Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of
1995
In this Quarterly Report, we have included statements that may constitute
"forward-looking statements" within the meaning of the safe harbor provisions of
the Private Securities Litigation Reform Act of 1995. Words such as "estimate,"
"project," "plan," "believe," "anticipate," "intend," "planned," "potential" and
similar expressions, or future or conditional verbs such as "will," "should,"
"would," "could," and "may", or the negative of those expressions or verbs,
identify forward-looking statements. We caution readers that these statements
are not guarantees of future performance. Forward-looking statements are not
historical facts but instead represent only our beliefs regarding future events,
which, may by their nature be inherently uncertain and some of which may be
outside our control. These statements may relate to plans and objectives with
respect to the future, among other things which may change. We are alerting you
to the possibility that our actual results may differ, possibly materially, from
the expected objectives or anticipated results that may be suggested, expressed
or implied by these forward-looking statements. Important factors that could
cause our results to differ, possibly materially, from those indicated in the
forward-looking statements include, among others, those discussed under "Risk
Factors" in Part I, Item 1A of the 2011 Annual Report on Form 10-K and Part II,
Item 1A of this Form 10-Q.
Any or all of management's forward-looking statements here or in other
publications may turn out to be incorrect and are based on Ambac Financial
Group, Inc. ("Ambac" or the "Company") management's current belief or opinions.
Ambac's actual results may vary materially, and there are no guarantees about
the performance of Ambac's securities. Among events, risks, uncertainties or
factors that could cause actual results to differ materially are: (1) a plan of
reorganization under Chapter 11 will not be consummated; (2) if Ambac is not
successful in consummating a plan of reorganization under Chapter 11, it is
likely it would have to liquidate pursuant to Chapter 7; (3) the impact of the
bankruptcy proceeding on the holders of Ambac securities; (4) our dispute with
the United States Internal Revenue Service may not be satisfactorily resolved;
(5) the unlikely ability of Ambac Assurance Corporation ("Ambac Assurance")
paying dividends to Ambac in the foreseeable future; (6) adverse events arising
from the Segregated Account Rehabilitation Proceedings, including the failure of
the injunctions issued by the Wisconsin Rehabilitation Court to protect the
Segregated Account and Ambac Assurance from certain adverse actions;
(7) litigation arising from the Segregated Account Rehabilitation Proceedings;
(8) decisions made by the Rehabilitator for the benefit of policyholders may
result in material adverse consequences for Ambac's securityholders;
(9) potential of a full rehabilitation proceeding against Ambac Assurance or
material changes to the Segregated Account Rehabilitation Plan, with resulting
adverse impacts; (10) inadequacy of reserves established for losses and loss
expenses, including our inability to realize the remediation recoveries or
future commutations included in our reserves; (11) adverse developments in our
portfolio of insured public finance credits; (12) market risks impacting assets
in our investment portfolio or the value of our assets posted as collateral in
respect of investment agreements and interest rate swap and currency swap
transactions; (13) risks relating to determination of amount of impairments
taken on investments; (14) credit and liquidity risks due to unscheduled and
unanticipated withdrawals on investment agreements; (15) market spreads and
pricing on insured collateralized loan obligations ("CLOs") and other derivative
products insured or issued by Ambac or its subsidiaries; (16) Ambac's financial
position and the Segregated Account Rehabilitation Proceedings may prompt
departures of key employees and may impact our ability to attract qualified
executives and employees; (17) the risk of litigation and regulatory inquiries
or investigations, and the risk of adverse outcomes in connection therewith,
which could have a material adverse effect on our business, operations,
financial position, profitability or cash flows; (18) credit risk throughout our
business, including but not limited to credit risk related to residential
mortgage-backed securities, pooled student loan securitizations, CLOs, public
finance obligations and exposures to reinsurers; (19) default by one or more of
Ambac Assurance's portfolio investments, insured issuers, counterparties or
reinsurers; (20) the risk that our risk management policies and practices do not
anticipate certain risks and/or the magnitude of potential for loss as a result
of unforeseen risks; (21) factors that may influence the amount of installment
premiums paid to Ambac, including the continuation of the moratorium with
respect to claims payments as a result of Segregated Account Rehabilitation
Proceedings; (22) changes in prevailing interest rates; (23) the risk of
volatility in income and earnings, including volatility due to the application
of fair value accounting, required under the relevant derivative accounting
guidance, to the portion of our credit enhancement business which is executed in
credit derivative form; (24) changes in accounting principles or practices that
may impact Ambac's reported financial results; (25) legislative and regulatory
developments; (26) operational risks, including with respect to internal
processes, risk models, systems and employees; (27) changes in tax laws, tax
disputes and other tax-related risks; and (28) other risks and uncertainties
that have not been identified at this time.
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OVERVIEW
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 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 has continued 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. The Company, as debtor
and debtor-in-possession, filed a Fifth Amended Plan of Reorganization on
March 12, 2012 (such Fifth Amended Plan of Reorganization, as it may be amended,
the "Reorganization Plan"). The Bankruptcy Court entered an order confirming the
Reorganization Plan on March 14, 2012. Under the Reorganization Plan, Ambac's
debt holders and other 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.
Ambac Assurance is Ambac's principal operating subsidiary. Ambac Assurance is a
financial guarantee insurer 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 the Commissioner of Insurance for
the State of Wisconsin as rehabilitator of the Segregated Account (the
"Rehabilitator"), 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 is Theodore Nickel, the Commissioner of Insurance of the State of
Wisconsin. Ambac Assurance is not, itself, in rehabilitation proceedings.
Through its financial services subsidiaries, Ambac provided financial and
investment products, including investment agreements, funding conduits, interest
rate and currency swaps, principally to the clients of its financial guarantee
business. Ambac Assurance insured all of the obligations of its financial
services subsidiaries. The interest rate swap and investment agreement
businesses are in active runoff, which is being effectuated by means of
transaction terminations, settlements, assignments and scheduled amortization of
contracts.
Financial information concerning our business segments is set forth in the
unaudited consolidated financial statements and the notes, "Management's
Discussion and Analysis of Financial Condition and Results of Operations," and
"Quantitative and Qualitative Disclosures About Market Risk," which are in Part
I of this Quarterly Report on Form 10-Q. Our Internet address is www.ambac.com.
We make available free of charge, on or through the investor relations section
of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and
current reports on Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as
well as proxy statements, as soon as reasonably practicable after we
electronically file such material with, or furnish it to, the U.S. Securities
and Exchange Commission. Our Investor Relations Department can be contacted at
Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004,
Attn: Investor Relations, telephone: 212-208-3222.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial condition and results of operations
is based upon our Unaudited Consolidated Financial Statements, which have been
prepared in accordance with U.S. generally accepted accounting principles
("GAAP"). The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amount of assets and
liabilities, revenues and expenses and related disclosure of contingent assets
and liabilities at the date of our financial statements. Actual results may
differ from these estimates under different assumptions or conditions.
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Critical accounting policies are considered critical because they place
significant importance on management to make difficult, complex or subjective
estimates regarding matters that are inherently uncertain. Financial results
could be materially different if alternative methodologies were used or if
management modified its assumptions or estimates. Management has identified
(i) the accounting for loss and loss expenses of non-derivative financial
guarantees, (ii) the valuation of financial instruments, including the
determination of whether an investment impairment is other-than-temporary and
the (iii) valuation allowance on deferred tax assets, as critical accounting
policies. This discussion should be read in conjunction with the Unaudited
Consolidated Financial Statements and notes thereon included elsewhere in this
report. We have discussed with the Audit Committee management's assessment of
such critical accounting policies, the reasons why they are considered critical,
and how current and anticipated future events impact those determinations. The
Company's critical accounting policies and estimates are as follows:
Losses and Loss Expenses of Non-derivative Financial Guarantees:
The loss and loss expense reserves for financial guarantee insurance discussed
herein relates only to Ambac's non-derivative insurance business for insurance
policies issued to beneficiaries, including variable interest entites ("VIEs"),
for which we do not consolidate the VIE. Losses and loss expenses 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 the level of reserves is subject to certain estimates and
judgments.
ASC Topic 944, Financial Services-Insurance provides guidance for financial
guarantee insurance contracts issued by insurance enterprises, including the
recognition and measurement of claim liabilities (i.e. loss reserves). Under ASC
Topic 944, a loss reserve is recorded on the balance sheet for the excess of
(a) the present value of expected losses, over (b) the unearned premium reserve
("UPR") for that contract. Expected losses represent projected net cash flows
and are defined as the expected future claims to be paid under an insurance
contract plus the impact of potential settlement outcomes upon future
installment premiums, less potential recoveries. To the extent (a) is less than
(b), no loss reserve is recorded. Changes to the loss reserve estimate in
subsequent periods are recorded as a loss and loss expense on the Consolidated
Statements of Total Comprehensive Income. For those policies where the potential
recovery is less than the expected future claims, the resulting net cash outflow
is recorded as a "Loss and loss expense reserve" liability. For those policies
where losses have been paid, but not yet recovered, the potential recovery may
be greater than the expected future claims and the resulting net cash inflow is
recorded as a "Subrogation recoverable" asset.
Ambac's loss reserves are based on management's on-going review of the
non-derivative financial guarantee insurance 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
credit ratings for each transaction. Non-adversely classified credits are
assigned a Class I or Survey List ("SL") risk classification, while adversely
classified credits are assigned a risk classification 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 and loss mitigation efforts could cause an increase in
delinquencies and potential defaults of the underlying obligations. 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 default-related expenses which are deemed to be recoverable by the
servicer, (ii) pursuit of loan charge-offs which maximize cash flows from pool's
securitized assets, and (iii) other asset disposition strategies and timelines.
The population of credits evaluated in Ambac's loss reserve process are (i) all
adversely classified credits and (ii) non-adversely classified credits which had
an internal Ambac credit 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
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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 were established and
approved by Ambac's senior management. For certain credit exposures, Ambac's
additional monitoring; loss remediation efforts and probabilities of potential
settlement outcomes may provide information relevant to adjust this estimate of
"base case" statistical expected losses. As such, the 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, as
well as the potential for additional remediation activities.
The second approach entails the use of more precise estimates of 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 appropriate cash flow scenarios.
This approach can include the utilization of internal or external models to
project future claim payment estimates. We have utilized external models for
residential mortgage-backed and student loan exposures. In general, these tools
use historical performance of the collateral pools in order to then assume or
derive future performance characteristics, such as default and voluntary
prepayment rates, which in turn determine projected future claim payments. In
this approach a probability-weighted expected loss estimate is developed based
on assigning probabilities to multiple claim payment scenarios and applying an
appropriate discount factor. Additionally, we assign a probability to the
issuer's ability to refinance an insured issue and/or Ambac's ability to execute
a potential settlement (i.e. commutation) of the insurance policy, inclusive of
the impact on future installment premiums. The methodology used to estimate the
most substantial amount of the potential recovery component of expected losses
is further described in the "RMBS Representation and Warranty Subrogation
Recovery" section below.
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.
Ambac establishes loss expense reserves based on our estimate of expected net
cash outflows for loss expenses, such as legal and consulting costs.
As the probability of default for an individual credit increases and/or the
severity of loss given a default increases, our loss reserve for that insured
obligation will also increase. Political, economic, credit or other unforeseen
events could have an adverse impact on default probabilities and loss
severities. The performance and loss reserves for many transactions (such as
many public finance exposures) are derived from the issuer's obligation to pay.
The performance and loss reserves of other transactions such as most structured
finance exposures including RMBS have no direct issuer support and therefore are
derived from the default activity and loss given default of collateral
supporting the transactions. Many transactions have a combination of
issuer/entity and collateral support. Loss reserves reflect our assessment of
the transaction's overall structure, support and expected performance. Loss
reserve volatility will be a direct result of the credit performance of our
insured portfolio, including the number, size, bond types and quality of credits
included in our loss reserves as well as our ability to execute commutations.
The number and severity of credits included in our loss reserves depend to a
large extent on transaction specific attributes, but will generally increase
during periods of economic stress and decline during periods of economic
stability. Reinsurance recoveries do not have a significant effect on loss
reserve volatility because Ambac has little exposure ceded to reinsurers and has
received collateral from the majority of its reinsurers.
Ambac has exposure to various bond types issued in the debt capital markets. Our
experience has shown that, for the majority of bond types, we have not
experienced significant claims. We have observed that, with respect to certain
bond types, it is reasonably possible that a material change in actual loss
severities and defaults could occur over time. In the future, our experience may
differ with respect to the types of guaranteed bonds affected or the magnitude
of the effect. The bond types that have experienced the most significant claims
are residential mortgage-backed securities ("RMBS"), student loan securities and
collateralized debt obligations ("CDOs"). These three bond types represent 92%
of our ever-to-date insurance claims presented with RMBS comprising 88% of our
ever-to-date claims payments.
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The table below indicates the number of credits, gross par outstanding and gross
loss reserves (including loss adjustment expenses) related to policies in
Ambac's loss reserves on credits at March 31, 2012:
Number of Gross par Gross Loss
($ in millions) credits outstanding Reserves(2)
RMBS 176 $ 16,779 $ 4,410
Student Loans 64 5,981 1,109
All other credits 95 5,865 739 Loss adjustment expenses n.a. n.a.
147
Totals 335 $ 28,625 $ 6,405 (1)
(1) Ceded Par Outstanding and ceded loss reserves are $1,287 and $155,
respectively. Ceded loss reserves are included in Reinsurance Recoverable on
paid and unpaid losses.
(2) Loss reserves of $6,405 are included in the balance sheet in the following
line items: Loss and loss expense reserve-$6,924 and Subrogation
recoverable-$519.
RMBS:
Ambac insures RMBS transactions that contain first-lien mortgages. Ambac
classifies its insured first-lien RMBS exposure principally into two broad
credit risk classes: mid-prime (including Alt-A, interest only, and negative
amortization) and sub-prime. Mid-prime loans were typically made to borrowers
who had stronger credit profiles relative to sub-prime loans, but weaker than
prime loans. Compared with mid-prime loans, sub-prime loans typically had higher
loan-to-value ratios, reflecting the greater difficulty that sub-prime borrowers
have in making down payments and the propensity of these borrowers to extract
equity during refinancing. The mid-prime category includes:
• Loans with specific payment features that afforded borrowers the option to
have lower payments in the early years with potential resets after several
years. For example, so-called interest only loans have monthly payments
comprised of interest but no principal. So called negative amortization
loans permit borrowers to defer interest and principal in the early years
and then make higher payments in the period after the reset. Both types
may also have lower interest rates in the early years. Future increases in
monthly payments, commonly called payment shock, raise the probability of
delinquencies and defaults given the decline in house prices over the past
few years.
