continue to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. Ambac Financial Group, Inc.’s common stock trades in the over-the-counter market under ticker symbol ABKFQ. Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a guarantor of public finance and structured finance obligations, has a Caa2 rating from Moody’s Investors Service, Inc. and an R (regulatory intervention) financial strength rating from Standard & Poor’s Ratings Services. Everspan Financial Guarantee Corp. has a CC financial strength rating from S&P and Ambac Assurance UK, Ltd. has a financial strength rating Caa2 from Moody’s.

Ambac’s principal business strategy going forward is to increase the residual value of its financial guarantee business by mitigating losses on poorly performing transactions (including through the pursuit of recoveries in respect of paid claims, commutations of policies and repurchases of surplus notes issued in respect of claims) and maximizing the yield on its investment portfolio. The Company’s existing investment agreement and derivative product portfolios are in active runoff. In the course of managing the inherent risks of these portfolios during runoff, the Financial Services segment may enter into new financial instrument transactions to the extent we are able to do so.

The financial strength rating downgrades and regulatory actions taken to date with respect to Ambac Assurance have eliminated Ambac’s ability to generate new business and will continue to negatively impact Ambac’s operations and financial results. The constraints imposed upon Ambac Assurance by the covenants made for the benefit of the Segregated Account and the Counterparties to the Settlement Agreement (as described in Recent Developments below), and the authority of the Rehabilitator (as defined below) to control the management of the Segregated Account may limit our ability to achieve our objectives, thereby reducing the value of Ambac Assurance. Further, there can be no assurance that Ambac will be successful in realizing any of the foregoing operating strategies. As a result of these uncertainties and the Chapter 11 Reorganization described below, management has concluded that there is substantial doubt about the ability to continue as a going concern. The accompanying financial statements do not purport to reflect or provide for the consequences of our bankruptcy filing. In particular, the financial statements do not purport to show assets at their realizable value on a liquidation basis. The Company’s financial statements as of September 30, 2010 and December 31, 2009, and for the three and nine months ended September 30, 2010 and 2009, are prepared assuming the Company continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern.

Recent Developments:

Chapter 11 Reorganization

On November 8, 2010 (the “Petition Date”), Ambac filed a voluntary petition for relief under Chapter 11 (“Bankruptcy Filing”) of the Bankruptcy Code in the Bankruptcy Court. The Company will continue to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court.

 

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The Company was unable to raise additional capital as an alternative to seeking bankruptcy protection and was also unable to agree to terms with an ad-hoc committee of certain senior debt holders in order to restructure its outstanding debt through a prepackaged bankruptcy proceeding. However, Ambac, Ambac Assurance, OCI and the ad hoc committee have agreed to a non-binding term sheet that will serve as the basis for further negotiation which, if successful, may allow the Company to emerge from bankruptcy more expeditiously. The principal issues raised in the non-binding term sheet relate to (i) the allocation of tax attributes (including, without limitation, NOLs) among the Company and its subsidiaries, including Ambac Assurance, (ii) cost sharing agreements among the Company and its subsidiaries, and (iii) possible repurchases of outstanding securities of Ambac Assurance. As such, OCI and the Rehabilitator will participate in negotiations with respect to the non-binding term sheet. If the negotiations do not produce an agreement among the parties, Ambac (or its creditors) could take actions which would adversely affect Ambac Assurance and/or the Segregated Account. As such, OCI may determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance, either pre-emptively, or in response to any such action.

As of September 30, 2010, the Company had debt outstanding amounting to $1,622,189. The Bankruptcy Filing constituted an event of default with respect to the following debt instruments (collectively, the “Debt Documents”):

 

   

Indenture, dated as of August 1, 1991, between the Company and The Bank of New York Mellon (as successor trustee to The Chase Manhattan Bank (National Association)) (the “1991 Indenture”), as trustee, with respect to approximately $122,189 principal and accrued and unpaid interest on outstanding debt securities in the form of 9- 3/8% debentures due August 1, 2011;

 

   

1991 Indenture with respect to approximately $75,000 principal and accrued and unpaid interest on outstanding debt securities in the form of 7- 1/2% debentures due May 1, 2023;

 

   

Indenture, dated as of August 24, 2001, between the Company and The Bank of New York Mellon (as successor trustee to JP Morgan Chase Bank) (the “2001 Indenture”), as trustee, with respect to approximately $200,000 principal and accrued and unpaid interest on outstanding debt securities in the form of 5.95% debentures due February 28, 2103;

 

   

2001 Indenture with respect to approximately $175,000 principal and accrued and unpaid interest on outstanding debt securities in the form of 5.875% debentures due March 24, 2103;

 

   

Indenture, dated as of April 22, 2003, between the Company and The Bank of New York Mellon (as successor trustee to JP Morgan Chase Bank), as trustee, with respect to approximately $400,000 principal and accrued and unpaid interest on outstanding debt securities in the form of 5.95% debentures due December 5, 2035;

 

   

Indenture, dated as of February 15, 2006, as supplemented by the Supplemental Indenture, dated as of March 12, 2008, both between the Company and The Bank of New York Mellon, as trustee, with respect to approximately $250,000 principal and accrued and unpaid interest on outstanding debt securities in the form of 9.50% senior notes due February 15, 2021; and

 

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Junior Subordinated Indenture and First Supplemental Indenture, both dated as of February 12, 2007, between the Company and The Bank of New York Mellon, as trustee, with respect to approximately $400,000 principal and accrued and unpaid interest on outstanding debt securities in the form of 6.15% Directly Issued Subordinated Capital Securities due February 15, 2037.

As a result of the bankruptcy filing, Ambac’s obligations under the debt securities described above are accelerated. Upon the bankruptcy filing, any efforts to enforce such payment obligations under the Debt Documents are stayed pursuant to the automatic stay provisions of section 362 of the Bankruptcy Code, and the creditors’ rights of enforcement in respect of the Debt Documents are subject to the applicable provisions of the Bankruptcy Code.

As a result of the bankruptcy filing, Ambac is now required to file various documents with, and provide certain information to, the Bankruptcy Court, including statements of financial affairs, schedules of assets and liabilities and monthly operating reports in forms prescribed by federal bankruptcy law, as well as certain financial information on an unconsolidated basis. While these documents and information accurately provide then-current information required under federal bankruptcy law, they are nonetheless unconsolidated, unaudited and are prepared in a format different from that used in Ambac’s US GAAP basis consolidated financial statements filed under the securities laws. Accordingly, Ambac believes that the substance and format do not allow meaningful comparison with its publicly-disclosed US GAAP basis consolidated financial statements. Moreover, the materials filed with the Bankruptcy Court are not prepared for the purpose of providing a basis for an investment decision relating to the Company’s securities, or for comparison with other financial information filed with the SEC.

Shortly after the Petition Date, Ambac began notifying current or potential creditors of the Bankruptcy Filing. Subject to certain exceptions under the Bankruptcy Code, the bankruptcy filing automatically enjoined, or stayed, the continuation of any judicial or administrative proceedings or other actions against the Company. Thus, for example, most creditor actions to obtain possession of property from Ambac, or to create, perfect or enforce any lien against the property of Ambac, or to collect on monies owed or otherwise exercise rights or remedies to a claim arising prior to the Petition Date are enjoined unless and until the Bankruptcy Court lifts the automatic stay. Vendors are being paid for goods furnished and services provided after the Petition Date in the ordinary course of business. The deadline for filing of proofs of claims against the Company has not yet been established by the Bankruptcy Court.

In order to successfully emerge from bankruptcy, Ambac will need to propose and obtain confirmation by the Bankruptcy Court of a plan of reorganization that satisfies the requirements of the Bankruptcy Code. A plan of reorganization would, among other things, resolve Ambac’s obligations arising prior to the Petition Date, set forth the revised capital structure of a newly reorganized Ambac and provide for corporate governance subsequent to emergence from bankruptcy.

Upon commencing the Bankruptcy Filing, Ambac has the exclusive right for 120 days after the Petition Date (and subject to any Bankruptcy Court authorized extension thereof) to file a plan of reorganization and, if we do so, 60 additional days (and subject to any Bankruptcy Court authorized extension thereof) to obtain necessary acceptances of the plan. If Ambac’s exclusivity period lapses, any party in interest would be able to file a plan of reorganization for Ambac. In additional to being voted on by holders of impaired claims and equity interests, a plan of reorganization must satisfy certain requirements of the Bankruptcy Code and must be approved, or confirmed by the Bankruptcy Court in order to become effective.

A plan of reorganization will be deemed accepted by holders of claims against and equity interests in Ambac if (1) at least one-half in number and two-thirds in dollar amount of claims actually

 

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voting in each impaired class of claims have voted to accept the plan, and (2) at least two-thirds in amount of equity interests actually voting in each impaired class of equity interests has voted to accept the plan. Under certain circumstances set forth in Section 1129(b) of the Bankruptcy Code, however, the Bankruptcy Court may confirm a plan even if such plan has not been accepted by all impaired classes of claims and equity interests. A class of claims or equity interests that does not receive or retain any property under the plan on account of such claims or interests is deemed to have voted to reject the plan. The precise requirements and evidentiary showing for confirming a plan, notwithstanding its rejection by one or more impaired classes of claims or equity interests, depends upon a number of factors, including, without limitation, the status and seniority of the claims or equity interests in the rejecting class (i.e. secured claims or unsecured claims, subordinate or senior claims, preferred or common stock). Generally, with respect to common stock interests, a plan may be “crammed down” even if the stockholders receive no recovery if the proponent of the plan demonstrates that (1) no class junior to the common stock is receiving or retaining property under the plan and (2) no class of claims or interests senior to the common stock is being paid more than in full.

A significant consideration for any restructuring or reorganization is the impact, if any, on the Company’s estimated $7,603,665 net operating loss (“NOLs”) tax carry forward. The Company considers the NOLs to be a valuable asset. However, the Company’s ability to use the NOLs could be substantially limited if there were an “ownership change” as defined under Section 382 of the Internal Revenue Code of 1986, as amended. In general, an ownership change would occur if shareholders owning 5% or more of the Company’s stock increased their percentage ownership (by value) in the Company to 50% or more, as measured over a rolling three year period beginning with the last ownership change. These provisions can be triggered by new issuances of stock, merger and acquisition activity or normal market trading. On February 2, 2010, the Company entered into a Tax Benefit Preservation Plan to reduce the risk of an ownership change resulting from the trading of the Company’s stock.

Stock issued to the Company’s debt holders in connection with a reorganization could trigger an ownership change if a significant portion of the debt being exchanged had been held by such debt holders for less than 18 months prior to the filing for bankruptcy and certain other factual or legal exceptions were not applicable. Accordingly, extensive buying of the Company’s debentures prior to a bankruptcy filing by persons who could hold 5% or more of the Company’s stock following a bankruptcy reorganization could substantially limit the Company’s ability to use its NOLs. See “Part II, Item 1A. Risk Factors—The Ambac Assurance NOL (and certain other tax attributes or tax benefits of the Ambac Consolidated Tax Group) may be subject to limitation as a result of a bankruptcy reorganization.”

In connection with the Bankruptcy Filing, the Bankruptcy Court issued an interim order (the “Interim Order”) restricting certain transfers of equity interests in and claims against the Company. The purpose of the Interim Order is to preserve the Company’s NOLs, which totaled approximately $7,603,665 as of September 30, 2010. Under section 382 of the Internal Revenue Code of 1986, as amended (the “Tax Code”), transfers by persons or entities holding 5 percent or more of the Company’s outstanding equity interests could impair or permanently eliminate the Company’s NOLs. Moreover, transfers of claims against the Company by persons or entities who may receive 5 percent or more of the reorganized Company’s stock pursuant to a bankruptcy plan of reorganization may impair or permanently eliminate the Company’s NOLs. Accordingly, the Interim Order implements notice and hearing procedures for transfers by a person or entity that beneficially owns, or would beneficially own, more than 13,500,000 shares of the Company’s stock. Transfers of stock in violation of this Interim Order will be void ab initio. In addition, the Interim Order requires persons or entities that beneficially own claims against the Company totaling more than an amount which could permit such claimholder to acquire 4.5 percent or more of the reorganized debtor agree to “sell down” a portion of its claims against the Company prior to a bankruptcy reorganization, such that the claimholder would receive less than 4.5

 

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percent of the reorganized Company’s stock in a bankruptcy plan of reorganization that may qualify for section 382(l)(5) of the Tax Code. Any claimholder who does not comply with the Interim Order would only receive stock in the reorganized Company equal to less than 4.5 percent of the reorganized Company’s outstanding stock.

