PINX:ABKFQ Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the Quarterly Period Ended June 30, 2012

 

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

Commission File Number: 1-10777

 

 

Ambac Financial Group, Inc.

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

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   13-3621676
(State of incorporation)   (I.R.S. employer
identification no.)

One State Street Plaza

New York, New York

  10004
(Address of principal executive offices)   (Zip code)

(212) 668-0340

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

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

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

As of August 1, 2012, 302,436,107 shares of common stock, par value $0.01 per share, of the Registrant were outstanding.

 

 

 


Table of Contents

Ambac Financial Group, Inc. and Subsidiaries

TABLE OF CONTENTS

 

     PAGE  

PART I FINANCIAL INFORMATION

  

Item 1.

   Financial Statements of Ambac Financial Group, Inc. and Subsidiaries   
   Consolidated Balance Sheets – June 30, 2012 (unaudited) and December 31, 2011      3   
  

Consolidated Statements of Total Comprehensive Income (unaudited) – three and six months ended June 30, 2012 and 2011

     4   
   Consolidated Statements of Stockholders’ Equity (unaudited) – six months ended June 30, 2012 and 2011      5   
   Consolidated Statements of Cash Flows (unaudited) – six months ended June 30, 2012 and 2011      6   
   Notes to Unaudited Consolidated Financial Statements      8   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      66   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      105   

Item 4.

   Controls and Procedures      105   
PART II OTHER INFORMATION   
Item 1.    Legal Proceedings      106   
Item 1A.    Risk Factors      106   
Item 6.    Exhibits      107   

SIGNATURES

     108   

INDEX TO EXHIBITS

     109   


Table of Contents

Part I Financial Information

 

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

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Balance Sheets

 

(Dollars in Thousands, Except per Share Data)    June 30,
2012
    December 31,
2011
 
     (unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $4,945,921 in 2012 and $5,346,897 in 2011)

   $ 5,390,290      $ 5,830,289   

Fixed income securities pledged as collateral, at fair value (amortized cost of $286,115 in 2012 and $261,958 in 2011)

     286,660        263,530   

Short-term investments (amortized cost of $1,009,868 in 2012 and $783,015 in 2011)

     1,010,059        783,071   

Other (approximates fair value)

     100        100   
  

 

 

   

 

 

 

Total investments

     6,687,109        6,876,990   

Cash

     49,012        15,999   

Restricted cash

     2,500        2,500   

Receivable for securities

     112,013        38,164   

Investment income due and accrued

     42,651        45,328   

Premium receivables

     1,829,874        2,028,479   

Reinsurance recoverable on paid and unpaid losses

     169,961        159,902   

Deferred ceded premium

     197,437        221,303   

Subrogation recoverable

     442,097        659,810   

Deferred acquisition costs

     211,907        223,510   

Loans

     10,153        18,996   

Derivative assets

     132,914        175,207   

Other assets

     103,804        104,300   

Variable interest entity assets:

    

Fixed income securities, at fair value

     2,162,062        2,199,338   

Restricted cash

     2,276        2,140   

Investment income due and accrued

     4,034        4,032   

Loans (includes $14,238,273 and $14,126,994 at fair value)

     14,446,047        14,329,515   

Other assets

     5,940        8,182   
  

 

 

   

 

 

 

Total assets

   $ 26,611,791      $ 27,113,695   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity:

    

Liabilities:

    

Liabilities subject to compromise

   $ 1,707,411      $ 1,707,421   

Unearned premiums

     3,138,275        3,457,157   

Losses and loss expense reserve

     7,607,663        7,044,070   

Ceded premiums payable

     98,279        115,555   

Obligations under investment agreements

     424,840        523,046   

Obligations under investment repurchase agreements

     18,276        23,500   

Current taxes

     96,752        95,709   

Long-term debt

     144,036        223,601   

Accrued interest payable

     192,984        170,169   

Derivative liabilities

     394,040        414,508   

Other liabilities

     94,678        107,441   

Payable for securities purchased

     5,328        1,665   

Variable interest entity liabilities:

    

Accrued interest payable

     3,645        3,490   

Long-term debt (includes $14,132,936 and $14,039,450 at fair value)

     14,376,872        14,288,540   

Derivative liabilities

     2,063,809        2,087,052   

Other liabilities

     282        304   
  

 

 

   

 

 

 

Total liabilities

     30,367,170        30,263,228   
  

 

 

   

 

 

 

Stockholders’ deficit:

    

Preferred stock

     —          —     

Common stock

     3,080        3,080   

Additional paid-in capital

     2,172,027        2,172,027   

Accumulated other comprehensive income

     417,593        463,259   

Accumulated deficit

     (6,598,384     (6,039,922

Common stock held in treasury at cost

     (410,755     (411,419
  

 

 

   

 

 

 

Total Ambac Financial Group, Inc. stockholders’ deficit

     (4,416,439     (3,812,975

Noncontrolling interest

     661,060        663,442   
  

 

 

   

 

 

 

Total stockholders’ deficit

     (3,755,379     (3,149,533
  

 

 

   

 

 

 

Total liabilities and stockholders’ deficit

   $ 26,611,791      $ 27,113,695   
  

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Table of Contents

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Statements of Total Comprehensive Income (Unaudited)

 

      Three Months Ended June 30,     Six Months Ended June 30,  
(Dollars in Thousands, Except Share Data)    2012     2011     2012     2011  

Revenues:

        

Net premiums earned

   $ 103,042      $ 99,271      $ 197,992      $ 191,070   

Net investment income

     93,836        95,639        205,953        172,107   

Other-than-temporary impairments:

        

Total other-than-temporary impairment losses

     (7,492     (17,793     (11,803     (19,506

Portion of loss recognized in other comprehensive income

     5,164        215        6,404        215   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net other-than-temporary impairment losses recognized in earnings

     (2,328     (17,578     (5,399     (19,291

Net realized investment gains (losses)

     67,067        (2,528     67,459        (78

Change in fair value of credit derivatives:

        

Realized gains and other settlements

     3,073        4,224        6,327        9,547   

Unrealized (losses) gains

     (10,488     20,063        (20,964     5,837   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change in fair value of credit derivatives

     (7,415     24,287        (14,637     15,384   

Derivative products

     (124,091     (65,595     (77,134     (44,591

Net realized (losses) gains on extinguishment of debt

     (177,745     3,119        (177,745     3,119   

Other income

     36,137        9,227        100,930        37,530   

Income (loss) on variable interest entities

     5,536        2,353        20,756        (3,772
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues before expenses and reorganization items

     (5,961     148,195        318,175        351,478   
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses:

        

Losses and loss expenses

     741,411        196,398        739,091        1,116,045   

Underwriting and operating expenses

     33,567        15,533        70,101        61,000   

Interest expense

     31,855        31,670        65,694        61,930   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses before reorganization items

     806,833        243,601        874,886        1,238,975   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax loss from continuing operations before reorganization items

     (812,794     (95,406     (556,711     (887,497

Reorganization items

     767        6,470        3,228        31,275   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax loss from continuing operations

     (813,561     (101,876     (559,939     (918,772

(Benefit) provision for income taxes

     (211     542        89        2,892   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (813,350   $ (102,418   $ (560,028   $ (921,664

