Attached files

file filename
EX-32.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 906 - AMBAC FINANCIAL GROUP INCdex322.htm
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 302 - AMBAC FINANCIAL GROUP INCdex311.htm
EX-31.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 302 - AMBAC FINANCIAL GROUP INCdex312.htm
EX-32.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 906 - AMBAC FINANCIAL GROUP INCdex321.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 June 30, 2011

 

¨ 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   x

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 July 31, 2011, 302,428,811 shares of Common Stock, par value $0.01 per share, (net of 5,587,953 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 – June 30, 2011 (unaudited) and December 31, 2010      3   
   Consolidated Statements of Operations (unaudited) – three and six months ended June 30, 2011 and 2010      4   
   Consolidated Statements of Stockholders’ Equity (unaudited) – six months ended June 30, 2011 and 2010      5   
   Consolidated Statements of Cash Flows (unaudited) – six months ended June 30, 2011 and 2010      7   
   Notes to Unaudited Consolidated Financial Statements      8   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      68   
Item 3.    Quantitative and Qualitative Disclosures About Market Risk      103   
Item 4.    Controls and Procedures      106   

PART II OTHER INFORMATION

  
Item 1.    Legal Proceedings      107   
Item 1A.    Risk Factors      107   
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds      111   
Item 6.    Exhibits      112   
SIGNATURES      113   
INDEX TO EXHIBITS      114   


Table of Contents

PART 1 – FINANCIAL INFORMATION

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

Ambac Financial Group Inc. and Subsidiaries

Debtor-In-Possession

Consolidated Balance Sheets

 

(Dollars in Thousands)

   June 30,
2011
    December 31,
2010
 
     (unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $5,350,418 in 2011 and $5,424,957 in 2010)

   $ 5,872,977      $ 5,738,125   

Fixed income securities pledged as collateral, at fair value (amortized cost of $134,309 in 2011 and $120,918 in 2010)

     140,104        123,519   

Short-term investments (amortized cost of $1,066,353 in 2011 and $991,567 in 2010)

     1,066,353        991,567   

Other, at cost (approximates fair value)

     100        100   
  

 

 

   

 

 

 

Total investments

     7,079,534        6,853,311   

Cash and cash equivalents

     17,379        9,497   

Restricted cash and cash equivalents

     2,500        2,500   

Receivable for securities sold

     34,218        23,505   

Investment income due and accrued

     45,562        45,066   

Premium receivables

     1,924,925        2,422,596   

Reinsurance recoverable on paid and unpaid losses

     158,097        136,986   

Deferred ceded premium

     232,935        264,858   

Subrogation recoverable

     739,658        714,270   

Deferred acquisition costs

     238,225        250,649   

Loans

     20,271        20,167   

Derivative assets

     248,950        290,299   

Other assets

     127,174        82,579   

Variable interest entity assets:

    

Fixed income securities, at fair value

     2,023,513        1,904,361   

Restricted cash and cash equivalents

     48,319        2,098   

Investment income due and accrued

     4,087        4,065   

Loans (includes $14,442,912 in 2011 and $15,800,918 in 2010 at fair value)

     14,651,253        16,005,066   

Derivative assets

     —          4,511   

Intangible assets

     318,180        —     

Other assets

     25,649        10,729   
  

 

 

   

 

 

 

Total assets

   $ 27,940,429      $ 29,047,113   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Deficit:

    

Liabilities:

    

Liabilities subject to compromise

   $ 1,706,518      $ 1,695,231   

Unearned premiums

     3,408,568        4,007,886   

Losses and loss expense reserve

     6,444,519        5,288,655   

Ceded premiums payable

     121,887        141,450   

Obligations under investment agreements

     556,458        767,982   

Obligations under investment repurchase agreements

     34,040        37,650   

Current taxes

     23,435        22,534   

Long-term debt

     217,345        208,260   

Accrued interest payable

     114,451        61,708   

Derivative liabilities

     364,913        348,791   

Other liabilities

     101,156        124,748   

Payable for securities purchased

     17,849        —     

Variable interest entity liabilities:

    

Accrued interest payable

     3,465        3,425   

Long-term debt (includes $15,277,137 in 2011 and $15,885,711 in 2010 at fair value)

     15,496,820        16,101,026   

Derivative liabilities

     1,371,856        1,580,120   

Other liabilities

     31,130        11,875   
  

 

 

   

 

 

 

Total liabilities

     30,014,410        30,401,341   
  

 

 

   

 

 

 

Stockholders’ deficit:

    

Ambac Financial Group, Inc.:

    

Preferred stock

     —          —     

Common stock

     3,080        3,080   

Additional paid-in capital

     2,172,027        2,187,485   

Accumulated other comprehensive income

     509,300        291,774   

Accumulated deficit

     (5,001,201     (4,042,335

Common stock held in treasury at cost

     (411,419     (448,540
  

 

 

   

 

 

 

Total Ambac Financial Group, Inc. stockholders’ deficit

     (2,728,213     (2,008,536

Noncontrolling interest

     654,232        654,308   
  

 

 

   

 

 

 

Total stockholders’ deficit

     (2,073,981     (1,354,228
  

 

 

   

 

 

 

Total liabilities and stockholders’ deficit

   $ 27,940,429      $ 29,047,113   
  

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

3


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Debtor-In-Possession

Consolidated Statements of Operations

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 

(Dollars in Thousands, Except Share Data)

   2011     2010     2011     2010  

Revenues:

        

Financial Guarantee:

        

Net premiums earned

   $ 99,271      $ 167,005      $ 191,070      $ 292,236   

Net investment income

     87,964        69,028        159,629        186,598   

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     (17,793     (7,777     (19,506     (41,245

Portion of loss recognized in other comprehensive income

     215        290        215        2,409   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net other-than-temporary impairment losses recognized in earnings

     (17,578     (7,487     (19,291     (38,836
  

 

 

   

 

 

   

 

 

   

 

 

 

Net realized investment (losses) gains

     (2,435     18,281        (2,450     73,420   

Change in fair value of credit derivatives:

        

Realized gains (losses) and other settlements

     4,224        (2,777,295     9,547        (2,767,371

Unrealized gains

     20,063        2,979,476        5,837        2,802,413   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change in fair value of credit derivatives

     24,287        202,181        15,384        35,042   

Other income (loss)

     9,227        (30,243     37,530        (86,146

Income (loss) on variable interest entities

     2,353        (38,546     (3,772     (531,250

Financial Services:

        

Investment income

     7,600        8,861        12,326        18,129   

Derivative products

     (65,592     (70,957     (44,588     (129,184

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     —          (3,079     —          (3,079

Portion of loss recognized in other comprehensive income

     —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net other-than-temporary impairment losses recognized in earnings

     —          (3,079     —          (3,079
  

 

 

   

 

 

   

 

 

   

 

 

 

Net realized investment gains

     3,026        65,832        5,491        67,242   

Net mark-to-market losses on non-trading derivative contracts

     —          (11,556     —          (14,295

Corporate and Other:

        

Other income

     72        1,157        149        1,461   

Net realized gains

     —          10,693        —          10,693   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     148,195        381,170        351,478        (117,969
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses:

        

Financial Guarantee:

        

Losses and loss expenses

     196,398        323,326        1,116,045        412,478   

Underwriting and operating expenses

     11,836        58,931        54,212        109,427   

Interest expense

     29,646        6,886        57,715        6,886   

Financial Services:

        

Interest from investment and payment agreements

     2,024        4,357        4,215        9,791   

Other expenses

     2,707        3,124        5,321        6,751   

Corporate and Other:

        

Interest

     —          29,597        —          59,756   

Other expenses

     990        12,645        1,467        24,593   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses before reorganization items

     243,601        438,866        1,238,975        629,682   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax loss from continuing operations before reorganization items

     (95,406     (57,696     (887,497     (747,651

Reorganization items, net

     6,470        —          31,275        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax loss from continuing operations

     (101,876     (57,696     (918,772     (747,651

Provision (benefit) for income taxes

     542        (122     2,892        (15
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

     ($102,418     ($57,574     ($921,664     ($747,636

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

     14        (15     47        (26
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to Ambac Financial Group, Inc.

     ($102,432     ($57,559     ($921,711     ($747,610
  

 

 

   

 

 

   

 

 

   

 

 

 

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

     ($0.34     ($0.20     ($3.05     ($2.59

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

     ($0.34     ($0.20     ($3.05     ($2.59

Weighted-average number of common shares outstanding:

        

Basic

     302,467,255        290,050,931        302,410,881        289,147,236   

Diluted

     302,467,255        290,050,931        302,410,881        289,147,236   

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

4


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Debtor-In-Possession

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, 2011

  $ (1,354,228     $ (4,042,335   $ 291,774      $ —        $ 3,080      $ 2,187,485      $ (448,540   $ 654,308   

Comprehensive loss:

                 

Net (loss) income

    (921,664   $ (921,664     (921,711               47   
 

 

 

   

 

 

               

Other comprehensive loss:

                 

Unrealized gains on securities, net of deferred income taxes of $0(1)

    212,585        212,585          212,585             

Gain on foreign currency translation, net of deferred income taxes of $0

    4,093        4,093          4,216                (123
 

 

 

   

 

 

               

Other comprehensive gain

    216,678        216,678                 
 

 

 

   

 

 

               

Total comprehensive loss

  $ (704,986   $ (704,986              
 

 

 

   

 

 

               

Amortization of postretirement benefit, net of tax

    725            725             

Stock-based compensation

    (52,613       (37,155           (15,458    

Cost of shares acquired

    (35                 (35  

Shares issued under equity plans

    37,156                    37,156     
 

 

 

     

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2011

  $ (2,073,981     $ (5,001,201   $ 509,300      $ —        $ 3,080      $ 2,172,027      $ (411,419   $ 654,232   
 