• Loans backed by borrowers who typically did not meet standard agency guidelines for documentation requirement, property type or loan-to-value
ratio. These are typically higher-balance loans made to individuals who
might have past credit problems that were not severe enough to warrant
"sub-prime" classification, or borrowers who chose not to obtain a prime
mortgage due to documentation requirements.
Ambac has also insured RMBS transactions that contain predominantly second-lien
mortgage loans such as closed-end seconds and home equity lines of credit. A
second-lien mortgage loan is a type of loan in which the borrower uses the
equity in their home as collateral and the second-lien loan is subordinate to
the first-lien loan outstanding on the home. The borrower is obligated to make
monthly payments on both their first and second-lien loans. If the borrower
defaults on the payments due under these loans and the property is subsequently
liquidated, the liquidation proceeds are first utilized to pay off the
first-lien loan (as well as costs due the servicer) and any remaining funds are
applied to pay off the second-lien loan. As a result of this subordinate
position to the first-lien loan, second-lien loans carry a significantly higher
severity in the event of a loss, typically at or above 100% in the current
housing market.
RMBS transaction-specific behavior is analyzed on a risk-priority basis. We
employ a screening tool to assess the sufficiency of credit enhancement
remaining in a transaction, as well as other adverse credit data that may
identify deterioration. Transactions which are experiencing escalating
delinquencies and increasing loss severities and/or which are experiencing
declining levels of subordination or overcollateralization relative to
collateral losses are identified as underperforming. For underperforming
transactions, historical collateral performance is examined and future
collateral performance and cash flows are projected and evaluated. These
underperforming transactions are then included in an adversely classified credit
list and assigned a credit classification consistent with the degree of
underperformance.
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Methodology for Projecting Expected Losses in our RMBS Portfolio
For the first three quarters of 2011, we determined expected losses by using
(i) an internal roll-rate model to project losses for our second-lien
transactions; (ii) and a licensed third-party multi-scenario stochastic (Monte
Carlo) cash flow model ("stochastic model") to project losses for our first-lien
transactions; and (iii) a licensed statistical regression model ("regression
model") to develop estimates of projected losses for both our second and
first-lien transactions. As of the quarter ending December 31, 2011, we
discontinued the use of both the stochastic model and the internal roll-rate
model and utilized the regression model to develop estimates of projected
losses.
Our reserving methodology in the first three quarters of 2011 reflected a
blending of the results of the two approaches used for each transaction, with
50% probability assigned to the regression model and 50% assigned to either our
internal roll-rate model in the case of second-lien transactions or to the
stochastic model in the case of our first-lien transactions. In the months
leading up to the transition to one model, we worked extensively with the vendor
for the regression model to ensure the model was adequately projecting the
performance of our transactions, and to provide additional information and data
to improve the precision of the model's projections. Prior to solely utilizing
the results of the regression model, our internal RMBS credit and quantitative
professionals evaluated and analyzed the results of the regression model versus
loss estimates generated utilizing our internal roll-rate model for second-lien
transactions and our stochastic model for first-lien transactions. This cross
disciplined team compared the specific drivers and methodology of the regression
model with our existing approaches, and analyzed deal performance and model
outputs across the portfolio. For example, the team considered the general
reasonableness of the models' projected defaults of borrowers not currently in
seriously delinquent or worse payment status and also conducted selective
collateral analyses. The team also assessed the models' cumulative loss
estimates and compared such estimates by asset type and vintage with rating
agency and other published loss projections. Based upon this analysis, we
believe the exclusive use of the regression model to project RMBS losses is
reasonable at this time. Although RMBS loss projections can be widely disparate
and there can be no certainty with regard to projecting such losses, we believe
our current reserving approach, including the regression model itself and the
assumptions utilized, is sound and reasonable.
The regression model is subject to ongoing refinements resulting from industry
research and performance that better inform model assumptions, enhanced model
capabilities and other factors. A new release of this model was implemented in
the first quarter of 2012 and includes, among other enhancements, improved
treatment of borrowers' payment history to better reflect our belief that
borrowers with strong payment history will experience lower default rates than
borrowers with poor payment history.
In our experience, market performance and model characteristics change and are
updated through time and a regular review of models and the overall approach to
loss estimation is beneficial. Our ability to drive change in the models we
license is limited and subject to the expertise and views of the independent
developer/vendor. On the other hand, our ability to estimate losses without such
models is difficult and challenging for a large portfolio across multiple RMBS
exposure types.
Summarized below is our approach to projecting claims and ultimate losses in our
RMBS portfolio.
Second-Lien
The regression model estimates mortgage loan collateral performance, the effect
of such collateral cash flows within the transaction waterfall and the liability
structure we insure. Collateral performance is frequently modeled at the deal
level given the paucity of mortgage loan level data for second-lien
transactions. Without specific loan-level information, the deal-level approach
processes a loan pool as if it were a single loan, selecting certain aggregated
deal-level characteristics to then perform a statistical analysis using a
multinomial logistic regression model. We use three home price appreciation
("HPA") projection scenarios to develop a base case as well as stress and upside
cases. The highest probability is assigned to the base case, with significantly
lower probabilities to the stress and upside cases. This deal-level approach of
the regression model takes a relatively complicated monthly cash flow and
simplifies it into two parts: a borrower-behavior-dependent stage and a
servicer-behavior-dependent stage. The borrower stage is designed to forecast
the probability of a loan's present delinquency status transitioning to any of
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eight future statuses. Through the borrower-behavior-dependent stage, at any
given monthly period, a loan can take on one of the following eight statuses:
current, 30, 60, 90, 120, 150, 180+ days delinquent, or prepaid. The deal-level
approach calculates defaults using a roll-rate that evaluates the possible
future state of a set of loans based on its current status and three variables:
average FICO (credit score), average current consolidated loan to value ratio
("CLTV"), and an overall quality indicator. The servicer-behavior-dependent
stage of the regression model governs a loan's life cycle after it reaches 180
or more days delinquent. This stage evaluates the servicer's propensity to
foreclose or pursue a short sale, the speed of the foreclosure process, and the
speed of the post-foreclosure distressed property liquidation. The transition
probabilities between advanced delinquency and foreclosure, foreclosure and REO,
and finally REO and ultimate liquidation are assumed by the model to depend upon
how long a loan has already been in a particular status, as well as on the
servicer and on state-specific liquidation timeline factors.
The internal roll-rate model used until third quarter 2011 observes trends in
delinquencies, defaults, loss severities and prepayments and extrapolates
ultimate performance from this data on an individual transaction basis (and
their component pools where they exist). As more information (performance and
other) accumulates for each underperforming transaction we were able to update
assumptions in this model to reflect these changes. In employing the roll-rate
methodology, we examined the historical rate at which delinquent loans in each
transaction rolled into later delinquency categories (i.e. 30-59 days, 60-89
days, 90+ days). This historical rate was adjusted each period to reflect
current performance. The key inputs for this model were prepayment rates and
loss severity. Voluntary prepayments have declined, driven by negative HPA, an
impaired mortgage market, and borrowers' inability to prepay balances. In our
opinion, these factors will not improve in the foreseeable future and thus we
generally projected recent trends into the future. This resulted in projected
prepayment rates in the 2% to 5% range. We estimated loss severities between
100% and 105% as we expected complete write-offs of mortgage loans exacerbated
by carrying costs. We determined a pool specific current-to-30-to-59 day
delinquency curve and applied a statistical regression technique to historical
roll rates. We carried forward the non-performing mortgages through the
delinquency pipeline through the 60-89 and 90+ day delinquency categories all
the way through to charge-off. We used this data in the internal roll-rate model
to project a default curve for the life of the transaction.
First-Lien
For most first-lien transactions, the regression model utilizes home mortgage
loan level data from recognized market sources to calculate each loan's
probability of default and prepayment based on the characteristics of the loan.
The loan-level approach of the regression model uses the results of a regression
analysis to project prepayment and default vectors on a monthly basis based on
its embedded risks. For first-lien transactions that do not have loan-level data
available, we use the deal-level approach of the regression model that is
described in the Second-Lien section above.
There are three transitional stages with the loan-level approach of the
regression model: current, prepayment or default. The model then looks beyond
the stages to assess a set of loans based on a number of individual
characteristics that are distinct to that set of loans. These individual
characteristics are property type, occupancy status, loan purpose, documentation
type, cumulative loan-to-value ratio, originator quality rating, servicer
quality rating, FICO score, original loan balance, interest rate margin, and
regional unemployment rate. The model then estimates the rate at which a loan
will prepay or default reducing the balance of each loan monthly during the
projection period based on the borrower's given probability of defaulting or
prepaying for that month. Servicer behavior is a unique variable in the
loan-level approach of the regression model and is used to calculate the impact
of servicer performance on expected prepayments and defaults. Consistent with
the second-lien modeling, we consider three HPA scenarios in the regression
model to develop a base case as well as stress and upside cases. The highest
probability is assigned to the base case, with significantly lower probabilities
to the stress and upside cases.
The stochastic model used in prior periods projected multiple scenarios at the
individual mortgage loan level using various inputs, including:
(i) Home price projections obtained from an independent third party at the
Core Based Statistical Area (CBSA) level;
(ii) An interest rate tool to generate term interest rate scenarios;
(iii) An unemployment module to project unemployment rates at the state level;
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(iv) A mortgage home loan-level credit module to estimate the probability of
monthly loan level credit performance through time across eight possible
status states (current, 30 day delinquent, 60 day delinquent, 90 + day
delinquent, foreclosure, REO, prepay, and default); and
(v) A severity module which pairs with the credit module and, on the basis of
loan level information, generates a Loss Given Default severity time line.
The pool of mortgage loans backing each securitization was selected from a
loan-level database and the loss and prepayment scenarios across all loans were
used to generate aggregated future collateral cash flows. The stochastic model
embeds all the priority of payments and cash-diversion structures documented in
the contracts which define the liability payment obligations of the security
being analyzed. We took the average of the 300 stochastic claim cash-flow
scenarios and discount it, as appropriate, to estimate the net cash outflows.
Additional RMBS factors for first and second-lien transactions
Additional factors that may impact ultimate RMBS losses include, but may not be
limited to, mortgage insurance, government programs and servicer intervention.
These factors, and the impact on our loss reserve estimate, are further
discussed below:
Mortgage insurance: Six of our mortgage-backed transactions have pool-level
mortgage insurance remaining. Pool mortgage insurance is a master policy issued
to the mortgage securitization trust, which indemnifies the trust either on a
first loss or mezzanine basis in the event that covered mortgage loans in the
trust default. The mortgage insurance master policy specifies the particular
characteristics and conditions of each individual loan within the mortgage trust
that is subject to coverage. The policy also includes various conditions
including exclusions, conditions for notification of loans in default and claims
settlement. We have noted with regard to these transactions that payment by
mortgage insurers of claims presented by the mortgage trusts has been
inconsistent; resulting in higher claims presented under Ambac Assurance's
financial guarantee policies. As a result, the impact of mortgage insurance on
our loss reserve estimate is negligible.
Government programs: In May of 2009, the Federal Government initiated the Home
Affordable Modification Plan (HAMP) which allows servicers to modify loans.
After determining a borrower's eligibility, a servicer can take a series of
steps to reduce the monthly mortgage payment. HAMP is applicable to the
Ambac-wrapped transactions serviced by the servicers that have signed servicer
participation agreements to modify loans under HAMP. Based on the activity HAMP
offers and indications from government published sources that suggest this
program is unlikely to have a material impact on Ambac-wrapped transactions,
beginning in the third quarter of 2011 we no longer assumed any impact for HAMP
on our first-lien portfolio. At December 31, 2010, Ambac's first-lien stochastic
model assumed that 0.5% of HAMP-eligible loans will be modified monthly for 24
months for Ambac portfolios serviced by HAMP participating servicers. During the
first half of 2011 we reduced the impact of HAMP modifications to reflect the
reported performance of HAMP. We have not given credit to any other government
programs, most of which are targeted to home mortgages that are bank owned, and
not in RMBS securitizations.
Servicer Intervention: With the exception of the internal second-lien roll-rate
model used until the fourth quarter of 2011, we are able to include in our
modeling the steps which Ambac is taking to address shortcomings in servicing
performance including transfers of servicing where the legal right exists to do
so. Ambac has initiated, with the cooperation of the Rehabilitator of the
Segregated Account, programs with special servicers that we believe will
mitigate losses on such transactions through intervention strategies such as
loan modifications, improved liquidation timelines, and short sales. Ambac
believes these are the principal factors that will result in reduced losses over
time. Given the uncertainty in initiating additional programs of this nature, we
are projecting that only exposures that have already transferred servicing or
entered into special servicing agreements will benefit from the effects of
servicer intervention strategies.
RMBS Representation and Warranty Subrogation Recoveries:
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 include (i) high levels of early
payment
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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. 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 actions to recover against the collateral, and the securitization has
incurred losses to the extent such actions did not result in full repayment of
the borrower's obligations. Generally, the sponsor of the transaction provided
representations and warranties with respect to the securitized loans, including
representations with respect to 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. In such cases, the sponsor
of the transaction is contractually obligated to repurchase, cure or substitute
collateral for any loan that breaches the representations and warranties. Refer
to Note 6 of the Unaudited Consolidated Financial Statements included Part I,
Item 1 of this Form 10-Q for more information regarding representation and
warranty subrogation recoveries.