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

     (2,232     14        (2,230     47   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss attributable to common shareholders

   $ (811,118   $ (102,432   $ (557,798   $ (921,711
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive loss after tax:

        

Net loss

   $ (813,350   $ (102,418   $ (560,028   $ (921,664
  

 

 

   

 

 

   

 

 

   

 

 

 

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

     36,466        117,081        15,562        192,506   

Less: reclassification adjustment for net gain (loss) included in net loss

     59,529        (21,094     55,477        (20,079

(Loss) gain on foreign currency translation, net of deferred income taxes of $0

     (5,324     (291     (2,111     4,093   

Amortization of postretirement benefit, net of tax

     —          14        (3,792     725   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other comprehensive (loss) income, net of tax

     (28,387     137,898        (45,818     217,403   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive (loss) income

     (841,737     35,480        (605,846     (704,261

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

        

Net (loss) income

     (2,232     14        (2,230     47   

Currency translation adjustments

     (183     (167     (152     (123
  

 

 

   

 

 

   

 

 

   

 

 

 

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

     (839,322     35,633        (603,464     (704,185
  

 

 

   

 

 

   

 

 

   

 

 

 

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

   $ (2.68   $ (0.34   $ (1.84   $ (3.05
  

 

 

   

 

 

   

 

 

   

 

 

 

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

   $ (2.68   $ (0.34   $ (1.84   $ (3.05
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average number of common shares outstanding:

        

Basic

     302,469,196        302,467,255        302,467,762        302,410,881   

Diluted

     302,469,196        302,467,255        302,467,762        302,410,881   

See accompanying Notes to Unaudited Consolidated Financial Statements

 

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AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Statements of Stockholders’ Equity (Unaudited)

 

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

Balance at January 1, 2012

  ($ 3,149,533   ($ 6,039,922   $ 463,259      $ —        $ 3,080      $ 2,172,027      ($ 411,419   $ 663,442   

Net loss

    (560,028     (557,798               (2,230

Other comprehensive loss, net of tax

    (45,818       (45,666             (152

Stock-based compensation

    (664     (664            

Shares issued under equity plans

    664                  664     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2012

  ($ 3,755,379   ($ 6,598,384   $ 417,593      $ —        $ 3,080      $ 2,172,027      ($ 410,755   $ 661,060   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at January 1, 2011

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

Net (loss) income

    (921,664     (921,711               47   

Other comprehensive gain (loss), net of tax

    217,403          217,526                (123

Stock-based compensation

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

Cost of shares acquired

    (35               (35  

Shares issued under equity plans

    37,156                  37,156     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2011

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Table of Contents

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Consolidated Statements of Cash Flows (Unaudited)

 

     Six Months Ended June 30,  
(Dollars in Thousands)    2012     2011  

Cash flows from operating activities:

    

Net loss attributable to common shareholders

   $ (557,798   $ (921,711

Noncontrolling interest in subsidiaries’ earnings

     (2,230     47   
  

 

 

   

 

 

 

Net loss

   $ (560,028   $ (921,664

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

    

Depreciation and amortization

     1,546        2,186   

Amortization of bond premium and discount

     (121,602     (86,333

Reorganization items

     3,228        31,275   

Share-based compensation

     —          (15,459

Current income taxes

     1,043        901   

Deferred acquisition costs

     11,603        12,424   

Unearned premiums, net

     (295,016     (567,395

Losses and loss expenses, net

     771,247        1,109,365   

Ceded premiums payable

     (17,276     (19,563

Investment income due and accrued

     2,677        (496

Premium receivables

     198,605        497,671   

Accrued interest payable

     53,425        52,743   

Net mark-to-market losses (gains)

     20,964        (5,837

Net realized investment (gains) losses

     (67,459     78   

Losses (gains) on extinguishment of debt

     177,745        (3,119

Other-than-temporary impairment charges

     5,399        19,291   

Variable interest entity activities

     (20,756     3,772   

Other, net

     (129,916     97,723   
  

 

 

   

 

 

 

Net cash provided by operating activities

     35,429        207,563   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Proceeds from sales of bonds

     427,281        240,418   

Proceeds from matured bonds

     521,807        362,668   

Purchases of bonds

     (448,691     (464,175

Change in short-term investments

     (226,988     (74,786

Loans, net

     8,843        (104

Change in swap collateral receivable

     26,391        (52,260

Other, net

     (7,343     4,146   
  

 

 

   

 

 

 

Net cash (used in) provided by investing activities

     301,300        15,907   
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Paydown of variable interest entity secured borrowing

     (10,636     —     

Proceeds from issuance of investment and repurchase agreements

     —          26   

Payments for investment and repurchase agreement draws

     (104,634     (213,174

Payments for extinguishment of long-term debt

     (188,446     —     

Net cash collateral received

     —          (2,440
  

 

 

   

 

 

 

Net cash used in financing activities

     (303,716     (215,588
  

 

 

   

 

 

 

Net cash flow

     33,013        7,882   

Cash at January 1

     15,999        9,497   
  

 

 

   

 

 

 

Cash at June 30

   $ 49,012      $ 17,379   

Supplemental disclosure of cash flow information:

    

Cash paid during the period for:

    

Income taxes

   $ —        $ 1,991   

Interest on variable interest entity secured borrowing

   $ 927      $ —     

Interest on investment agreements

   $ 4,570      $ 4,362   

Cash receipts and payments related to reorganization items:

    

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

   $ 6,956      $ 11,725   

 

 

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Table of Contents

Supplemental disclosure of noncash financing activities:

In March 2011, the Segregated Account of Ambac Assurance issued surplus notes in connection with the commutation of two student loan transactions with a par value of $3,000 and in May, 2011, the Segregated Account issued junior surplus notes with a par value of $36,082 in connection with an office lease settlement.

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Table of Contents

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

DEBTOR-IN-POSSESSION

Notes to Unaudited Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

1. Background and Basis of Presentation

These unaudited consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2011 Annual Report on Form 10-K.

Ambac Financial Group, Inc. (“Ambac” or the “Company”), headquartered in New York City, is a financial services holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. On November 8, 2010 (the “Petition Date”), Ambac filed a voluntary petition for relief (the “Bankruptcy Filing”) under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). Ambac 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. Therefore, if the Reorganization Plan is consummated, our existing common stock will be cancelled and extinguished and the holders thereof would not be entitled to receive, and would not receive or retain, any value on account of such equity interests. 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 Corporation (“Ambac Assurance”) is Ambac’s principal operating subsidiary. Ambac Assurance is a financial guarantee insurer that 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 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.

On October 8, 2010, the Rehabilitator filed a plan of rehabilitation for the Segregated Account (the “Segregated Account Rehabilitation Plan”) in the Circuit Court of Dane County, Wisconsin in which the Segregated Account Rehabilitation Proceedings are pending (the “Rehabilitation Court”). The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. The confirmed Segregated Account Rehabilitation Plan also makes permanent the injunctions issued by the Rehabilitation Court on March 24, 2010.