Ambac Assurance’s CDS portfolio experienced significant losses. The majority of these CDS contracts are on a “pay as you go” basis, and we believe that they are properly characterized as notional principal contracts for U.S. federal income tax purposes. Generally, losses on notional principal contracts are ordinary losses. However, the federal income tax treatment of credit default swaps is an unsettled area of the tax law. As such, it is possible that the Internal Revenue Service may decide that the “pay as you go” CDS contracts should be characterized as capital assets or that certain payments made with respect to the CDS contracts should be characterized as capital losses. Recently, the Internal Revenue Service opened an examination into certain issues related to Ambac Assurance’s tax accounting methods with respect to such CDS contracts and Ambac Assurance’s related characterization of such losses as ordinary losses. Although, as discussed above, Ambac Assurance believes these contracts are properly characterized as notional principal contracts, if the Internal Revenue Service today were to successfully assert, as a result of its examination, that these contracts should be characterized as capital assets or as generating capital losses, Ambac Assurance would be subject to both a substantial reduction in its net operating loss carryforwards and would suffer a material assessment for federal income taxes.

On November 9, 2010, the Company and the Internal Revenue Service (the “IRS”) agreed to a stipulation on the record that provides that the IRS would give notice at least 5 business days prior to taking any action against the Company’s nondebtor subsidiaries in the consolidated tax group that would violate the State Court Injunction, whether or not in effect. The stipulation permits the status quo to be maintained from November 9, 2010 until a hearing on the preliminary injunction that the Company plans to seek under Bankruptcy Code section 105(a) barring assessment and collection of the 2003 through 2008 tax refunds by the IRS against the Company’s nondebtor subsidiaries in the consolidated tax group. On the same date, Ambac filed and served a complaint against the IRS for a declaratory judgment relating to the tax refunds.

Ambac’s liquidity and solvency, both on a near-term basis and a long-term basis, are largely dependent on its current cash and investments of $63,179, dividends from Ambac Assurance, and on the residual value of Ambac Assurance. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future. The principal uses of liquidity will be the payment of operating expenses, expenses incurred in connection with the Bankruptcy Filing and expenses related to pending litigation. The likelihood of dividend payments to Ambac from Ambac Assurance could be further reduced, see “Part II, Item 1A. Risk Factors — The occurrence of certain events could result in the initiation of delinquency proceedings against Ambac Assurance.”

While management believes that Ambac will have sufficient liquidity to satisfy its needs until it emerges from the bankruptcy proceeding, no guarantee can be given that it will be able to pay all such expenses. If its liquidity runs out prior to emergence from bankruptcy, a liquidation of the Company pursuant to Chapter 7 of the Bankruptcy Code will occur. While Ambac’s NOLs could be used to offset income or gain realized prior to a completion of a liquidation, the NOLs would not be available following the liquidation or sale of Ambac’s assets. As a result, in the event of a Chapter 7 liquidation, Ambac is likely to be unable to utilize a substantial portion of its NOLs.

NYSE Delisting

On November 9, 2010, NYSE Regulation, Inc. (“NYSE Regulation”) announced immediate suspension of trading on the New York Stock Exchange (the “NYSE”) of the common stock of the Company and the suspension of trading on the NYSE of certain other securities of the Company (collectively, the “Suspended NYSE Securities”). NYSE Regulation determined that the Company is no longer suitable for listing in light of the Bankruptcy Filing, which is sufficient grounds for the commencement of delisting procedures according to Section 802.01D of the NYSE’s Listed Company Manual. In its announcement regarding the suspension, NYSE Regulation noted the uncertainty as to the timing and outcome of the bankruptcy process as well as the ultimate effect of this process on the Company’s equity holders. Additionally, NYSE Regulation noted that the Company had previously been notified that it had fallen below the NYSE’s continued listing standard for average closing price of less than $1.00 over a consecutive 30 trading day period.

At this time the Company does not intend to take any action to appeal the NYSE’s decision and, therefore, it is expected that the Suspended NYSE Securities will be delisted after completion by the NYSE of application to the Securities and Exchange Commission (the “SEC”).

The Suspended NYSE Securities include:

 

   

Common Stock, $0.01 per share (NYSE ticker symbol: ABK);

 

   

5.875% Debentures, Due March 24, 2103 (NYSE ticker symbol: AKT);

 

   

5.95% Debentures, Due February 28, 2103 (NYSE ticker symbol: AKF); and

 

   

9.50% Equity Units, Due February 15, 2021 (NYSE ticker symbol: ABK PRZ).

As a result of the delisting, the Company’s common stock and the shares of its equity units began trading exclusively on the over-the-counter (“OTC”) market on November 9, 2010. On the OTC market, shares of the Company’s common stock, which previously traded on the NYSE under the symbol ABK, trade under the symbol ABKFQ. Shares of the Company’s equity units, which previously traded on the NYSE under the symbol ABK-PRZ, trade under the symbol ABKOQ.

Segregated Account

On March 24, 2010, Ambac Assurance acquiesced to the request of the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”) to establish a segregated account pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”). Under Wisconsin insurance law, the Segregated Account is a separate insurer from Ambac Assurance for purposes of the Segregated Account Rehabilitation Proceedings (as defined and described below). The purpose of the Segregated Account is to segregate certain segments of Ambac Assurance’s liabilities. The Segregated Account will be operated in accordance with a Plan of Operation (the “Plan of Operation”) and certain operative documents relating thereto (which include the Secured Note, the Reinsurance Agreement, the Management Services Agreement and the Cooperation Agreement). These operative documents provide that the Segregated Account will act exclusively through the rehabilitator. Pursuant to the Plan of Operation, Ambac Assurance has allocated to the Segregated Account (1) certain policies insuring or relating to credit default swaps; (2) residential mortgage-backed securities (“RMBS”) policies; (3) certain Student Loan Policies, some of which were allocated to the Segregated Account on March 24, 2010 (or shortly thereafter), and some of which were allocated on October 8, 2010, after undergoing an assessment process contemplated by the Plan of Operations; and (4) other policies insuring obligations with substantial projected impairments or relating to transactions which have contractual triggers based upon Ambac Assurance’s financial condition or the commencement of rehabilitation, which triggers are potentially damaging (collectively, the “Segregated Account Policies”). The policies described in (4) above include (a) certain types of securitizations, including commercial asset-backed transactions, consumer asset-backed transactions and other types of structured transactions; (b) the policies relating to Las Vegas Monorail Company; (c) policies relating to debt securities purchased by, and the debt securities issued by,

 

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Juneau Investments, LLC and Aleutian Investments, LLC, which are both finance companies owned by Ambac Assurance; (d) policies relating to leveraged lease transactions; and (e) policies relating to interest rate, basis, and/or currency swap or other swap transactions. Ambac Assurance also allocated the following to the Segregated Account: (i) all remediation claims, defenses, offsets, and/or credits (except with respect to recoveries arising from remediation efforts or reimbursement or collection rights), if any, in respect of the Segregated Account Policies, (ii) Ambac Assurance’s disputed contingent liability, if any, under the long-term lease with One State Street, LLC, and its contingent liability (as guarantor), if any, under the Ambac Assurance UK Limited (“Ambac UK”) lease with British Land, (iii) Ambac Assurance’s limited liability interests in Ambac Credit Products, LLC (“ACP”), Ambac Conduit Funding LLC, Aleutian Investments, LLC (“Aleutian”) and Juneau Investments, LLC (“Juneau”) and (iv) all of Ambac Assurance’s liabilities as reinsurer under reinsurance agreements (except for reinsurance assumed from Everspan). Net par exposure as of September 30, 2010 for policies allocated to the Segregated Account, including student loan policies allocated on October 8, 2010, is $45,949,138. Net par exposure allocated to the Segregated Account no longer includes exposure previously assumed from Ambac UK. See below for further discussion on the Commutation of the AUK Reinsurance Agreement on September 28, 2010.

On March 24, 2010, the OCI commenced rehabilitation proceedings with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit the OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. The rehabilitator of the Segregated Account is Sean Dilweg, the Commissioner of Insurance of the State of Wisconsin. On March 24, 2010, the rehabilitation court also issued an injunction effective until further order of the court enjoining certain actions by Segregated Account policyholders and other counterparties, including the assertion of damages or acceleration of losses based on early termination and the loss of control rights in insured transactions. Certain Segregated Account policyholders have filed lawsuits challenging the Segregated Account Rehabilitation Proceedings (see “Legal Proceedings”).

In July 2010, the Segregated Account issued $50,000 of Segregated Account Surplus Notes in connection with the commutation of an insurance policy allocated to the Segregated Account. At September 30, 2010, the Segregated Account Surplus Notes are reported in long-term debt on the consolidated balance sheet with a carrying value of $5,012 based on an imputed interest rate of 53.9% at the date of issuance and have a scheduled maturity of June 7, 2020. Interest on the Segregated Account Surplus Notes is payable annually at the rate of 5.1% on the unpaid principal balance outstanding. All payments of principal and interest on the Segregated Account Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the Segregated Account Surplus Notes, such interest will accrue and compound annually until paid. The Segregated Account Surplus Notes were issued pursuant to a fiscal agency agreement entered into with The Bank of New York Mellon, as fiscal agent.

On October 8, 2010, the Rehabilitator filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Dane County Circuit Court in Wisconsin (the “Rehabilitation Court”). Before the Segregated Account Rehabilitation Plan can become effective it must be confirmed by the Rehabilitation Court. The hearing on the Rehabilitator’s motion for confirmation of the Segregated Account Rehabilitation Plan has been scheduled to begin on November 15, 2010. Claims on Segregated Account Policies remain subject to a payment moratorium until the Segregated Account Rehabilitation Plan becomes effective. Insurance claims presented during the moratorium of $1,083,796 for policies allocated to the Segregated Account have not yet been paid. If the Segregated Account Rehabilitation Plan is confirmed by the Rehabilitation Court, holders of permitted policy claims will receive 25% of their permitted claims in cash and 75% in surplus notes (the “Segregated Account Surplus Notes”) with the same terms as the Ambac Assurance Surplus Notes (as defined below), and delivery of

 

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such cash and Segregated Account Surplus Notes will constitute satisfaction in full of the Segregated Account’s obligations in respect of each claim. The policyholders will not have the option to reject the surplus notes as consideration for settling claim liabilities. The Segregated Account Rehabilitation Plan also makes permanent the injunctions issued by the Rehabilitation Court on March 24, 2010.

Effective November 7, 2010, the Plan of Operation for the Segregated Account was amended for the purpose of allocating to the Segregated Account (i) any and all liabilities (including contingent liabilities) it has or may have, now or in the future, to the Company, or any successor to the Company, in regard to, or respecting, tax refunds and/or the July 18, 1991 Tax Sharing Agreement, as amended (other than any liability to the Company pertaining to any possible misallocation of up to $38,486 of tax refunds received by Ambac Assurance in September 2009 and February 2010), (ii) any and all liabilities (including contingent liabilities) it has or may have, now or in the future, to the IRS and/or the United States Department of the Treasury (the “U.S. Treasury”) in regard to, or in respect of, taxes imposed under the Internal Revenue Code of 1986, as amended (the “Federal Taxes”), for taxable periods ending on or prior to December 31, 2009 and, (iii) to the extent not described in clause (ii), any and all liabilities (including contingent liabilities) Ambac Assurance has or may have, now or in the future, to the IRS and/or the U.S. Treasury in regard to, or respect of, any Federal Tax refunds that were received prior to November 7, 2010 by Ambac Assurance, the Company or their affiliates (each of clauses(i), (ii) and (iii), the “Allocated Disputed Contingent Liabilities”). In addition, on November 8, 2010, the rehabilitation court issued an order for temporary supplemental injunctive relief (the “State Court Injunction”) enjoining the Company, any successor-in-interest, any state court receiver of the Company, all persons purporting to be creditors of the Company, the IRS and all other federal and state governmental entities from commencing or prosecuting any actions, claims, lawsuits or other formal legal proceedings relating to the Allocated Disputed Contingent Liabilities.

Ambac Assurance has issued a $2,000,000 secured note due in 2050 (the “Secured Note”) to the Segregated Account. The Segregated Account has the ability to demand payment from time to time to pay claims and other liabilities. The balance of the Secured Note is $1,918,176 at September 30, 2010, inclusive of capitalized interest since the date of issuance. In addition, once the Secured Note has been exhausted, the Segregated Account has the ability to demand payment from time to time under an aggregate excess of loss reinsurance agreement provided by Ambac Assurance (the “Reinsurance Agreement”) to pay claims and other liabilities. Ambac Assurance is not obligated to make payments on the Secured Note or under the Reinsurance Agreement if its surplus as regards to policyholders is (or would be) less than $100,000, or such higher amount as the OCI permits pursuant to a prescribed accounting practice (the “Minimum Surplus Amount”). As long as the surplus as regards to policyholders is not less than the Minimum Surplus Amount, payments by the general account of Ambac Assurance (the “General Account”) to the Segregated Account under the Reinsurance Agreement are not capped. There is no Wisconsin insurance fund available to pay claims.

Pursuant to the terms of the Plan of Operation (defined below), assets and investments, if any, allocated to the Segregated Account will be available and used solely to satisfy costs, expenses, charges, and liabilities attributable to the items allocated to the Segregated Account. Such assets and investments, if any, will not be charged with any costs, expenses, charges, or liabilities arising out of any other business of Ambac Assurance, except as otherwise provided in the Secured Note or the Reinsurance Agreement. Likewise, assets and investments in the General Account will not be charged with any costs, expenses, charges, or liabilities arising out of the direct business allocated to the Segregated Account, except as otherwise provided in the Secured Note or the Cooperation Agreement (as defined and described below).