The table below distinguishes between RMBS credits for which we have not
established a representation and warranty subrogation recovery and those for
which we have, providing in both cases the number of credits, gross par
outstanding, gross loss reserves before subrogation recoveries, subrogation
recoveries, and gross loss reserves net of subrogation for all RMBS exposures
for which Ambac established reserves at March 31, 2012:
Gross loss
reserve Gross loss
Gross before reserve net of
Number of par subrogation Subrogation subrogation
($ in millions) policies outstanding recoveries recoveries recoveries
Second-lien 20 $ 2,462 559 - $ 559
First-lien-Mid-prime 58 4,286 2,144 - 2,144
First-lien-Sub-prime 40 1,657 202 - 202
Other 13 554 276 - 276
Total Credits Without Subrogation 131 8,959 3,181 - 3,181
Second-lien 24 3,746 1,660 (1,549 ) 111
First-lien Mid-prime 16 1,830 1,186 (621 ) 565
First-lien Sub-prime 5 2,244 1,038 (485 ) 553
Total Credits With Subrogation 45 7,820 3,884 (2,655 ) 1,229
Total 176 $ 16,779 $ 7,065 $ (2,655 ) $ 4,410
STUDENT LOANS:
Our student loan portfolio consists of credits collateralized by (i) federally
guaranteed loans under the Federal Family Education Loan Program ("FFELP") and
(ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of
97% of defaulted principal and interest, private loans have no government
guarantee and therefore are subject to credit risk as with other types of
unguaranteed credits. Private student loans are outside the purview of recent
government programs designed to assist borrowers. Recent default data has shown
a continued deterioration in the performance of private student loans underlying
our transactions. Due to the failure of the auction rate and variable rate
markets in 2008, the interest rates on the Ambac insured securities increased
significantly to punitive levels pursuant to the terms of the transactions. Such
increases have caused the collateralization ratio in these transactions to
deteriorate due to negative excess spread and/or the use of principal receipts
to pay current interest. Further rating agency downgrades of outstanding auction
rate notes has resulted in a step-ups of the interest rate payable on such
securities which further accelerate the erosion of the trust estate.
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Methodology for Projecting Expected Losses in our Student Loan Portfolio
The calculation of loss reserves for our student loan portfolio involves
evaluating numerous factors that can impact ultimate losses. The factor which
contributes to the greatest degree of uncertainty in ascertaining appropriate
loss reserves is the long time horizon associated with the final legal maturity
date of the bonds. Most of the student loan bonds which we insure were issued
with original terms of 20 to 40 years until final maturity. Since our policy
covers timely interest and ultimate payment of principal, our loss projections
must make assumptions for many factors covering a long time horizon. Key
assumptions that will impact ultimate losses include but are not limited to the
following: collateral performance which is highly correlated to the economic
environment, interest rates, operating risks associated with the issuer,
servicers, administrators, issuers willingness and ability to refinance,
investor appetitive for tendering Auction Rate Securities at a discount and, as
applicable, Ambac's ability and willingness to commute policies.
In evaluating our Student Loan portfolio, losses were projected using either a
cash flow or statistical expected loss approach. As noted above, the statistical
methodology uses probability of default and loss given default (LGD) under
various scenarios to derive at a weighted average loss expectation. The
scenarios used under the statistical expected loss approach evaluate each
transaction under base case and stress case scenarios. The main drivers in
assigning appropriate probabilities to LGDs for each policy includes an analysis
of the collateral mix; debt type and interest rates; parity level; enhancement
levels and remediation opportunities. We believe the statistical expected loss
approach is a more efficient methodology for certain deals in our student loan
portfolio, such as (i) deals where collateral loan level data is unavailable
(and thus the cash flow model, as more fully discussed below could not be used),
and (ii) deals where we do not expect to experience meaningful losses.
We use a third party deterministic cash flow model to develop loss projections
for a portion of our portfolio. The model allows us to capture each
transaction's particular structure (i.e. the waterfall structure, triggers,
redemption priority). For collateral performance, the model uses loan level
detail that allows us to make specific default and recovery assumptions for each
type of loan. We contract with a separate third party to run the model at our
direction. We provide the third party with the material deal level assumptions
such as default, recovery and interest rate assumptions.
We develop multiple cash flow scenarios and assign probabilities to each cash
flow scenario based on each transaction's unique situation. Probabilities
assigned are based on available data related to the credit, any contact with the
issuer, and any economic or market information that may impact the outcomes of
the various scenarios being evaluated. Our base case usually projects the deal
out to maturity using expected loss assumptions and interest rates adhering to
the projected forward interest rate curve at the reporting date. We also develop
stress cases that incorporate various stresses to the transaction, including but
not limited to defaults, recoveries and interest rates. In estimating loss
reserves, we also incorporate scenarios which represent remediation strategies.
Remediation scenarios may include the following; (i) a potential refinancing of
the transactions by the issuer; (ii) the issuer's ability to redeem outstanding
auction rate securities at a discount, thereby increasing the structure's
ability to absorb future losses; and (iii) our ability to terminate the policy
in whole or in part (e.g. commutation). The remediation scenarios and the
related probabilities of occurrence vary by policy depending on on-going
discussions and negotiations that are underway with issuers and/or investors. In
addition to commutation negotiations that are underway with various
counterparties in various forms, our reserve estimates may also include
scenarios which incorporate our ability to commute additional exposure with
other counterparties.
REASONABLY POSSIBLE ADDITIONAL LOSSES:
RMBS:
It is possible that our loss estimate assumptions for the RMBS insurance
policies discussed above could be materially under-estimated as a result of
continued deterioration in housing prices, poor servicing, the effects of a
weakened economy marked by growing unemployment and wage pressures, inability to
execute commutation transactions with insurers and/or investors and/or continued
illiquidity of the mortgage market. Additionally, our actual subrogation
recoveries could be lower than our current estimates of $2,655.4 million if the
sponsors of these transactions: (i) fail to honor their obligations to
repurchase the mortgage loans, (ii) successfully dispute our breach findings, or
(iii) no longer have the financial means to fully satisfy their obligations
under the transaction documents.
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We have attempted to identify the reasonably possible additional losses using
more stressful assumptions. Different methodologies, assumptions and models
could produce different base and reasonably possible additional losses and
actual results may differ materially from any of these various modeled results.
In the case of both first and second-lien exposures, the regression model's
reasonably possible stress case assumes a significantly harsher HPA projection,
which in turn drives higher defaults and severities. Using this approach, the
reasonably possible increase in loss reserves for RMBS credits for which we have
an estimate of expected loss at March 31, 2012 could be approximately $901
million. The reasonably possible scenario considers the highest stress scenario
that was utilized in the development of our probability-weighted expected loss
at March 31, 2012 and assumes an inability to execute commutation transactions
with issuers and/or investors.
Student Loans:
It is possible that our loss estimate assumptions for student loan credits could
be materially under-estimated as a result of various uncertainties including but
not limited to, the interest rate environment, an increase in default rates and
loss severities on the collateral due to economic factors, inadequate servicing,
inability to execute commutation transactions with issuers and/or investors, as
well as a failure of issuers to refinance insured bonds which have a failed debt
structure, such as auction rate securities and variable rate debt
obligations. For student loan credits for which we have an estimate of expected
loss at March 31, 2012, the reasonably possible increase in loss reserves from
loss reserves at March 31, 2012 could be approximately $1,034 million. The
reasonably possible scenario considers the highest stress scenario that was
utilized in the development of our probability-weighted expected loss at
March 31, 2012 and assumes an inability to execute commutation transactions with
issuers and/or investors.
Ambac's management believes that the reserves for losses and loss expenses and
unearned premium reserves are adequate to cover the ultimate net cost of claims,
but reserves are based on estimates and there can be no assurance that the
ultimate liability for losses will not exceed such estimates.
Valuation of Financial Instruments:
Ambac's financial instruments that are reported on the Consolidated Balance
Sheets at fair value and subject to valuation estimates include investments in
fixed income securities, VIE assets and liabilities and derivatives comprising
credit default, interest rate and currency swap transactions. Surplus notes
issued by Ambac Assurance or the Segregated Account of Ambac Assurance are
recorded at fair value at the date of issuance and subsequently reported at
amortized cost within Long-term debt on the Consolidated Balance Sheets.
Determination of fair value for newly issued surplus notes is a highly
subjective process which relies upon the use of significant unobservable inputs
and management judgment consistent with a Level 3 valuation.
The fair market values of financial instruments held are determined by using
independent market quotes when available and valuation models when market quotes
are not available. ASC Topic 820, Fair Value Measurements and Disclosures
requires the categorization of these assets and liabilities according to a fair
value valuation hierarchy. Approximately 83% of our assets and approximately 71%
of our liabilities are carried at fair value and categorized in either Level 2
of the valuation hierarchy (meaning that their fair value was determined by
reference to quoted prices for similar instruments in active markets, quoted
prices for identical or similar instruments in inactive markets and other
observable inputs) or Level 3 (meaning that their fair value was determined by
reference to significant inputs that are unobservable in the market and
therefore require a greater degree of management judgment). The determination of
fair value for financial instruments categorized in Level 2 or 3 involves
significant judgment due to the complexity of factors contributing to the
valuation. Third-party sources from which we obtain independent market quotes
also use assumptions, judgments and estimates in determining financial
instrument values and different third parties may use different methodologies or
provide different prices for securities. In addition, the use of internal
valuation models for certain highly structured instruments, such as credit
default swaps, require assumptions about markets in which there has been a
negligible amount of trading activity for several years. As a result of these
factors, the actual trade value of a financial instrument in the market, or exit
value of a financial instrument position owned by Ambac, may be significantly
different from its recorded fair value. Refer to Note 7 to the Unaudited
Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for
discussion related to the transfers in and/or out of Level 1, 2 and 3 fair value
categories.
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Investment in Fixed Income Securities:
Investments in fixed income securities are accounted for in accordance with ASC
Topic 320, Investments-Debt and Equity Securities. ASC Topic 320 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. The fair values
of fixed income investments held in the investment portfolios of Ambac and its
operating subsidiaries are based primarily on quoted market prices received from
dealer quotes or alternative pricing sources with reasonable levels of price
transparency. For those fixed income investments where quotes were not
available, fair values are based on internal valuation models. Refer to Note 7
to the Unaudited Consolidated Financial Statements in Part I, Item 1 of this
Form 10-Q for further discussion of the valuation methods, inputs and
assumptions for fixed income securities. Ambac performs various review and
validation procedures to quoted and modeled prices for fixed income securities,
including price variance analyses, missing and static price reviews, overall
valuation analyses by senior traders and finance managers and reviews associated
with our ongoing impairment analysis. Unusual prices identified through these
procedures will be evaluated further against separate broker quotes (if
available) or internally modeled prices, and the pricing source values will be
challenged as necessary. Price challenges generally result in the use of the
pricing source's quote as originally provided or as revised by the source
following their internal diligence process. A price challenge may result in a
determination that the pricing source cannot provide a reasonable value for a
security or cannot adequately support a quote, in which case Ambac would resort
to using either other quotes or internal models. Results of price challenges are
reviewed and approved by senior traders and finance managers. Valuation results,
particularly those derived from valuation models and quotes on certain mortgage
and asset-backed securities, could differ materially from amounts that would
actually be realized in the market.
Ambac's investments in fixed income securities (excluding VIE investments)
classified as "available-for-sale" are carried at fair value, with the after-tax
difference from amortized cost reflected in stockholders' equity as a component
of Accumulated Other Comprehensive Income ("AOCI"). One of the significant
estimates related to available-for-sale securities is the evaluation of
investments for other-than-temporary impairments. Under GAAP, if management
assesses that it either (i) has the intent to sell its investment in a debt
security or (ii) more likely than not will be required to sell the debt security
before the anticipated recovery of its amortized cost basis less any current
period credit loss, then an other-than-temporary impairment charge must be
recognized in earnings, with the amortized cost of the security being
written-down to fair value. If these conditions are not met, but it is
determined that a credit loss exists, the impairment is separated into the
amount related to the credit loss, which is recognized in earnings, and the
amount related to all other factors, which is recognized in other comprehensive
income. To determine whether a credit loss has occurred, management considers
certain factors, including the length of time and extent to which the fair value
of the security has been less than its amortized cost and downgrades of the
security's credit rating. If such factors indicate that a potential credit loss
exists, management will compare the present value of estimated cash flows from
the security to the amortized cost basis to assess whether the entire amortized
cost basis will be recovered. When it is determined that all or a portion of the
amortized cost basis will not be recovered, a credit impairment charge is
recorded in earnings in the amount of the difference between the present value
of cash flows and the amortized cost at the balance sheet date, with the
amortized cost basis of the impaired security written-down to the present value
of cash flows. Ambac estimates expected future cash flows from residential
mortgage-backed securities using models and assumptions consistent with those
used to project losses in the financial guarantee RMBS portfolio described above
under "Critical Accounting Policies-Losses and Loss Expenses of Non-derivative
Financial Guarantees." Estimated cash flows are discounted at the effective
interest rate implicit in the security at the date of acquisition or, for debt
securities that are beneficial interests in securitized financial assets, at a
rate equal to the current yield used to accrete the beneficial interest. For
floating rate securities, estimated cash flows are projected using the relevant
index rate forward curve and the discount rate is adjusted for changes in that
curve. For debt securities for which other-than-temporary impairments were
recognized in earnings, the difference between the new amortized cost basis and
the cash flows expected to be collected are accreted as interest income over the
expected remaining life of the security.
Ambac's investment portfolio includes certain securities that are guaranteed by
Ambac Assurance. As described further in Note 8 to the Unaudited Consolidated
Financial Statements in Part I, Item 1 of this Form 10-Q, future cash flows used
to measure credit impairment of Ambac-wrapped bonds represents the sum of
(i) the bond's intrinsic cash flows and (ii) the estimated fair value of Ambac
claim payments. Under the Segregated Account Rehabilitation Plan, which has been
confirmed but is not effective and is subject to change, future claim payments
made by Ambac Assurance on these securities would be satisfied 25% in cash and
75% in surplus notes. However, it is uncertain whether the actual form and
amount of claim payments will conform to that set forth in the Segregated
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Account Rehabilitation Plan. Pursuant to the injunctions issued by the
Rehabilitation Court, claims on policies allocated to the Segregated Account
have not been paid since the commencement of the Segregated Account
Rehabilitation Proceedings. The Rehabilitator may seek to effectuate the current
Segregated Account Rehabilitation Plan, modify such Plan or modify the
injunctions issued by the Rehabilitation Court to allow for the payment of
policy claims in such manner and at such times as the Rehabilitator determines
to be in the best interest of policyholders. As a result, the date that claim
payments will resume is uncertain and estimation of the fair value of future
claim payments is highly subjective.