 

 

     

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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

    (747,636     ($747,636     (747,610               (26
 

 

 

   

 

 

               

Other comprehensive loss:

                 

Unrealized gains on securities, net of deferred income taxes of $193,119(1)

    277,271        277,271          277,271             

Loss on derivative hedges, net of deferred income taxes of ($404)

    (752     (752       (752          

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

    (34,238     (34,238       (34,550             312   
 

 

 

   

 

 

               

Other comprehensive gain

    242,281        242,281                 
 

 

 

   

 

 

               

Total comprehensive loss

    ($505,355     ($505,355              
 

 

 

   

 

 

               

Adjustment to initially apply ASC 2009-17

    705,046          702,042        3,004             

Dividends declared – subsidiary shares to non-controlling interest

    (816       (816            

Issuance of stock

    9,618                136        9,482       

Amortization of postretirement benefit, net of tax

    (207         (207          

Stock-based compensation

    (103,660       (106,656           2,996       

Cost of shares acquired

    (316                 (316  

Shares issued under equity plans

    106,656                    106,656     
 

 

 

     

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2010

    ($1,422,679       ($4,031,055   $ 219,939      $ —        $ 3,080      $ 2,185,134      $ (454,203   $ 654,426   
 

 

 

     

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

5


Table of Contents
(1) Disclosure of Reclassification Amount:

 

     June 30, 2011     June 30, 2010  

Unrealized holding gains arising during period

   $ 192,506      $ 363,793   

Less: reclassification adjustment for net (losses) gains included in net loss

     (20,079     86,522   
  

 

 

   

 

 

 

Net unrealized gains on securities

   $ 212,585      $ 277,271   

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

6


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Debtor-In-Possession

Consolidated Statements of Cash Flows

(Unaudited)

 

     Six Months Ended
June 30,
 

(Dollars in Thousands)

   2011     2010  

Cash flows from operating activities:

    

Net loss attributable to common shareholders

     ($921,711     ($747,610

Noncontrolling interest in subsidiaries’ earnings

     47        (26
  

 

 

   

 

 

 

Net loss

     ($921,664     ($747,636

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

    

Depreciation and amortization

     2,186        1,718   

Amortization of bond premium and discount

     (86,333     (78,607

Reorganization items, net

     31,275        —     

Share-based compensation

     (15,459     3,012   

Current income taxes

     901        443,822   

Deferred acquisition costs

     12,424        16,446   

Unearned premiums, net

     (567,395     (858,448

Loss and loss expense, net

     1,109,365        262,604   

Ceded premiums payable

     (19,563     (67,103

Investment income due and accrued

     (496     25,067   

Premium receivables

     497,671        928,805   

Accrued interest payable

     52,743        11,220   

Net mark-to-market losses (gains)

     (5,837     (2,788,118

Net realized investment gains

     (3,041     (151,355

Other-than-temporary impairment charges

     19,291        41,915   

Variable interest entity activities

     3,772        531,250   

Other, net

     97,723        72,175   
  

 

 

   

 

 

 

Net cash provided by (used in) operating activities

     207,563        (2,353,233
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Proceeds from sales of bonds

     240,418        2,339,636   

Proceeds from matured bonds

     362,668        386,191   

Purchases of bonds

     (464,175     (661,755

Change in short-term investments

     (74,786     447,227   

Loans, net

     (104     9,562   

Change in swap collateral receivable

     (52,260     64,448   

Other, net

     4,146        10,851   
  

 

 

   

 

 

 

Net cash provided by investing activities

     15,907        2,596,160   
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Dividends paid – subsidiary shares to noncontrolling interest

     —          (817

Proceeds from issuance of investment and payment agreements

     26        1,253   

Payments for investment and payment agreement draws

     (213,174     (213,106

Net cash collateral paid/received

     (2,440     (85,659
  

 

 

   

 

 

 

Net cash used in financing activities

     (215,588     (298,329
  

 

 

   

 

 

 

Net cash flow

     7,882        (55,402

Cash and cash equivalents at January 1

     9,497        112,079   
  

 

 

   

 

 

 

Cash and cash equivalents at June 30

   $ 17,379      $ 56,677   
  

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

    

Cash paid during the year for:

    

Income taxes

   $ 1,991     $ —     

Interest expense on long-term debt

   $ —        $ 44,358   

Interest on investment agreements

   $ 4,362      $ 10,529   

Cash receipts and payments related to reorganization items:

    

Professional fees paid for services rendered in connection with the Chapter 11 proceeding

   $ 11,725      $ —     

Supplemental disclosure of cash flow information:

In March 2011, the Segregated Account of Ambac Assurance issued surplus notes in connection with the commutation of two student loan transactions with a par value of $3,000 and in May 2011, the Segregated Account of Ambac Assurance issued junior surplus notes with a par value of $36,082 in connection with an office lease settlement. In 2010, Ambac Financial Group, Inc. issued an aggregate of 13,638,482 shares of its common stock upon the extinguishment of $20,311 in long-term debt. In addition, Ambac Assurance issued surplus notes with a par value of $2,000,000 in connection with the settlement of certain credit derivative liabilities.

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

7


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

(1) Background and Basis of Presentation

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. On November 8, 2010, Ambac filed a voluntary petition for relief (the “Bankruptcy Filing”) 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”). Ambac 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’s common stock trades on the over-the-counter market under the symbol ABKFQ.

Ambac Assurance Corporation (“Ambac Assurance”) is Ambac’s principal operating subsidiary, which provided financial guarantees and financial services to clients in both the public and private sectors around the world. In March 2010, Ambac Assurance established a segregated account pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities. The Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to refer as well to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account, as the context requires)) 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 Theodore Nickel, the Commissioner of Insurance of the State of Wisconsin.

The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio has made it impossible for it to write new business, which will negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends and, as a result, Ambac’s liquidity have been significantly restricted by the deterioration of Ambac Assurance’s financial condition, by the rehabilitation of the Segregated Account and by the terms of a settlement agreement entered into in 2010 with counterparties of CDO of ABS transactions, which is described in more detail in Ambac’s Annual Report on Form 10-K for the year ended December 31, 2010.

Ambac’s principal business strategy is to reorganize its capital structure and financial obligations through the bankruptcy process and 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, litigation to recover losses or mitigate future losses, commutations of policies and repurchases of surplus notes issued in respect of claims) and maximizing the return on its investment portfolio. The execution of such strategy with respect to policies allocated to the Segregated Account will be subject to the authority of the rehabilitator of the Segregated Account to control the management of the Segregated Account. In exercising such authority, the rehabilitator will act for the benefit of policyholders, and will not take into account the interests of Ambac. Similarly, by operation of the contracts executed in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the rehabilitator retains rights to oversee and approve certain actions taken in respect of Ambac Assurance. This oversight by the rehabilitator could impair Ambac’s ability to execute the foregoing strategy. As a result of uncertainties associated with the aforementioned factors, management has concluded that there is substantial doubt about the ability of the Company to continue as a going concern. The Company’s financial statements as of June 30, 2011 and December 31, 2010 and for the three and six month periods ended June 30, 2011 and 2010 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.

Ambac’s liquidity and solvency are largely dependent on its current cash and investments of $51,311 at June 30, 2011 (excluding $2,500 of restricted cash), reaching a bankruptcy settlement with Ambac Assurance or otherwise restructuring, 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, professional advisory fees incurred in connection with the bankruptcy and expenses related to pending litigation.

While management believes that Ambac will have sufficient liquidity to satisfy its needs if it emerges from the bankruptcy proceeding in the near term, no guarantee can be given that it will reach a settlement with Ambac Assurance or otherwise restructure to be able to pay all such expenses. If its liquidity runs out prior to emergence from bankruptcy, a liquidation of Ambac pursuant to Chapter 7 of the Bankruptcy Code will occur. While the Company’s net operating losses (“NOLs”) could be used to offset income of Ambac Assurance realized prior to a completion of a liquidation (and/or by Ambac in the event that a transaction allocating NOLs to Ambac is completed), 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, the Company is likely to be unable to utilize a substantial portion of its NOLs.

 

8


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

 

Chapter 11 Reorganization

As required by the Bankruptcy Code, on November 17, 2010, the United States Trustee appointed a statutory committee of creditors (“Creditors’ Committee”). The Creditors’ Committee and its legal representatives have a right to be heard on all matters that come before the Bankruptcy Court with respect to the Company. There can be no assurance that the Creditors’ Committee will support the Company’s positions on matters to be presented to the Bankruptcy Court, including any plan of reorganization. Disagreements between the Company and the Creditors’ Committee could prolong the court proceedings, negatively impact the Company’s ability to operate, and delay the Company’s emergence from bankruptcy.

Ambac has filed and will continue 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. 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 Ambac’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 Ambac. 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.

On July 6, 2011, the Company, as debtor and debtor-in-possession, filed a Plan of Reorganization (as it may be amended, the “Reorganization Plan”). Under the Reorganization Plan, Ambac’s debt holders and creditors will receive all of the equity in the reorganized company. Additionally, the Reorganization Plan sets forth the revised capital structure of a newly reorganized Ambac and provides for corporate governance subsequent to emergence from bankruptcy.