The Secured Note will be subject to mandatory prepayment on demand in an amount equal to (i) the cash portion of claim liabilities, loss settlements, commutations and purchases of Segregated

 

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Account Policies (or related insured obligations) due and payable by the Segregated Account (“Segregated Account Policy Cash Payments”), amounts due and payable by the Segregated Account arising out of the non-policy obligations allocated thereto, and any cash interest payment and cash principal repayment under any Segregated Account Surplus Notes in connection with any of the foregoing, provided in each case such amounts due and payable are in accordance with the Segregated Account Rehabilitation Plan and not otherwise disapproved by the rehabilitator of the Segregated Account plus (ii) amounts due and payable by the Segregated Account in respect of specified administrative expenses of the Segregated Account plus (iii) other amounts directed to be paid by the rehabilitator of the Segregated Account in conjunction with the rehabilitation proceeding, minus (iv) the amount of the Segregated Account’s liquid assets as determined by the Segregated Account. In addition, if an event of default occurs under the Secured Note, the Segregated Account is entitled to accelerate the outstanding principal amount due under the Secured Note.

Interest on the Secured Note accrues at the rate of 4.5% per annum, and accrued interest will be added to principal quarterly. Ambac Assurance has secured its obligations under the Secured Note and the Reinsurance Agreement by granting to the Segregated Account a security interest in all of Ambac Assurance’s right, title and interest in installment premiums received in respect of the Segregated Account Policies; reinsurance premiums received in respect of assumed reinsurance agreements with respect to which the liabilities of Ambac Assurance have been allocated to the Segregated Account; recoveries under third party reinsurance agreements in respect of the Segregated Account Policies; and any recoveries arising from remediation efforts or reimbursement or collection rights with respect to policies allocated to the Segregated Account. Pursuant to the Secured Note, Ambac Assurance has made certain covenants to the Segregated Account, including covenants that Ambac Assurance will not, (i) without the Segregated Account’s consent (not to be unreasonably withheld), amend its investment policies if doing so would have a material adverse effect on Ambac Assurance’s ability to perform its obligations under the Secured Note, the Reinsurance Agreement and the documents relating thereto or under any other material agreement to which it is a party, (ii) without the prior approval of the OCI and the rehabilitator of the Segregated Account, directly or indirectly make any distribution to its shareholder or redeem any of its securities and, (iii) without the Segregated Account’s consent (not to be unreasonably withheld), enter into any transaction other than pursuant to the reasonable requirements of Ambac Assurance’s business and which Ambac Assurance reasonably believes are fair and reasonable terms and provisions.

Pursuant to the Reinsurance Agreement, Ambac Assurance has agreed to pay Segregated Account Policy Cash Payments, any cash interest payment and cash principal repayment under any Segregated Account Surplus Notes in connection with any of the foregoing and other amounts directed to be paid by the rehabilitator of the Segregated Account in conjunction with the rehabilitation proceeding, minus the amount of the Segregated Account’s liquid assets as determined by the Segregated Account. Ambac Assurance’s liability under the Reinsurance Agreement will attach only after all principal under the Secured Note has been paid. The Reinsurance Agreement contains the same covenants for the benefit of the Segregated Account as those that appear in the Secured Note, as described in the preceding paragraph.

Policy obligations not transferred to the Segregated Account remain in the General Account, and such policies in the General Account are not subject to and, therefore, will not be directly impacted by, the Segregated Account Rehabilitation Plan. Ambac Assurance is not, itself, in rehabilitation proceedings.

During the Segregated Account Rehabilitation Proceedings, the Rehabilitator controls the management of the Segregated Account. Ambac Assurance will provide certain management and administrative services to the Segregated Account and the Rehabilitator pursuant to a Management Services Agreement (the “Management Services Agreement”), including information technology

 

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services, credit exposure management, treasury, accounting, tax, management information, risk management, loss management, internal audit services and business continuity services. Services will be provided at cost, subject to mutual agreement of the Segregated Account and Ambac Assurance. Either party may terminate the Management Services Agreement for cause upon 120 days written notice (or such shorter period as the rehabilitator may determine) and the Segregated Account may terminate without cause at any time upon at least 30 days prior notice. If the Segregated Account elects to terminate the Management Services Agreement, Ambac Assurance will not have the right to consent to the replacement services provider.

Ambac Assurance and the Segregated Account have also entered into a Cooperation Agreement (the “Cooperation Agreement”), pursuant to which the parties have agreed to certain matters related to decision-making, information sharing, tax compliance and allocation of expenses (including an agreement by Ambac Assurance to reimburse the Segregated Account for specified expenses to the extent not reimbursed under the Secured Note, subject to the Minimum Surplus Amount). Ambac Assurance has made certain covenants to the Segregated Account, including an agreement to not enter into any transaction involving more than $5,000 (or such higher amount as is agreed with the rehabilitator) without the Segregated Account’s prior consent (other than policy claim payments made in the ordinary course of business and investments in accordance with Ambac Assurance’s investment policy), and providing the Segregated Account with an annual budget and projection for Ambac Assurance and its subsidiaries for the forthcoming fiscal year, as well as quarterly updates thereto. The Cooperation Agreement also addresses Ambac Assurance’s rights in the event Ambac Assurance is no longer the management and administrative services provider to the Segregated Account as described above.

Settlement Agreement

On June 7, 2010, Ambac Assurance Corporation entered into a Settlement Agreement (the “Settlement Agreement”) with the counterparties (the “Counterparties”) to outstanding credit default swaps with Ambac Credit Products, LLC (“ACP”) that were guaranteed by Ambac Assurance. Pursuant to the terms of the Settlement Agreement, in exchange for the termination of the Commuted CDO of ABS Obligations (as defined below), Ambac Assurance paid to the Counterparties in the aggregate (i) $2,600,000 in cash and (ii) $2,000,000 in principal amount of newly issued surplus notes of Ambac Assurance (the “Ambac Assurance Surplus Notes”). In addition, effective June 7, 2010, the outstanding credit default swaps with the Counterparties remaining in the General Account of Ambac Assurance have been amended to remove certain events of default and termination events, as set forth in the Settlement Agreement.

Pursuant to the Settlement Agreement, Ambac Assurance has filed an amendment to its articles of incorporation. Under such amendment, at all times after September 30, 2010, at least two members of the board of directors of Ambac Assurance must be Unaffiliated Qualified Directors (as defined in the Settlement Agreement) and, at all times after November 29, 2010, at least one-third (and, in any event, not less than three members) of the board of directors of Ambac Assurance must be Unaffiliated Qualified Directors. If at any time Ambac Assurance does not have the requisite number of Unaffiliated Qualified Directors, Ambac Assurance has agreed to use its commercially reasonable efforts to find additional Unaffiliated Qualified Directors. Effective October 25, 2010, one-third of Ambac Assurance’s Board of Directors are Unaffiliated Qualified Directors.

The Settlement Agreement includes covenants that remain in force until the Ambac Assurance Surplus Notes have been redeemed, repurchased or repaid in full. These covenants generally restrict the operations of Ambac Assurance and its subsidiaries to runoff activities. Certain of these restrictions may be waived with the approval of a majority of the Unaffiliated Qualified Directors and/or the OCI. However, other restrictions may only be waived with the approval of the holders of a majority of the outstanding Ambac Assurance Surplus Notes (excluding any notes held by Ambac Assurance or its affiliates) that cast a ballot and, in certain cases, with the approval of all of the Counterparties.

 

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     (Dollars in thousands, except share amounts)

 

 

Pursuant to a commutation agreement entered into with each of the Counterparties that is a party to credit default swaps written by ACP with respect to certain CDO of ABS obligations and related financial guaranty insurance policies written by Ambac Assurance with respect to ACP’s obligations thereunder, Ambac Assurance and ACP have commuted all of such obligations (the “Commuted CDO of ABS Obligations”), totaling $16,542,575 of par. In addition to the commutation of the Commuted CDO of ABS Obligations, Ambac Assurance has also commuted for $96,518 of cash certain additional obligations, including certain non-CDO of ABS obligations, to the Counterparties with par or notional amounting to $1,406,544. Ambac Assurance commuted another CDO of ABS transaction in an amount equal to its remaining par value of $90,016. It is expected that, subject to certain conditions, certain other non-CDO of ABS obligations with par amounting to a maximum of approximately $1,494,125 will be commuted within the next twelve months for a maximum amount of approximately $115,000 of cash plus surplus notes of Ambac Assurance with a par value of $60,000. Each of the Counterparties, in the aggregate and Ambac Assurance, ACP and Ambac, in the aggregate, have released the other party from any claims relating to any credit default swaps or financial guaranty insurance policies commuted pursuant to the Commutation Agreements. In addition, Ambac Assurance, ACP and Ambac, in the aggregate, and a Counterparty have generally released the other parties from any claims relating to actions taken or omitted to be taken prior to June 7, 2010, subject to certain exceptions.

At September 30, 2010, the Ambac Assurance Surplus Notes issued in connection with the Settlement Agreement are reported in long-term debt on the consolidated balance sheet with a carrying value of $201,542 based on an imputed interest rate of 53.9% at the date of issuance and have a scheduled maturity of June 7, 2020. Interest on the Ambac Assurance Surplus Notes is payable annually at the rate of 5.1% on the unpaid principal balance outstanding. All payments of principal and interest on the Ambac Assurance Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the Ambac Assurance Surplus Notes, such interest will accrue and compound annually until paid. The Ambac Assurance Surplus Notes were issued pursuant to a Fiscal Agency Agreement entered into on June 7, 2010 with The Bank of New York Mellon, as fiscal agent (the “Fiscal Agency Agreement”).

Ambac Assurance has entered into call options with certain of the Counterparties pursuant to which, with the prior consent of OCI, Ambac Assurance may repurchase Ambac Assurance Surplus Notes from such Counterparties. As of the date hereof, Ambac Assurance has options to call an aggregate of $940,000 in principal amount of Ambac Assurance Surplus Notes at a weighted average call price of $0.22 per $1.00 face amount. At September 30, 2010, these options have a weighted average maturity of approximately 23 months.

Pursuant to the terms of the Settlement Agreement, on June 7, 2010, Ambac entered into an amendment to the Tax Sharing Agreement (the “Tax Sharing Agreement”) with its affiliates. Under the Tax Sharing Agreement, the consolidated net operating losses (“NOL”) of the group are treated as an asset of Ambac Assurance and its subsidiaries. Ambac is required to compensate Ambac Assurance on a current basis for use of any portion of that asset, except that Ambac is not required to compensate Ambac Assurance for Ambac’s use of NOL in connection with cancellation of debt income associated with restructurings of its debt outstanding as of March 15, 2010. The Tax Sharing Agreement can be amended with the consent of OCI and majority of the Unaffiliated Qualified Directors.

Ambac UK

Pursuant to the Amended and Restated 1997 Reinsurance Agreement between Ambac UK and Ambac Assurance (the “AUK Reinsurance Agreement”), Ambac Assurance reinsured on a quota share basis 90% of the liabilities under policies issued by Ambac UK, and reinsured on an excess of loss basis Ambac UK policy liabilities in excess of £500,000 per anum. Ambac UK purported to terminate the

 

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AUK Reinsurance Agreement on March 22, 2010, and then again on March 24, 2010, after commencement of the Proceeding. On March 24, 2010, Ambac Assurance’s liabilities under the AUK Reinsurance Agreement were allocated to the Segregated Account.

On September 28, 2010, Ambac Assurance entered into a Commutation and Release Agreement (the “AUK Commutation Agreement”) with Ambac UK and the Special Deputy Commissioner of OCI, pursuant to which (i) the “AUK Reinsurance Agreement” was commuted and (ii) the Net Worth Maintenance Agreement, dated as of January 1, 1997, by and between Ambac UK and Ambac Assurance (the “NWMA”) was terminated in exchange for, among other things, certain mutual releases, including, without limitation, any right of Ambac Assurance or the Segregated Account to reinsurance premiums from Ambac UK. Ambac Assurance paid a nominal termination amount of one U.S. dollar to Ambac UK in connection with the commutation. The overall consolidated effect of terminating this reinsurance agreement was a net gain of $157,792, which is reported in Financial Guarantee Other Income. This gain resulted primarily from the recognition of foreign currency gains that, prior to the termination, were not reflected in certain of Ambac Assurance’s non-monetary assets or liabilities, such as unearned premium reserves or deferred acquisition costs, since these non-monetary assets and liabilities were required to be recorded based on their historical foreign exchange rates.