The evaluation of securities for impairments is a quantitative and qualitative
process, which is subject to risks and uncertainties and is intended to
determine whether declines in the fair value of investments should be recognized
in current period earnings. The risks and uncertainties include changes in
general economic conditions, the issuer's or guarantor's financial condition
and/or future prospects, the effects of changes in interest rates or credit
spreads and the expected recovery period. There is also significant judgment in
determining whether Ambac intends to sell securities or will continue to have
the ability to hold temporarily impaired securities until recovery. Future
events could occur that were not reasonably foreseen at the time management
rendered its judgment on the Company's intent to retain such securities until
recovery. Examples of such events include, but are not limited to, the
deterioration in the issuer's or guarantor's creditworthiness, a change in
regulatory requirements or a major business combination or major disposition.
VIE Assets and Liabilities:
The financial assets and liabilities of VIEs consolidated under ASC Topic 810,
Consolidation consist primarily of fixed income securities, loans receivable,
derivative instruments and debt instruments and are generally carried at fair
value with changes in fair value recognized in Income (loss) on variable
interest entities of the Consolidated Statements of Total Comprehensive Income.
These consolidated VIEs are primarily securitization entities which have
liabilities and/or assets guaranteed by Ambac Assurance or Ambac UK. The fair
values of VIE debt instruments are determined using the same methodologies used
to value Ambac's fixed income securities in its investment portfolio as
described above.
VIE derivative asset and liability fair values are determined using valuation
models. When specific derivative contractual terms are available and may be
valued primarily by reference to interest rates, exchange rates and yield curves
that are observable and regularly quoted, the derivatives are valued using
vendor-developed models. Other derivatives within the VIEs that include
significant unobservable valuation inputs are valued using internally developed
models.
The fair value of VIE assets are obtained from market quotes when available.
Typically the asset fair values are not readily available from market quotes and
are estimated internally. The consolidated VIEs are securitization entities in
which net cash flows from assets and derivatives (after adjusting for financial
guarantor cash flows and other expenses) will be paid out to note holders or
equity interests. Therefore, when market quotes are not available, our valuation
of VIE assets (fixed income securities or loans) are derived from the fair value
of debt and derivatives, as described above, adjusted for the fair value of cash
flows related to the financial guarantee. The fair value of financial guarantee
cash flows include: (i) estimated future premiums discounted at a rate
consistent with that implicit in the fair value of the VIE's liabilities and
(ii) internal estimates of future loss payments by Ambac Assurance or Ambac UK
discounted to consider the guarantor's credit risk.
Derivatives:
Ambac's operating subsidiaries' exposure to derivative instruments is created
primarily through interest rate swaps, US Treasury futures contracts and credit
default swaps. These contracts are accounted for at fair value under ASC Topic
815, Derivatives and Hedging. Valuation models are used for the derivatives
portfolios, using market data from a variety of third-party data sources.
Several of the more significant types of market data that influence fair value
include interest rates (taxable and tax-exempt), credit spreads, default
probabilities, recovery rates, comparable securities with observable pricing,
and the credit rating of the referenced entities. The valuation of certain
interest rate and currency swaps as well as all credit derivative contracts also
require the use of data inputs and assumptions that are determined by management
and are not readily observable in the market, including the amount that Ambac's
own credit risk impacts the fair value of derivative liabilities. Refer to Note
7 to the Unaudited Consolidated Financial Statements in Part I, Item 1 of this
Form 10-Q for further discussion of the models, model
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inputs and assumptions used to value derivative instruments. Due to the inherent
uncertainties of the assumptions used in the valuation models to determine the
fair value of derivative instruments, actual value realized in a market
transaction may differ significantly from the estimates reflected in our
financial statements.
Ambac's credit derivative valuation model, like any financial model, has certain
strengths and weaknesses. We believe our model's primary strength is that it
maximizes the use of market-driven inputs. Most importantly, the model uses
market-based discount rates and fair values of the underlying reference
obligations. Ambac employs a three-level hierarchy for obtaining reference
obligation fair values used in the model as follows: (i) broker quotes on the
reference obligation, (ii) prices and spreads from other transactions in the
portfolio with similar asset, structure and credit attributes, and
(iii) internal models comparable to those used for invested assets when quotes
are unavailable. We believe using this type of approach is preferable to other
models, which may emphasize modeled expected losses or which rely more heavily
on the use of market indices that may not be reflective of the underlying
reference obligation. Another strength is that our model is relatively easy to
understand, which increases its transparency.
A potential weakness of our valuation model is our reliance on broker quotes
obtained from dealers which originated the underlying transactions, who in
certain cases may also be the counterparty to our CDS transaction. All of the
transactions falling into this category are illiquid and it is usually difficult
to obtain alternative quotes. Ambac employs various procedures to corroborate
the reasonableness of quotes received; including comparing to other quotes
received on similarly structured transactions, observed spreads on structured
products with comparable underlying assets and, on a selective basis when
possible, values derived through internal estimates of discounted future cash
flows. Each quarter, the portfolio of CDS transactions is reviewed to ensure
every reference obligation price has been updated. Period to period valuations
are compared for each CDS and by underlying bond type. For each CDS, this
analysis includes comparisons of key valuation inputs to the prior period and
against other CDS within the bond type. No adjustments were made to the broker
quotes we received when determining fair value of CDS contracts as of March 31,
2012. Another potential weakness of our valuation model is the lack of new CDS
transactions executed by financial guarantors, which makes it difficult to
validate the percentage of the reference obligation spread which would be
captured as a CDS fee at the valuation date (i.e. the relative change ratio).
Changes to the relative change ratio based on internal ratings assigned are
another potential weakness as internal ratings could differ from actual ratings
provided by rating agencies. However, we believe our internal ratings are
updated at least as frequently as the external ratings. We believe the approach
we have developed to increase the relative change ratio as the underlying
reference obligation experiences credit deterioration is consistent with a
market-based approach to valuation. Ultimately, our approach exhibits the same
weakness as other modeling approaches, as it is unclear if we could execute at
these values.
Valuation of Deferred Tax Assets:
Our provision for taxes is based on our income, statutory tax rates and tax
planning opportunities available to us in the jurisdictions in which we operate.
Tax laws are complex and subject to different interpretations by the taxpayer
and respective governmental taxing authorities. Significant judgment is required
in determining our tax expense and in evaluating our tax positions. We review
our tax positions quarterly and adjust the balances as new information becomes
available. Deferred tax assets arise because of temporary differences between
the financial reporting and tax bases of assets and liabilities, as well as from
net operating loss and tax credit carry forwards. More specifically, deferred
tax assets represent a future tax benefit (or receivable) that results from
losses recorded under U.S. GAAP in a current period which are only deductible
for tax purposes in future periods and net operating loss carry forwards. In
accordance with ASC Topic 740, Income Taxes, we evaluate our deferred income
taxes quarterly to determine if valuation allowances are required. ASC Topic 740
requires that companies assess whether valuation allowances should be
established against their deferred tax assets based on the consideration of all
available evidence using a "more likely than not" standard. All available
evidence, both positive and negative, needs to be identified and considered in
making the determination with significant weight given to evidence that can be
objectively verified. The level of deferred tax asset recognition is influenced
by management's assessment of future expected taxable income, which depends on
the existence of sufficient taxable income of the appropriate character
(ordinary vs. capital) within the carry back or carry forward periods available
under the tax law. In the event that we determine that we would not be able to
realize all or a portion of our deferred tax assets, we would record a valuation
allowance against the deferred tax assets that we estimate will not ultimately
be recoverable in the period in which that determination is made.
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Financial Guarantees in Force
Financial guarantee products were sold in three principal markets: the U.S.
public finance market, the U.S. structured finance market and the international
finance market. The following table provides a breakdown of guaranteed net par
outstanding by market sector at March 31, 2012 and December 31, 2011. Guaranteed
net par outstanding includes the exposures of policies that insure VIEs
consolidated in accordance with ASC Topic 810, Consolidation:
March 31, December 31,
($ in millions) 2012 2011
Public Finance $ 170,313 $ 176,817
Structured Finance 52,201 55,145
International Finance 40,894 40,542
Total net par outstanding $ 263,408 $ 272,504
Included in the above net par exposures at March 31, 2012 and December 31, 2011
are $13,643 and $14,167, respectively, of exposures that were executed in the
form of credit derivatives, primarily collateralized loan exposures.
Ratings Distribution
The following tables provide a rating distribution of guaranteed total net par
outstanding based upon internal Ambac Assurance credit ratings at March 31, 2012
and December 31, 2011 and a distribution by bond type of Ambac Assurance's below
investment grade exposures at March 31, 2012 and December 31, 2011. Below
investment grade is defined as those exposures with a credit rating below BBB-:
Percentage of Guaranteed Portfolio (1)
March 31, December 31,
2012 2011
AAA 1 % 1 %
AA 24 24
A 43 43
BBB 17 17
BIG 15 15
Total 100 % 100 %
(1) Internal credit ratings are provided solely to indicate the underlying credit
quality of guaranteed obligations based on the view of Ambac Assurance. In
cases where Ambac Assurance has insured multiple tranches of an issue with
varying internal ratings, or more than one obligation of an issuer with
varying internal ratings, a weighted average rating is used. Ambac Assurance
credit ratings are subject to revision at any time and do not constitute
investment advice. Ambac Assurance, or one of its affiliates, has guaranteed
the obligations listed and may also provide other products or services to the
issuers of these obligations for which Ambac Assurance may have received
premiums or fees.
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Summary of Below Investment Grade Exposure
March 31, December 31,
Bond Type 2012 2011
($ in millions)
Public Finance:
Transportation $ 646 $ 669
Health care 77 79
General obligation 532 492
Tax-backed 753 764
Housing 776 790
Other 1,188 1,137
Total Public Finance 3,972 3,931
Structured Finance:
Residential mortgage-backed and home equity-first-lien 11,223 11,673
Residential mortgage-backed and home equity-second-lien 8,567 8,784
Student loans 7,368 7,728
Structured Insurance 1,657 1,657
Auto Rentals 745 820
Mortgage-backed and home equity-other 578 586
Enhanced equipment trust certificates 401 401
Other 617 639
Total Structured Finance 31,156 32,288
International Finance:
Airports 1,511 1,466
Other 3,470 3,399
Total International Finance 4,981 4,865
Total $ 40,109 $ 41,084
The sections that follow will discuss below investment grade exposures with
residential mortgage-backed and student loan exposures.
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U.S. residential mortgage-backed securities exposure included in financial
guarantee insurance portfolio
Ambac has exposure to the U.S. mortgage market through direct financial
guarantees of RMBS. Ambac insures tranches issued in RMBS, including
transactions that contain risks to first and second-liens. The following tables
provide current gross par outstanding by vintage and type, and underlying credit
rating of Ambac's affected U.S. RMBS book of business:
Total Gross Par Outstanding
At March 31, 2012 ($ in millions)
Year of Issue Second-Lien Sub-prime Mid-prime(1) Other(4)
1998-2001 $ 86.7 $ 631.4 $ 5.4 $ 518.4
2002 41.9 566.2 63.0 17.9
2003 29.6 859.4 428.3 176.1
2004 1,186.6 462.6 733.7 40.2
2005 1,217.1 1,101.8 2,375.9 62.4
2006 2,997.1 788.8 1,529.2 203.3
2007 3,271.7 521.5 2,339.2 287.5
Total $ 8,830.7 $ 4,931.7 $ 7,474.7 $ 1,305.8
% of Total RMBS Portfolio 39.2 % 21.9 % 33.2 % 5.7 %
Gross claim liability, before Subrogation Recoveries
At March 31, 2012 ($ in millions)
Year of Issue Second-Lien Sub-prime Mid-prime(1) Other(4)
1998-2001 $ - $ 72.3 $ - $ 17.2
2002 - 69.3 1.8 -
2003 - 34.5 6.7 -
2004 149.9 38.5 33.3 1.6
2005 291.9 438.9 989.3 21.8
2006 1,462.3 429.6 1,066.8 158.5
2007 383.6 215.4 1,277.7 86.6
Total $ 2,287.7 $ 1,298.5 $ 3,375.6 $ 285.7
Gross Subrogation Recoveries
At March 31, 2012 ($ in millions)
Year of Issue Second-Lien Sub-prime Mid-prime(1) Other(4)
1998-2001 $ - $ - $ - $ -
2002 - - - -
2003 - - - -
2004 (54.4 ) - - -
2005 (144.9 ) (209.7 ) (246.2 ) -
2006 (795.0 ) (200.8 ) (165.6 ) -
2007 (554.5 ) (75.2 ) (209.1 ) -
Total $ (1,548.8 ) $ (485.7 ) $ (620.9 ) $ -
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Percent of Related RMBS Transactions'
Gross Par At March 31, 2012
Internal Ambac Credit Rating(2) Second-Lien Sub-prime Mid-prime(1) Other(4)
AAA 0 % 3 % 0 % 10 %
AA <0.1 % 3 % 4 % 24 %
A 1 % 5 % 1 % 13 %
BBB(3) 1 % 1 % 1 % 6 %
Below investment grade(3) 98 % 88 % 94 % 47 %
(1) Mid-prime includes Alt-A transactions and affordability product transactions,
which includes interest only or option adjustable rate features.
(2) Ambac Assurance ratings set forth above reflect internal credit ratings as of
March 31, 2012, and may be changed at any time based on our internal credit
review. Ambac Assurance undertakes no obligation to update such ratings. This
does not constitute investment advice. Ambac Assurance or one of its
affiliates has guaranteed the obligations listed and may also provide other
products or services to the issuers of these obligations for which Ambac
Assurance may have received premiums or fees.
(3) 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 condition
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 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. Ambac Assurance's
below investment grade category includes transactions on which claims have
been submitted.
(4) Other includes primarily manufactured housing and lot loan exposures.
Student Loans
Our student loan portfolio consists of credits collateralized by (i) federally
guaranteed loans under the Federal Family Education Loan Program ("FFELP") and
(ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of
97% of defaulted principal and interest, private loans have no government
guarantee and, therefore, are subject to credit risk as with other types of
unguaranteed credits. Private student loans are outside the purview of recent
government programs designed to assist borrowers. Recent default data has shown
a significant deterioration in the performance of private student loans
underlying our transactions. Additionally, due to the failure of the auction
rate and variable rate markets as noted below in Auction Rate and Variable Rate
Demand Obligation, the interest rates on student loan securities has increased
significantly to punitive levels pursuant to the transaction terms. Such
increases have caused the collateralization ratio in these transactions to
deteriorate on an accelerated basis due to negative excess spread and/or the use
of principal receipts to pay current interest. Effective July 1, 2010, lenders
were unable to originate federal guaranteed loans, due to the termination of the
FFELP program. The resulting reduction in new revenues may adversely affect a
number of smaller issuers, whose ability to remain a going concern may be at
risk.