The Reorganization Plan also proposes a resolution of certain issues (the “Plan Settlement”) among the Company, the Creditors’ Committee, Ambac Assurance, the Segregated Account and OCI related to (i) approximately $7,300,000 of NOLs of the consolidated tax group of which the Company is the parent and Ambac Assurance is a member (the “Ambac Consolidated Group”), (ii) certain tax refunds received in respect thereof (the “Tax Refunds”) and (iii) the sharing of expenses between the Company and Ambac Assurance. If Ambac Assurance and OCI do not accept the Plan Settlement, the Reorganization Plan provides that the Company may reject the Ambac Consolidated Group tax-sharing agreement, cause a deconsolidation of Ambac Assurance from the Ambac Consolidated Group for U.S. federal income tax purposes, and either (a) make an election pursuant to applicable Treasury Regulations to allocate to the reorganized Company the maximum amount of NOLs held by the Ambac Consolidated Group or (b) take a worthless stock loss in respect of its ownership of stock in Ambac Assurance. Further, in the absence of a Plan Settlement, the Reorganization Plan also provides for the establishment of a litigation trust for Ambac’s estate to pursue claims and causes of action against Ambac Assurance, the Segregated Account and OCI.

The Reorganization Plan specified July 29, 2011 as the deadline for Ambac Assurance and OCI to accept the Plan Settlement, and a hearing to determine whether the Disclosure Statement relating to the Reorganization Plan contains “adequate information,” as defined by the Bankruptcy Code, to enable Ambac’s creditors to decide how to vote on the Reorganization Plan (the “Disclosure Statement Approval Hearing”) was initially scheduled for August 12, 2011. On July 21, 2011, the Company, the Creditors’ Committee, Ambac Assurance and OCI agreed that the Company would adjourn the Disclosure Statement Approval Hearing, thereby delaying the vote-solicitation process. Recognizing that the delay in solicitation will result in additional costs to Ambac’s estate, OCI and Ambac Assurance’s Board of Directors approved a cash payment to the Company in the amount of $2,000 (the “Payment”) by Ambac Assurance, which was made on July 26, 2011. The parties further agreed that if the terms of a consensual Reorganization Plan are subsequently agreed upon by and among OCI, Ambac Assurance, the Company and the Creditors’ Committee, the Payment shall be credited towards any agreed obligation of Ambac Assurance to reimburse Ambac for a percentage share of the fees and disbursements incurred in the litigation with the IRS. See Note 12 to the Unaudited Consolidated Financial Statements contained in this Form 10-Q for further information on the IRS litigation. The agreement further provides that it is without prejudice of any kind with respect to the rights, remedies and positions of the Company, Ambac Assurance and OCI under, or pertaining to, any intercompany agreements. Additionally, the Company, the Creditors’ Committee, Ambac Assurance and OCI have agreed to mediate

 

9


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

 

open issues related to the Plan Settlement. Mediation is currently scheduled for August 16 and 17, 2011. The Disclosure Statement Approval Hearing is scheduled for September 8, 2011, and the deadline for Ambac Assurance and OCI to accept the Plan Settlement is August 25, 2011.

Ambac’s exclusive right to file a plan of reorganization expired on July 6, 2011, the date the Reorganization Plan was filed. Ambac’s exclusive right to solicit votes to accept or reject a plan of reorganization currently expires on September 6, 2011. Because of the adjournment of the Disclosure Statement Approval Hearing and the resulting delay in solicitation of votes to accept or reject the Reorganization Plan, Ambac has filed a motion seeking to extend its exclusive right to solicit votes to accept or reject a plan of reorganization to December 5, 2011. This motion is scheduled to be heard by the Bankruptcy Court on August 10, 2011. If Ambac’s exclusivity period lapses, any party in interest would be able to file a plan of reorganization for Ambac. In addition to being approved by at least one class of holders of impaired claims, a plan of reorganization must satisfy certain requirements of the Bankruptcy Code and must be 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 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 Ambac’s estimated $7,300,000 net operating loss tax carry forward. Ambac considers the NOLs to be a valuable asset. However, Ambac’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 (the “Code”). In general, an ownership change would occur if shareholders owning 5% or more of Ambac’s stock increased their percentage ownership (by value) in Ambac 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, Ambac entered into a Tax Benefit Preservation Plan to reduce the risk of an ownership change resulting from the trading of Ambac’s stock. Moreover, on November 30, 2010, the Bankruptcy Court entered an order restricting certain transfers of equity interests in, and claims against, Ambac in order to mitigate the possibility of an ownership change occurring prior to consummation of the Reorganization Plan and to increase the likelihood that Ambac will be able to utilize a special exception under Section 382 of the Code for ownership changes occurring as a result of a bankruptcy plan of reorganization. On July 21, 2011, the Company filed a notice (the “Reporting Notice”) requiring that any entity holding claims against the Company in an amount that equals or exceeds $55,000 (each, a “Substantial Claimholder”) to serve upon the Company and its counsel a “Substantial Claimholder Notice” in the form attached to the Reporting Notice. Each Substantial Claimholder could, in certain circumstances, be required to sell a portion of its claims pursuant to a further order of the Bankruptcy Court.

Segregated Account

Pursuant to the Plan of Operation for the Segregated Account, 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; 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, 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. Claims on Segregated Account Policies remain subject to a payment moratorium until the Segregated Account Rehabilitation Plan (as defined below) becomes effective. Insurance claims presented during the moratorium of $2,113,754 for policies allocated to the Segregated Account have not yet been paid. Net par exposure as of June 30, 2011 for policies allocated to the Segregated Account is $40,523,516. Ambac Assurance also allocated the

 

10


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

 

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 under the recently settled long-term lease with One State Street, LLC (“OSS”), and its contingent liability (as guarantor), if any, under the recently terminated 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). 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 Ambac, or any successor to Ambac, in regard to, or respecting, tax refunds and/or the July 18, 1991 Tax Sharing Agreement, as amended (other than any liability to Ambac 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, Ambac 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 Ambac, any successor-in-interest, any state court receiver of Ambac, all persons purporting to be creditors of Ambac, 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.

Policy obligations not allocated 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.

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”). The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. The effective date of the Segregated Account Rehabilitation Plan will be determined by the rehabilitator. The Segregated Account Rehabilitation Plan also makes permanent the injunctions issued by the Rehabilitation Court on March 24, 2010.

The confirmed Segregated Account Rehabilitation Plan provides that holders of permitted policy claims will receive 25% of their permitted claims in cash and 75% in surplus notes issued by the Segregated Account. The issuance of surplus notes by both Ambac Assurance, and by the Segregated Account as contemplated by the current Segregated Account Rehabilitation Plan, could subject Ambac Assurance to the risk of deconsolidation from Ambac for tax purposes, which may also result in a Section 382 limitation with respect to Ambac Assurance’s NOLs or an attribution of NOLs to Ambac, or could subject Ambac Assurance to the risk of recognizing significant cancellation of indebtedness income (“CODI”). Any of these consequences would likely have a material adverse effect on the financial condition of Ambac Assurance and the Segregated Account. As such, the rehabilitator is considering substantial amendments to the Segregated Account Rehabilitation Plan and/or the initiation of rehabilitation proceedings with respect to Ambac Assurance. Such amendments to the Segregated Account Rehabilitation Plan (and, presumably, any rehabilitation plan with respect to Ambac Assurance) could include the elimination of the issuance of surplus notes by the Segregated Account and/or the imposition of transfer restrictions on any surplus notes issued by the Segregated Account. Any such amendments to the Segregated Account Rehabilitation Plan could adversely affect the interests of Ambac security holders and holders of securities insured by Ambac Assurance as such amendments could reduce the likelihood of consummation of an agreement between Ambac and Ambac Assurance with respect to the Plan Settlement. The parties’ failure to consummate such an agreement increases the likelihood that Ambac’s bankruptcy case will convert to a Chapter 7 liquidation proceeding, with attendant adverse consequences to Ambac security holders and holders of securities insured by Ambac Assurance (including, without limitation, the loss of the NOLs or limiting the use of the NOLs to offset gain realized in connection with the sale of Ambac’s assets).

In March 2011, the Segregated Account issued Segregated Account Surplus Notes with a par value of $3,000 in connection with the commutation of insurance policies allocated to the Segregated Account. At June 30, 2011, the Segregated Account had outstanding Segregated Account Surplus Notes in an aggregate par amount of $53,000, which are reported in Long-term Debt on the Consolidated Balance Sheet with a carrying value of $5,843 based on an imputed interest rate of 52.8% at the date of issuance and have a scheduled maturity of June 7, 2020. Interest on the Segregated Account Surplus Notes is payable annually in June 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

 

11


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

 

fiscal agency agreement entered into with The Bank of New York Mellon, as fiscal agent. To the extent that interest payments are deferred for more than five years, a portion of the deferred interet may not be deducted until paid of disallowed under the applicable high yield debt obligation provisions of the Code.

In May 2011, the Segregated Account issued Segregated Account Junior Surplus Notes with a par value of $36,082 in connection with a settlement agreement (the “Settlement Agreement”) to terminate Ambac’s existing headquarters office lease with One State Street LLC (“OSS”). The Junior Surplus Notes are reported in Long-term Debt on the Consolidated Balance Sheet with a carrying value of $3,639 based on an imputed interest rate of 58.3% at the date of issuance and have a scheduled maturity of June 7, 2020. Interest on the Segregated Account Junior Surplus Notes is payable annually in June at the rate of 5.1% on the unpaid principal balance outstanding. No payment of interest on or principal of the junior surplus notes may be made until all existing and future indebtedness of the Segregated Account, inclusive of Segregated Account Surplus Notes, policy claims and claims having statutory priority have been paid in full. 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 Settlement Agreement settled all claims among Ambac, Ambac Assurance, the Segregated Account of Ambac Assurance Corporation and OSS relating to the terminated lease. Additionally, Ambac Assurance entered into a new lease (the “New AAC Lease”) with OSS for an initial term commencing on May 19, 2011 through December 31, 2015. The New AAC Lease provides for the rental of a reduced amount of space at Ambac’s current location, One State Street Plaza. The Settlement Agreement also provides that OSS will have an allowed general unsecured claim in Ambac’s bankruptcy case for approximately $14,000 (the “AFG Payment”). The AFG Payment will be made by Ambac in the same form as payment is made to Ambac’s other creditors.