The Segregated Account Rehabilitation Plan has not been made effective and is subject to modification. 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. Net par exposure as of June 30, 2012 for policies allocated to the Segregated Account was $32,156,856. 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. On May 16, 2012, the Rehabilitator filed a motion seeking approval from the Rehabilitation Court to make partial interim policy claim payments to Segregated Account policyholders. A hearing in the Rehabilitation Court relating to such motion was held on June 4, 2012, and on that date the Rehabilitation Court approved the motion. As a result, the Segregated Account will, upon the direction of the Rehabilitator, begin paying 25% of each permitted policy claim that has arisen since the commencement of the Segregated Account Rehabilitation Proceedings and 25% of each policy claim submitted and permitted in the future. On August 1, 2012, the Rehabilitator promulgated Rules Governing the Submission, Processing and Partial Payment of Policy Claims in Accordance with June 4, 2012 Interim Cash Payment Order (the “Policy Claim Rules”), and filed such document with the Rehabilitation Court, to inform Segregated Account policyholders as to the process governing the submission and approval of policy claims. As a result, holders of policies allocated to the Segregated Account may begin to submit policy claims for partial payment in accordance with the Policy Claim Rules. Policyholders that submit permitted policy claims in any calendar month are eligible to receive 25% of the amount of the policy claim from the Segregated Account on or around the 20th day of the following calendar month. Accordingly, policyholders that submit permitted policy claims during the month of August 2012, in accordance with the Policy Claim Rules, will receive 25% of the amount of each permitted policy claim from the Segregated Account on September 20, 2012. No decision has been announced with respect to effectuating or amending the Segregated Account Rehabilitation Plan or whether surplus notes will be issued with respect to the remaining balance of unpaid claims. The Rehabilitator has previously announced that more specific information regarding the status of the Segregated Account Rehabilitation Plan, including possible modifications, will be provided as soon as appropriate.

 

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The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio caused downgrades, and ultimately withdrawals of Ambac Assurance’s financial strength ratings from the independent rating agencies. These losses have prevented Ambac Assurance from being able to write new business. An inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends, and as a result Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition, by the rehabilitation of the Segregated Account, the terms of its Auction Market Preferred Shares (“AMPS”) and by the terms of the Settlement Agreement entered into on June 7, 2010 by Ambac, Ambac Assurance, Ambac Credit Products, LLC (“ACP”) and counterparties to outstanding credit default swaps with ACP (the “Settlement Agreement”). Based on such restrictions and circumstances, it is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future.

Consideration paid by Ambac Assurance under the Settlement Agreement included $2,000,000 in principal amount of newly issued surplus notes of Ambac Assurance (the “Ambac Assurance Surplus Notes”), of which $1,210,821 remain outstanding at June 30, 2012. In June 2012, Ambac Assurance repurchased $500,000 of the Ambac Assurance Surplus Notes for an aggregate cash payment of $100,000 pursuant to a call option agreement entered into with respect to such surplus notes. This call option had been considered a stand-alone derivative and accordingly was carried at fair value as an asset on the Consolidated Balance Sheet. Also in June 2012, Ambac Assurance repurchased an additional $289,179, and accrued interest thereon, of Ambac Assurance Surplus Notes for an aggregate cash payment of $88,446 pursuant to a separate call option agreement entered into with respect to such surplus notes. The acquisition of such surplus notes pursuant to such call option agreements had been approved by OCI and by the Rehabilitator, whose approval was conditioned upon the approval of such transactions by the Rehabilitation Court, which was granted on June 4, 2012. Ambac Assurance had sought approval from OCI and the Rehabilitator to repurchase an additional $150,000 of Ambac Assurance Surplus Notes pursuant to a third call option agreement entered into with respect to such surplus notes, but OCI and the Rehabilitator declined to approve the repurchase of such surplus notes.

Chapter 11 Reorganization

The Reorganization Plan reflects a resolution of certain issues (the “Amended Plan Settlement”) among the Company, the statutory committee of creditors appointed by the United States Trustee on November 17, 2010 (the “Creditors’ Committee”), Ambac Assurance, the Segregated Account and OCI related to (i) the net operating loss carryforwards (“NOLs”) of the consolidated tax group of which the Company is the parent and Ambac Assurance is a member (the “Ambac Consolidated Group”), (ii) certain tax refunds received in respect thereof (the “Tax Refunds”) and (iii) the sharing of expenses between the Company and Ambac Assurance. The terms of the Amended Plan Settlement are memorialized in that certain Mediation Agreement dated September 21, 2011 (the “Mediation Agreement”) among such parties. In accordance with the Amended Plan Settlement, the Company shall retain ownership of Ambac Assurance, and except as otherwise approved by OCI, the Company shall use its best efforts to preserve the use of NOLs as contemplated by the Amended Plan Settlement.

Pursuant to the Amended Plan Settlement, (i) the Company, Ambac Assurance and certain affiliates entered into an amended and restated tax sharing agreement (the “Amended TSA”), (ii) the Company, Ambac Assurance and certain affiliates entered into an expense sharing and cost allocation agreement (the “Cost Allocation Agreement”) and (iii) the Company, Ambac Assurance, the Segregated Account and OCI entered into an amendment (the “Cooperation Agreement Amendment”), of that certain Cooperation Agreement, dated as of March 24, 2010, by and between the Segregated Account and Ambac Assurance (the “Cooperation Agreement”).

The Amended TSA replaces, supersedes and nullifies in its entirety the existing tax sharing agreement among the Company and its affiliates. The Amended TSA addresses certain issues including, but not limited to, the allocation and use of NOLs by the Company, Ambac Assurance and their respective subsidiaries.

The Cost Allocation Agreement provides for the allocation of costs and expenses among the Company, Ambac Assurance and certain affiliates. The Mediation Agreement also provides for sharing by the Company and Ambac Assurance of the expenses incurred since November 1, 2010 in connection with the litigation with the United States Internal Revenue Service (“IRS”) described in Note 12.

The Cooperation Agreement Amendment provides for the Rehabilitator to have certain rights with respect to the tax positions taken by the Company as well as the loss reserves, investments and operating actions of Ambac Assurance.

The Amended Plan Settlement, Mediation Agreement, Amended TSA, Cost Allocation Agreement and Cooperation Agreement Amendment collectively memorialize the settlement of certain claims among the Company and Ambac Assurance, OCI and the Segregated Account, and contain broad releases of the Company, Ambac Assurance, the Segregated Account, OCI, the board of directors and board committees of the Company and Ambac Assurance, all current and former individual directors, officers, or employees of the Company and Ambac Assurance, the Creditors’ Committee and the individual members thereof, and certain other released parties.