Student loan net par outstanding, excluding debt service reserve funds on Ambac
insured obligations:
March 31, December 31,
2012 % of Net 2011 % of Net
Issuer Type ($ in millions) Net Par Par Net Par Par
For-Profit Issuers $ 3,267.0 45 % $ 3,288.5 43 %
Not-For-Profit Issuers 4,064.9 55 % 4,391.1 57 %
Total $ 7,331.9 100 % $ 7,679.6 100 %
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Collateral for the For-Profit Issuers consists of private loans which are
uninsured and do not have any federal guarantee as to defaulted principal and
interest. Collateral for the Not-For-Profit Issuers consists of both FFELP and
private loans. For the total student loan portfolio, approximately 65% of the
collateral backing student loan trusts consists of private loans while the
remaining 35% consists of FFELP loans. Private loan defaults have been on the
rise since the credit crisis in 2008 began. Elevated unemployment rates,
combined with high student loan debt levels will continue to put pressure on
borrower's ability to pay their loans.
The following table represents the student loan net par outstanding by
underlying debt type, excluding debt service reserve funds on Ambac insured
obligations:
March 31, 2012 % of net December 31, 2011 % of net
Debit Type ($ in millions) Net Par Par Net Par Par
Auction Rate $ 4,531.5 62 % $ 4,644.6 61 %
Fixed Rate 399.5 5 % 414.9 5 %
VRDOs - - % 204.6 3 %
Floating Rate Notes 2,400.9 33 % 2,415.5 31 %
Total $ 7,331.9 100 % $ 7,679.6 100 %
RESULTS OF OPERATIONS
Ambac follows the accounting prescribed by ASC Topic 852, "Reorganizations".
Entities operating in bankruptcy and expecting to reorganize under Chapter 11 of
the Bankruptcy Code are subject to the additional accounting and financial
reporting guidance in ASC Topic 852. While ASC Topic 852 provides specific
guidance for certain matters, other portions of US GAAP continue to apply so
long as the guidance does not conflict with ASC Topic 852. This accounting
literature provides guidance for periods subsequent to a Chapter 11 filing for,
among other things, the presentation of liabilities that are and are not subject
to compromise by the Bankruptcy Court proceedings, as well as the treatment of
interest expense and presentation of costs associated with the proceedings.
Accordingly, the financial results in the prior periods or filed in future
filings may not be comparable.
Ambac's net income was $253.3 million or $0.84 per diluted share, compared to a
net loss of ($819.3) million or ($2.71) per diluted share, for the three months
ended March 31, 2012 and 2011, respectively. The first quarter 2012 financial
results compared to 2011 were primarily positively impacted by (i) a lower
provision for loss and loss expenses; (ii) higher gains on variable interest
entities; (iii) higher net investment income; (iv) lower reorganization items
related to our Chapter 11 bankruptcy filing and (v) higher derivative product
and other income.
The following paragraphs describe the consolidated results of operations of
Ambac and its subsidiaries for the three months ended March 31, 2012 and 2011
and its financial condition as of March 31, 2012 and December 31, 2011.
Commutations, Terminations and Settlements of Financial Guarantee Contracts. A
key business strategy for Ambac is to increase the residual value of its
financial guarantee business by mitigating losses on poorly performing
transactions via the pursuit of commutations and terminations of financial
guarantee insurance contracts, including insurance policies and credit
derivative contracts. For three months ended March 31, 2012 and 2011, Ambac
executed a number of such transactions as follows:
In the three months ended March 31, 2012, the Segregated Account of Ambac
Assurance made a gross cash payment of $17.5 million ($10.5 million net of
reinsurance) to commute $204.6 million of net par exposure relating to two
student loan transactions.
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In the three months ended March 31, 2011, the Segregated Account of Ambac
Assurance completed the commutation of two student loan transactions
representing $419.9 million of net par exposure, with cash payment of $11.0
million, and the issuance of Segregated Account surplus notes with a par value
of $3.0 million.
Net Premiums Earned. Net premiums earned during the three months ended March 31,
2012 were $95.0 million, an increase of 3.5% from $91.8 million for the three
months ended March 31, 2011. Net premiums earned include accelerated premiums,
which result from refunding, calls and other accelerations. Ambac had
accelerated earnings of $15.8 million during the first quarter of 2012 versus
($0.1) million in the first quarter of 2011. The net increase in accelerated
earnings was driven by an increase in overall volume of calls of Ambac insured
debt within the public finance market. Ambac recognizes negative accelerations
on polices when the GAAP premiums receivable for the policy exceeds the policy's
unearned premium reserve at termination. Normal net premiums earned exclude
accelerated premiums. Normal net premiums earned for 2012 has been negatively
impacted by the runoff of the insured portfolio either via transaction
terminations, refundings or scheduled maturities. Normal net premiums earned and
accelerated premiums are reconciled to total net premiums earned in the table
below and are included in the Financial Guarantee segment. The following table
provides a breakdown of net premiums earned by market sector:
Three Months Ended
March 31,
($ in millions) 2012 2011
Public Finance $ 39.0 $ 42.4
Structured Finance 18.3 29.7
International Finance 21.9 19.8
Total normal premiums earned 79.2 91.9
Accelerated earnings 15.8 (0.1 )
Total net premiums earned $ 95.0 $ 91.8
The following table provides a breakdown of accelerated earnings by market
sector:
Three Months Ended
March 31,
($ in millions) 2012 2011
Public Finance $ 23.0 $ 4.7
Structured Finance (7.3 ) (5.3 )
International Finance 0.1 0.5
Total accelerated earnings $ 15.8 $ (0.1 )
Net Investment Income. Net investment income the three months ended March 31,
2012 was $112.1 million, an increase of 47% from $76.5 million for the three
months ended March 31, 2011. The following table provides details by segment for
the three months ended March 31, 2012 and 2011:
Three Months Ended
March 31,
($ in millions) 2012 2011
Financial Guarantee $ 105.2 $ 71.7
Financial Services 6.8 4.7
Corporate 0.1 0.1
Total net investment income $ 112.1 $ 76.5
The increase in Financial Guarantee net investment income in the three months
ended March 31, 2012, reflects the benefit of higher yielding assets in the
portfolio and a higher average invested asset base compared to the three months
ended March 31, 2011. Higher average yields on the portfolio resulted from the
shift in the portfolio mix away from tax-exempt municipals toward taxable
securities, primarily corporate bonds, taxable municipals and Ambac-insured
securities. In addition to the impact of greater holdings of Ambac Assurance
guaranteed securities, investment income from such securities in the first
quarter 2012 was higher than first quarter 2011 due to the impact of changes in
projected cash flows in each period. Favorable changes to projected cash flows
increased investment income in the 2012 period, while adverse changes reduced
income in the first quarter 2011. The par value of Ambac Assurance-wrapped
securities as of March 31, 2012 was $1,297
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million compared to $1,136 million at March 31, 2011. The overall size of the
Financial Guarantee long-term asset portfolio has grown by approximately $294
million since March 31, 2011, benefiting from the moratorium on claim payments
and continuing collection of installment paying financial guarantee premiums and
coupon receipts on invested assets.
The increase in Financial Services investment income for the three months ended
March 31, 2012, compared to the three months ended March 31, 2011, was driven
primarily by improved cash flows on certain RMBS securities which had a positive
impact on income for the quarter, partially offset by the effects of a smaller
portfolio of investments in the investment agreement business. The portfolio
decreased primarily as a result of sales of securities to fund repayment of
investment agreements as Ambac's investment agreement obligations were reduced
from $717.1 million at March 31, 2011, to $547.3 million at March 31, 2012.
Corporate investment income relates to the investments from Ambac's investment
portfolio.
Net Other-Than-Temporary Impairment Losses. Net other-than-temporary impairment
losses recorded in the Consolidated Statements of Total Comprehensive Income
include only the credit related impairment amounts to the extent management does
not intend to sell and it is not more likely than not that the company will be
required to sell before recovery of the amortized cost basis less any current
period credit impairment. Non-credit related impairment amounts are recorded in
accumulated other comprehensive income on the balance sheet. Alternatively, the
non-credit related impairment would be recorded in net other-than-temporary
impairment losses in the Consolidated Statements of Total Comprehensive Income
if management intends to sell the securities or it is more likely than not the
company will be required to sell before recovery of amortized cost less any
current period credit impairment. Charges for other-than-temporary impairment
losses were $3.1 million and $1.7 million for the three months ended March 31,
2012 and 2011, respectively.
As further described in Note 1 to the Unaudited Consolidated Financial
Statements located in Part I, Item 1 of this Form 10-Q, on March 24, 2010, OCI
commenced the Segregated Account Rehabilitation Proceedings in order to
facilitate an orderly run-off and/or settlement of the liabilities allocated to
the Segregated Account. As a result of actions taken by the OCI, financial
guarantee payments on securities guaranteed by Ambac Assurance which have been
allocated to the Segregated Account were suspended in March 2010 and are no
longer under the control of Ambac management. The form and timing of future
financial guarantee payments will be determined by the Rehabilitator. Claim
payments under Segregated Account policies have been suspended since March 24,
2010. Changes in the estimated date of resumption of claim payments have
resulted in adverse changes in projected cash flows on certain impaired
Ambac-wrapped securities during 2012 and 2011. Net other-than-temporary
impairments for the three months ended March 31, 2012 and 2011 resulted
primarily from adverse changes to projected cash flows on Ambac-wrapped
securities stemming from the continued suspension of claim payments as described
above and from credit impairments on certain other non-agency RMBS securities.
As of March 31, 2012, management has not asserted an intent to sell any
securities from its portfolio that are in an unrealized loss position. Future
changes in our estimated liquidity needs could result in a determination that
Ambac no longer has the ability to hold such securities, which could result in
additional other-than-temporary impairment charges.
Net Realized Investment Gains. The following table provides a breakdown of net
realized gains for the three months ended March 31, 2012 and 2011:
Financial Financial
($ in millions) Guarantee Services Corporate Total
March 31, 2012:
Net gains on securities sold or called $ - $ 0.5 $ - $ 0.5
Foreign exchange losses (0.1 ) - - (0.1 )
Total net realized (losses) gains (0.1 ) $ 0.5 - 0.4
March 31, 2011:
Net gains (losses) on securities sold
or called $ 0.3 $ 2.5 $ - $ 2.8
Foreign exchange losses (0.3 ) - - (0.3 )
Total net realized gains $ - $ 2.5 $ - $ 2.5
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Change in Fair Value of Credit Derivatives. The net change in fair value of
credit derivatives was a loss of $7.2 million for the three months ended
March 31, 2012, compared to a loss of $8.9 million for the three months ended
March 31, 2011. The net losses on change in fair value of credit derivatives for
both periods resulted from a reduction of the Ambac credit valuation adjustment
("CVA") to reflect Ambac's own credit risk in the fair value of credit
derivatives partially offset by improvement in reference obligation prices,
gains associated with runoff of the portfolio and CDS fees earned. The CVA
reductions reflected observed increases in the market value of Ambac Assurance's
direct and guaranteed obligations during the period. Of the change in fair value
of credit derivatives reported for the three month periods ended March 31, 2012
and 2011, losses of $33.5 million and $47.2 million, respectively, are
attributable to reductions of the Ambac CVA. See Note 7 for a further
description of Ambac's methodology for determining the fair value of credit
derivatives.
Realized gains and other settlements on credit derivative contracts were $3.3
million and $5.3 million for the three months March 31, 2012 and 2011,
respectively. These amounts represent premiums received and accrued on written
contracts plus net losses and settlements paid and payable where a formal
notification of shortfall has occurred. There were no losses or settlements
included in net realized gains for the three months ended March 31, 2012 or
2011.
Unrealized gains (losses) on credit derivative contracts were ($10.5) million
and ($14.2) million in the three months ended March 31, 2012 and 2011,
respectively. The net unrealized gains (losses) in fair value of credit
derivatives reflect the same factors as the overall change in fair value of
credit derivatives as noted above.
Derivative Product Revenues. Net gains reported in derivative product revenues
for the three months ended March 31, 2012 were $47.0 million compared to net
gains of $21.0 million for the three months ended March 31, 2011. Results for
both periods were driven primarily from mark-to-market gains caused by changes
in long-term interest rates during the respective periods. The derivative
products portfolio is positioned to benefit from rising rates as an economic
hedge against interest rate exposure in the financial guarantee portfolio (the
"macro-hedge"). This additional interest rate sensitivity contributed gains of
$49.7 million for the three months ended March 31, 2012 compared to the $16.5
million for the three months ended March 31, 2011. Excluding the impact of the
macro-hedge, derivative products revenue resulted in a loss of ($2.7) million
and a gain of $4.5 million for the three months ended March 31, 2012 and 2011,
respectively, primarily reflecting mark-to-market gains on financial guarantee
customer swaps, net of the negative impact of adjustments to the Ambac CVA as
described below.
The fair value of derivatives includes a valuation adjustment to reflect Ambac's
own credit risk when appropriate (Ambac "CVA"). Within the financial services
derivatives portfolio, an Ambac CVA is generally applicable for uncollateralized
derivative liabilities that may not be offset by derivative assets under a
master netting agreement. Changes to the Ambac CVA contributed losses within
derivative products revenues of $35.3 million and $4.2 million for the three
months ended March 31, 2012 and 2011, respectively.
Other Income. Other income for the three months ended March 31, 2012 was $64.8
million, as compared to $28.3 million for the three months ended March 31, 2011.
Included within other income are mark-to market gains and losses relating to
options to call certain Ambac Assurance surplus notes, non-investment portfolio
related foreign exchange gains and losses, deal structuring fees, commitment
fees and reinsurance settlement gains (losses). Other income for the three
months ended March 31, 2012 primarily resulted from mark-to-market gains of
$61.7 million related to Ambac's option to call up to $500 million par of bank
surplus notes. Other income for the three months ended March 31, 2011 includes
mark-to-market gains of $16.7 million related to surplus note call option and
the impact of the movement in the British Pound and Euro to US Dollar exchange
rate upon premium receivables which resulted in a gain of approximately $3.0
million.