Impact of Settlement Agreement and Segregated Account Rehabilitation Proceeding on Ambac

Under the terms of the Settlement Agreement, Ambac Assurance has issued Ambac Assurance Surplus Notes to the Counterparties. In addition, pursuant to the terms of the Segregated Account Rehabilitation Plan, the Segregated Account will issue Segregated Account Surplus Notes (together with the Ambac Assurance Surplus Notes, the “Surplus Notes”) to pay a portion of the claims of the Segregated Account. The aggregate par value of the Surplus Notes issued by Ambac Assurance will be substantial. The Surplus Notes rank senior to Ambac’s equity investment in Ambac Assurance. There is residual value to Ambac in Ambac Assurance only to the extent that funds remain at Ambac Assurance after the payment of claims under outstanding financial guaranty policies and the redemption, repurchase or repayment in full of the Surplus Notes and Ambac Assurance’s auction market preferred shares. The value of Ambac’s equity investment in Ambac Assurance is difficult to estimate, and will primarily depend on the performance of Ambac Assurance’s insured portfolio (i.e., the ultimate losses therein relative to its claims paying resources), ongoing remediation efforts of Ambac Assurance with respect to policies allocated to the Segregated Account, including those relating to residential mortgage-backed securities, and on other factors, including Ambac Assurance’s ability to repurchase Surplus Notes and its auction market preferred shares at less than their face value.

In addition, the rehabilitator of the Segregated Account retains significant decision-making authority with respect to the Segregated Account and has the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities which remain in Ambac Assurance, and such decisions will be made by the rehabilitator for the benefit of policyholders and the rehabilitator will not take into account the interests of securityholders of Ambac. Actions taken by the rehabilitator could further reduce the equity value of Ambac Assurance.

Tax Treatment of Surplus Notes

It is possible that the Surplus Notes may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. If the Surplus Notes are characterized as equity of Ambac Assurance and it is determined the Surplus Notes represent more than 20% of the total value of the stock of Ambac Assurance, Ambac Assurance may no longer be characterized as an includable corporation that is affiliated with Ambac. As a result, Ambac Assurance may no longer be characterized as a member of the U.S. federal income tax consolidated group of which Ambac is the common parent (the “Company Consolidated Tax Group”) and Ambac Assurance would be required to file a separate consolidated tax return as the common parent of a new U.S. federal income tax consolidated group including Ambac Assurance, as the new common parent, and Ambac Assurance’s subsidiaries (the “Ambac Assurance Consolidated Tax Group”).

 

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To the extent Ambac Assurance is no longer a member of the Company Consolidated Tax Group, the Ambac Assurance NOL (and certain other available tax attributes of Ambac Assurance and the other members of the Ambac Assurance Consolidated Tax Group) may no longer be available for use by Ambac or any of the remaining members of the Company Consolidated Tax Group to reduce the U.S. federal income tax liabilities of the Company Consolidated Tax Group. This could result in a material increase in future tax liabilities of Ambac Consolidated Tax Group. In addition, certain other benefits resulting from U.S. federal income tax consolidation may no longer be available to the Company Consolidated Tax Group, including certain favorable rules relating to transactions occurring between members of the Company Consolidated Tax Group and members of the Ambac Assurance Consolidated Tax Group.

If the Surplus Notes are characterized as equity of Ambac Assurance and it is determined the Surplus Notes represent more than 50% of the total value of the stock of Ambac Assurance, the Ambac Assurance NOL (and certain other tax attributes or tax benefits of the Ambac Assurance Consolidated Tax Group) may be subject to limitation, including the limitation provided by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). If Section 382 were applicable with respect to the Ambac Assurance Consolidated Tax Group, in general, the Ambac Assurance Consolidated Tax Group annual use of the group’s NOL may be limited to an amount equal to the product of (i) the value of the Ambac Assurance Consolidated Tax Group’s stock and (ii) the applicable federal long-term tax exempt interest rate. However, certain exemptions to the Code Section 382 limitation may be applicable.

Furthermore, to the extent Ambac Assurance is no longer characterized as a member of the Company Consolidated Tax Group, the Ambac Assurance Consolidated Tax Group may not reconsolidate with Ambac Consolidated Tax Group for a period of five years following such event, even if Ambac were to be characterized as reacquiring or owning 80% or more of the stock of the Ambac Assurance Consolidated Tax Group following any deconsolidation. In addition, depending upon certain facts related to the potential deconsolidation of the Ambac Assurance Consolidated Tax Group and any reconsolidation with the Company Consolidated Tax Group, the acquisition by the Company Consolidated Tax Group of additional value with respect to the stock of the Ambac Assurance Consolidated Tax Group may also result in the imposition of a Code Section 382 limitation with respect to the Ambac Assurance Consolidated Tax Group’s NOL, reducing or eliminating the potential tax benefit of the NOL to the Ambac Assurance Consolidated Tax Group.

Reclassifications:

Certain reclassifications have been made to prior periods’ amounts to conform to the current period’s presentation, including those related to the adoption of ASU 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprise Involved with Variable Interest Entities.

(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 adopted in 2009. Retrospective application is required. Ambac had participating securities consisting of nonvested common stock with the same voting and dividend rights as our common stock. These shares of common stock vested in January 2010. Accordingly, Ambac applied the two-class

 

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method in 2009 and is no longer required to apply the two-class method in 2010. Basic net income per share is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during 2010. 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 2009. The amount of income allocated to participating securities amounted to a $0.03 and $0.00 reduction to basic net income per common share outstanding during the three and nine months ended September 30, 2009, respectively.

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 plus effects of assumed debt retirement 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, 2010 and 2009. The following table presents securities outstanding that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because they were antidilutive for the three and nine months ended September 30, 2010 and 2009:

 

     Three Months Ended
Sept. 30,
     Nine Months Ended
Sept. 30,
 
     2010         2009         2010         2009   

Stock options

     2,704,875         3,832,109         2,840,390         3,961,631   

Restricted stock and units

     994,065         2,655,417         1,120,815         2,814,636   

Stock purchase contracts

     37,037,000         37,037,000         37,037,000         37,037,000   

(3) Application of the New Consolidation Accounting Standard on Special Purposes Entities, Including Variable Interest Entities

In December 2009, the FASB issued ASU 2009-16, Transfers and Servicing (Topic 860): Accounting for Transfers of Financial Assets and ASU 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprise Involved with Variable Interest Entities. Ambac adopted ASU 2009-16 and ASU 2009-17 effective January 1, 2010. Among other changes, ASU 2009-16 eliminated the concept of a qualifying special-purpose entity (QSPE) and all QSPEs need to be considered for consolidation under ASU 2009-17. Among other things, ASU 2009-17 requires an enterprise to perform an analysis to determine whether the enterprise’s variable interests give it a controlling financial interest in a variable interest entity (VIE). ASU 2009-17 identifies the primary beneficiary of a VIE as the enterprise that has both the following characteristics: a) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and b) the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

ASU 2009-17 eliminated the quantitative approach previously required to determine the primary beneficiary of a VIE, which was based on determining which enterprise absorbs the majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both upon the inception of that holder’s involvement in the VIE. ASU 2009-17 requires ongoing reassessments of whether an enterprise is the primary beneficiary of a VIE. The previous guidance required reconsideration of whether an enterprise is the primary beneficiary only when specific events occur.

 

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A VIE is an entity: a) that lacks enough equity investment at risk to permit the entity to finance its activities without additional subordinated financial support from other parties; or b) where the group of equity holders does not have: (1) the power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance; (2) the obligation to absorb the entity’s expected losses; or (3) the right to receive the entity’s expected residual returns. Ambac performs ongoing assessments to determine if we are the primary beneficiary of the VIE and, as such, conclusions may change over time. The determination of whether Ambac is the primary beneficiary involves performing a qualitative analysis of the VIE that includes, among other factors, its capital structure, contractual terms including the rights of each variable interest holder, the activities of the VIE, whether Ambac has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, whether Ambac has the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE, related party relationships and the design of the VIE.

Ambac has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac has provided financial guarantees, 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. Finally, Ambac is an investor in collateralized debt obligations, mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE and/or Ambac does not have rights that direct the activities that are most significant to such VIE. Refer to Note 8 for our exposure in such securities issued by VIEs. Our maximum exposure to loss is limited to the cost of our investments.

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, 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. Generally, upon deterioration in the performance of a transaction or upon an event of default as specified in the transaction legal documents, Ambac will obtain certain loss remediation rights. These rights enable Ambac to direct the activities of the entity that most significantly impact the entity’s economic performance.

We determined that Ambac generally has the obligation to absorb the VIE’s expected losses given that we have issued financial guarantees supporting the liabilities (and in certain cases assets) of a VIE. We also determined for certain transactions that experienced the aforementioned performance deterioration, that we had the power, through voting rights or similar rights, to direct the activities of

 

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certain VIEs that most significantly impact the VIE’s economic performance because: a) certain triggers had been breached in these transactions resulting in Ambac having the ability to exercise certain loss remediation activities, or b) due to the passive nature of the VIEs’ activities, Ambac’s contingent loss remediation rights upon a breach of certain triggers in the future is considered to be the power to direct the activities that most significantly impact the VIEs’ economic performance.

Ambac Sponsored VIEs:

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 special purpose entities are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve these entities. The permitted activities of these entities are limited to those outlined below. As a result of the adoptions of both ASU-2009-16 and ASU 2009-17 on January 1, 2010, Ambac was required to consolidate these VIEs on January 1, 2010. As mentioned below, effective March 24, 2010, Ambac was required to deconsolidate these entities because Ambac’s policies issued to these entities have been allocated to the Segregated Account of Ambac Assurance. The consolidation of these entities did not have any effects on Ambac’s beginning retained earnings as these entities were accounted for at fair value before initial consolidation. Prior to 2010 and upon deconsolidation, Ambac has elected to account for its equity interest in these entities at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments. We believe that the fair value of these investments in these entities provides for greater transparency for recording profit or loss as compared to the equity method under ASC Topic 323, Investments – Equity Method in Joint Ventures. At September 30, 2010 and December 31, 2009 the fair value of these entities is $18,758 and $18,843, respectively, and is reported within Other Assets within the Consolidated Balance Sheets. The change in fair value of these entities for the three months ended September 30, 2010 and September 30, 2009, is ($1,753) and $408, respectively, and is included within Other Income on the Consolidated Statements of Operations. The change in fair value of these entities for the nine months ended September 30, 2010 and September 30, 2009, is ($85) and ($495), respectively.

As of September 30, 2010, there have been 15 individual transactions with these entities, of which 6 are outstanding. In each case, Ambac sold fixed income debt obligations to these entities. The fixed income debt obligations are composed of asset-backed securities and utility obligations with a weighted average rating of BBB+ and weighted average life of 7.5 years at September 30, 2010. The purchase by these entities is financed through the issuance of medium-term notes (“MTNs”), which are cross-collateralized by the purchased assets. The MTNs have the same expected weighted average life as the purchased assets. Derivative contracts (interest rate and currency swaps) may be used within the entities for economic hedging purposes only. Hedges are established at the time MTNs are issued to purchase financial assets. The activities of these entities 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, 2010, Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities.

Insurance premiums paid to Ambac Assurance by these entities are earned in a manner consistent with other insurance policies, over the risk period. Additionally, 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.

 

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There were no assets sold to these entities during the nine months ended September 30, 2010 and the year ended December 31, 2009. Ambac Assurance received premiums for issuing the financial guarantee policies on the assets, MTNs and derivative contracts of $578 and $1,188 for the three months ended September 30, 2010 and 2009, respectively; and $2,114 and $3,828 for the nine months ended September 30, 2010 and 2009, respectively. Ambac paid claims to these entities of $0 and $0 for the three months ended September 30, 2010 and 2009, respectively, and $24,411 and $42,588 for the nine months ended September 30, 2010 and 2009, respectively, under these financial guarantee contracts. Ambac also earned fees for providing other services amounting to $5 and $46 for the three months ended September 30, 2010 and 2009, respectively, and $42 and $154 for the nine months ended September 30, 2010 and 2009, respectively.

Derivative contracts are provided by Ambac Financial Services to these entities. Consistent with other non-hedging derivatives, Ambac Financial Services accounts for these contracts on a trade date basis at fair value. Ambac Financial Services received $25, and paid $13,798 for the three months ended September 30, 2010 and 2009, respectively; and received $6,335 and paid $12,248 for the nine months ended September 30, 2010 and 2009, respectively, under these derivative contracts.

Consolidation of VIEs:

Except for consolidations resulting from the adoption of ASU 2009-17 on January 1, 2010, upon initial consolidation of a VIE, we recognized a gain or loss in earnings for the difference between: a) the fair value of the consideration paid, the fair value of any non-controlling interests and the reported amount of any previously held interests and b) the net amount as measured on a fair value basis, of the assets and liabilities consolidated. Upon deconsolidation of a VIE, we recognized a gain or loss for the difference between: a) the fair value of any consideration received, the fair value of any retained non-controlling investment in the VIE and the carrying amount of any non-controlling interest in the VIE and b) the carrying amount of the VIE’s assets and liabilities. Gains or losses from consolidation and deconsolidation that are reported in earnings are reported within Financial Guarantee: Income (Loss) on variable interest entities.