On June 1, OCI issued its disapproval of the requests of Ambac Assurance and the rehabilitator of the Segregated Account, acting for and on behalf of the Segregated Account, to pay interest on all outstanding Surplus Notes issued by Ambac and the Segregated Account on the first scheduled interest payment date of June 7, 2011.

Reclassifications:

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

(2) Debtor in Possession Financial Information

Liabilities Subject to Compromise

As required by ASC Topic 852, Reorganizations, the amount of the Liabilities Subject to Compromise represents our estimate of known or potential pre-petition and post-petition claims to be addressed in connection with the Bankruptcy Filing. Such claims are subject to future adjustments. Adjustments may result from, among other things, negotiations with creditors, rejection of executory contracts and unexpired leases and orders of the Bankruptcy Court. The Liabilities subject to compromise in the Consolidated Balance Sheet consists of the following:

 

     June 30, 2011      December 31, 2010  

Accrued interest payable

   $ 68,123       $ 68,091   

Other

     16,206         4,951   

Senior unsecured notes

     1,222,189         1,222,189   

Directly-issued Subordinated capital securities

     400,000         400,000   
  

 

 

    

 

 

 

Consolidated liabilities subject to compromise

     1,706,518         1,695.231   

Payable to non-debtor subsidiaries

     1,653         1,657   
  

 

 

    

 

 

 

Debtor’s Liabilities subject to compromise

   $ 1,708,171       $ 1,696,888   
  

 

 

    

 

 

 

 

12


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

 

Reorganization Items, net

Professional advisory fees and other costs directly associated with our reorganization are reported separately as reorganization items pursuant to ASC Topic 852. Reorganization items also include adjustments to reflect the carrying value of certain pre-petition liabilities at their estimated allowable claim amounts. The reorganization items in the Consolidated Statement of Operations for the three and six months ended June 30, 2011 consisted of the following items:

 

     Three months ended
June 30, 2011
    Six months ended
June  30, 2011
 

U.S. Trustee fees

   $ 13      $ 18   

Professional fees

     6,720        17,218   

Lease settlement

     (295     14,007   

Other

     32        32   
  

 

 

   

 

 

 

Total reorganization items

   $ 6,470      $ 31,275   
  

 

 

   

 

 

 

Refer to Note 1 to the Unaudited Consolidated Financial Statements for further discussion of the office lease settlement.

(3) 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. 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 all vested in January 2010. At such time Ambac was in a net loss position; consequently, no income or loss was allocated to participating securities during the three and six months ended June 30, 2011 and 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. Common shares outstanding includes common stock issued less treasury shares plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding 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 six months ended June 30, 2011 and 2010. 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 six month periods ended June 30, 2011 and 2010:

 

     Three months ended June 30,      Six months ended June 30,  
     2011      2010      2011      2010  

Stock options

     1,721,735         2,843,528         1,753,883         2,908,148   

Restricted stock and units

     461,589         2,194,464         467,403         2,259,637   

Stock purchase contracts

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

In March 2008, Ambac issued 5,000,000 Corporate Units. Each Corporate Unit had a stated amount of $50 and initially consisted of (a) a Purchase Contract for Ambac common stock issued by Ambac and (b) a 5% beneficial ownership interest in $1,000 principal amount of Ambac’s 9.50% Senior Notes due 2021, to be held by the Collateral Agent to secure the performance of the holder’s obligations under the Purchase Contract.

As discussed in Note 1, on November 8, 2010, Ambac filed a petition for relief under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court. Pursuant to the Purchase Contract Agreement the filing of the bankruptcy case constituted a termination event. As a result, the Purchase Contracts were terminated and the Corporate Units thereafter represented the rights of the Holders to receive their applicable ownership interests in the $250,000 Senior Notes. On November 16, 2010, Ambac filed a motion seeking an order approving the termination of the Purchase Contracts and the release of the Senior Notes. On November 30, 2010, the Bankruptcy Court approved the motion. Consequently, at June 30, 2011, no Purchase Contracts are outstanding.

 

13


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

 

(4) Special Purposes Entities, Including Variable Interest Entities

Ambac has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac most commonly has provided financial guarantees, including credit derivative contracts, for various debt obligations issued by special purpose entities, including VIEs. Ambac has also sponsored two special purpose entities that issued 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.

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 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, 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, effective on January 1, 2010, Ambac was required to consolidate these VIEs. As a result of the Rehabilitation Proceedings of the Segregated Account on 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. 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 the 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 June 30, 2011 and December 31, 2010 the fair value of these entities is $18,451 and $17,909, respectively and is reported within Other Assets within the Consolidated Balance Sheets. The change in fair value of these entities is ($554) and $3,585 for the three months ended June 30, 2011 and 2010, respectively, and $542 and ($1,668) for the six months ended June 30, 2011 and 2010, respectively. For the six months ended June 30, 2011 and the three months ended June 30, 2010, income from these entities is included within Financial Guarantee: Other income (loss) on the Consolidated Statement of Operations. For the three months ended March 31, 2010, while the entities were consolidated, income was included in Financial Guarantee: Income (loss) on variable interest entities on the Consolidated Statements of Operations.

Since their inception, there have been 15 individual transactions with these entities, of which 5 transactions were outstanding as of June 30, 2011 and December 31, 2010. Total principal amount of debt outstanding was $585,402 and $588,967 at June 30, 2011

 

14


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

 

and December 31, 2010, respectively. In each case, Ambac sold assets to these entities. The assets are composed of asset-backed securities and utility obligations with a weighted average rating of BBB+ and weighted average life of 9.0 years at June 30, 2011 and December 31, 2010. The purchase by these entities was 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 swaps) are 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. As of June 30, 2011 and December 31, 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.

There were no assets sold to these entities during the three and six months ended June 30, 2011 and 2010. Ambac Assurance earned premiums for issuing the financial guarantee policies on the assets, MTNs and derivative contracts of $191 and $675 for the three months ended June 30, 2011 and 2010, respectively; and $427 and $1,396 for the six months ended June 30, 2011 and 2010, respectively. Ambac paid no claims to these entities under its financial guarantee policies during the three and six months ended June 30, 2011 and the three months ended June 30, 2010. For the six months ended June 30, 2010 Ambac paid claims of $24,411 to these entities. Ambac also earned fees for providing other services amounting to $12 for both the three months ended June 30, 2011 and 2010; and $23 and $35 for the six months ended June 30, 2011 and 2010, 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 $4,206 and $5,161 for the three months ended June 30, 2011 and 2010, respectively; and $4,075 and $6,310 for the six months ended June 30, 2011 and 2010, 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 recognize 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 recognize 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 non-controlling 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 financial 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 non-controlling 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 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, 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 debt of such trust; (iii) international and other asset-backed securitizations as a result of insurance policies guarantying the debt of such financing

 

15


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

 

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 was 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

   $ 23,112,303   

Addition of VIE liabilities

     (22,798,176
  

 

 

 

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, 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 Aluetian, effective March 24, 2010. 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 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 and ASU 2009-16 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. Financial Guarantee: Income (loss) on variable interest entities included no losses for the three month periods ended June 30, 2011 and 2010; and losses of $8,422 and $495,077 for the six month periods ended June 30, 2011 and 2010, respectively, related to VIEs that were no longer consolidated as of the end the respective periods. The losses on these VIEs is primarily a result of deconsolidation, including for 2010 the deconsolidation of transactions allocated to the Segregated Account as discussed above, as the carrying value of the re-established net insurance liabilities exceeded the net liabilities of the VIEs which were carried at fair value in consolidation.

As of June 30, 2011, consolidated VIE assets and liabilities relating to 19 consolidated entities were $17,071,001 and $16,903,271, respectively. As of December 31, 2010, consolidated VIE assets and liabilities relating to 19 consolidated entities were $17,930,829 and $17,696,445, respectively. Ambac is not primarily liable for, and does not guarantee all of the debt obligations issued by the VIEs. Ambac would only be required to make payments on the guaranteed 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.

 

16


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

 

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.

The table below provides the fair value of fixed income securities, by asset-type, held by consolidated VIEs as of June 30, 2011 and December 31, 2010:

 

     June 30, 2011      December 31, 2010  

Investments:

     

Corporate obligations

   $ 2,023,513       $ 1,904,361   
  

 

 

    

 

 

 

Total Variable interest entity assets: Fixed income securities

   $ 2,023,513       $ 1,904,361   
  

 

 

    

 

 

 

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 June 30, 2011 and December 31, 2010:

 

     Estimated  fair
value
     Unpaid  principal
balance
 

June 30, 2011:

     

Loans

   $ 14,442,912       $ 14,541,744   

Long-term debt

   $ 15,277,137       $ 16,784,088   

December 31, 2010:

     

Loans

   $ 15,800,918       $ 16,750,029   

Long-term debt

   $ 15,885,711       $ 18,156,968   

Effective April 1, 2011, Ambac was required to consolidate one VIE. The assets of this VIE consist primarily of identified intangible assets associated with its subsidiaries’ operations. The intangible assets recorded at fair value upon consolidation on April 1, 2011 were $326,342, and are being amortized over their estimated useful lives. The weighted-average amortization period at the consolidation date was 28 years. Accumulated amortization on the intangible assets as of June 30, 2011 is $8,162.

Amortization expense for intangible assets for the three and six months ended June 30, 2011 was $8,162 and is included in Financial Guarantee: Income (loss) on variable interest entities on the Consolidated Statement of Operations.