The surplus note call options that are free-standing derivatives expire on
June 7, 2012. These options are carried as assets on the balance sheet at a fair
value of $67.7 million at March 31, 2012. Upon the earlier of exercise or
expiration of the options, the asset will be reversed with the change in fair
value recognized as a loss in the Consolidated Statement of Total Comprehensive
Income. The board of directors of Ambac Assurance has approved the exercise of
all options to purchase surplus notes issued by Ambac Assurance. The exercise of
such options also requires the approval of OCI and the Rehabilitator of the
Segregated Account. Ambac Assurance is seeking such approvals. There can be no
assurance that such approvals will be obtained.
Income (loss) on variable interest entities. Income (loss) on variable interest
entities for the three months ended March 31, 2012 and 2011 was $15.2 million
and ($6.1) million, respectively. Included within Income (loss)
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on variable interest entities are income statement amounts relating to VIEs
consolidated under ASC Topic 810, including gains or losses attributable to
consolidating or deconsolidating VIEs during the period reported. Generally, the
Company's consolidated VIEs are entities for which Ambac has provided financial
guarantees on its assets or liabilities. In consolidation, most assets and
liabilities of the VIEs are reported at fair value and the related insurance
assets and liabilities are eliminated. Differences between the net carrying
value of the insurance accounts and the carrying value of the consolidated VIE's
net assets are recorded through income at the time of consolidation or
deconsolidation.
The gain for the three months ended March 31, 2012 reflects the positive change
in the fair value of net assets of consolidated VIEs during the period. The loss
for the three months ended March 31, 2011 primarily reflects the loss upon
deconsolidation of a transaction.
Losses and Loss Expenses. Losses and loss expenses are based upon estimates of
the aggregate losses inherent in the non-derivative financial guarantee
portfolio for insurance policies issued to beneficiaries, including
unconsolidated VIEs. Loss and loss expenses for the three months ended March 31,
2012 and 2011 were $(2.3) million and $919.6 million, respectively. The net
benefit realized for the three months ended March 31, 2012 was driven by lower
estimated losses in the first-lien RMBS and student loan portfolios, partially
offset by higher estimated losses for public finance credits and loss expense
reserves for RMBS credits. Losses for the three months ended March 31, 2011 were
driven by higher estimated losses in the first-lien RMBS portfolio, offset by a
reduction in estimated losses for the second lien RMBS portfolio, as well as
higher expected losses for certain structured insurance, student loan, and
transportation credits.
The following table summarizes the changes in the total net loss reserves for
three months ended March 31, 2012 and the year ended December 31, 2011:
Three Months Ended Year Ended
($ in millions) March 31, 2012 December 31, 2011
Beginning balance of loss reserves,
net of Subrogation recoverable and
reinsurance $ 6,230.8 $ 4,424.5
Provision for losses and loss expenses (2.3 ) 1,859.5
Losses paid (35.3 ) (308.6 )
Recoveries of losses paid from
reinsurers 10.0 21.0
Other recoveries, net of reinsurance 32.8 105.7
Other adjustments (including foreign
exchange) 12.5 (5.9 )
Net deconsolidation of certain VIEs - 134.6
Ending balance of net loss reserves $ 6,248.5 $ 6,230.8
Refer to Note 5 to the Unaudited Consolidated Financial Statements in Part I,
Item 1 of the Form 10-Q for further information on the basis for consolidations
and deconsolidations of VIEs.
The losses and loss expense reserves as of March 31, 2012 and December 31, 2011
are net of estimated recoveries under representation and warranty breaches for
certain RMBS transactions in the amount of $2,655.4 million and $2,720.2
million, respectively. Please refer to the "Critical Accounting Estimates"
section of this Management's Discussion and Analysis of Financial Condition and
Results of Operations and to Note 6 of the Unaudited Consolidated Financial
Statements in Part I, Item 1 of this Form 10-Q for further background
information on the change in estimated recoveries.
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The following tables provide details of net claims presented, net of recoveries
received for the three months ended March 31, 2012 and 2011:
Three Months Ended
March 31,
($ in millions) 2012 2011
Net claims presented:
Public Finance $ 19.0 $ 5.3
Structured Finance 363.5 345.1
International Finance - -
Total(1) $ 382.5 $ 350.4
(1) On March 24, 2010 the Rehabilitation Court instituted a claim moratorium on
the Segregated Account of Ambac Assurance. As a result, for the period from
March 24, 2010 up to and including March 31, 2012, there have been $3,162.4
million of claims presented to Ambac Assurance that have not been paid.
Claims presented to the Segregated Account of Ambac Assurance and not paid
for the three months ended March 31, 2012 and 2011 were $393.8 million and
$357.3 million, respectively.
Please refer to the "Critical Accounting Policies and Estimates-Losses and Loss
Expenses of Non-derivative Financial Guarantees" section of this Management's
Discussion and Analysis of Financial Condition and Results of Operations and to
the Loss Reserves section located in Note 6 of the Unaudited Consolidated
Financial Statements located in Part I, Item 1 of this Form 10-Q for further
background information on loss reserves.
Underwriting and Operating Expenses. Underwriting and operating expenses for the
three months ended March 31, 2012 and 2011 were $36.5 million and $45.5 million,
respectively, a decrease of 20%. Underwriting and operating expenses consist of
gross underwriting and operating expenses plus the amortization of previously
deferred expenses (included in Financial Guarantee segment). The following table
provides details of underwriting and operating expenses by segment for three
months ended March 31, 2012 and 2011:
Three Months Ended
March 31,
($ in millions) 2012 2011
Underwriting and operating expenses:
Financial Guarantee $ 33.8 $ 42.4
Financial Services 0.8 2.6
Corporate 1.9 0.5
Total $ 36.5 $ 45.5
The decrease in Financial Guarantee underwriting and operating expenses for
three months ended March 31, 2012 were primarily due to lower compensation,
premises, premium taxes and rating agency fees, partially offset by higher legal
costs. The decrease in Financial Services underwriting and operating expenses
for the three months ended March 31, 2012 were primarily due to lower
compensation costs and legal fees.
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 the hiring
of advisors. During the three months ended March 31, 2012 and 2011 expenses
incurred in connection with legal and consulting services provided for the
benefit of OCI amounted to $1.0 million and $2.2 million. Future expenses may
include a significant amount of advisory costs for the benefit of OCI that are
outside the control of Ambac's management.
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Interest Expense. Interest expense includes accrued interest and accretion of
the discount on surplus notes issued by Ambac Assurance and the Segregated
Account, the interest expense relating to investment agreements, and the
interest expense related to a secured borrowing transaction closed in December
2011. The following table provides details for the three months ended March 31,
2012 and 2011:
Three Months Ended
March 31,
($ in millions) 2012 2011
Interest expense:
Surplus notes $ 31.5 $ 28.1
Investment agreements 1.8 2.2
Secured borrowing 0.5 -
Total $ 33.8 $ 30.3
The increase in interest expense on surplus notes resulted from the higher
average par amount of surplus notes outstanding during the three months ended
March 31, 2012 compared to the three months ended March 31, 2011 and to the
impact of applying the level yield method as the discount to the face value of
the surplus notes accretes over time. Surplus note interest payments require the
approval of OCI. On June 1, 2011 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. Such interest was capitalized and the Company is
accruing interest on these additional amounts.
The decline in interest expense related to investment agreements stemmed
primarily from reductions on outstanding investment agreements, as the carrying
value declined to $547.3 million at March 31, 2012 from $717.1 million at
March 31, 2011.
Interest expense in the period ended March 31, 2012 includes interest on a $35.6
million (balance of $28.3 million as of March 31, 2012) 6.65% note issued on
December 16, 2011. The note is secured by certain Ambac Assurance-wrapped RMBS
securities that were deposited into a bankruptcy remote trust. The trusts used
to effectuate this transaction qualify as VIEs and are consolidated by Ambac.
Interest expense in the three months ended March 31, 2012 was $0.5 million.
Interest was no longer accrued on Ambac's debt obligations included in
Liabilities Subject to Compromise on the Consolidated Balance Sheets after Ambac
filed for bankruptcy protection on November 8, 2010. If Ambac had continued to
accrue interest on its debt obligations, contractual interest expense would have
been $24.2 million and $28.6 million for the three months ended March 31, 2012
and 2011.
Reorganization Items.Reorganization items are primarily expenses directly
attributed to our Chapter 11 reorganization process. Reorganization items in
three months ended March 31, 2012 and 2011 were $2.5 million and $24.8 million,
respectively, including professional advisory fees of approximately $2.4 million
and $10.0 million in 2012 and 2011, respectively. On March 1, 2011, Ambac, Ambac
Assurance, the Segregated Account and One State Street, LLC ("OSS") entered into
a settlement agreement (the "OSS Settlement Agreement") to terminate the
Company's office lease with OSS and to settle all claims among the parties. The
OSS Settlement Agreement provides that OSS will have an allowed general
unsecured claim in Ambac's bankruptcy case for approximately $14.1 million.
Provision for Income Taxes. Income tax expense was $0.3 million and $2.4 million
for the three months ended March 31, 2012 and 2011, respectively. The income tax
expense for the three months ended March 31, 2012 and 2011 relates predominantly
to pre-tax profits in Ambac UK's Italian branch, which can not be offset by
losses in other jurisdictions.
Ambac Assurance Statutory Basis Financial Results
Ambac Assurance's statutory financial statements are prepared on the basis of
accounting practices prescribed or permitted by the OCI ("SAP"). OCI recognizes
only statutory accounting practices prescribed or permitted by the State of
Wisconsin for determining and reporting the financial condition and results of
operations of an insurance company for determining its solvency under Wisconsin
Insurance Law. The National Association of Insurance Commissioners ("NAIC")
Accounting Practices and Procedures manual ("NAIC SAP") has been adopted as a
component of prescribed practices by the State of Wisconsin.
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On March 24, 2010, Ambac Assurance acquiesced to the request of OCI to establish
a Segregated Account. Under Wisconsin insurance law, the Segregated Account is a
separate insurer from Ambac Assurance and accordingly is subject to all of the
filing and statutory reporting requirements of Wisconsin domiciled insurers. The
purpose of the Segregated Account is to segregate certain segments of Ambac
Assurance's liabilities. The total assets, total liabilities, and total surplus
of the Segregated Account are reported as discrete components of Ambac
Assurance's assets, liabilities, and surplus reported in Ambac Assurance's
statutory basis financial statements. Accordingly, Ambac Assurance's statutory
financial statements include the results of Ambac Assurance's account, the
Segregated Account, as well as, Ambac Assurance's equity investment in its
subsidiaries.
Ambac Assurance reported statutory capital and surplus of $262.9 million and
$495.3 million as of March 31, 2012 and December 31, 2011, respectively. Ambac
Assurance, combined with Everspan, reported contingency reserves of $287.9
million and $192.7 million as of March 31, 2012 and December 31, 2011,
respectively. Ambac Assurance reported a statutory net loss of $146.9 million
and $183.3 million for the three month periods ended March 31, 2012 and 2011,
respectively. The primary drivers of the statutory net loss were increases in
statutory loss and loss expenses related primarily to RMBS financial guarantee
contracts that defaulted during 2012.
Statutory surplus is sensitive to: (i) further credit deterioration on the
defaulted credits in the insured portfolio, (ii) deterioration in the financial
position of Ambac Assurance subsidiaries that have their obligations guaranteed
by Ambac Assurance, (iii) first time payment defaults of insured obligations,
which increases statutory loss reserves, (iv) commutations of insurance policies
or credit derivative contracts at amounts that differ from the amount of
liabilities recorded, (v) reinsurance contract terminations at amounts that
differ from net assets recorded, (vi) reductions in the fair value of previously
impaired investments or additional downgrades of the ratings on investment
securities to below investment grade by the independent rating agencies,
(vii) settlements of representation and warranty breach claims at amounts that
differ from amounts recorded, including failures to collect such amounts, and
(viii) issuance of surplus notes.
LIQUIDITY AND CAPITAL RESOURCES
Ambac Financial Group, Inc. Liquidity. The matters described herein, to the
extent that they relate to future events or expectations, may be significantly
affected by Ambac's Chapter 11 Bankruptcy filing. We believe the consummation of
a successful restructuring under Chapter 11 of the Bankruptcy Code is critical
to our continued viability and long term liquidity. As with any judicial
proceeding, there are risks of unavoidable delay with a Chapter 11 proceeding.
Delays in the consummation of a plan would add expense as Ambac may be required
to incur substantial costs for professional fees and other expenses associated
with the administration of the Chapter 11 proceedings. While management believes
that Ambac will have sufficient liquidity to satisfy its needs until it emerges
from the bankruptcy proceeding, delays, higher than anticipated costs, or
unforeseen events may jeopardize its ability 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 likely occur.
Ambac's liquidity and solvency are largely dependent on its current cash and
investments of $34.0 million at March 31, 2012 (excluding $2.5 million of
restricted cash), consummation of the Reorganization Plan and on the residual
value of Ambac Assurance. Pursuant to the Mediation Agreement, Amended TSA and
Cost Allocation Agreement (as each such term is defined in Note 1 to the
Unaudited Consolidated Financial Statements in Part I, Item 1 of this Form
10-Q), Ambac Assurance is required, under certain circumstances, to make
payments to the Company with respect to the utilization of NOLs and to reimburse
certain costs and expenses. It is highly unlikely that Ambac Assurance will be
able to make dividend payments to Ambac for the foreseeable future and therefore
the aforementioned payments and reimbursements will be Ambac's principal source
of funds in the near term. The principal uses of liquidity are the payment of
operating expenses, professional advisory fees incurred in connection with the
bankruptcy and expenses and settlements related to pending litigation. Ambac's
liquidity requirements are being funded by cash on hand and reimbursements of a
portion of IRS litigation expenses from Ambac Assurance, and any contingencies
could cause material additional liquidity strains.