Upon the adoption of ASU 2009-17, Ambac generally measured the assets and liabilities of newly consolidated VIEs at fair value, as the carrying amount transition method was not practical. The carrying amount transition method (whereby assets, liabilities, and noncontrolling interests of the VIE are recorded in amounts that would have been carried in the consolidated financial statements if ASU 2009-17 had been effective when Ambac first met the conditions to be the primary beneficiary) was used for one VIE. Ambac has elected to account for the assets and liabilities of the VIEs which were consolidated at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments in subsequent periods. The fair value option is elected to allow for consistency in the measurement attributes of assets and liabilities of these VIEs. For VIEs where the assets, liabilities, and noncontrolling interests were measured at initial consolidation under the carrying amount transition method, balances continue to be measured and reported based on other applicable GAAP guidance.

Impact of adopting ASU 2009-17 and ASU 2009-16

As a result of adopting ASU 2009-17, a cumulative effect gain adjustment of $705,046 was recorded as a net increase to total equity as of January 1, 2010 (increase in assets of $21,960,991 offset by an increase in liabilities of $21,255,945), which includes changes to the opening balance of retained earnings and accumulated other comprehensive loss, net of taxes as Ambac was required to consolidate 83 additional VIEs. The types of entities that Ambac was required to consolidate included: (i) RMBS securitization trusts as a result of financial guarantee insurance policies on the senior debt of such trusts; (ii) collateralized debt obligation trusts as a result of credit derivative contracts issued to investors of the

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

debt of such trust; (iii) international and other asset-backed securitizations as a result of insurance policies guarantying the debt of such financing entities; and (iv) other transactions, including the Ambac sponsored special purpose entities, Juneau and Aleutian. The net impact of consolidating these VIEs on Ambac’s balance sheet at adoption of ASU 2009-17 and ASU 2009-16 was as follows:

 

   

Ambac is required to recognize the assets and liabilities of the VIE. The aggregate amount of the VIE assets and liabilities recorded upon adoption were generally recognized at fair value as described above.

 

   

For a financial guarantee policy issued to a consolidated VIE, Ambac does not reflect the financial guarantee insurance policy in accordance with the related insurance accounting rules under ASC Topic 944, Financial Services—Insurance. The financial guarantee policy would be eliminated upon consolidation. Consequently, Ambac eliminated insurance assets (premium receivables, reinsurance recoverables, deferred ceded premium, subrogation recoverable and deferred acquisition costs) and insurance liabilities (unearned premiums, loss and loss expense reserves and ceded premiums payable) from the Consolidated Balance Sheet.

 

   

For VIEs consolidated as a result of Ambac’s credit derivative transactions, the consolidation results in offsetting increases to assets and liabilities with no transition effect. The credit derivative liabilities remained on Ambac’s consolidated financial statements and were not eliminated upon the consolidation of the VIE because Ambac’s credit derivative contracts are not entered into directly with the VIE, but rather entered into with third parties, typically the holders of the notes issued by the VIEs.

 

   

For investment securities owned by Ambac that are debt instruments issued by the VIE, the investment securities balance is eliminated upon consolidation.

The impact of the above items upon adoption of ASU 2009-17 and ASU 2009-16 on January 1, 2010 is summarized below:

 

Addition of VIE assets

   $ 22,839,549   

Addition of VIE liabilities

     (22,525,422
        

Net VIE assets added upon adoption

     314,127   
  

Elimination of insurance assets

     (833,716

Elimination of insurance liabilities

     1,269,477   
        

Net insurance liabilities eliminated upon adoption

     435,761   
  

Elimination of intercompany invested assets

     (44,842
        

Net decrease of Shareholders’ deficit upon adoption

   $ 705,046   
        

As a result of the establishment of the Segregated Account and the rehabilitation proceedings with respect to the Segregated Account as discussed in Note 1, including the terms of the management agreement which permit OCI to terminate the agreement with Ambac at any point in time, Ambac no longer has the unilateral power to direct the activities of the VIEs that most significantly impact the entity’s economic performance for those insurance policies that were allocated to the Segregated Account. Accordingly, Ambac deconsolidated 49 VIEs, including 43 RMBS securitization trusts and certain other entities including the Ambac sponsored VIEs, Juneau and Aleutian, effective March 24, 2010. Juneau and Aleutian are related parties of Ambac. While the RMBS securitization and other trusts are not related parties of Ambac, the company continues to provide financial guarantee policies on the senior debt or

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

assets of such trusts upon deconsolidation. The effect of this deconsolidation was to reverse a significant portion of the transition adjustment to adopt ASU 2009-17 on January 1, 2010 and to deconsolidate one additional VIE which was consolidated as of December 31, 2009, effectively re-establishing insurance accounting for such transactions.

These deconsolidated VIEs contributed a combined loss of $0 during the three months and $495,077 during nine months ended September 30, 2010, which is included in Financial Guarantee: Income (loss) income on variable interest entities. The loss on these VIEs is primarily a result of deconsolidation. Additional details of the effect of deconsolidation associated with insurance policies allocated to the Segregated Account are as follows:

 

   

Ambac re-established $244,540 in insurance assets (premium receivables, reinsurance recoverables, deferred ceded premium, subrogation recoverable and deferred acquisition costs), $780,077 in insurance liabilities (unearned premiums, loss and loss expense reserves and ceded premiums payable) and $48,530 in fixed income securities, at fair value as of March 31, 2010 in connection with the establishment of the Segregated Account. The fair value of available-for-sale securities at deconsolidation becomes the new cost basis for such securities.

 

   

Of the VIE assets and liabilities consolidated on January 1, 2010, Ambac removed $4,760,396 and $4,800,857, respectively, upon deconsolidation.

As a result of the Settlement Agreement that Ambac Assurance entered into with Counterparties to credit default swaps during the second quarter of 2010, as discussed in Note 1, Ambac commuted certain CDO of ABS obligations and related financial guaranty insurance policies written by Ambac Assurance with respect to ACP’s obligations thereunder. During the third quarter of 2010, all financial guarantee policies associated with one VIE expired in connection with full pay-down of the guaranteed obligations. Such obligations were Ambac’s only variable interests in the associated VIEs. Accordingly, Ambac no longer has the unilateral power to direct the activities of these VIEs that most significantly impact the entities’ economic performance, or any further involvement in these VIEs. In connection with these events, Ambac deconsolidated one VIE during the third quarter of 2010 and 18 VIEs during the nine months ended September 30, 2010. Financial Guarantee: Income (loss) on variable interest entities includes losses of ($511) and ($1,023) during the three and nine months ended September 30, 2010 associated with these formerly consolidated VIEs, respectively.

As of September 30, 2010, consolidated VIE assets and liabilities relating to 23 consolidated entities were $19,159,915 and $18,929,669, respectively. As of December 31, 2009, consolidated VIE assets and liabilities were $3,276,615 and $3,012,170, respectively. 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. Ambac evaluates the net income statement effects and earnings per share effects to determine attributions between Ambac and non-controlling interests as a result of consolidating a VIE. Ambac has determined that the net changes in fair value of most consolidated VIE assets and liabilities are attributable to Ambac due to Ambac’s interest through financial guarantee premium and loss payments with the VIE. VIE activities related to entities that remain consolidated as of September 30, 2010 resulted in a gain (loss) of $26,888 and ($8,774) for the three and nine months ended September 30, 2010, respectively, which is included in Financial Guarantee: Income (loss) income on variable interest entities.

The financial reports of certain VIEs 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 certain VIEs are consolidated on a time lag that is no longer than 90 days.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

The table below provides the fair value of fixed income securities, by asset-type, held by consolidated VIEs as of September 30, 2010 and December 31, 2009:

 

     September 30, 2010      December 31, 2009  

Investments:

     

Corporate obligations

   $ 1,939,492       $ 160,518   

Residential mortgage-backed securities

     —           173,066   

Other asset-backed securities

     —           192,363   

The following table provides supplemental information about the loans held as assets and long-term debt associated with the VIEs for which the fair value option has been elected as of September 30, 2010 and December 31, 2009:

 

     Estimated fair value      Unpaid principal balance  

September 30, 2010:

     

Loans

   $ 17,007,648       $ 17,625,336   

Long-term debt

   $ 17,130,379       $ 19,043,010   

December 31, 2009:

     

Loans

   $ 2,428,352       $ 2,459,003   

Long-term debt

   $ 2,789,556       $ 3,547,842   

Loans at September 30, 2010 included loans receivable that are 90 days or more past due, which had an aggregate unpaid principal balance of $21,353 and fair value of $8,911. See Note 11, Fair Value Measurements for disclosures about the valuation methodologies used to determine fair value of VIE assets and liabilities.

The total unpaid principal amount of all outstanding long-term debt associated with the VIEs were $19,247,665 and $3,766,914 as of September 30, 2010 and December 31, 2009, respectively. The range of final maturity dates of the outstanding long-term debt associated with the VIEs is August 2011 to December 2047 as of September 30, 2010. As of September 30, 2010, the interest rates on the VIE long-term debt ranged from 0.74% to 12.63%.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

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 variable interests in non-consolidated VIEs resulting from financial guarantee and credit derivative contracts by major underlying asset classes as of September 30, 2010:

 

     Carrying Value of Assets and Liabilities  
     Maximum
Exposure To
Loss(1)
     Insurance
Assets (2)
     Insurance
Liabilities(3)
     Derivative
Liabilities(4)
 

Global Structured Finance:

           

Collateralized debt obligations

   $ 22,483,848       $ 50,111       $ 118,811       $ 188,090   

Mortgage-backed – residential

     38,532,733         1,091,706         3,830,051         196   

Mortgage-backed – commercial

     974,313         —           —           7,820   

Other consumer asset-backed

     13,395,292         166,925         736,388         10,234   

Other commercial asset-backed

     22,222,423         966,147         931,082         6,891   

Other

     8,788,215         147,238         533,973         1,875   
                                   

Total Global Structured Finance

     106,396,824         2,422,127         6,150,305         215,106   

Global Public Finance

     41,760,416         655,947         779,997         11,849   
                                   

Total

   $ 148,157,240       $ 3,078,074       $ 6,930,302       $ 226,955   
                                   

 

(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 assets represents the amount recorded in “Premium receivables” and “Subrogation recoverable” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(3) 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.
(4) Derivative liabilities represents the fair value recognized on credit derivative contracts on Ambac’s Consolidated Balance Sheets.

(4) 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 expected 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, 2010 and December 31, 2009 is 2.9% and 2.7%, respectively, and 11.2 years and 10.2 years, respectively. Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

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.

Below is the premium receivable roll-forward for the period ended September 30, 2010 and December 31, 2009:

 

     September 30,
2010
    December 31,
2009
 

Premium receivable at December 31, 2009

   $  3,718,158     

Impact of adoption of ASU 2009-17(1)

     (670,997  
          

Premium receivable at January 1, 2010 and 2009

     3,047,161      $  4,622,858   

Premium payments received

     (204,780     (416,280

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

     (219,304     (628,421

Accretion of premium receivable discount

     64,622        111,587   

Deconsolidation of certain VIEs(1)

     148,213        —     

Other adjustments (including foreign exchange)

     (33,101     28,414   
                

Premium receivable at September 30, 2010 and December 31, 2009

   $ 2,802,811      $ 3,718,158   
                

 

(1) Refer to Note 3 of these unaudited consolidated financial statements for discussion of the new consolidation accounting standard.

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 expected 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 to deferred acquisition costs) and recognized in income in proportion to ceded premiums.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at September 30, 2010:

 

      Future
premiums
expected to
be collected(1)
     Future
expected
premiums  to be

earned, net of
reinsurance(1)
 

Three months ended:

     

December 31, 2010

   $ 65,428       $ 84,359   

Twelve months ended:

     

December 31, 2011

     236,742         319,817   

December 31, 2012

     222,944         295,045   

December 31, 2013

     209,998         269,659   

December 31, 2014

     200,235         249,787   

Five years ended:

     

December 31, 2019

     887,738         1,042,079   

December 31, 2024

     762,978         784,060   

December 31, 2029

     636,447         569,305   

December 31, 2034

     408,973         331,818   

December 31, 2039

     160,777         129,819   

December 31, 2044

     39,456         35,278   

December 31, 2049

     10,240         10,440   

December 31, 2054

     1,176         2,186   

December 31, 2059

     5         3   
                 

Total

   $ 3,843,137       $ 4,123,655   
                 

 

(1) The future undiscounted premiums expected to be collected and future net premiums earned disclosed in the above table relate to the discounted 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 ended September 30, 2010 was $30,004 and $96,450, respectively. 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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Item 1. 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, 2010 and 2009:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
   2010      2009     2010     2009  

Revenues:

         

Financial Guarantee:

         

Gross premiums written

   $ 53,200       ($ 231,213   ($ 137,935   ($ 388,884

Ceded premiums written

     45,583         389,679        62,521        577,225   
                                 

Net premiums written

   $ 98,783       $ 158,466      ($ 75,414   $ 188,341   
                                 

(5) Losses and Loss Expenses

Ambac’s financial guarantee insurance policies generally pay scheduled interest and principal if the issuer of the insured obligation fails to meet its obligation. Until the Segregated Account Rehabilitation Plan is approved, it is anticipated that no claims will be paid on Segregated Account Policies, except as approved by the rehabilitation court. 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 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.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

All credits are assigned risk classifications by the Surveillance Group using the following guidelines:

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).