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 June 30, 2011 and December 31, 2010:

 

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

June 30, 2011:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 17,981,764       $ 18,707       $ 106,821       $ 161,167   

Mortgage-backed – residential

     33,189,994         975,303         4,818,899         —     

Mortgage-backed – commercial

     792,150         —           —           5,761   

Other consumer asset-backed

     11,686,697         165,327         1,242,353         21,363   

Other commercial asset-backed

     13,118,525         363,036         373,034         4,325   

Other

     8,008,982         119,794         555,681         2,599   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     84,778,112         1,642,167         7,096,788         195,215   

Global Public Finance

     40,392,776         603,265         726,407         13,266   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 125,170,888       $ 2,245,432       $ 7,823,195       $ 208,481   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

17


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

 

     Carrying Value of Assets and Liabilities  
     Maximum
Exposure To

Loss(1)
     Insurance
Assets (2)
     Insurance
Liabilities(3)
     Derivative
Liabilities(4)
 

December 31, 2010:

           

Global Structured Finance:

           

Collateralized debt obligations

     20,976         36,372         122,158         168,219   

Mortgage-backed – residential

     35,304         962,835         4,192,877         95   

Mortgage-backed – commercial

     935         —           —           7,340   

Other consumer asset-backed

     12,705         171,725         1,049,142         23,148   

Other commercial asset-backed

     18,406         710,685         716,796         5,444   

Other

     8,635         145,110         504,199         1,974   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     96,961         2,026,727         6,585,172         206,220   

Global Public Finance

     41,358         638,626         774,000         9,786   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     138,319         2,665,353         7,359,172         216,006   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(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.

(5) 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 present value of premiums to be collected over the expected life of the transaction (the “expected” method). 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 at June 30, 2011 and December 31, 2010 was 3.1% and the weighted average period of future premiums used to estimate the premium receivable at June 30, 2011 and December 31, 2010 was 10.9 years and 10.4 years, respectively. Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities and consumer auto loans. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk free rate.

Generally, the priority for the payment of financial guarantee premiums to Ambac, as required by the bond indentures of the insured obligations, is very senior in the waterfall. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees are required under the Rehabilitation Plan to continue to pay installment premiums, notwithstanding the claims moratorium. As such, Ambac has not historically written off any meaningful amount of uncollectible premiums. In evaluating the credit quality of the premiums receivable, management evaluates the internal ratings of the transactions underlying the premiums receivable. As of June 30, 2011 and December 31, 2010, approximately 31% and 29% of the premiums receivable related to transactions with non-investment grade internal ratings, comprised mainly of non-investment grade MBS and student loan transactions, which comprised 12% and 13%, and 9% and 11% of the total premiums receivable at June 30, 2011 and December 31, 2010, respectively. Past due premiums on policies insuring non-investment grade obligations amounted to less than $250 at June 30, 2011.

 

18


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

 

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 periods ended June 30, 2011 and December 31, 2010:

 

     June 30,
2011
    December 31,
2010
 

Premium receivable at December 31, 2009

     $ 3,718,158   

Impact of adoption of ASU 2009-17(1)

       (670,997
    

 

 

 

Premium receivable at January 1, 2011 and 2010

   $ 2,422,596        3,047,161   

Premium payments received

     (106,475     (266,028

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

     (402,513     (577,626

Accretion of premium receivable discount

     34,401        84,567   

(Consolidation)/Deconsolidation of certain VIEs(1)

     (44,001     173,511   

Other adjustments (including foreign exchange)

     20,917        (38,989
  

 

 

   

 

 

 

Premium receivable at June 30, 2011 and December 31, 2010

   $ 1,924,925      $ 2,422,596   
  

 

 

   

 

 

 

 

(1) Refer to Note 4 to the Unaudited Consolidated Financial Statements for discussion of the consolidation 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 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 as 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 cost) and recognized in income in proportion to ceded premiums.

 

19


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

 

The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at June 30, 2011:

 

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

Three months ended:

     

September 30, 2011

   $ 43,607       $ 80,436   

December 31, 2011

     44,424         67,473   

Twelve months ended:

     

December 31, 2012

     164,265         250,360   

December 31, 2013

     154,606         225,579   

December 31, 2014

     147,285         208,694   

December 31, 2015

     138,390         194,588   

Five years ended:

     

December 31, 2020

     615,300         812,430   

December 31, 2025

     501,183         576,490   

December 31, 2030

     416,559         403,640   

December 31, 2035

     289,145         236,590   

December 31, 2040

     101,776         83,760   

December 31, 2045

     30,879         26,336   

December 31, 2050

     7,339         7,970   

December 31, 2055

     557         1,287   
  

 

 

    

 

 

 

Total

   $ 2,655,315       $ 3,175,633   
  

 

 

    

 

 

 

 

(1) The future premiums expected to be collected and future premiums expected to be earned, net of reinsurance 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 a bond issue insured by Ambac Assurance has been retired, including those retirements due to refunding or calls, any remaining UPR is recognized at that time to the extent the financial guarantee contract is legally extinguished. For installment premium paying transactions, we offset the recognition of any remaining UPR by the reduction of the related premium receivable to zero (as it will not be collected as a result of the retirement), which may cause negative accelerated premium revenue. Accelerated premium revenue for retired obligations for the three and six months ended June 30, 2011 was $11,331 and $11,261, respectively. Accelerated premium revenue for retired obligations for the three and six months ended June 30, 2010 was $54,308 and $66,446, 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.

 

20


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

 

The table below shows premiums written on a gross and net basis for the three and six month periods ended June 30, 2011 and 2010:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Revenues:

        

Financial Guarantee:

        

Gross premiums written

   ($ 208,074   ($ 41,735   ($ 368,285   ($ 191,135

Ceded premiums written

     11,571        (1,678     20,789        16,938   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums written

   ($ 196,503   ($ 43,413   ($ 347,496   ($ 174,197
  

 

 

   

 

 

   

 

 

   

 

 

 

(6) 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. 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” in Note 7. 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 credits, including our active surveillance of the insured book of business and observation of deterioration in the obligor’s performance and credit standing.

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

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.

 

21


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

 

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

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

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

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

CLASS II – “Substandard Requiring Intervention”

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

CLASS III – “Doubtful with Clear Potential for Loss”

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

CLASS IV – “Imminent Default or Defaulted”

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

CLASS V – “Fully Reserved”

The credit has defaulted and payments have occurred. The claim payments are scheduled and known, 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 risk management professionals and other senior management. For certain credit exposures, Ambac’s additional monitoring and loss remediation efforts may provide information relevant to adjust this estimate of “base case” statistical expected losses. As such, 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 primarily for residential mortgage-backed and student loans exposures. These tools, in conjunction with detailed data of the historical performance of the collateral pools, assist

 

22


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

 

Ambac in the determination of certain assumptions, such as home price and interest rate forecasts, and default and voluntary prepayment rates, which are needed in order to estimate expected future net cash outflows associated with the credit. In this approach a probability-weighted expected loss estimate is developed based on assigning probabilities to multiple net cash outflow scenarios and applying an appropriate discount factor. Probabilities assigned are based on all known data related to the credit, any contact with the issuer or investors, and any economic or market information that may impact the possibilities of the various scenarios being evaluated. For a limited number of policies, certain net cash outflow scenarios incorporate various remediation strategies. These remediation scenarios may include: 1) a potential refinancing of the transaction by the issuer; (2) the issuer’s ability to redeem outstanding insured bonds at a discount, thereby increasing equity in the deal to absorb future losses; and (3) Ambac’s ability to terminate the policy in whole or in part (a “commutation”). The remediation scenarios and the related probabilities of occurrence vary by transaction depending on on-going discussions and negotiations that are underway with issuers and/or investors. In addition to commutation negotiations that are underway with certain counterparties in various forms, our loss reserve estimates may include net cash outflow scenarios that incorporate our ability to commute additional exposure with other counterparties under similar terms where we deem such expectations to be reasonably possible based on historical results. A loss reserve is recorded for the excess, if any, of estimated expected losses (net cash outflows), over UPR. For certain policies, estimated potential recoveries exceed estimated future claim payments because all or a portion of such recoveries relate to claims previously paid. The expected net cash inflows for these policies are recorded as a subrogation recoverable asset.

The discount factor applied to both of the above described approaches is based on a risk-free discount rate corresponding to the remaining expected weighted-average life of the exposure and the exposure currency. The discount factor is updated for the current risk-free rate each reporting period. The weighted average risk-free rate used to discount the loss reserves at June 30, 2011 and December 31, 2010 was 2.9% and 3.0%, respectively.