Ambac Assurance Liquidity. Ambac Assurance's liquidity is dependent on the
balance of liquid investments and, over time, the net impact of sources and uses
of funds. The principal sources of Ambac Assurance's liquidity are
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gross installment premiums on insurance and credit default swap contracts,
investment coupon receipts, scheduled investment maturities, sales of investment
securities, proceeds from repayment of affiliate loans, claim and reinsurance
recoveries and RMBS subrogation recoveries. The principal uses of Ambac
Assurance's liquidity are the payment of operating expenses, claim and
commutation payments on both insurance and credit derivative contracts, ceded
reinsurance premiums, surplus notes principal and interest payments and
additional loans to affiliates. Additionally, an exercise of surplus note call
options and payment of the IRS Settlement amount may be a potential use of
liquidity in 2012. The board of directors of Ambac Assurance has approved the
exercise of all options to purchase surplus notes issued by Ambac Assurance. The
exercise of such options also requires the approval of OCI and the Rehabilitator
of the Segregated Account. Ambac Assurance is seeking such approvals. There can
be no assurance that such approvals will be obtained. Pursuant to the
injunctions issued by the Rehabilitation Court, claims on policies allocated to
the Segregated Account have not been paid since the commencement of the
Segregated Account Rehabilitation Proceedings. The Rehabilitator may seek to
effectuate the current Segregated Account Rehabilitation Plan, modify such Plan
or modify the injunctions issued by the Rehabilitation Court to allow for the
payment of policy claims in such manner and at such times as the Rehabilitator
determines to be in the best interest of policyholders. The date of resumption
of claim payments is uncertain. Surplus note interest payments require the
approval of OCI. On June 1, 2011 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.
Our ability to recover 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
$2,718.8 million, beginning in 2013. 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 materially. Similarly, our right to
receive installment premium as well as the amount is impacted by the contractual
terms of each policy and period in which the insured obligation remains
outstanding. Termination of installment premium policies on an accelerated basis
may adversely impact Ambac Assurance's liquidity.
A subsidiary of Ambac Assurance provides a $360 million liquidity facility to a
reinsurance company which acts as reinsurer with respect to a portfolio of life
insurance policies. The liquidity facility, which is guaranteed by Ambac
Assurance, provides temporary funding in the event that the reinsurance
company's capital is insufficient to make payments under the reinsurance
agreement. The reinsurer is required to repay all amounts drawn under the
liquidity facility. At March 31, 2012 and December 31, 2011, $8.8 million was
drawn on this liquidity facility. On March 26, 2012, the subsidiary received
notice that the reinsurance treaty was terminated, as such there will be no
further draws on the facility and Ambac Assurance expects full repayment of the
$8.8 million in 2012.
Ambac and its affiliates participate in leveraged lease transactions with
municipalities, utilities and quasi-governmental agencies (collectively
"lessees"), either directly or through various affiliated companies. Assets
underlying these leveraged lease transactions involve equipment and facilities
used by the lessees to provide basic public services such as mass transit and
utilities. Ambac and its affiliates provided one or more of the following
financial products in these transactions: (i) credit default swaps,
(ii) guarantees of the lessees' termination payment obligations, (iii) loans,
(iv) sureties and (v) investment agreements and payment agreements, both of
which serve as collateral to economically defease portions of the lessees'
payment obligations in respect of termination payments.
These transactions expose Ambac to the following risks, primarily as a result of
Ambac Assurance's rating downgrades:
• Collateral posting requirements due to Ambac Assurance rating downgrade
triggering events under certain agreements.
• Lease events of default and the requirement for a lessee to make a
termination payment upon a demand by the lessor. Portions of any termination payments may be funded from the liquidation of the related
defeasance collateral (i.e. payment agreements, investment agreements
and/or other securities). To the extent a lessee fails to make a required
termination payment, Ambac may be required to make a surety bond payment,
or a swap settlement, under its guarantee policy or credit default swap,
as applicable.
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The payment required under the Ambac credit enhancement will be based on
the difference between the termination amount and the value derived from
the defeasance collateral. Following a payment, Ambac would then be
entitled to settle a credit default swap with the lessee or exercise its
reimbursement rights against the lessee. In such circumstances Ambac,
through subrogation or ownership in the leased assets, would have the
right, along with other remedies, to liquidate the leased assets.
Ambac Assurance's aggregate financial guarantee exposure to termination payments
related to leveraged lease transactions that contain Ambac Assurance rating
downgrade triggers at March 31, 2012 and December 31, 2011 was $836.6 million
and $844.3 million, respectively. Ambac Assurance's financial guarantee exposure
to these termination payments, net of defeasance collateral was $690.4 million
and $699.9 million at March 31, 2012 and December 31, 2011, respectively.
However, the court supervising the rehabilitation of the Segregated Account has
issued an injunction barring the early termination of contracts based on the
occurrence of events or the existence of circumstances like those described
above. As a result, Ambac Assurance does not expect to make early termination
payments in respect of leveraged lease transactions where such amounts are
claimed based on the occurrence of events, or the existence of circumstances,
relating to the financial condition of Ambac Assurance.
A wholly-owned subsidiary of Ambac Assurance is a party to credit default swaps
("CDS") with various commercial counterparties. Ambac Assurance guarantees its
subsidiary's payment obligations under such CDS. The terms of such CDS include
events of default or termination events based on the occurrence of certain
events, or the existence of certain circumstances, relating to the financial
condition of Ambac Assurance, including the commencement of an insolvency,
rehabilitation or like proceeding. If such an event of default or termination
event were to occur, the CDS counterparties could claim the contractual right to
terminate the CDS and require Ambac Assurance, as financial guarantor, to make
termination payments. Ambac Assurance estimates that such potential termination
payments amounted to $1,265.6 million as of March 31, 2012, and $1,454.2 million
as of December 31, 2011. However, the court supervising the rehabilitation of
the Segregated Account has issued an injunction barring the early termination of
contracts based on the occurrence of events or the existence of circumstances
like those described above. As a result, Ambac Assurance does not expect to make
early termination payments in respect of CDSs where such amounts are claimed
based on the occurrence of events, or the existence of circumstances, relating
to the financial condition of Ambac Assurance.
Financial Services Liquidity. The principal uses of liquidity by Financial
Services subsidiaries are payments on investment and repurchase agreement
obligations; payments on intercompany loans; payments under derivative contracts
(primarily interest rate swaps and US Treasury futures); collateral posting; and
operating expenses. Management believes that its Financial Services' short and
long-term liquidity needs can be funded from investment coupon receipts; the
maturity of invested assets; sales of invested assets; intercompany loans from
Ambac Assurance; and receipts from derivative contracts.
While meaningful progress has been made in unwinding the Financial Services
businesses, multiple sources of risk continue to exist. These include further
deterioration in investment security market values, additional unexpected draws
on outstanding investment agreements, the settlement of potential swap
terminations and the inability to replace or establish new hedge positions.
Investment agreements subject Ambac to liquidity risk associated with
unanticipated withdrawals of principal as allowed by the terms of certain
contingent withdrawal investment agreements, including those issued to entities
that provide credit protection with respect to collateralized debt obligations.
These entities issue credit linked-notes, invest a portion of the proceeds in
the contingent withdrawal investment agreements and typically sell credit
protection by issuing a credit default swap referencing specified asset-backed
or corporate securities. Upon a credit event of one of the underlying reference
obligations, the issuer may need to draw on the investment agreement to pay
under the terms of the credit default swap. Accordingly, these investment
agreements may be drawn prior to our original expectations, resulting in an
unanticipated withdrawal. As of March 31, 2012, $361.6 million of contingent
withdrawal investment agreements issued to CDOs remained outstanding. To manage
the liquidity risk of unscheduled withdrawals, Ambac utilizes several tools,
including regular surveillance of the related transactions. This surveillance
process is customized for each investment agreement transaction and includes a
review of past activity, recently issued trustee reports, reference name
performance characteristics and third party tools to analyze early withdrawal
risk.
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Credit Ratings and Collateral. The significant rating downgrades and withdrawals
of ratings of Ambac Assurance by Moody's and S&P resulted in the triggering of
required cure provisions in nearly all of the investment agreements issued. In
many cases, Ambac chose to terminate investment agreements, particularly when it
was able to do so at levels that resulted in meaningful discounts to book value.
In addition, Ambac has posted collateral of $563.2 million in connection with
its outstanding investment agreements, including accrued interest, at March 31,
2012.
Ambac Financial Services ("AFS") provided interest rate and currency swaps for
states, municipalities, asset-backed issuers and other entities in connection
with their financings. AFS hedges most of the related risks of these instruments
with standardized derivative contracts, which include collateral support
agreements. Under these agreements, AFS is required to post collateral to a swap
dealer to cover unrealized losses. In addition, AFS is often required to post
independent amounts of collateral in excess of the amounts needed to cover
unrealized losses. Additionally, AFS hedges part of its interest rate risk with
financial futures contracts which require it to post margin with its futures
clearing merchant. All AFS derivative contracts possessing rating-based
downgrade triggers that could result in collateral posting or a termination have
been triggered. If additional terminations were to occur, it would generally
result in a return of collateral to AFS in the form of cash, U.S. Treasury or
U.S. government agency obligations with market values approximately equal to or
in excess of market values of the swaps. In most cases, AFS will look to
re-establish the hedge positions that are terminated early. This may result in
additional collateral posting obligations or the use of futures contracts or
other derivative instruments which could require AFS to post margin amounts. The
amount of additional collateral required or margin posted on futures contracts
will depend on several variables including the degree to which counterparties
exercise their termination rights and the ability to replace these contracts
with existing counterparties under existing documents and credit support
arrangements. All contracts that require collateral posting are currently
collateralized. Collateral and margin posted by AFS totaled a net amount of
$295.0 million, including independent amounts, under these contracts at
March 31, 2012.
Ambac Credit Products ("ACP") entered into credit derivative contracts. ACP is
not required to post collateral under any of its contracts.
BALANCE SHEET
Total assets increased by approximately $259.2 million to $27.37 billion at
March 31, 2012, primarily as a result of higher consolidated variable interest
entity assets. As of March 31, 2012, total stockholders' deficit was $2.91
billion; at December 31, 2011, total stockholders' deficit was $3.15 billion.
This change was primarily caused by net income for the period, partially offset
by a decline in fair value of investment securities during the period.
Investment Portfolio. Ambac Assurance's investment objective for the Financial
Guarantee portfolio is to achieve the highest after-tax yield on a diversified
portfolio of fixed income investments while employing asset/liability management
practices to satisfy all operating and strategic liquidity needs. Ambac
Assurance's investment portfolio is subject to internal investment guidelines
and is subject to limits on types and quality of investments imposed by the
insurance laws and regulations of the States of Wisconsin and New York. Such
guidelines set forth minimum credit rating requirements and credit risk
concentration limits. Within these guidelines, Ambac Assurance opportunistically
purchases Ambac Assurance insured securities in the open market given their
relative risk/reward characteristics and to mitigate the effect of potential
future adverse development in the insured portfolio. Further, Ambac Assurance's
investment policies are subject to oversight by the Rehabilitator of the
Segregated Account pursuant to contracts entered into between Ambac Assurance
and the Segregated Account.
Ambac UK's investment policy is designed with the primary objective of ensuring
that Ambac UK is able to meet its financial obligations as they fall due, in
particular with respect to policy holders and meeting their claims. Ambac UK's
investment portfolio is subject to internal investment guidelines and may be
subject to limits on types and quality of investments imposed by the FSA as
regulator of Ambac UK. Ambac UK's investment policy sets forth minimum credit
rating requirements and concentration limits, among other restrictions.
The Financial Services investment portfolio consists primarily of assets funded
with proceeds from the issuance of investment agreement liabilities. The
investment objectives are to invest in primarily high-grade securities that
produce sufficient cash flow to satisfy all investment agreement liabilities and
intercompany loans, and which will satisfy investment agreement collateral
requirements. The investment portfolio is subject to internal investment
guidelines. Such guidelines set forth minimum credit rating requirements and
credit risk concentration limits.
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The following table summarizes the composition of Ambac's investment portfolio
at fair value by segment at March 31, 2012 and December 31, 2011:
Financial Financial
($ in millions) Guarantee Services Corporate Total
March 31, 2012:
Fixed income securities:
Municipal obligations(1) $ 1,971.3 $ - $ - $ 1,971.3
Corporate obligations 1,036.0 112.2 - 1,148.2
Foreign obligations 70.6 - - 70.6
U.S. government obligations 89.0 40.2 - 129.2
U.S. agency obligations 81.9 4.3 - 86.2
Residential mortgage-backed
securities(2) 1,063.5 363.2 - 1,426.7
Collateralized debt obligations 29.6 13.8 - 43.4
Other asset-backed securities 669.1 218.5 - 887.6
5,011.0 752.2 - 5,763.2
Short-term(1) 848.4 11.5 33.9 893.8
Other 0.1 - - 0.1
5,859.5 763.7 33.9 6,657.1
Fixed income securities pledged as
collateral:
U.S. government obligations 284.7 - - 284.7
Residential mortgage-backed securities 3.0 - - 3.0
287.7 - - 287.7
Total investments $ 6,147.2 $ 763.7 $ 33.9 $ 6,944.8
Percent total 88.5 % 11.0 % 0.5 % 100 %
December 31, 2011:
Fixed income securities:
Municipal obligations(1) $ 2,003.0 $ - $ - $ 2,003.0
Corporate obligations 1,015.6 111.9 - 1,127.5
Foreign obligations 94.8 - - 94.8
U.S. government obligations 86.2 25.4 - 111.6
U.S. agency obligations 82.6 4.3 - 86.9
Residential mortgage-backed securities 1,054.5 358.0 - 1,412.5
Collateralized debt obligations 31.7 14.5 - 46.2
Other asset-backed securities 669.6 278.2 - 947.8
5,038.0 792.3 - 5,830.3
Short-term(1) 729.5 18.7 34.9 783.1
Other 0.1 - - 0.1
5,767.6 811.0 34.9 6,613.5
Fixed income securities pledged as
collateral:
U.S. government obligations 260.8 - - 260.8
Residential mortgage-backed securities 2.7 - - 2.7
263.5 - - 263.5
Total investments $ 6,031.1 $ 811.0 $ 34.9 $ 6,877.0
Percent total 87.7 % 11.8 % 0.5 % 100 %
(1) Includes taxable and tax exempt securities.
(2) Includes RMBS insured by Ambac Assurance.