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

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, reserves have been established to fully cover such claims, and no claim volatility is expected.

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 an internal Ambac 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 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, management-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 loss reserves at September 30, 2010 was 2.26%.

Loss expenses are established for anticipated expenses associated with loss mitigation strategies, such as legal and consulting costs for credits which may or may not have an associated loss reserve. Ambac establishes loss expense reserves based on our estimate of expected net cash outflows for loss expenses.

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

Additional surveillance 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 frequently 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.

As a consequence of the Segregated Account Rehabilitation Proceedings, the rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation and loss mitigation. Similarly, by virtue of the contracts executed between Ambac Assurance and the Segregated Account in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities which remain in Ambac Assurance. As such, the discussion of Ambac’s risk management practices is qualified by reference to the rehabilitator’s exercise of its discretion to alter or eliminate any of these risk management practices.

 

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     (Dollars in thousands, except share amounts)

 

 

The table below summarizes information related to policies currently included in Ambac’s loss reserves at September 30, 2010:

Surveillance Categories

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     28        9        35        135        120        1        328   

Remaining weighted-average contract period (in years)

     5        9        17        19        9        10        14   

Gross insured contractual payments outstanding:

              

Principal

     2,088,253        511,322        2,548,273        17,509,799        14,137,834        47        36,795,528   

Interest

     496,391        148,248        2,881,579        11,956,474        4,061,325        27        19,544,044   
                                                        

Total

     2,584,644        659,570        5,429,852        29,466,273        18,199,159        74        56,339,572   
                                                        

Gross undiscounted claim liability

     25,334        59,177        87,829        2,894,586        6,813,859        74        9,880,859   

Discount, gross claim liability

     (914     (4,788     (6,220     (361,258     (1,161,423     (26     (1,534,629
                                                        

Gross claim liability before all subrogation and before reinsurance

     24,420        54,389        81,609        2,533,328        5,652,436        48        8,346,230   
                                                        

Less:

              

Gross RMBS subrogation(1)

     —          —          —          —          (2,497,955     —          (2,497,955

Discount, RMBS subrogation

     —          —          —          —          76,658        —          76,658   
                                                        

Discounted RMBS subrogation, before reinsurance

     —          —          —          —          (2,421,297     —          (2,421,297
                                                        

Less:

              

Gross other subrogation(2)

     —          (2,128     (16     (764,763     (828,815     —          (1,595,722

Discount, other subrogation

     —          109        —          193,983        137,488        —          331,580   
                                                        

Discounted other subrogation, before reinsurance

     —          (2,019     (16     (570,780     (691,327     —          (1,264,142
                                                        

Gross claim liability, net of all subrogation, before reinsurance

     24,420        52,370        81,593        1,962,548        2,539,812        48        4,660,791   
                                                        

Less: Unearned premium reserves

     (12,370     (11,332     (38,468     (291,764     (156,839     —          (510,773

Plus: Loss adjustment expenses reserves

     —          —          —          15,062        98,502        —          113,564   
                                                        

Claim liability reported on Balance Sheet, before reinsurance(3)

     12,050        41,038        43,125        1,685,846        2,481,475        48        4,263,582   
                                                        

Reinsurance recoverable reported on Balance Sheet

     822        520        3,296        90,238        31,582        —          126,458   
                                                        

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

(1)    RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction
sponsors for representations and warranty breaches. Please see “Representation and Warranty
Breaches by RMBS Transaction Sponsors” below for detailed discussion.
            
(2)    Other subrogation represents subrogation other than RMBS subrogation as defined in (1) above.             
(3)    Claim liability reported is included in the Consolidated Balance Sheets as follows:             
   Loss and loss expense reserve (net of potential remediation subrogation of $679,217)    $ 5,510,541     
   Subrogation recoverable (includes gross potential remediation of $1,742,081)      (1,222,216  
   Other assets (within)      (24,744  
             
      $ 4,263,581     
             

Loss reserves on non-defaulted credits were $1,463,916 and $2,646,517 at September 30, 2010 and December 31, 2009, respectively. These loss reserves were comprised of 204 credits with net par of $20,180,247 at September 30, 2010 and 130 credits with net par of $21,424,301 at December 31, 2009. Loss reserves on defaulted credits were $2,571,589 and $1,098,352 at September 30, 2010 and December 31, 2009, respectively, comprising 124 credits with net par outstanding of $14,333,040 at September 30, 2010 and 85 credits with net par outstanding of $11,345,697 at December 31, 2009. Included in loss reserves at September 30, 2010 are $1,083,796 of claims that were presented and not paid under the claim moratorium on the Segregated Account, as required by the OCI. Loss expense reserves were also established for significant surveillance and mitigation expenses associated with adversely classified credits, including legal costs associated with Representation and Warranty Breaches by RMBS transaction sponsors. Total loss expense reserves were $110,625 and $32,452 at September 30, 2010 and December 31, 2009, respectively. Loss reserves ceded to reinsurers at September 30, 2010 and December 31, 2009 were $118,388 and $64,311, respectively. Amounts were included in reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet.

Representation and Warranty Breaches by RMBS Transaction Sponsors:

In an effort to better understand the unprecedented levels of mortgage delinquencies, Ambac engaged consultants with significant mortgage lending experience to review the underwriting documentation for mortgage loans underlying certain insured RMBS transactions. 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 poor performance include (i) increased level of early payment defaults, (ii) significant number of loan liquidations or charge-offs and resulting high level of losses, and (iii) rapid elimination of credit protections inherent in the transactions’ structures. With respect to item (ii), “loan liquidations” refers to loans for which the servicer has liquidated the related collateral and the securitization has realized losses on the loan; “charge-offs” refers to loans which have been written off as uncollectible by the servicer, thereby generating no recoveries to the securitization, and may also refer to the unrecovered balance of liquidated loans. In either case, the servicer has taken such actions as it has deemed viable to recover against the collateral, and the securitization has incurred losses to the extent such actions did not fully repay the borrower’s obligations. 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. Per the transaction documents, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute any loan that breaches the representations and warranties. 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

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

(i.e., more than two years have lapsed since the closing of the transaction). To effect a repurchase, depending on the transaction, the sponsor is contractually required to repurchase the loan (a) for loans which have not been liquidated or charged off, either at (i) the current unpaid principal balance of the loan, (ii) the current unpaid principal balance plus accrued unpaid interest, or (iii) the current unpaid principal balance plus accrued interest plus unreimbursed servicer advances/expenses and/or trustee expenses resulting from the breach of representations and warranties that trigger the repurchase, and (b) for a loan that has already been liquidated or charged-off, the amount of the realized loss (which in certain cases excludes accrued unpaid interest). Notwithstanding the material breaches of representations and warranties, up until the establishment of the Segregated Account and associated Segregated Account Rehabilitation Proceeding, Ambac had continued to pay claims submitted under the financial guarantee insurance policies related to these securitizations and will, once again, pay claims in accordance with the Rehabilitation Plan after the plan has been approved in court. In cases where loans are repurchased by a sponsor, the effect is typically to offset current period losses and then to increase the over-collateralization of the securitization, depending on the extent of loan repurchases and the structure of the securitization. Specifically, the repurchase price is paid by the sponsor to the securitization trust which holds the loan. The cash becomes an asset of the trust, replacing the loan that was repurchased by the sponsor. On a monthly basis the cash received related to loan repurchases by the sponsor is aggregated with cash collections from the underlying mortgages and applied in accordance with the trust indenture payment waterfall. This payment waterfall typically includes principal and interest payments to the note holders, various expenses of the trust and reimbursements to Ambac, as financial guarantor, for claim payments made in previous months. With respect to transactions for which Ambac has recorded estimated subrogation recoveries (as further described below), Ambac insures all or a portion of the senior tranches in the capital structure of the issuer, thus any sponsor cash received from loan repurchases would entirely benefit Ambac or Ambac insured note holders. Notwithstanding the reimbursement of previous monthly claim payments, to the extent there continues to be insufficient cash in the waterfall in the current month to make scheduled principal and interest payments to the note holders, Ambac is required to make additional claim payments to cover the shortfall.

Ambac’s estimate of subrogation recoveries includes two components: (1) estimated dollar amounts of loans with material breaches of representations and warranties based on an extrapolation of the breach rate identified in a random sample of loans taken from the entire population of loans in a securitization (“random sample approach”); and (2) dollar amount of actual loans with identified material breaches of representations and warranties discovered from samples of impaired loans in a securitization (“adverse sample approach”). We do not include estimates of damages in our estimate of subrogation recoveries under either approach. The amount the sponsors believe to be their liability for these breaches is not known; however, certain sponsors have disclosed that reserves have been established related to claims by financial guarantors and others for breaches of representations and warranties.

The random sample approach to estimate subrogation recoveries was based on obtaining a statistically valid random sample for all the original loans in the pool. First, a “breach rate” was computed by dividing (i) the loans identified in sample as having breached representations and warranties by (ii) the total sample size. Second, an extrapolation to the entire loan pool was performed by multiplying the breach rate by the sum of (a) the current unpaid loan pool balance (“CULPB”) plus (b) realized losses resulting from loan liquidations or charge-offs to date, to compute an estimated repurchase obligation. The CULPB includes principal only on non-charged-off and non-liquidated loans, and the realized losses include principal, interest and unreimbursed servicer advances and/or trustee expenses on charged-off and liquidated loans. As a result, the CULPB and realized loss components, which are used in extrapolating the estimated repurchase obligation, do not precisely correspond to each sponsor’s contractual repurchase obligation as defined in the transaction documents. Nonetheless, the CULPB and realized loss components are provided through trustee reports we receive in the normal course of our surveillance of these transactions and is the best information we have available to estimate the sponsor’s

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

repurchase obligation under the random sample approach. Third, a realization factor (which incorporates Ambac’s views about the uncertainties surrounding the litigation process and/or settlement negotiation) was then applied to the estimated repurchase obligation to compute the undiscounted subrogation recovery. The realization factor was developed from a range of realization factors using Ambac’s own assumptions about the likelihood of outcomes based on all the information available to it including (i) discussions with external legal counsel and their views on ultimate settlement, (ii) recent experience with loan put back negotiations where the existence of a material breach was debated and negotiated at the loan level, and (iii) the pervasiveness of the breach rates. Finally, a discount factor was applied (using the assumptions discussed in the paragraph subsequent to the next table below) to the undiscounted subrogation recovery to compute the estimated subrogation recovery.

Due to the nature of the sampling methodology used, the subrogation recovery estimate Ambac has recorded based on the above-described random sample approach includes all breached loans which Ambac believes the sponsor is contractually required to repurchase, including extrapolation to a loan pool which includes loans which have not defaulted, and, in fact, may not default in the future (i.e. performing loans). In theory, a loan that continues to perform in accordance with its terms through repayment should have little or no effect on Ambac’s anticipated claim payments, regardless of whether or not the sponsor repurchases the loan. In other words, since there will be sufficient cash flows to service the notes in either situation (i.e. whether cash is received from a sponsor loan repurchase or whether cash is received from the underlying performing loan), there should be no claim payment under Ambac’s insurance policy in respect of such loans. Nonetheless, Ambac may have recorded a subrogation recovery for certain performing loans because it believes the breaches of representations and warranties are so pervasive that a court would deem it impractical to have the sponsor re-underwrite every loan in a given transaction and repurchase only individual loans that have breached. Rather, Ambac believes there is precedent for the utilization of a statistical sampling and extrapolation methodology across a population to prove liability and damages where it would be impractical to make a determination on an individual loan basis. Ambac believes a court would likely award damages based on a reasonable methodology, such as our random sample approach, which damages would be either remitted directly to Ambac, placed in the securitization trust, or otherwise held under an arrangement for the benefit of the securitization trust; however, Ambac believes that under such an approach individual loans would not be repurchased from the trust. In either case, Ambac believes those damages would compensate Ambac for past and future claim payments. Consequently, since the sponsor is contractually obligated to repurchase those loans which breach representations and warranties regardless of whether they are current or defaulted, Ambac believes the appropriate measure in estimating subrogation recoveries is to apply the breach rate to both performing and defaulted loans.

The adverse sample approach to estimate subrogation recoveries was based on a sample taken from those loans in the pool that were impaired, meaning loans greater than 90 days past due, charged-off, in foreclosure, REO or bankruptcy. The estimated subrogation recovery under this approach represents 100% of the original principal balance of those specific loans identified as having not met the underwriting criteria or otherwise breaching representations and warranties (i.e. the adverse loans), multiplied by a discount factor using the same assumptions used for the discount factor in the random sample approach. For transactions subject to the adverse sample approach, given Ambac’s limitations in developing a statistically valid random sample and its belief that the subrogation estimate under this approach is inherently conservative (for reasons discussed below), Ambac did not attempt to develop probability-weighted alternative cash flow scenarios as it believes such results would not be meaningful. The three primary differences between this adverse sample approach and the random sample approach, discussed in the previous paragraph, are as follows:

 

  (i)

There is no extrapolation to the CULPB and realized losses under the adverse sample approach. At September 30, 2010, the adverse sample approach is used for 15 transactions that are with the same sponsor, who has limited our access to the underlying loan files and, therefore, a

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

statistically valid random sample from the entire loan pool cannot be selected. This is in contrast to the transactions subject to the random sample approach where Ambac’s access to individual loan files has not been limited and the Company, therefore, has been able to develop a statistically valid representative sample.