The tables below summarize information related to policies currently included in Ambac’s loss reserves at June 30, 2011 and December 31, 2010:

Surveillance Categories (at June 30, 2011)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     27        8        35        134        140        1        345   

Remaining weighted-average contract period (in years)

     5        9        18        19        10        10        14   

Gross insured contractual payments outstanding:

              

Principal

     1,429,228        356,336        1,810,616        15,292,054        14,749,969        47        33,638,250   

Interest

     378,130        159,952        1,099,132        10,999,903        3,995,892        27        16,633,036   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     1,807,358        516,288        2,909,748        26,291,957        18,745,861        74        50,271,286   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

     16,894        9,936        51,067        4,712,818        7,990,055        75        12,780,845   

Discount, gross claim liability

     (992     (3,602     (5,840     (1,920,636     (1,327,809     (20     (3,258,899
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross discounted claim liability before all subrogation and before reinsurance

     15,902        6,334        45,227        2,792,182        6,662,246        55        9,521,946   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          (162,702     (2,483,689     —          (2,646,391

Discount, RMBS subrogation

     —          —          —          10,338        62,801        —          73,139   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          (152,364     (2,420,888     —          (2,573,252
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          (6     (4     (139,540     (855,425     —          (994,975

Discount, other subrogation

     —          1        —          34,990        81,056        —          116,047   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          (5     (4     (104,550     (774,369     —          (878,928
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross discounted claim liability, net of all subrogation, before reinsurance

     15,902        6,329        45,223        2,535,268        3,466,989        55        6,069,766   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (5,629     (4,959     (20,621     (271,872     (172,682     —          (475,763

Plus: Loss adjustment expenses reserves

     —          —          —          —          95,556        —          95,556   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted claim liability reported on Balance Sheet, before reinsurance(3)

     10,273        1,370        24,602        2,263,396        3,389,863        55        5,689,559   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

     1,191        14        1,224        139,347        16,321          158,097   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

23


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

 

 

(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 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 $1,056,242)    $ 6,444,519     
  Subrogation recoverable (includes gross potential remediation of $1,517,009)      (739,658  
  Other assets (within)      (15,302  
    

 

 

   
     $ 5,689,559     
    

 

 

   

Surveillance Categories (at December 31, 2010)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     24        4        34        118        127        1        308   

Remaining weighted-average contract period (in years)

     5        9        17        19        9        10        14   

Gross insured contractual payments outstanding:

              

Principal

   $ 1,831,525      $ 198,460      $ 2,620,973      $ 17,723,814      $ 13,766,322      $ 47      $ 36,141,141   

Interest

     392,486        58,317        1,983,875        10,609,295        3,327,242        27        16,371,242   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 2,224,011      $ 256,777      $ 4,604,848      $ 28,333,109      $ 17,093,564      $ 74      $ 52,512,383   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

   $ 19,664      $ 9,952      $ 62,469      $ 4,195,891      $ 7,197,833      $ 75      $ 11,485,884   

Discount, gross claim liability

     (925     (4,700     13,974        (1,517,671     (1,234,704     (20     (2,744,046
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross discounted claim liability before all subrogation and before reinsurance

   $ 18,739      $ 5,252      $ 76,443      $ 2,678,220      $ 5,963,129      $ 55      $ 8,741,838   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          —          (2,514,477     —          (2,514,477

Discount, RMBS subrogation

     —          —          —          —          97,371        —          97,371   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          —          (2,417,106     —          (2,417,106
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          —          (11     (629,022     (1,033,055     —          (1,662,088

Discount, other subrogation

     —          —          —          207,811        89,166        —          296,977   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          —          (11     (421,211     (943,889     —          (1,365,111
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross discounted claim liability, net of all subrogation, before reinsurance

     18,739        5,252        76,432        2,257,009        2,602,134        55        4,959,621   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (9,095     (3,959     (49,782     (289,408     (149,235     —          (501,479

Plus: Loss adjustment expenses reserves

     —          —          —          9,762        85,495        —          95,257   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted claim liability reported on Balance Sheet, before reinsurance(3)

     9,644        1,293        26,650        1,977,363        2,538,394        55        4,553,399   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

     542        8        1,588        107,920        26,928        —          136,986   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

24


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

 

 

(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 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 $714,679)    $ 5,288,655     
   Subrogation recoverable (includes gross potential remediation of $1,702,427)      (714,270  
   Other assets (within)      (20,986  
     

 

 

   
      $ 4,553,399     
     

 

 

   

Loss expense reserves were also established for significant surveillance and mitigation expenses associated with adversely classified credits. Total loss expense reserves, net of reinsurance, were $93,881 and $93,900 at June 30, 2011 and December 31, 2010, respectively. Loss reserves ceded to reinsurers at June 30, 2011 and December 31, 2010 were $148,605 and $128,993, respectively. Amounts were included in reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet.

Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the six months ended June 30, 2011 and the year ended December 31, 2010:

 

     Six months
Ended  June 30,
2011
    Year Ended
December 31,
2010
 

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

     $ 3,777,321   

Impact of adopting ASU 2009-17

       (503,887
  

 

 

   

 

 

 

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

     4,424,450        3,273,434   

Changes in the loss reserves due to:

    

Current year:

    

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

     187,876        266,913   

Claim (payments) recoveries, net of reinsurance

     (649     (874

Establishment of RMBS subrogation recoveries, net of reinsurance

     (217,666     (342,979
  

 

 

   

 

 

 

Total current year

     (30,439     (76,940

Prior year:

    

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

     1,050,745        822,848   

Change in previously established RMBS subrogation recoveries, net of reinsurance

     63,619        (26,864

Claim payments, net of RMBS subrogation recoverable and reinsurance

     30,902        (244,661
  

 

 

   

 

 

 

Total prior year

     1,145,266        551,323   

Changes in loss reserves

     1,114,827        474,383   

Deconsolidation of certain VIEs under ASU 2009-17

     —          676,633   
  

 

 

   

 

 

 

Ending loss reserves, net of subrogation recoverable and reinsurance

   $ 5,539,277      $ 4,424,450   
  

 

 

   

 

 

 

Representation and Warranty Breaches by RMBS Transaction Sponsors:

In an effort to better understand the unprecedented levels of delinquencies, Ambac or its counsel engaged consultants with significant mortgage underwriting experience to review the underwriting documentation for mortgage loans underlying certain insured RMBS transactions. Transactions which exhibited exceptionally poor performance were chosen for further examination of the underwriting documentation supporting the underlying loans. Factors which Ambac believes to be indicative of poor performance

 

25


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

 

include (i) increased levels of early payment defaults, (ii) significant number of loan liquidations or charge-offs and resulting high levels 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 provided representations and warranties with respect to the securitized loans including the loan characteristics, the absence of fraud or other misconduct in the origination process, and attesting to the compliance of loans with the prevailing underwriting policies. Per the underlying transaction documents, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations and warranties.

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. To effect a repurchase, depending on the transaction, the sponsor is obligated to repurchase the loan at (a) for loans which have not been liquidated or charged off, either (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 may exclude accrued unpaid interest). Notwithstanding the material breaches of representations and warranties, until the establishment of the Segregated Account and the associated Segregated Account Rehabilitation Proceedings, Ambac continued to pay claims submitted under the financial guarantee insurance policies related to these securitizations and will resume paying such claims in accordance with the Rehabilitation Plan after the plan is effective. 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. 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 this 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 amounts 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 large financial institutions which have served as sponsors for certain transactions that Ambac has insured have disclosed that they have established reserves related to claims by financial guarantors and others for breaches of representations and warranties in RMBS transactions.

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, based on a protocol developed by a statistical expert. For March 31, 2011 and prior periods the following approach was used:

 

   

A “breach rate” was computed by dividing (i) the loans identified in the sample as having breached representations and warranties by (ii) the total sample size.

 

   

Next, the estimated repurchase obligation was determined by multiplying the breach rate by the sum of (a) realized losses resulting from loan liquidations or charge-offs to date plus (b) the current unpaid loan pool balance (“CULPB”). 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 were 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 was the best information we had available to

 

26


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

 

 

estimate the sponsor’s repurchase obligation under the random sample approach used for March 31, 2011 and prior periods.

 

   

Then, 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 to the undiscounted subrogation recovery to compute the estimated subrogation recovery.

Due to the nature of the sampling methodology used for March 31, 2011 and prior periods the subrogation recovery estimate Ambac has recorded based on the above-described random sample approach included 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. A recent court ruling in a similar suit unrelated to Ambac, but in the same jurisdiction in which Ambac has filed its litigation to date, supports the view that a sampling methodology is permissible. 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 previously estimated its subrogation recoveries by applying the breach rate to both performing and defaulted loans.

Starting with the June 30, 2011 reporting period, Ambac revised its random sample approach by replacing the CULPB with estimated future collateral pool losses in the above-described calculation. Specifically, the estimated repurchase obligation in the second step above was developed by multiplying the breach rate by the sum of (a) realized losses resulting from loan liquidations or charge-offs to date plus (b) the estimated future collateral pool losses. While we believe both the previous and current random sample approaches are statistically valid, the current approach only extrapolates against the estimated population of adverse loans. No other changes were made to the random sample approach at June 30, 2011.

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, or are 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 paragraphs, are as follows:

 

  (i) There is no extrapolation to the sum of realized losses and estimated future losses under the adverse sample approach. At June 30, 2011, the adverse sample approach is being used for 20 transactions that are with the same sponsor, which has limited access to loan files precluding the selection of statistically valid random sample from the entire loan pool. 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.

 

27


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

 

  (ii) The adverse sample approach is 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, or the sponsor’s buyback obligation is not 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 was 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 estimatable.

 

  (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 39% 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.

Ambac has updated its estimated subrogation recoveries to $2,573,251 ($2,545,385 net of reinsurance) at June 30, 2011 from $2,417,106 ($2,391,335, net of reinsurance) at December 31, 2010. The balance of subrogation recoveries and the related claim liabilities at June 30, 2011 and December 31, 2010 are as follows:

 

     June 30, 2011  

Method

   Count     Gross claim liability
before subrogation
recoveries
     Subrogation
recoveries(1)
    Gross claim liability
after subrogation
recoveries
 

Adverse samples

     20 (2)    $ 1,856,248       $ (872,927   $ 983,321   

Random samples

     16 (3)      1,149,846         (1,700,324     (550,478
  

 

 

   

 

 

    

 

 

   

 

 

 

Totals

     36      $ 3,006,094       $ (2,573,251   $ 432,843   
  

 

 

   

 

 

    

 

 

   

 

 

 
     December 31, 2010  

Method

   Count     Gross claim liability
before subrogation
recoveries
     Subrogation
recoveries(1)
    Gross claim liability
after subrogation
recoveries
 

Adverse samples

     15 (2)    $ 1,644,488       $ (719,448   $ 925,040   

Random samples

     12 (3)      1,010,704.         (1,697,658     (686,954
  

 

 

   

 

 

    

 

 

   

 

 

 

Totals

     27      $ 2,655,192       $ (2,417,106   $ 238,086   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(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 $2,573,251 of subrogation recoveries recorded at June 30, 2011, $1,517,099 was included in “Subrogation recoverable” and $1,056,242 was included in “Loss and loss expense reserves.” Of the $2,417,106 of subrogation recoveries recorded at December 31, 2010, $1,702,426 was included in “Subrogation recoverable” and $714,679 was included in “Loss and loss expense reserves.”
(2) Of these 20 (15 in 2010) transactions, 10 contractually require the sponsor to repurchase loans at the unpaid principal balance and 10 (5 in 2010) 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.