 

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Consummation of the Reorganization Plan is subject to the satisfaction or waiver of the following conditions: (i) the Bankruptcy Court shall have entered an order confirming the Reorganization Plan and such order shall have become final in accordance with the Reorganization Plan; (ii) the Bankruptcy Court shall have approved any supplement filed with respect to the Reorganization Plan; (iii) new organizational documents of the Company shall have been effected; (iv) the Company shall have executed and delivered all documents necessary to effectuate the issuance of the common stock and warrants (if applicable) pursuant to the Reorganization Plan; (v) all authorizations, consents and regulatory approvals required, if any, in connection with the consummation of the Reorganization Plan shall have been obtained; (vi) the Stipulation (as defined in Note 12) shall have become effective; (vii) the terms of the IRS Settlement (as defined in Note 12) shall have been approved by OCI, the United States, the Rehabilitation Court, and the Creditors’ Committee, and all conditions to the effectiveness of the IRS Settlement shall have been satisfied; (viii) the IRS Settlement and all transaction documents relating thereto shall have been executed by the parties thereto; (ix) the Bankruptcy Court shall have entered an order pursuant to Bankruptcy Rule 9019 approving the IRS Settlement; (x) the aggregate face amount of allowed and disputed general unsecured claims shall be less than $50,000; (xi) the Rehabilitation Court shall have approved the transactions contemplated by the Mediation Agreement, the Amended TSA, the Cost Allocation Agreement, and the Cooperation Agreement Amendment; (xii) $30,000 shall have been paid or paid into escrow by Ambac Assurance as provided in the Mediation Agreement; (xiii) the Amended TSA, the Cooperation Agreement Amendment and the Cost Allocation Agreement shall have been executed; and (xiv) all other actions, documents, certificates and agreements necessary to implement the Reorganization Plan shall have been effected or executed and delivered to the required parties and, to the extent required, filed with applicable governmental units in accordance with applicable laws. Of the conditions enumerated above, the following have been satisfied: (i); (x); (xi); (xii) and (xiii). Furthermore, on June 14, 2012, the Rehabilitation Court entered an order authorizing the Rehabilitator and the Segregated Account to proceed with the IRS Settlement. There can be no assurance about whether or when the remaining conditions will be met.

Ambac’s principal business strategy is to reorganize its capital structure and financial obligations through the bankruptcy process and to increase the residual value of its financial guarantee business by mitigating losses on poorly performing transactions (via the transfer of servicing on transaction collateral, pursuit of recoveries in respect of paid claims, commutations of policies, purchases of Ambac-insured obligations, and repurchases of surplus notes issued by Ambac Assurance or the Segregated Account) and maximizing the return on its investment portfolio. Ambac is also exploring the possibility of entering into new businesses, apart from Ambac Assurance and Everspan Financial Guarantee Corp., as it prepares to emerge from bankruptcy. The execution of Ambac’s principal strategy with respect to liabilities allocated to the Segregated Account is subject to the authority of the Rehabilitator to control the management of the Segregated Account. In exercising such authority, the Rehabilitator will act for the benefit of policyholders, and will not take into account the interests of Ambac. Similarly, by operation of the contracts executed in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the Rehabilitator retains rights to oversee and approve certain actions taken in respect of Ambac Assurance. This oversight by the Rehabilitator could impair Ambac’s ability to execute the foregoing strategy. As a result of uncertainties associated with the aforementioned factors, management has concluded that there is substantial doubt about the ability of the Company to continue as a going concern. The Company’s financial statements as of June 30, 2012 and December 31, 2011 and for the periods ended June 31, 2012 and 2011 are prepared assuming the Company continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern.

Ambac’s liquidity and solvency are largely dependent on its current cash and investments of $33,876 at June 30, 2012 (excluding $2,500 of restricted cash), consummation of the Reorganization Plan, and on the residual value of Ambac Assurance. The principal uses of liquidity are the payment of operating expenses, professional advisory fees incurred in connection with the bankruptcy and expenses related to pending litigation. Management believes that Ambac will have sufficient liquidity to satisfy its needs until it emerges from the bankruptcy proceeding; however, no assurance can be given regarding the timing or certainty of such emergence. If its cash and investments run out prior to emergence from bankruptcy, a liquidation of Ambac pursuant to Chapter 7 of the Bankruptcy Code will occur.

 

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2. Debtor in Possession Financial Information

Liabilities Subject to Compromise

As required by ASC Topic 852, Reorganizations, the amount of the Liabilities subject to compromise represents our estimate of known or potential pre-petition and post-petition claims to be addressed in connection with the Bankruptcy Filing. Such claims are subject to future adjustments. The Liabilities subject to compromise in the Consolidated Balance Sheet consists of the following:

 

     June 30, 2012      December 31, 2011  

Debt obligations and accrued interest payable

   $ 1,690,312       $ 1,690,312   

Other

     17,099         17,109   
  

 

 

    

 

 

 

Consolidated Liabilities subject to compromise

     1,707,411         1,707,421   

Payable to non-debtor subsidiaries

     35         35   
  

 

 

    

 

 

 

Debtor’s Liabilities subject to compromise

   $ 1,707,446       $ 1,707,456   
  

 

 

    

 

 

 

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 $20,277 and $44,439 for the three and six months ended June 30, 2012, and $28,645 and $57,221 for the three and six months ended June 30, 2011. The lower interest expense in 2012 is due to the maturity of certain debt obligations in 2011.

Reorganization Items, net

Professional advisory fees and other costs directly associated with our reorganization are reported separately as reorganization items pursuant to ASC Topic 852. The reorganization items in the Consolidated Statements of Total Comprehensive Income for the three and six month periods ended June 30, 2012 and 2011, consisted of the following items:

 

     Three months ended
June 30, 2012
     Six months ended
June 30, 2012
 

U.S. Trustee fees

   $ 6       $ 26   

Professional fees

     761         3,202   
  

 

 

    

 

 

 

Total reorganization items

   $ 767       $ 3,228   
  

 

 

    

 

 

 

 

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

U.S. Trustee fees

   $ 13      $ 18   

Professional fees

     6,720        17,218   

Lease settlement

     (295     14,007   

Other

     32        32   
  

 

 

   

 

 

 

Total reorganization items

   $ 6,470      $ 31,275   
  

 

 

   

 

 

 

3. Net Premiums Earned

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially established in an amount equal to: (i) the present value of future contractual premiums due (the “contractual” method) or, (ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be collected over the expected life of the transaction (the “expected” method). An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted

 

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average risk-free rate at June 30, 2012 and December 31, 2011 was 2.5% and 2.6%, respectively, and the weighted average period of future premiums used to estimate the premium receivable at June 30, 2012, and December 31, 2011 was 10.3 years and 10.0 years, respectively.

Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities and consumer auto loans. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk free rate.

Generally, the priority for the payment of financial guarantee premiums to Ambac, as required by the bond indentures of the insured obligations, is very senior in the waterfall, which governs the payments of cash in the transaction. Additionally, in connection with the allocation of certain liabilities to the Segregated Account, trustees are required under the Segregated Account Rehabilitation Plan and related court orders to continue to pay installment premiums, notwithstanding the claims moratorium. In evaluating the credit quality of the premiums receivable, management evaluates i.) the internal ratings of the transactions underlying the premiums receivable, and, as applicable, ii.) expected future premium collections for transactions for which loss reserves have been recognized. As of June 30, 2012, and December 31, 2011 approximately 43% of the premiums receivable related to transactions with non-investment grade internal ratings were due from MBS and student loan transactions, which comprised 11% and 11%, and 12% and 11%, of the total premiums receivable at June 30, 2012, and December 31, 2011, respectively. As of June 30, 2012 and December 31, 2011, $108,105 and $90,930 of premium receivables relating to a non-investment obligation were deemed uncollectible, respectively. For the three and six months ended June 30, 2012, respectively, $12,758 and $17,175 of premium receivables relating to a non-investment grade obligation were deemed uncollectible and written off. As of June 30, 2012, past due premiums on policies insuring non-investment grade obligations that were not written off amounted to less than $500.