 

  (ii) The adverse sample approach is only based on the original principal balance rather than the principal balance at the time of default and liquidation or charge-off. Furthermore, it does not include other components of the sponsor’s contractual repurchase obligation where the sponsor is also obligated to repay accrued interest, servicer advances and/or trustee expenses. The adverse sample approach relies on individual loan level data where all of the components of the sponsor’s buyback obligation have not been specifically provided by the sponsor nor is easily estimable. For example, home equity lines of credit (HELOCs) are revolving loans whose principal balances may be higher or lower at the time of default and liquidation or charge-off than at the time of origination. However, given the limited information available to Ambac in estimating such principal balances at the time of liquidation or charge-off, the original principal balance must be used in calculating subrogation recoveries. Another example is closed-end second lien RMBS where the interest due on a particular loan will be a function of the length of time of delinquency prior to liquidation or charge-off, and cannot be readily estimated. Incremental costs, including fees and servicer advances for such items as property taxes and maintenance, are likewise not readily estimated.

 

  (iii) Unlike the random sample approach, for the adverse sample approach Ambac did not apply a realization factor to the estimated repurchase obligation for the adverse loans related to uncertainties surrounding settlement negotiation or litigation processes given that the adverse loans selected represent only approximately 35% of the value of the impaired population of loans, only approximately 4% of the value of the original loans in the pool, and the breach rate in the sample was pervasive. In other words, because the adverse loans selected represent only a fraction of the population of impaired loans and a very small proportion of the original loans in the pools, Ambac believes there is an ample population of additional impaired loans where breaches of representations and warranties exist that could potentially replace any adverse loans it already identified that might be successfully challenged in negotiations or litigation.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

Ambac has updated its estimated subrogation recoveries from $2,046,788 ($2,026,266 net of reinsurance) at December 31, 2009 to $2,421,298 ($2,395,456 net of reinsurance) at September 30, 2010. The balance of subrogation recoveries and the related claim liabilities at September 30, 2010 and December 31, 2009 are as follows:

 

      September 30, 2010  

Method

   Count     GCL      Subrogation     GCL After  

Adverse samples

     15 (2)      1,587,749         (708,518     879,231   

Random samples

     12 (3)      958,152         (1,712,780     (754,628
                                 

Totals

     27        2,545,901         (2,421,298     124,603   
                                 

 

      December 31, 2009  

Method

   Count      GCL      Subrogation     GCL After  

Adverse samples

     10         759,369         (460,617     298,752   

Random samples

     9         937,272         (1,586,171     (648,899
                                  

Totals

     19         1,696,641         (2,046,788     (350,147
                                  

 

(1) The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the projected future paid losses for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than projected future paid losses, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability. Of the $2,421,298 of subrogation recoveries recorded at September 30, 2010, $1,742,081 was included in “Subrogation recoverable” and $679,217 was included in “Loss and loss expense reserves.”
(2) Of these 15 transactions, 10 contractually require the sponsor to repurchase loans at the unpaid principal balance and 5 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest. However, for reasons discussed above in the description of the adverse sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor’s contractual repurchase obligation.
(3) Of these 12 transactions, 3 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest and 9 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest plus servicer advances/expense and/or trustee expenses. However, for reasons discussed above in the description of the random sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor’s contractual repurchase obligation.

While the obligation by sponsors to repurchase loans with material breaches is clear, generally the sponsors have not yet 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 estimates that it will take approximately three years from the initiation of litigation with the

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

sponsor to ultimate resolution. Based on this estimate as a basis for projecting the future subrogation cash flows, Ambac assumes, on average, approximately three and a half years to collect recoveries, discounted at a risk-free rate of 1.8%. 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 and five first-lien transactions that have experienced exceptionally poor performance. However, the loan file examinations and related estimated recoveries we have reviewed and recorded to date have been limited to only those transactions whose sponsors (or their successors) are subsidiaries of large financial institutions, all of which carry an investment grade rating from at least one nationally recognized rating agency. A total of seven sponsors represent the 27 transactions which have been reviewed as of September 30, 2010. While our contractual recourse is generally to the sponsor/subsidiary, rather than to the financial institutional parent, each of these financial institutions has significant financial resources and an ongoing interest in mortgage finance, and we therefore believe that the financial institution/parent would not seek to disclaim financial responsibility for these obligations if the sponsor/subsidiary is unable to honor its contractual obligations or pay a judgement that we may obtain in litigation. Additionally, in the case of successor institutions, 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. We believe that focusing our loan remediation efforts on large financial institutions first will provide the greatest economic benefit to Ambac. Ambac retains the right to review all RMBS transactions for representations and warranties breaches. Since a significant number of other second-lien and first-lien transactions are also experiencing poor performance, management is considering expanding the scope of this effort.

Below is the rollforward of RMBS subrogation for the period December 31, 2009 through September 30, 2010:

 

      Random sample      # of
deals
     Adverse
Sample
    # of
deals
 

Rollforward:

          

Discounted RMBS subrogation (gross of reinsurance) at 12/31/09

   $ 1,586,171         9       $ 460,617        10   
                                  

Changes recognized in 2010:

          

Additional transactions reviewed

     126,184         3         193,860        5   

Additional adverse sample loans reviewed

     —           n/a         59,461        n/a   

Loans repurchased by the sponsor

     —           n/a         (23,882     n/a   
                                  

Subtotal of changes recognized in current period

     126,184         3         229,439        5   
                                  

Changes from re-estimation of opening balance:

          

Change in pre-recovery loss reserves

     425         n/a         19,813        n/a   

Other

     —           n/a         (1,351     n/a   
                                  

Subtotal of changes from re-estimation of opening balance

     425         —           18,462        —     
                                  

Discounted RMBS subrogation (gross of reinsurance) at 9/30/10

   $ 1,712,780         12       $ 708,518        15   
                                  

As a consequence of the Segregated Account Rehabilitation Proceedings, the rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation and loss mitigation. As noted in Item 1 “Recent Developments,” all RMBS policies were allocated to the Segregated Account and as such, the foregoing discussion of Ambac’s risk management practices is qualified by reference to the rehabilitator’s exercise of its discretion to alter or eliminate the above risk management practices relating to representation and warranty breaches by RMBS transaction sponsors.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

Our ability to recover the RMBS subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties (and/or their respective parents and affiliates), timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. Our current estimate considers that we will receive subrogation recoveries of $903,846 and $1,599,523 in 2011 and 2013, respectively. The amount of these subrogation recoveries is significant and if we’re unable to recover any amounts our future available liquidity to pay claims would be reduced and our stockholders’ deficit as of September 30, 2010 would increase from $1,217,580 to $3,613,036.

The following table summarizes the changes in the total net loss reserves for the nine months ended September 30, 2010:

 

($ in millions)    Nine Months Ended
September 30, 2010
 

Loss reserves at December 31, 2009, net of subrogation recoverable and reinsurance

   $ 3,777,321   

Impact of adopting ASU 2009-17(1)

     (503,887
        

Beginning balance of net loss reserves, net of subrogation recoverable and reinsurance

     3,273,434   

Changes in the loss reserves due to:

  

Current year:

  

Establishment of new loss reserves, gross of subrogation and net of reinsurance

     335,562   

Claim payments, net of subrogation and reinsurance

     7,790   

Establishment of subrogation recoveries, net of reinsurance

     (315,814
        

Total current year

     27,538   

Prior year:

  

Change in previously established loss reserves, gross of subrogation and net of reinsurance

     614,747   

Change in previously established subrogation recoveries, net of reinsurance

     (53,380

Claim payments, net of subrogation recoverable and reinsurance

     (262,899
        

Total prior year

     298,468   

Changes in loss reserves

     326,006   

Deconsolidation of certain VIEs(1)

     546,690   
        

Ending loss reserves, net of subrogation recoverable and reinsurance

   $ 4,146,130   
        

 

(1) Refer to Note 3 of this Unaudited Consolidated Financial Statements for discussion of ASU 2009-17.

(6) 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 11, Fair Value Measurements. ASC Topic 815 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. These disclosures have been included in the discussion below.

The Company 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, certain interest rate and currency swaps and futures

 

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contracts. Credit derivatives had also been purchased to mitigate portions of the risks assumed under written credit derivative contracts. All purchased credit derivatives have been settled prior to September 30, 2010. 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 had been 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.

Upon the adoption of ASU 2009-17 at January 1, 2010, Ambac was required to recognize the derivative assets and liabilities of the VIEs at fair value. Refer to Notes 3 and 11 for further information related to the VIE consolidation and fair value measurements, respectively.

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 $106,806 and $119,456 as of September 30, 2010 and December 31, 2009, respectively. The amounts representing the obligation to return cash collateral, recorded in “Other liabilities” were $9,440 and $90,009 as of September 30, 2010 and December 31, 2009, respectively. The following tables summarize the location and fair values of individual derivative instruments reported in the Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009. Amounts are presented gross of the effect of offsetting balances even where a legal right of offset exists:

 

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Fair Values of Derivative Instruments  
     Derivative Asset      Derivative Liability  
     Balance Sheet Location      Fair Value      Balance Sheet Location      Fair value  

September 30, 2010:

           

Derivatives held for trading

           

Credit derivatives

     Derivative assets       $ —           Derivative liabilities       $ 232,528   

Interest rate swaps

     Derivative assets         455,429         Derivative liabilities         245,046   
     Derivative liabilities         2,144         Derivative assets         156,672   

Currency swaps

     Derivative assets         —           Derivative liabilities         7,842   
     Derivative liabilities         —           Derivative assets         —     

Futures contracts

     Derivative assets         —           Derivative liabilities         3,317   

Other contracts

     Derivative assets         —           Derivative liabilities         289   
                       

Total derivatives held for trading

        457,573            645,694   
                       

Total derivatives

      $ 457,573          $ 645,694   
                       

Variable Interest Entities

     Derivative assets       $ 4,362         Derivative liabilities       $ 1,581,681   
                       

December 31, 2009:

           

Derivatives held for trading

           

Credit derivatives

     Derivative assets       $ 212,402         Derivative liabilities       $ 3,251,893   

Interest rate swaps

     Derivative assets         217,855         Derivative liabilities         320,766   
     Derivative liabilities         121,914         Derivative assets         14,013   

Currency swaps

     Derivative assets         76,347         Derivative liabilities         85,396   
     Derivative liabilities         —           Derivative assets         18,574   

Futures contracts

     Derivative assets         10,125         Derivative liabilities         —     

Other contracts

     Derivative assets         —           Derivative liabilities         717   
                       

Total derivatives held for trading

        638,643            3,691,359   
                       

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

           

Interest rate swaps

     Derivative assets         12,352         Derivative liabilities         —     
                       

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

        12,352            —     
                       

Total derivatives

      $ 650,995          $ 3,691,359   
                       

Variable Interest Entities

     Derivative assets       $ 109,411         Derivative liabilities       $ —     
                       

Derivative Contracts Classified as Held for Trading Purposes:

Financial Guarantee Credit Derivatives:

Until the third quarter of 2007, Ambac’s subsidiary, Ambac Credit Products (“ACP”) 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, all of which have been settled prior to September 30, 2010. Credit derivative assets included in the Consolidated Balance Sheets as of December 31, 2009 arose from such purchased credit default swaps. There were no purchased credit derivative transactions remaining in the portfolio as of September 30, 2010.

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, 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.

 

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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 21 transactions, which are not “pay-as-you-go”, with a combined notional of approximately $1,777,834 and a net liability fair value of $9,173 as of September 30, 2010. 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, 2010 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.

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, 2010:

 

Ambac Rating

   CLO      Other(1)      Total  

AAA

   $ 447,840       $ 3,156,934       $ 3,604,774   

AA

     8,953,933         1,182,635         10,136,568   

A

     2,804,310         2,928,219         5,732,529   

BBB

     40,332         594,477         634,809   

Below investment grade

     —           263,961         263,961   
                          
   $ 12,246,415       $ 8,126,226       $ 20,372,641   
                          

 

(1) Other CDS contracts include primarily Market Value CDOs, CDO of ABS containing less than 25% MBS and various other asset classes.