 

28


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

 

(3) Of these 16 (12 in 2010) transactions, 3 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest and 13 (9 in 2010) 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 sponsor to ultimate resolution. These future subrogation cash flows are discounted at a risk-free rate of 2.26%.

Ambac has performed the above-mentioned, detailed examinations on a variety of second-lien and 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 36 transactions which have been reviewed as of June 30, 2011. 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 judgment 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. In fact, we have witnessed to date, certain successor financial institutions make significant payments to certain claimants to settle breaches of representations and warranties perpetrated by sponsors that have been acquired by such financial institutions. 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 other 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, 2010 through June 30, 2011:

 

     Random sample     # of
deals
     Adverse
Sample
    # of
deals
 

Rollforward:

         

Discounted RMBS subrogation (gross of reinsurance) at December 31, 2010

   $ 1,697,658        12       $ 719,448        15   
  

 

 

   

 

 

    

 

 

   

 

 

 

Changes recognized in 2011:

         

Additional transactions reviewed

     128,590       4         91,866        5   

Additional adverse sample loans reviewed

     —          n/a         35,422        n/a   

Loans repurchased by the sponsor

     (22,899     n/a         (8,247     n/a   
  

 

 

   

 

 

    

 

 

   

 

 

 

Subtotal of changes recognized in current period

     105,691        n/a         119,041        n/a   
  

 

 

   

 

 

    

 

 

   

 

 

 

Changes from re-estimation of opening balance:

         

Change in pre-recovery loss reserves

     (103,025     n/a         34,438        n/a   

Discounted RMBS subrogation (gross of reinsurance) at June 30, 2011

   $ 1,700,324        16       $ 872,927        20   
  

 

 

   

 

 

    

 

 

   

 

 

 

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 $824,536 and $1,821,856 in 2012 and 2013, respectively (gross of discounting and reinsurance in the

 

29


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

 

amount of $73,140 and $27,866, respectively). The amount of these subrogation recoveries is significant and if we are unable to recover any amounts our future available liquidity to pay claims would be reduced and our stockholders’ deficit as of June 30, 2011 would increase from $2,073,981 to $4,619,366.

(7) 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 on a gross basis; assets and liabilities are netted by customer only when a legal right of offset exists. 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.

The Company has entered into derivative contracts both for trading purposes and to hedge certain economic risks inherent in its financial asset and liability portfolios. The Company also has certain options to repurchase Ambac Assurance’s surplus notes at a discount to par value which are required to be accounted for as stand-alone derivatives. VIEs consolidated under ASC Topic 810 entered into derivative contracts to meet specified purposes within the securitization structure. Changes in fair value of consolidated VIE derivatives are included within Financial Guarantee: Income (loss) on variable interest entities on the Consolidated Statements of Operations. The notional for VIE derivatives outstanding as of June 30, 2011 and December 31, 2010 are as follows:

 

Type of VIE derivative

   Notional  
   June 30, 2011      December 31, 2010  

Interest rate swaps—receive-fixed/pay-variable

   $ 1,761,597       $ 1,711,881   

Interest rate swaps—pay-fixed/receive-variable

     5,252,922         6,291,763   

Currency swaps

     746,372         725,307   

Credit derivatives

     22,073         21,976   

Derivatives for trading include credit derivatives issued as a form of financial guarantee, certain interest rate and currency swaps and futures contracts. 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.

Ambac determines that the amounts recognized for the right to reclaim cash collateral or futures margin or the obligation to return cash collateral are not at fair value and are not offset 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 $55,541 and $281 as of June 30, 2011 and December 31, 2010, respectively. The amounts representing the obligation to return cash collateral, recorded in “Other liabilities” were $0 and $7,005 as of June 30, 2011 and December 31, 2010, respectively. The following tables summarize the location and fair values of individual derivative instruments reported in the Consolidated Balance Sheets as of June 30, 2011 and December 31, 2010. Amounts are presented gross of the effect of offsetting balances even where a legal right of offset exists:

 

30


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

 

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

June 30, 2011:

           

Derivatives held for trading

           

Credit derivatives

   Derivative assets    $ —         Derivative liabilities    $ 215,847   

Interest rate swaps

   Derivative assets      330,023       Derivative liabilities      161,107   
   Derivative liabilities      17,793       Derivative assets      101,843   

Currency swaps

   Derivative assets      —         Derivative liabilities      4,976   

Futures contracts

   Derivative assets      —         Derivative liabilities      672   

Other contracts

   Derivative assets      —         Derivative liabilities      104   
     

 

 

       

 

 

 

Total derivatives held for trading

        347,816            484,549   
     

 

 

       

 

 

 

Call options on long-term debt

   Derivative assets      20,770       Derivative liabilities      —     
     

 

 

       

 

 

 

Total derivatives

      $ 368,586          $ 484,549   
     

 

 

       

 

 

 

Variable Interest Entities

           

Credit derivatives

   VIE - Derivative assets    $ —         VIE - Derivative liabilities    $ —     

Currency swaps

   VIE - Derivative liabilities      14,792       VIE - Derivative liabilities      115,921   

Interest rate swaps

   VIE - Derivative liabilities      5,864       VIE - Derivative liabilities      1,276,591   
     

 

 

       

 

 

 
      $ 20,656          $ 1,392,512   
     

 

 

       

 

 

 

December 31, 2010:

           

Derivatives held for trading

           

Credit derivatives

   Derivative assets    $ —         Derivative liabilities    $ 221,684   

Interest rate swaps

   Derivative assets      408,299       Derivative liabilities      124,932   
   Derivative liabilities      4,756       Derivative assets      129,185   

Currency swaps

   Derivative assets      —         Derivative liabilities      6,699   

Futures contracts

   Derivative assets      11,185       Derivative liabilities      —     

Other contracts

   Derivative assets      —         Derivative liabilities      232   
     

 

 

       

 

 

 

Total derivatives held for trading

        424,240            482,732   
     

 

 

       

 

 

 

Call options on long-term debt

   Derivative assets      —         Derivative liabilities      —     
     

 

 

       

 

 

 

Total derivatives

      $ 424,240          $ 482,732   
     

 

 

       

 

 

 

Variable Interest Entities

           

Credit derivatives

   VIE - Derivative assets    $ 4,511       VIE - Derivative liabilities    $ —     

Currency swaps

   VIE - Derivative liabilities      26,577       VIE - Derivative liabilities      105,037   

Interest rate swaps

   VIE - Derivative liabilities      2,203       VIE - Derivative liabilities      1,503,863   
     

 

 

       

 

 

 
      $ 33,291          $ 1,608,900   
     

 

 

       

 

 

 

 

31


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

 

Derivative Contracts Classified as Held for Trading Purposes:

Financial Guarantee Credit Derivatives:

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

In a small number of transactions, Ambac 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 16 transactions, which are not “pay-as-you-go”, with a combined notional of approximately $806,583 and a net liability fair value of $3,716 as of June 30, 2011. These transactions are primarily in the form of CLOs written between 2002 and 2005.

Substantially all of Ambac’s credit derivative contracts relate to structured finance transactions. Credit derivatives issued by Ambac are insured by Ambac Assurance. None of our outstanding credit derivative transactions at June 30, 2011 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 tables summarize the net par outstanding for CDS contracts, by Ambac rating, for each major category as of June 30, 2011 and December 31, 2010:

June 30, 2011

 

Ambac Rating

   CLO      Other      Total  

AAA

   $ 230,141       $ 2,021,600       $ 2,251,741   

AA

     8,026,333         1,102,431         9,128,764   

A

     2,561,081         2,539,595         5,100,676   

BBB

     —           549,276         549,276   

Below investment grade

     —           341,543         341,543   
  

 

 

    

 

 

    

 

 

 
   $ 10,817,555       $ 6,554,445       $ 17,372,000   
  

 

 

    

 

 

    

 

 

 

December 31, 2010

 

Ambac Rating

   CLO      Other      Total  

AAA

   $ 282,294       $ 2,209,540       $ 2,491,834   

AA

     8,323,435         1,237,993         9,561,428   

A

     2,955,030         2,851,213         5,806,243   

BBB

     31,938         627,021         658,959   

Below investment grade

     —           247,890         247,890   
  

 

 

    

 

 

    

 

 

 
   $ 11,592,697       $ 7,173,657       $ 18,766,354   
  

 

 

    

 

 

    

 

 

 

 

32


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

 

The tables below summarize information by major category as of June 30, 2011 and December 31, 2010:

June 30, 2011

 

     CLO     Other     Total  

Number of CDS transactions

     54        25        79   

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

     2.9        6.2        4.1   

Gross principal notional outstanding

   $ 10,817,555      $ 6,554,445      $ 17,372,000   

Net derivative liabilities at fair value

   $ (60,759   $ (155,088   $ (215,847

December 31, 2010

 

     CLO     Other     Total  

Number of CDS transactions

     59        30        89   

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

     3.4        4.4        3.8   

Gross principal notional outstanding

   $ 11,592,697      $ 7,173,657      $ 18,766,354   

Net derivative liabilities at fair value

   $ (70,467   $ (151,217   $ (221,684

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 4, Special Purpose Entities Including Variable Interest Entities.