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The following table represents the fair value of mortgage and asset-backed
securities at March 31, 2012 and December 31, 2011 by classification:
Financial Financial
($ in millions) Guarantee Services Corporate Total
March 31, 2012:
Residential mortgage-backed securities:
RMBS-First-lien-Alt-A $ 433.8 $ 241.7 $ - $ 675.5
RMBS-Second Lien 401.2 - - 401.2
U.S. Government Sponsored Enterprise Mortgages 86.5 117.1 - 203.6
RMBS-First Lien-Sub Prime 130.4 - - 130.4
RMBS-First Lien-Prime 11.5 - - 11.5
Government National Mortgage Association 3.1 4.4 - 7.5
Total residential mortgage-backed securities 1,066.5 363.2 - 1,429.7
Other asset-backed securities
Military Housing 344.6 - - 344.6
Credit Cards - 176.5 - 176.5
Structured Insurance 132.4 - - 132.4
Auto 87.0 32.0 - 119.0
Student Loans 15.9 10.0 - 25.9
Other 89.2 - - 89.2
Total other asset-backed securities 669.1 218.5 - 887.6
Total $ 1,735.6 $ 581.7 $ - $ 2,317.3
December 31, 2011
Residential mortgage-backed securities:
RMBS-First-lien-Alt-A $ 443.0 $ 224.4 $ - $ 667.4
RMBS-Second Lien 386.8 - - 386.8
U.S. Government Sponsored Enterprise Mortgages 93.7 128.7 - 222.4
RMBS-First Lien-Sub Prime 126.0 - - 126.0
RMBS-First Lien-Prime 4.4 - - 4.4
Government National Mortgage Association 3.3 4.9 - 8.2
Total residential mortgage-backed securities 1,057.2 358.0 - 1,415.2
Other asset-backed securities
Military Housing 376.7 - - 376.7
Credit Cards - 176.4 - 176.4
Structured Insurance 123.3 - - 123.3
Auto 55.6 78.1 - 133.7
Student Loans 16.6 13.6 - 30.2
Other 97.4 10.1 - 107.5
Total other asset-backed securities 669.6 278.2 - 947.8
Total $ 1,726.8 $ 636.2 $ - $ 2,363.0
The weighted average rating, which is based on the lower of Standard & Poor's or
Moody's ratings, of the mortgage and asset-backed securities is BB-, as of
March 31, 2012 and December 31, 2011. There is additional auto exposure in short
term investments of $14.2 million and $7.9 million at March 31, 2012 and
December 31, 2011, respectively.
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The following table provides the fair value of residential mortgage-backed
securities (excluding U.S. Government Sponsored Enterprises and Government
National Mortgage Association Mortgages) by vintage and type at March 31, 2012
and December 31, 2011:
First-lien First-lien First-lien
Year of Issue Alt-A Second-lien Prime Sub-Prime Total
($ in millions)
March 31, 2012
2003 and prior $ - $ 1.4 $ - $ 4.1 $ 5.5
2004 29.2 6.9 - 1.4 37.5
2005 145.5 65.8 11.5 3.7 226.5
2006 186.5 269.3 - 84.5 540.3
2007 314.3 57.8 - 36.7 408.8
Total $ 675.5 $ 401.2 $ 11.5 $ 130.4 $ 1,218.6
December 31, 2011
2003 and prior $ - $ 0.5 $ - $ 4.3 $ 4.8
2004 29.0 7.1 - 1.3 37.4
2005 135.9 63.7 4.4 3.6 207.6
2006 175.4 254.0 - 83.8 513.2
2007 327.1 61.5 - 33.0 421.6
Total $ 667.4 $ 386.8 $ 4.4 $ 126.0 $ 1,184.6
Ambac's fixed income portfolio includes securities covered by guarantees issued
by Ambac Assurance and other financial guarantors ("insured securities"). The
published Moody's and S&P ratings on these securities reflect the higher of the
financial strength rating of the financial guarantor and the rating of the
underlying issuer. Rating agencies do not always publish separate underlying
ratings (those ratings excluding the insurance by the financial guarantor)
because generally the insurance cannot be legally separated from the underlying
security by the insurer. Ambac obtains underlying ratings through ongoing
dialogue with rating agencies and other sources. In the event these underlying
ratings are not available from the rating agencies, Ambac will assign an
internal rating. Since the insurance cannot be legally separated from the
underlying security, the fair value of the insured securities in the investment
portfolio includes the value of any financial guarantee embedded in such
securities, including guarantees written by Ambac Assurance. In addition, a
hypothetical fair value assuming the absence of the insurance is not readily
available from our independent pricing sources.
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The following table represents the fair value, including the value of the
financial guarantee, and weighted-average underlying rating, excluding the
financial guarantee, of the insured securities at March 31, 2012 and
December 31, 2011, respectively:
Mortgage Weighted
and asset- Average
Municipal Corporate backed Underlying
($ in millions) obligations obligations securities Short term Total Rating(1)
March 31, 2012
Ambac Assurance Corporation $ 61.1 $ 4.6 $ 1,097.6 $ - $ 1,163.3 B+
National Public Finance Guarantee
Corporation 801.4 80.8 - - 882.2 A+
Assured Guaranty Municipal
Corporation 434.0 162.5 7.0 24.0 627.5 A
Assured Guaranty Corporation - - 24.6 - 24.6 CC
Financial Guarantee Insurance
Corporation 17.9 - 7.0 - 24.9 BBB+
MBIA Insurance Corporation - 19.8 3.5 - 23.3 BBB-
Total $ 1,314.4 $ 267.7 $ 1,139.7 $ 24.0 $ 2,745.8 BBB
December 31, 2011
Ambac Assurance Corporation $ 59.9 $ 4.6 $ 1,123.8 $ - $ 1,188.3 B+
National Public Finance Guarantee
Corporation 816.7 82.4 - - 899.1 A+
Assured Guaranty Municipal
Corporation 447.0 160.2 9.3 24.0 640.5 A
Financial Guarantee Insurance
Corporation 17.3 - 7.7 - 25.0 BBB+
Assured Guaranty Corporation - - 38.4 - 38.4 CCC+
MBIA Insurance Corporation - 19.1 3.8 - 22.9 BBB-
Total $ 1,340.9 $ 266.3 $ 1,183.0 $ 24.0 $ 2,814.2 BBB
(1) Ratings represent the lower underlying rating assigned by S&P or Moody's. If
unavailable, Ambac's internal rating is used.
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The following table provides the ratings distribution of the fixed income
investment portfolio at March 31, 2012 and December 31, 2011 by segment:
Rating(1):
Financial Financial
Guarantee Services Combined
March 31, 2012:
AAA 28 % 54 % 31 %
AA 30 17 29
A 15 <1 13
BBB 8 6 7
Below investment grade 14 23 15
Not rated 5 - 5
100 % 100 % 100 %
December 31, 2011:
AAA 25 % 57 % 29 %
AA 33 17 31
A 14 <1 12
BBB 8 5 8
Below investment grade 13 21 14
Not rated 7 - 6
100 % 100 % 100 %
(1) Ratings are based on the lower of Moody's or S&P ratings. If guaranteed,
rating represents the higher of the underlying or guarantor's financial
strength rating.
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The following table summarizes, for all securities in an unrealized loss
position as of March 31, 2012 and December 31, 2011, the aggregate fair value
and gross unrealized loss by length of time those securities have been
continuously in an unrealized loss position:
March 31, 2012 December 31, 2011
Estimated Gross Estimated Gross
Fair Unrealized Fair Unrealized
($ in millions) Value(1) Losses(1) Value(1) Losses(1)
Municipal obligations in continuous
unrealized loss for:
0-6 months $ 0.1 $ - $ 4.4 $ 0.1
7-12 months 2.0 - 5.0 0.2
Greater than 12 months 7.3 0.1 14.6 0.2
9.4 0.1 24.0 0.5
Corporate obligations in continuous
unrealized loss for:
0-6 months 157.3 2.0 139.3 4.1
7-12 months 28.6 0.5 16.2 2.1
Greater than 12 months 131.3 13.4 178.9 17.0
317.2 15.9 334.4 23.2
U.S. treasury obligations in
continuous unrealized loss for:
0-6 months 157.2 0.9 130.4 0.1
7-12 months 65.1 0.1 - -
Greater than 12 months - - - -
222.3 1.0 130.4 0.1
Residential mortgage-backed securities
in continuous unrealized loss for:
0-6 months 94.3 3.6 113.4 12.2
7-12 months 32.5 5.7 12.4 2.3
Greater than 12 months 111.1 33.2 105.7 43.3
237.9 42.5 231.5 57.8
Collateralized debt obligations in
continuous unrealized loss for:
0-6 months - 0.1 33.0 0.8
7-12 months 26.0 0.3 - -
Greater than 12 months 9.8 1.3 12.5 1.8
35.8 1.7 45.5 2.6
Other asset-backed securities in
continuous unrealized loss for:
0-6 months 99.4 1.1 176.6 8.3
7-12 months 109.2 - 5.2 -
Greater than 12 months 201.6 48.2 204.9 51.8
410.2 49.3 386.7 60.1
Short term securities in continuous
unrealized loss for:
0-6 months 4.6 - 5.8 -
7-12 months - - - -
Greater than 12 months - - - -
4.6 - 5.8 -
Total $ 1,237.4 $ 110.5 $ 1,158.3 $ 144.3
(1) Since the table is presented in millions, securities with market values and
unrealized losses that are less than $0.1 will be shown as zero.
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Management has determined that the unrealized losses in fixed income securities
at March 31, 2012 are primarily driven by the uncertainty in the structured
finance market, primarily with respect to non-agency residential mortgage backed
securities, including those guaranteed by Ambac Assurance, and a general
increase in risk and liquidity premiums demanded by fixed income investors.
Ambac has concluded that unrealized losses reflected in the table above are
temporary in nature based upon (a) no unexpected principal and interest payment
defaults on these securities; (b) analysis of the creditworthiness of the issuer
and financial guarantor, as applicable, and analysis of projected defaults on
the underlying collateral; (c) management has no intent to sell these
securities; and (d) it is not more likely than not that Ambac will be required
to sell these debt securities before the anticipated recovery of its amortized
cost basis. Of the $1,237.4 million that were in a gross unrealized loss
position at March 31, 2012, below investment grade securities and non-rated
securities had a fair value of $294.5 million and unrealized loss of $63.0
million, which represented 23.8% of the total fair value, and 57.0% of the
unrealized loss as shown in the table above. Of the $1,158.3 million that were
in a gross unrealized loss position at December 31, 2011, below investment grade
securities and non-rated securities had a fair value of $268.6 million and
unrealized loss of $77.9 million, which represented 23.2% of the total fair
value, and 54.0% of the unrealized loss as shown in the table above.
During the three months ended March 31, 2012 and 2011, there were
other-than-temporary impairment write-downs of $3.1 million and $1.7 million,
respectively. Other-than-temporary impairment charges to earnings in the three
months ended March 31, 2012 and 2011 were due to credit losses on securities
guaranteed by Ambac Assurance and on certain Alt-A residential mortgage-backed
securities. As a result of the rehabilitation of the Segregated Account,
financial guarantee payments on securities guaranteed by Ambac Assurance which
have been placed in the Segregated Account are no longer under the control of
Ambac management. As of March 31, 2012, management has not asserted an intent to
sell any securities in an unrealized loss position from its portfolio. Future
changes in our estimated liquidity needs could result in a determination that
Ambac no longer has the ability to hold such securities, which could result in
other-than-temporary impairment charges.
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The following table summarizes amortized cost and fair value for all securities
in an unrealized loss position as of March 31, 2012 and December 31, 2011 by
contractual maturity date:
March 31, 2012 December 31, 2011
Amortized Estimated Amortized Estimated
($ in millions) Cost Fair Value Cost Fair Value
Municipal obligations:
Due in one year or less $ 2.9 $ 2.8 $ 2.9 $ 2.8
Due after one year through five years 2.7 2.7 - -
Due after five years through ten years 1.9 1.9 15.1 14.9
Due after ten years 2.0 2.0 6.5 6.3
9.5 9.4 24.5 24.0
Corporate obligations:
Due in one year or less 6.7 6.6 - -
Due after one year through five years 127.5 126.3 114.3 111.1
Due after five years through ten years 164.6 155.5 189.7 177.3
Due after ten years 34.3 28.8 53.6 46.0
333.1 317.2 357.6 334.4
U.S. treasury obligations:
Due in one year or less - - - -
Due after one year through five years 211.5 210.9 130.3 130.2
Due after five years through ten years 11.8 11.4 0.2 0.2
Due after ten years - - - -
223.3 222.3 130.5 130.4
Residential mortgage-backed securities 280.4 237.9 289.3 231.5
Collateralized debt obligations 37.5 35.8 48.1 45.5
Other asset-backed securities 459.5 410.2 446.8 386.7
Short term securities 4.6 4.6 5.8 5.8
Total $ 1,347.9 $ 1,237.4 $ 1,302.6 $ 1,158.3
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Cash Flows. Net cash provided by operating activities was $40.3 million and
$82.8 million during the three months ended March 31, 2012 and 2011,
respectively. Operating cash flows decreased primarily due to higher interest
rate swaps payments during the first quarter of 2012. Future net cash provided
by operating activities will be impacted by the level of premium collections,
surplus note interest payments (subject to approval by OCI) and claim payments
(including the ultimate payment of presented but unpaid claims as a result of
the claim moratorium), including payments under credit default swap contracts.
Net cash used in financing activities was ($7.7) million and ($92.1) million
during the three months ended March 31, 2012 and 2011, respectively. Financing
activities for the three months ended March 31, 2012 and 2011 included a paydown
of $7.3 million on available interest entity secured borrowing and repayments of
investment and payment agreements of $0.4 million and $89.7 million,
respectively.
Net cash (used in) provided by investing activities was ($8.7) million and $7.4
million during the three months ended March 31, 2012 and 2011, respectively.
SPECIAL PURPOSE AND VARIABLE INTEREST ENTITIES
Please refer to Note 5, "Special Purpose Entities, Including Variable Interest
Entities" of the Unaudited Consolidated Financial Statements, located in Item 1
of this Form 10-Q, for information regarding special purpose and variable
interest entities. Ambac does not have any other off-balance sheet arrangements.
ACCOUNTING STANDARDS
Please refer to Note 13, "Future Application of Accounting Standards and
Adoption of New Accounting Standards" of the Unaudited Consolidated Financial
Statements, located in Part I, Item 1 of this Form 10-Q for a discussion of the
impact of recent accounting pronouncements on Ambac's financial condition and
results of operations.
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