 

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The tables below summarize information by major category as of September 30, 2010 and December 31, 2009:

September 30, 2010

 

     CLO     Other     Total  

Number of CDS transactions

     60        32        92   

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

     3.5        4.2        3.8   

Gross principal notional outstanding

   $ 12,246,415      $ 8,126,226      $ 20,372,641   

Gross and net derivative liabilities at fair value

   $ (81,110   $ (151,418   $ (232,528

December 31, 2009

 

     CDO of ABS     CLO     Other     Total  

Number of CDS transactions

     19        76        37        132   

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

     25.3        4.2        4.8        12.5   

Gross principal notional outstanding

   $ 17,052,686      $ 17,774,666      $ 8,783,969      $ 43,611,321   

Hedge principal notional outstanding

   $ 335,000      $ —        $ —        $ 335,000   

Net derivative liabilities at fair value

   $ (2,253,341   $ (381,707   $ (404,443   $ (3,039,491

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 3, Application of the New Consolidation Accounting Standard on Special Purpose Entities, including 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 $0 and $212,402 at September 30, 2010 and December 31, 2009, respectively. In August 2010, Ambac Assurance settled all of its remaining hedge contracts on certain of the company’s written credit derivative exposures that were commuted under the Settlement Agreement as further described in Note 1.

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

 

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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 $0 and $2,994,532 for the three and nine months ended September 30, 2010, respectively, and $745,672 and $769,456 for the three and nine months ended September 30, 2009, 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. Refer to Note 11 for a detailed description of the components of our credit derivative contracts’ fair value.

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 obligations from period to period. Adversely classified credits are assigned risk classifications by the surveillance group using the guidelines described in Note 5. As a result of the Settlement Agreement described in Note 1, there are no CDS contracts on Ambac’s adversely classified credit listing as of September 30, 2010.

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 and some excess interest rate sensitivity as an economic hedge against the effects of rising interest rates on Ambac’s financial guarantee exposures. 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, and (iii) variability between Treasury and swap rates. The derivative portfolio also includes an unhedged Sterling-denominated exposure to Consumer Price Inflation in the United Kingdom. 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.

The notional amounts of Ambac Financial Services’ trading derivative products at September 30, 2010 and December 31, 2009 are as follows:

 

Type of derivative

   Notional at
September 30, 2010
     Notional at
December 31, 2009
 

Interest rate swaps—receive-fixed/pay-variable

   $ 1,676,142       $ 2,040,984   

Interest rate swaps—pay-fixed/receive-variable

     3,497,174         2,862,866   

Interest rate swaps—basis swaps

     231,250         641,370   

Currency swaps

     41,731         1,165,213   

Futures contracts

     290,000         394,200   

Other contracts

     154,260         241,641   

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

 

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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. In 2009, all remaining total return swaps were terminated and settled.

The following table summarizes the location and amount of gains and losses of derivative contracts held for trading purposes in the Consolidated Statements of Operations for the three and nine months ended September 30, 2010:

 

    

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

   Amount of Gain or
(Loss) Recognized
in Consolidated
Statement of
Operations – Three
months ended

September 30, 2010
    Amount of Gain or
(Loss) Recognized
in Consolidated
Statement of
Operations – Nine
months ended

September 30, 2010
 

Financial Guarantee:

       

Credit derivatives

   Net change in fair value of credit derivatives    $ 9,412      $ 44,454   

Financial Services derivatives products:

       

Interest rate swaps

   Derivative products      (66,047     (81,754

Currency swaps

   Derivative products      (464     (70,702

Futures contracts

   Derivative products      (12,614     (56,038

Other derivatives

   Derivative products      581        683   
                   

Total Financial Services derivative products

        (78,544     (207,811
                   

Total derivative contracts held for trading purposes

      $ (69,132   $ (163,357
                   

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

 

    

Location of Gain or (Loss)
Recognized in Consolidated

Statement of Operations

   Amount of Gain or
(Loss) Recognized

in Consolidated
Statement of
Operations – Three
months ended
September 30, 2009
    Amount of Gain or
(Loss) Recognized

in Consolidated
Statement of
Operations – 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

 

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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. The number of designated hedges under ASC Topic 815 has been declining with the runoff of the investment agreement portfolio and, as of December 31, 2009, no accounting hedges remain in the company’s portfolio. In the second quarter 2010, all remaining derivatives of the investment agreement business were terminated.

The notional amounts of Ambac’s derivative contracts used for non-trading and hedging purposes at September 30, 2010 and December 31, 2009 are as follows:

 

     Notional at
September 30, 2010
     Notional at
December 31, 2009
 
Derivatives not designated or qualifying as hedging instruments under ASC Topic 815:              

Interest rate swaps

   $ —         $ 150,982   

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 (losses) gains 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 (losses) gains 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. As noted above, all designated hedge relationships under ASC Topic 815 were terminated by December 31, 2009. There were no designated accounting hedges in 2010.

 

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The following table summarizes the location and amount of gains and losses of fair value hedges designated under ASC Topic 815 and related hedge item reported in the Consolidated Statements of Operations for the three and nine months ended September 30, 2009:

Three 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
 

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
                           

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 Loss” in Stockholders’ Deficit. 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. All designated hedge relationships under ASC Topic 815 were terminated by December 31, 2009. There were no designated accounting hedges in 2010. In the first quarter of 2010, all remaining deferred gains on derivative instruments previously reported in Accumulated Other Comprehensive Loss have been reclassified to net income resulting in a gain of $1,156, included in “Net mark-to-market gains (losses) on non-trading derivative contracts” for the nine months ended September 30, 2010.

 

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The following table summarizes the location and amount of gains and losses of cash flow hedges reported in the Consolidated Statements of Operations for the three and nine month periods ended September 30, 2009:

Three months ended 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)
 

Interest rate swaps

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

Nine months ended 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)
 

Interest rate swaps

   $ (1,427   Financial Services: Investment income    $ 2,196       Net mark-to-market gains (losses) on non-trading derivative contracts    $ 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 Loss” 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 Loss” will be reclassified into net income immediately. All subsequent changes in fair values of derivatives previously designated as cash flow hedges will be recognized in net income.

Ambac’s operating subsidiaries enter 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 was $0 and ($15,451) for the three and nine months ended September 30, 2010, respectively, and ($6,709) and $1 for the three and nine months ended September 30, 2009, respectively.

Variable interest entities consolidated under ASC Topic 2009-17 use derivative instruments to economically hedge expected cash flow differences from collateral assets and VIE notes. The net gains or losses on VIE derivatives are included in earnings under Financial Guarantee: (Loss) Income on variable interest entities (refer to Note 3).

 

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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, 2010, 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 $155,158 related to which Ambac had posted assets as collateral with a fair value of $282,214. All such ratings-based contingent features have been triggered as of September 30, 2010, 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, 2010, 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.

(7) 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

     2008   

New York City

     2000   

United Kingdom

     2005   

As of September 30, 2010 and December 31, 2009, the liability for unrecognized tax benefits is approximately $23,000 and $22,850, respectively. Included in these balances at September 30, 2010 and December 31, 2009 are $23,000 and $22,850, respectively, of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

Ambac accrues interest and penalties related to unrecognized tax benefits in the provision for income taxes. During the nine months ended September 30, 2010 and 2009, Ambac recognized interest of approximately $150 and $3,075, respectively. During the three months ended September 30, 2010 and 2009, Ambac recognized interest of approximately $50 and $1,025, respectively. Ambac had approximately $15,170 and $15,020 for the payment of interest accrued at September 30, 2010 and December 31, 2009, respectively.

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

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. As of September 30, 2010 a full valuation allowance of $2,586,833 has been established against the deferred tax asset. As of December 31, 2009, the company had a valuation allowance of $2,701,493.

(8) Investments

ASC Topic 320, Investment – Debt and Equity Securities requires that all debt instruments and certain equity instruments be classified in Ambac’s Consolidated Balance Sheets according to their purpose and, depending on that classification, be carried at either cost or fair market value. Ambac’s investment portfolio is accounted for on a trade-date basis and consists primarily of investments in fixed income securities that are considered available-for-sale as defined by ASC Topic 320. Available-for-sale securities are reported in the financial statements at fair value with unrealized gains and losses, net of deferred taxes, reflected in Accumulated Other Comprehensive Loss in Stockholders’ Deficit and are computed using amortized cost as the basis. Fair value is based primarily on quotes obtained from independent market sources. When quotes are not available, valuation models are used to estimate fair value. These models include estimates, made by management, which utilize current market information. The quotes received or valuation results from valuation models could differ materially from amounts that would actually be realized in the market. For purposes of computing amortized cost, premiums and discounts are accounted for using the effective interest method over the remaining term of the securities. Premiums and discounts for bonds that do not have a large number of similar underlying loans to consider estimates of future principal payments, typically corporate and municipal bonds, are amortized or accreted over the remaining term of the securities even if they are callable. Premiums and discounts on mortgage-backed and asset-backed securities are adjusted for the effects of actual and anticipated prepayments on a retrospective basis. Certain short-term investments, such as money market funds, are carried at cost, which approximates fair value. Realized gains and losses on the sale of investments are determined on the basis of specific identification.

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

VIE investments in fixed income securities are carried at fair value under the fair value option in accordance with ASC Topic 825. For additional information about VIE investments, including fair value by asset-type, see Note 3. The amortized cost and estimated fair value of investments, excluding VIE investments, at September 30, 2010 and December 31, 2009 were as follows:

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Estimated
Fair Value
     Non-credit other-
than-temporary
Impairments(1)
 

September 30, 2010

Fixed income securities:

              

Municipal obligations

   $ 2,064,009       $ 129,098       $ 2,607       $ 2,190,500       $ —     

Corporate obligations

     893,210         63,350         24,812         931,748         —     

Foreign obligations

     114,125         6,951         —           121,076         —     

U.S. government obligations

     165,291         9,507         —           174,798         —     

U.S. agency obligations

     82,000         8,182         2         90,180         —     

Residential mortgage-backed securities

     1,236,339         257,430         46,023         1,447,746         2,012   

Collateralized debt obligations

     41,534         29         13,353         28,210         —     

Other asset-backed securities

     1,002,567         35,816         54,621         983,762         —     

Short-term

     617,748         —           —           617,748         —     

Other

     100         —           —           100         —     
                                            
     6,216,923         510,363         141,418         6,585,868         2,012   
                                            

Fixed income securities pledged as collateral:

              

U.S. government obligations

     181,403         3,413         —           184,816         —     

U.S. agency obligations

     —           —           —           —           —     

Residential mortgage-backed securities

     9,050         521         —           9,571         —     
                                            

Total collateralized investments

     190,453         3,934         —           194,387         —     
                                            

Total investments

   $ 6,407,376       $ 514,297       $ 141,418       $ 6,780,255       $ 2,012   
                                            

December 31, 2009

Fixed income securities:

              

Municipal obligations

   $ 3,103,761       $ 117,095       $ 15,376       $ 3,205,480       $ —     

Corporate obligations

     859,797         19,003         37,582         841,218         —     

Foreign obligations

     158,498         10,368         1,215         167,651         —     

U.S. government obligations

     230,587         3,541         712         233,416         —     

U.S. agency obligations

     68,719         4,877         116         73,480         —     

Residential mortgage-backed securities

     1,644,580         190,273         96,055         1,738,798         17,276   

Collateralized debt obligations

     79,135         22         22,706         56,451         —     

Asset-backed securities

     1,460,488         1,228         205,640         1,256,076         —     

Short-term

     962,007         —           —           962,007         —     

Other

     1,278         —           —           1,278         —     
                                            
     8,568,850         346,407         379,402         8,535,855         17,276   
                                            

Fixed income securities pledged as collateral:

              

U.S. government obligations

     122,139         1,688         777         123,050         —     

U.S. agency obligations

     16,832         617         —           17,449         —     

Residential mortgage-backed securities

     25,385         1,482         —           26,867         —     
                                            

Total collateralized investments

     164,356         3,787         777         167,366         —     
                                            

Total investments

   $ 8,733,206       $ 350,194       $ 380,179       $ 8,703,221       $ 17,276   
                                            

 

(1) Represents the amount of cumulative non-credit other-than-temporary impairment losses recognized in accumulated other comprehensive loss on securities that also had a credit impairment. These losses are included in gross unrealized losses as of September 30, 2010 and December 31, 2009.

Foreign obligations at September 30, 2010 consist primarily of government issued securities which are denominated in Pounds Sterling. All Euro and Australian dollar denominated securities held as of December 31, 2009 were sold in the first quarter of 2010.

 

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Table of Contents
Item 1. Notes to Unaudited Consolidated Financial Statements
     (Dollars in thousands, except share amounts)

 

 

The amortized cost and estimated fair value of investments, excluding VIE investments, at September 30, 2010, by contractual maturity, were as follows:

 

     Amortized
Cost
     Estimated
Fair Value
 

Due in one year or less

   $ 706,547       $ 707,361   

Due after one year through five years

     871,220         918,180   

Due after five years through ten years

     774,225         823,905   

Due after ten years

     1,765,894         1,861,520   
                 
     4,117,886         4,310,966   

Residential mortgage-backed securities

     1,245,389         1,457,317   

Collateralized debt obligations

     41,534         28,210   

Other asset-backed securities

     1,002,567         983,762   
                 
   $ 6,407,376       $ 6,780,255   
                 

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, 2010 and December 31, 2009:

 

     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, 2010:

                 

Fixed income securities:

                 

Municipal obligations