Below is the premium receivable roll-forward for the six month and twelve month periods ended June 30, 2012, and December 31, 2011, respectively:

 

     June 30,
2012
    December 31,
2011
 

Beginning premium receivable

   $ 2,028,479      $ 2,422,596   

Premium payments received

     (78,415     (190,823

Adjustments for changes in expected life of homogeneous pools and actual changes to contractual cash flows

     (129,934     (240,547

Accretion of premium receivable discount

     26,632        62,841   

Consolidation of certain VIEs

     —          (104,736

Deconsolidation of certain VIEs

     —          87,978   

Other adjustments (including foreign exchange)

     (16,888     (8,830
  

 

 

   

 

 

 

Ending premium receivable

   $ 1,829,874      $ 2,028,479   
  

 

 

   

 

 

 

 

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies.

 

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The table below summarizes the future gross undiscounted premiums expected to be collected, and future expected premiums earned, net of reinsurance at June 30, 2012:

 

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

Three months ended:

     

September 30, 2012

   $ 37,913       $ 65,322   

December 31, 2012

     38,483         62,328   

Twelve months ended:

     

December 31, 2013

     139,786         228,340   

December 31, 2014

     143,572         207,998   

December 31, 2015

     138,712         195,677   

December 31, 2016

     133,021         184,978   

Five years ended:

     

December 31, 2021

     592,846         776,076   

December 31, 2026

     475,668         558,672   

December 31, 2031

     352,191         370,130   

December 31, 2036

     207,703         201,599   

December 31, 2041

     70,918         63,460   

December 31, 2046

     21,500         19,331   

December 31, 2051

     5,331         6,241   

December 31, 2056

     242         686   
  

 

 

    

 

 

 

Total

   $ 2,357,886       $ 2,940,838   
  

 

 

    

 

 

 

 

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

When a bond issue insured by Ambac Assurance has been retired, including those retirements due to refundings or calls, any remaining UPR is recognized at that time to the extent the financial guarantee insurance policy is legally extinguished. For installment premium paying transactions, we offset the recognition of any remaining UPR by the reduction of the related premium receivable to zero (as it will not be collected as a result of the retirement), which may cause negative accelerated premium revenue. Accelerated premium revenue for retired obligations for the three and six months ended June 30, 2012 was $35,866 and $51,656, respectively. Accelerated premium revenue for retired obligations for the three and six months ended June 30, 2011 was $11,331 and $11,261, respectively. The table below shows premiums written on a gross and net basis for the three and six month periods ended June 30, 2012 and 2011:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2012     2011     2012     2011  

Revenues:

        

Financial Guarantee:

        

Gross premiums written

   ($ 27,873   ($ 208,074   ($ 120,467   ($ 368,285

Ceded premiums written

     (881     11,571        15,973        20,789   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums written

   ($ 28,754   ($ 196,503   ($ 104,494   ($ 347,496
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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(1) Premiums written represent the change in the present value of future installment premiums. Such changes will not have an immediate impact on earned premium but will be earned over the life of the transaction using the level yield method discussed above. Factors that generate written premium are prepayments of the insured obligation, premium rate changes for policies that have variable premium structures, discount rate changes, and early terminations of insured obligations.

4. Net Income Per Share

Basic net income per share is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding. Common shares outstanding includes common stock issued less treasury shares plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding plus all dilutive potential common shares outstanding during the period. All dilutive potential common shares outstanding consider common stock deliverable pursuant to stock options and nonvested restricted stock units. There were no dilutive effects for the three and six months ended June 30, 2012 and 2011. The following table presents securities outstanding that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because they were antidilutive for the three and six month periods ended June 30, 2012 and 2011:

 

     Three months ended June 30,      Six months ended June 30,  
     2012      2011      2012      2011  

Stock options

     850,308         1,721,735         868,990         1,753,883   

Restricted stock units

     71,296         461,589         72,060         467,403   

5. Special Purpose Entities, Including Variable Interest Entities

Ambac has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac most commonly has provided financial guarantees, including credit derivative contracts, for various debt obligations issued by special purpose entities, including VIEs. Ambac has also sponsored two special purpose entities that issued medium-term notes to fund the purchase of certain financial assets. Ambac is also an investor in collateralized debt obligations, mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE and/or Ambac does not have rights that direct the activities that are most significant to such VIE. In 2011, Ambac entered into a secured borrowing transaction under which two VIEs were created for the purpose of resecuritizing certain invested assets and collateralizing the borrowing. These VIEs are consolidated because Ambac was involved in their design and holds a significant amount of the beneficial interests issued by the VIEs or guarantees the assets held by the VIEs. VIE debt outstanding to third parties under this secured borrowing transaction was $24,964 and $35,600 as of June 30, 2012 and December 31, 2011, respectively. The debt represents the senior-most tranche of the securitization structure and is to be repaid from the non-insurance proceeds of certain RMBS securities which are guaranteed by Ambac Assurance. Such securities had a fair value of $193,346 and $172,880 as of June 30, 2012 and December 31, 2011, respectively. Refer to Note 8, Investments for further discussion of the restrictions on these securities.

Financial Guarantees:

Ambac has provided financial guarantees in respect of assets held or debt obligations of special purpose entities, including VIEs. Ambac’s primary variable interest exists through this financial guarantee insurance or credit derivative contract. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the debt obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the debt obligations that have been guaranteed by Ambac Assurance. In the case of first loss, the financial guarantee insurance policy only covers a senior layer of losses on assets held or debt issued by special purpose entities, including VIEs. The first loss with respect to the assets is either retained by the asset seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the securitized assets contributed to special purpose entities, including VIEs, generate interest cash flows that are in excess of the interest payments on the related debt; such excess cash flow is applied to redeem debt, thus creating over-collateralization. Generally, upon deterioration in the performance of a transaction or upon an event of default as specified in the transaction legal documents, Ambac will obtain certain loss remediation rights. These rights may enable Ambac to direct the activities of the entity that most significantly impact the entity’s economic performance.

We determined that Ambac generally has the obligation to absorb the VIE’s expected losses given that we have issued financial guarantees supporting the liabilities (and in certain cases assets) of a VIE. As further described below, we consolidated certain VIEs

 

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because: a) we determined for certain transactions that experienced the aforementioned performance deterioration, that we had the power, through voting rights or similar rights, to direct the activities of certain VIEs that most significantly impact the VIE’s economic performance because certain triggers had been breached in these transactions resulting in Ambac having the ability to exercise certain loss remediation activities, or b) due to the passive nature of the VIEs’ activities, Ambac’s contingent loss remediation rights upon a breach of certain triggers in the future is considered to be the power to direct the activities that most significantly impact the VIEs’ economic performance. With respect to existing VIEs involving Ambac financial guarantees, Ambac is generally required to consolidate a VIE in the period that applicable triggers result in Ambac having control over the VIE’s most significant economic activities. A VIE is deconsolidated in the period that Ambac no longer has such control, which generally occurs in connection with an insurance policy being allocated to the Segregated Account, execution of remediation activities on the transaction or amortization of insured exposure, any of which may reduce the degree of Ambac’s control over a VIE.