Ambac’s credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under ASC Topic 815. Changes in fair value are recorded in “Net change in fair value of credit derivatives” on the Consolidated Statements of Operations. The “Realized gains and losses and other settlements” component of this income statement line includes (i) premiums received and accrued on written credit derivative contracts, (ii) premiums paid and accrued on purchased credit derivative contracts, (iii) losses paid and payable on written credit derivative contracts and (iv) paid losses recovered and recoverable on purchased credit derivative contracts for the appropriate accounting period. Losses paid and payable and losses recovered and recoverable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under the contract terms or in connection with a negotiated termination of a contract. There were no paid losses on credit derivative contracts during the three and six month periods ended June 30, 2011. Paid losses included in realized gains and losses and other settlements were $2,789,299 and $2,789,037 for the three and six months ended June 30, 2010, 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 above. As of June 30, 2011, there are three CDS contracts on Ambac’s adversely classified credit listing, with a net derivative liability fair value of $21,363 and total notional principal outstanding of $240,728. As of December 31, 2010, there were three CDS contracts on Ambac’s adversely classified credit listing, with a net derivative liability fair value of $23,148 and a total notional principal outstanding of $247,890.

 

33


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

 

Financial Services Derivative Products:

Ambac, through its subsidiary Ambac Financial Services (“AFS”), provided interest rate and currency swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. AFS 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 excess interest rate sensitivity as an economic hedge against the effects of rising interest rates elsewhere in the Company, including on Ambac’s financial guarantee exposures. 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. As of June 30, 2011 and December 31, 2010 the notional amounts of AFS’s trading derivative products are as follows:

 

Type of derivative

   Notional
June 30,  2011
     Notional
December 31,  2010
 

Interest rate swaps—receive-fixed/pay-variable

   $ 1,569,005       $ 1,798,704   

Interest rate swaps—pay-fixed/receive-variable

     4,326,141         3,802,086   

Interest rate swaps—basis swaps

     231,250         231,250   

Currency swaps

     25,481         35,971   

Futures contracts

     107,500         290,000   

Other contracts

     137,410         154,045   

The following tables summarize 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 six months ended June 30, 2011 and 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
June 30, 2011
    Amount of Gain  or
(Loss) Recognized
in Consolidated
Statement of
Operations – Three
months ended
June 30, 2010
 

Financial Guarantee:

       

Credit derivatives

   Net change in fair value
of credit derivatives
   $ 24,287      $ 202,182   

Financial Services derivatives products:

       

Interest rate swaps

   Derivative products      (57,952     (37,336

Currency swaps

   Derivative products      (354     1,875   

Futures contracts

   Derivative products      (7,307     (35,184

Other derivatives

   Derivative products      21        (312
     

 

 

   

 

 

 

Total Financial Services derivative products

        (65,592     (70,957
     

 

 

   

 

 

 

Total derivative contracts held for trading purposes

      $ (41,305   $ 131,225   
     

 

 

   

 

 

 

 

34


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

 

     Location of Gain or  (Loss)
Recognized in Consolidated
Statement of Operations
   Amount of Gain  or
(Loss) Recognized
in Consolidated
Statement of
Operations – Six
months ended
June 30, 2011
    Amount of Gain  or
(Loss) Recognized
in Consolidated
Statement of
Operations – Six
months ended
June 30, 2010
 

Financial Guarantee:

       

Credit derivatives

   Net change in fair value
of credit derivatives
   $ 15,384      $ 35,042   

Financial Services derivatives products:

       

Interest rate swaps

   Derivative products      (34,260     (15,707

Currency swaps

   Derivative products      (556     (70,238

Futures contracts

   Derivative products      (9,875     (43,424

Other derivatives

   Derivative products      103        185   
     

 

 

   

 

 

 

Total Financial Services derivative products

        (44,588     (129,184
     

 

 

   

 

 

 

Total derivative contracts held for trading purposes

      $ (29,204   $ (94,142
     

 

 

   

 

 

 

Derivative Contracts used for Non-Trading and Hedging Purposes:

Interest rate and currency swaps have been used to manage specified risks 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. There were no designated hedges in effect under ASC Topic 815 subsequent to December 31, 2009. Additionally, the remaining derivative contracts that were not designated hedges under ASC Topic 815, but were considered by management to be for non-trading and hedging purposes, expired during 2010, resulting in a gain of $1,156, included in “Net mark-to-market gains (losses) on non-trading derivative contracts” for the six months ended June 30, 2010.

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 ($11,556) for the three months ended June 30, 2011 and 2010, respectively, and $0 and ($15,451) for the six months ended June 30, 2011 and 2010, respectively.

Call Option on Long-Term Debt

Ambac Assurance has certain contractual options to repurchase its surplus notes at a discount to their par value, and are considered stand-alone derivatives. The surplus notes were issued in connection with a settlement agreement with certain counterparties to credit default swaps in June 2010 and are classified under Long-term debt on the Consolidated Balance Sheets. The amount of surplus notes that may be repurchased under these options is $500,000 at June 30, 2011 and December 31, 2010. The fair value of the options was $20,770 and $0 as of June 30, 2011 and December 31, 2010, respectively. Gains of $4,045 and $0 from the change in fair value of the call options were recognized within Financial Guarantee: Other income (loss) in the Consolidated Statements of Operations for the three months ended June 30, 2011 and 2010, respectively, and $20,770 and $0 for the six months ended June 30, 2011 and 2010, respectively.

Contingent Features in Derivatives Related to Ambac Credit Risk:

Ambac’s interest rate swaps and currency swaps with professional swap-dealer counterparties and certain front-end counterparties are generally executed under standardized derivative documents including collateral support and master netting agreements. Under these agreements, Ambac is required to post collateral in the event net unrealized losses exceed predetermined threshold levels. Additionally, given that Ambac Assurance is no longer rated by an independent rating agency, counterparties have the right to terminate the swap positions.

As of June 30, 2011 and December 31, 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 $62,794 and $31,739, respectively, related to which Ambac had posted assets as collateral with a fair value of $140,104 and $123,519, respectively. All such ratings-based contingent features have been triggered as of June 30, 2011, requiring maximum collateral levels to be posted by Ambac while preserving counterparties’ rights to terminate the contracts. Assuming all contracts terminated on June 30, 2011, settlement of collateral balances and net derivative liabilities would result in a net receipt of cash and/or securities by Ambac. If counterparties elect

 

35


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

 

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.

(8) 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   

Italy

     2006   

As of June 30, 2011 and December 31, 2010, the liability for unrecognized tax benefits is approximately $23,150 and $23,050, respectively. Included in these balances at June 30, 2011, and December 31, 2010 are $23,150 and $23,050, 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 six months ended June 30, 2011 and 2010, Ambac recognized interest of approximately $100 and $100 respectively. During the three months ended June 30, 2011 and 2010, Ambac recognized interest of approximately $50 and $50 respectively. Ambac had approximately $15,320 and $15,220 for the payment of interest accrued at June 30, 2011 and December 31, 2010, respectively.

As a result of the development of additional losses and the related impact on the Company’s cash flows, management believes it is more likely than not that the Company will not generate sufficient taxable income to recover the deferred tax operating asset. As of June 30, 2011 a full valuation allowance of $2,700,000 has been established against the deferred tax asset. As of December 31, 2010, the company had a valuation allowance of $2,411,107.

(9) 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 Income in Stockholders’ Equity 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. For securities that are not structured securities with a large underlying pool of homogenous loans, such as typical corporate and municipal bonds, premiums and discounts 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. Realized gains and losses on the sale of investments are determined on the basis of specific identification.

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 4.

 

36


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

 

The amortized cost and estimated fair value of investments, excluding VIE investments, at June 30, 2011 and December 31, 2010 were as follows:

 

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

June 30, 2011

Fixed income securities:

              

Municipal obligations

   $ 1,889,072       $ 87,183       $ 1,936       $ 1,974,319       $ —     

Corporate obligations

     973,552         54,489         14,810         1,013,231         —     

Foreign obligations

     93,163         4,810         —           97,973         —     

U.S. government obligations

     92,743         325         47         93,021         —     

U.S. agency obligations

     81,333         6,419         —           87,752         —     

Residential mortgage-backed securities

     1,187,927         426,662         45,155         1,569,434         347  

Collateralized debt obligations

     43,776         118         2,520         41,374         —     

Other asset-backed securities

     988,852         36,998         29,977         995,873         —     

Short-term

     1,066,353         —           —           1,066,353         —     

Other

     100         —           —           100         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     6,416,871         617,004         94,445         6,939,430         347  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Fixed income securities pledged as collateral:

              

U.S. government obligations

     127,885         4,894         —           132,779         —     

Residential mortgage-backed securities

     6,424         901         —           7,325         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total collateralized investments

     134,309         5,795         —           140,104         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total investments

   $ 6,551,180       $ 622,799       $ 94,445       $ 7,079,534       $ 347  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2010

Fixed income securities:

              

Municipal obligations

   $ 1,878,857       $ 54,093       $ 11,614       $ 1,921,336       $ —     

Corporate obligations

     897,670         44,015         23,777         917,908         —     

Foreign obligations

     113,127         5,328         —           118,455         —     

U.S. government obligations

     153,609         3,299         35         156,873         —     

U.S. agency obligations

     81,696         6,598         —           88,294         —     

Residential mortgage-backed securities

     1,239,107         300,302         40,717         1,498,692         1,111   

Collateralized debt obligations

     40,997         391         9,132         32,256         —     

Other asset-backed securities

     1,019,894         28,274         43,857         1,004,311         —     

Short-term

     991,567         —           —           991,567         —     

Other

     100         —           —           100         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     6,416,624         442,300         129,132         6,729,792         1,111   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Fixed income securities pledged as collateral:

              

U.S. government obligations

     113,232         2,170         —           115,402         —     

Residential mortgage-backed securities

     7,686         431         —           8,117         —