Ambac Sponsored VIEs:

A subsidiary of Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These special purpose entities are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve these entities. The permitted activities of these entities are limited to those outlined below. Ambac does not consolidate these entities because Ambac’s policies issued to these entities have been allocated to the Segregated Account, thereby limiting Ambac’s control over the entities’ most significant economic activities. Ambac has elected to account for its equity interest in these entities at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments. We believe that the fair value of the investments in these entities provides for greater transparency for recording profit or loss as compared to the equity method under ASC Topic 323, Investments—Equity Method in Joint Ventures. Refer to Note 7 for further information on the valuation technique and inputs used to measure the fair value of Ambac’s equity interest in these entities. At June 30, 2012 and December 31, 2011 the fair value of these entities is $15,792 and $16,779, respectively, and is reported within Other assets on the Consolidated Balance Sheets. The change in fair value of these entities is ($231) and ($554) for the three months ended June 30, 2012 and 2011, respectively, and ($987) and $542 for the six months ended June 30, 2012 and 2011, respectively.

Since their inception, there have been 15 individual transactions with these entities, of which 5 transactions were outstanding as of June 30, 2012. Total principal amount of debt outstanding was $574,509 and $578,562 at June 30, 2012 and December 31, 2011, respectively. In each case, Ambac sold assets to these entities. The assets are composed of asset-backed securities and utility obligations with a weighted average rating of BBB+ at June 30, 2012 and weighted average life of 8.1 years. The purchase by these entities was financed through the issuance of medium-term notes (“MTNs”), which are cross-collateralized by the purchased assets. The MTNs have the same expected weighted average life as the purchased assets. Derivative contracts (interest rate swaps) are used within the entities for economic hedging purposes only. Hedges are established at the time MTNs are issued to purchase financial assets. The activities of these entities are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. As of June 30, 2012 Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities.

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

There were no assets sold to these entities during the three and six months ended June 30, 2012 and 2011. Ambac Assurance earned premiums for issuing the financial guarantee policies on the assets, MTNs and derivative contracts of $110 and $191 for the three months ended June 30, 2012 and 2011, respectively; and $255 and $427 for the six months ended June 30, 2012 and 2011, respectively. Ambac paid no claims to these entities under its financial guarantee policies during the three and six months ended June 30, 2012 and 2011. Ambac also earned fees for providing other services amounting to $11 and $12 for the three months ended June 30, 2012 and 2011, respectively; and $22 and $23 for the six months ended June 30, 2012 and 2011, respectively.

Derivative contracts are provided by Ambac Financial Services to these entities. Consistent with other derivatives, Ambac Financial Services (“AFS”) accounts for these contracts on a trade date basis at fair value. AFS received $3,886 and $4,206 for the three months ended June 30, 2012 and 2011, respectively; and received $3,747 and $4,075 for the six months ended June 30, 2012 and 2011, respectively, under these derivative contracts.

Consolidation of VIEs:

Upon initial consolidation of a VIE, we recognize a gain or loss in earnings for the difference between: a) the fair value of the consideration paid, the fair value of any non-controlling interests and the reported amount of any previously held interests and b) the net amount, as measured on a fair value basis, of the assets and liabilities consolidated. Upon deconsolidation of a VIE, we recognize a gain or loss for the difference between: a) the fair value of any consideration received, the fair value of any retained non-controlling

 

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investment in the VIE and the carrying amount of any non-controlling interest in the VIE and b) the carrying amount of the VIE’s assets and liabilities. Gains or losses from consolidation and deconsolidation that are reported in earnings are reported within Income (loss) on variable interest entities.

The variable interest in VIE generally involves one or more of the following: a financial guarantee policy issued to the VIE, a written credit derivative contract that references liabilities of the VIE or an investment in securities issued by the VIE. The impact of consolidating such VIEs on Ambac’s balance sheet is follows. For a financial guarantee policy issued to a consolidated VIE, Ambac does not reflect the financial guarantee insurance policy in accordance with the related insurance accounting rules under ASC Topic 944, Financial Services—Insurance. The financial guarantee policy would be eliminated upon consolidation. Consequently, Ambac eliminates insurance assets (premium receivables, reinsurance recoverable, deferred ceded premium, subrogation recoverable and deferred acquisition costs) and insurance liabilities (unearned premiums, loss and loss expense reserves and ceded premiums payable) from the Consolidated Balance Sheets. For investment securities owned by Ambac that are debt instruments issued by the VIE, the investment securities balance is eliminated upon consolidation.

As of June 30, 2012, consolidated VIE assets and liabilities relating to 18 consolidated entities were $16,620,359 and $16,444,608, respectively. As of December 31, 2011, consolidated VIE assets and liabilities relating to 19 consolidated entities were $16,543,207 and $16,379,386, respectively. Ambac is not primarily liable for, and does not guarantee all of the debt obligations issued by the VIEs. Ambac would only be required to make payments on the guaranteed debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of the VIEs. Ambac evaluates the net income statement effects and earnings per share effects to determine attributions between Ambac and non-controlling interests as a result of consolidating a VIE. Ambac has determined that the net changes in fair value of most consolidated VIE assets and liabilities are attributable to Ambac due to Ambac’s interest through financial guarantee premium and loss payments with the VIE.

The financial reports of certain VIEs are prepared by outside trustees and are not available within the time constraints Ambac requires to ensure the financial accuracy of the operating results. As such, the financial results of certain VIEs are consolidated on a time lag that is no longer than 90 days.

The table below provides the fair value of fixed income securities, by asset-type, held by consolidated VIEs as of June 30, 2012 and December 31, 2011:

 

     June 30, 2012      December 31, 2011  

Investments:

     

Corporate obligations

   $ 2,162,062       $ 2,199,338   
  

 

 

    

 

 

 

Total variable interest entity assets: Fixed income securities

   $ 2,162,062       $ 2,199,338   
  

 

 

    

 

 

 

 

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The following table provides supplemental information about the loans held as assets and long-term debt associated with the VIEs for which the fair value option has been elected as of June 30, 2012 and December 31, 2011:

 

      Estimated fair value      Unpaid principal balance  

June 30, 2012:

     

Loans

   $ 14,238,273       $ 13,508,803   

Long-term debt

   $ 14,132,936       $ 14,923,319   

December 31, 2011:

     

Loans

   $ 14,126,994       $ 13,735,799   

Long-term debt

   $ 14,039,450       $ 15,134,711   

Effective April 1, 2011, Ambac was required to consolidate one VIE which was subsequently deconsolidated effective December 31, 2011. The assets of this VIE consisted primarily of identified intangible assets associated with its subsidiaries’ operations. The intangible assets recorded at fair value upon consolidation on April 1, 2011 were $326,342, and were being amortized over their estimated useful lives. The weighted-average amortization period at the consolidation date was 28 years. Accumulated amortization on the intangible assets as of June 30, 2011 was $8,162. Amortization expense for intangible assets for the three and six months ended June 30, 2011 was $8,162 and is included in Income (loss) on variable interest entities on the Consolidated Statements of Total Comprehensive Income.

Variable Interests in Non-Consolidated VIEs

The following table displays the carrying amount of the assets, liabilities and maximum exposure to loss of Ambac’s variable interests in non-consolidated VIEs resulting from financial guarantee and credit derivative contracts by major underlying asset classes, as of June 30, 2012 and December 31, 2011:

 

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

June 30, 2012:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 12,408,367       $ 12,834       $ 20,677       $ 119,319   

Mortgage-backed—residential

     27,072,283         597,836         5,483,692         —     

Mortgage-backed—commercial

     646,669         —           —           6,196   

Other consumer asset-backed

     7,072,240         125,354         1,184,897         42,853   

Other commercial asset-backed

     11,228,636         471,108         1,397,059         7,606   

Other

     5,812,959         133,287         647,864         2,456   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     64,241,154         1,340,419         8,734,189         178,430   

Global Public Finance

     37,097,587         555,461         687,564         23,516   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 101,338,741       $ 1,895,880       $ 9,421,753       $ 201,946   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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

December 31, 2011:

           

Global Structured Finance:

           

Collateralized debt obligations

   $ 14,093,243       $ 15,096       $ 105,219       $ 120,614   

Mortgage-backed—residential

     30,307,753         783,329         5,396,711         —     

Mortgage-backed—commercial

     685,870         —           —           6,241   

Other consumer asset-backed

     7,851,980         129,234         1,315,146         35,583   

Other commercial asset-backed

     13,363,434         559,884         1,045,477         4,541   

Other

     7,552,264         139,586         643,864         1,837   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Global Structured Finance

     73,854,544         1,627,129         8,506,417         168,816   

Global Public Finance

     37,893,726         569,032         700,690         14,850   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 111,748,270       $ 2,196,161       $ 9,207,107       $ 183,666   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Maximum exposure to loss represents the gross maximum future payments of principal and interest on insured obligations and credit derivative contracts. Ambac’s maximum exposure to loss does not include the benefit of any financial instruments (such as reinsurance or hedge contracts) that Ambac may utilize to mitigate the risks associated with these variable interests.
(2) Insurance assets represent the amount recorded in “Premium receivables” and “Subrogation recoverable” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(3) Insurance liabilities represent the amount recorded in “Losses and loss expense reserve” and “Unearned premiums” for financial guarantee contracts on Ambac’s Consolidated Balance Sheets.
(4) Derivative liabilities represent the fair value recognized on credit derivative contracts on Ambac’s Consolidated Balance Sheets.

6. Losses and Loss Expense Reserve

A loss reserve is recorded on the balance sheet on a policy-by-policy basis for the excess of: (a) the present value of expected net cash flows to be paid under an insurance contract, over (b) the UPR for that contract. Below is the loss reserve roll-forward, net of subrogation recoverable and reinsurance for the six months ended June 30, 2012 and the year ended December 31, 2011:

 

     Six months
Ended June 30,
2012
    Year Ended
December 31,
2011
 

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

     6,230,780        4,424,450   

Changes in the loss reserves due to:

    

Current year:

    

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

     147,712        503,697   

Claim payments, net of subrogation and reinsurance

     (2,968     (2,442

Establishment of subrogation recoveries, net of reinsurance

     —          (9,761
  

 

 

   

 

 

 

Total current year

     144,744        491,494   

Prior year:

    

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

     662,809        1,683,831   

Change in previously established subrogation recoveries, net of reinsurance

     (64,420     (324,151

Claim recoveries (payments), net of subrogation recoverable and reinsurance

     28,705        (179,440
  

 

 

   

 

 

 

Total prior year

     627,094        1,180,240   

Changes in loss reserves

     771,838        1,671,734   

Net deconsolidation of certain VIEs

     —          134,596   
  

 

 

   

 

 

 

Ending loss reserves, net of subrogation recoverable and reinsurance

   $ 7,002,618      $ 6,230,780   
  

 

 

   

 

 

 

 

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The adverse development in loss reserves established in prior years for the six months ended June 30, 2012 was driven by higher estimated losses in the RMBS and asset-backed portfolios, offset by higher expected subrogation recoveries.

The adverse development in loss reserves established in prior years for the year ended December 31, 2011 was primarily due to the continued deterioration of collateral supporting structured finance policies, including RMBS and student loan exposures which resulted in greater expected ultimate losses, partially offset by higher expected subrogation recoveries related to representation and warranty breaches on insured RMBS securitizations.

The net change in loss and loss expense reserves, net of reinsurance, of $771,838 and $1,671,734 for the six month period and year ended June 30, 2012 and December 31, 2011, respectively, are included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income. Loss expense reserves, net of reinsurance, were $138,419 and $86,171 at June 30, 2012 and December 31, 2011. Such reserves are established for surveillance, legal and other mitigation expenses associated with adversely classified credits. Total loss and loss expenses of $741,411 and $196,398 for the three month periods ended June 30, 2012 and 2011, respectively, and $739,091 and $1,116,045 for the six month periods ended June 30, 2012 and 2011, respectively, are included in the Consolidated Statements of Total Comprehensive Income. During the three and six month periods ended June 30, 2012 and 2011, respectively, reinsurance recoveries of losses included in loss and loss expenses in the Consolidated Statements of Total Comprehensive Income were $9,334 and $17,051, respectively, and $21,852 and $24,742, respectively. The tables below summarize information related to policies currently included in Ambac’s loss reserves at June 30, 2012 and December 31, 2011:

 

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Table of Contents

Surveillance Categories (at June 30, 2012)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     29        9        39        122        153        1        353   

Remaining weighted-average contract period (in years)

     21        10        18        18        10        6        14   

Gross insured contractual payments outstanding:

              

Principal

     1,471,818        149,122        2,025,972        10,755,291        13,190,115        47        27,592,365   

Interest

     904,999        72,942        1,136,858        6,355,180        3,459,207        22        11,929,208   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     2,376,817        222,064        3,162,830        17,110,471        16,649,322        69        39,521,573   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

     43,445        34,536        55,755        4,261,839        8,837,054        69        13,232,698   

Discount, gross claim liability

     (3,686     (3,690     (3,740     (1,227,473     (807,445     (16     (2,046,050
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability before all subrogation and before reinsurance

     39,759        30,846        52,015        3,034,366        8,029,609        53        11,186,648   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          (203,515     (2,610,036     —          (2,813,551

Discount, RMBS subrogation

     —          —          —          2,995        40,365        —          43,360   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          (200,520     (2,569,671     —          (2,770,191
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          (83     (0     (51,912     (813,462     —          (865,457

Discount, other subrogation

     —          22        0        7,001        26,373        —          33,396   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          (61     (0     (44,911     (787,089     —          (832,060
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability, net of all subrogation and discounts, before reinsurance

     39,759        30,785        52,015        2,788,935        4,672,849        53        7,584,396   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (21,956     (1,987     (23,501     (364,919     (146,339     —          (558,702

Plus: Loss adjustment expenses reserves

     —          —          —          —          139,872        —          139,872   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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

     17,803        28,798        28,514        2,424,016        4,666,382        53        7,165,566   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

     2,124        —          6,240        143,202        18,395        —          169,961   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches.
(2) Other subrogation represents subrogation other than subrogation as defined in (1) above.
(3) Claim liability reported is included in the Consolidated Balance Sheets as follows:

 

Loss and loss expense reserve (net of potential remediation subrogation of $1,965,070)

   $ 7,607,663   

Subrogation recoverable (includes gross potential remediation of $805,121)

     (442,097
  

 

 

 
   $ 7,165,566   
  

 

 

 

Loss reserves ceded to reinsurers at June 30, 2012 and December 31, 2011 were $162,948 and $153,480, respectively. Amounts were included in reinsurance recoverable on the Consolidated Balance Sheet.

 

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Table of Contents

Surveillance Categories (at December 31, 2011)

 

     I/SL     IA     II     III     IV     V     Total  

Number of policies

     27        10        38        125        129        1        330   

Remaining weighted-average contract period (in years)

     18        10        17        19        9        6        13   

Gross insured contractual payments outstanding:

              

Principal

   $ 2,222,493      $ 354,713      $ 2,060,102      $ 13,342,814      $ 13,092,057      $ 47      $ 31,072,226   

Interest

     1,069,538        100,448        1,088,036        8,117,496        3,587,812        29        13,963,359   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 3,292,031      $ 455,161      $ 3,148,138      $ 21,460,310      $ 16,679,869      $ 76      $ 45,035,585   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross undiscounted claim liability

   $ 48,573      $ 10,667      $ 52,355      $ 4,766,815      $ 7,632,709      $ 75      $ 12,511,194   

Discount, gross claim liability

     (4,208     (2,316     (3,800     (1,440,704     (828,061     (20     (2,279,109
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability before all subrogation and before reinsurance

   $ 44,365      $ 8,351      $ 48,555      $ 3,326,111      $ 6,804,648      $ 55      $ 10,232,085   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross RMBS subrogation(1)

     —          —          —          (461,725     (2,316,920     —          (2,778,645

Discount, RMBS subrogation

     —          —          —          12,278        46,101        —          58,379   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted RMBS subrogation, before reinsurance

     —          —          —          (449,447     (2,270,819     —          (2,720,266
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less:

              

Gross other subrogation(2)

     —          (256     —          (52,871     (667,744     —          (720,871

Discount, other subrogation

     —          77        —          6,550        45,912        —          52,539   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discounted other subrogation, before reinsurance

     —          (179     —          (46,321     (621,832     —          (668,332
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross claim liability, net of all subrogation and discounts, before reinsurance

     44,365        8,172        48,555        2,830,343        3,911,997        55        6,843,487   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: Unearned premium reserves

     (25,264     (5,126     (22,111     (335,332     (158,687     —          (546,520

Plus: Loss adjustment expenses reserves

     —          —          —          —          87,294        —          87,294   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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

     19,101        3,046        26,444        2,495,011        3,840,603        55        6,384,261   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Reinsurance recoverable reported on Balance Sheet

     1,117        9        5,714        139,499        13,563        —          159,902   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches.
(2) Other subrogation represents subrogation other than subrogation as defined in (1) above.
(3) Claim liability reported is included in the Consolidated Balance Sheets as follows:

 

Loss and loss expense reserve (net of potential remediation subrogation of $1,890,797)

   $ 7,044,070   

Subrogation recoverable (includes gross potential remediation of $829,469)

     (659,810
  

 

 

 
   $ 6,384,260   
  

 

 

 

 

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Ambac records estimated subrogation recoveries for breaches of representations and warranties by sponsors of certain RMBS transactions utilizing an Adverse and Random Sample approach. Ambac has updated its estimated subrogation recoveries to $2,770,191 ($2,741,210 net of reinsurance) at June 30, 2012 from $2,720,266 ($2,692,414 net of reinsurance) at December 31, 2011. The balance of subrogation recoveries and the related claim liabilities, by estimation approach, at June 30, 2012 and December 31, 2011, are as follows:

 

     June 30, 2012  

Approach

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

Adverse samples

     29 (2)    $ 2,853,854       $ (1,553,195   $ 1,300,659   

Random samples

     16 (2)      1,318,084         (1,216,996     101,088   
  

 

 

   

 

 

    

 

 

   

 

 

 

Totals

     45      $ 4,171,938       $ (2,770,191   $ 1,401,747   
  

 

 

   

 

 

    

 

 

   

 

 

 
     December 31, 2011  

Approach

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

Adverse samples

     30 (2)    $ 2,637,479       $ (1,457,472   $ 1,180,006   

Random samples

     16 (2)      1,140,102         (1,262,794     (122,691
  

 

 

   

 

 

    

 

 

   

 

 

 

Totals

     46      $ 3,777,581       $ (2,720,266   $ 1,057,315   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(1) The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the expected future claims for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than expected future claims, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability. Of the $2,770,191 of subrogation recoveries recorded at June 30, 2012, $805,121 was included in “Subrogation recoverable” and $1,965,070 was included in “Loss and loss expense reserves.” Of the $2,720,266 of subrogation recoveries recorded at December 31, 2011, $829,469 was included in “Subrogation recoverable” and $1,890,797 was included in “Loss and loss expense reserves.”
(2) The sponsor’s repurchase obligation may differ depending on the terms of the particular transaction and the status of the specific loan, such as whether it is performing or has been liquidated or charged off. The estimated subrogation recovery for these transactions is based primarily on loan level data provided through trustee reports received in the normal course of our surveillance activities or provided by the sponsor. While this data may not include all the components of the sponsor’s contractual repurchase obligation we believe it is the best information available to estimate the subrogation recovery.

 

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Below is the rollforward of RMBS subrogation, by estimation approach, for the period December 31, 2011 through June 30, 2012:

 

     Random
sample
    Number of
transactions
     Adverse
sample
     Number of
transactions
    Total  

Rollforward:

            

Discounted RMBS subrogation (gross of reinsurance) at December 31, 2011

   $ 1,262,794        16       $ 1,457,472         30        2,720,266   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Additional transactions reviewed

     —          n/a         —           n/a        —     

Additional adverse sample loans reviewed

     —          n/a         —           n/a        —     

Adverse loans repurchased by the sponsor

     —          n/a         36        n/a        36   

All other changes(1)

     (45,798     n/a         95,687         (1     49,889   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Discounted RMBS subrogation (gross of reinsurance) at June 30, 2012

   $ 1,216,996        16       $ 1,553,195         29        2,770,191   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Other changes which may impact subrogation recoveries include changes in actual or projected collateral performance and/or the projected timing of recoveries. For the six months ended June 30, 2012, one transaction was removed from the Adverse Sample subrogation population; however, the impacts on RMBS subrogation disclosed in the Adverse Sample column relate to multiple transactions.

7. Fair Value Measurements

ASC Topic 820, Fair Value Measurements and Disclosures establishes a framework for measuring fair value and disclosures about fair value measurements.

Fair value Hierarchy:

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

 

•   Level 1

      Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US Treasury securities, exchange traded futures contracts, variable rate demand obligations, money market funds and mutual funds.

•   Level 2

      Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Assets and liabilities classified as Level 2 generally include direct investments in fixed income securities representing municipal, asset-backed and corporate obligations, financial services derivatives (including certain interest rate and currency swap derivatives), certain credit derivative contracts and most long-term debt of variable interest entities consolidated under ASC Topic 810.

•   Level 3

      Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. This hierarchy requires the use of observable market data when available. Assets and liabilities classified as Level 3 include most credit derivative contracts written as part of the financial guarantee business, certain financial services interest rate swap contracts which are not referenced to commonly quoted interest rates, call options on long-term debt, equity interests in Ambac sponsored special purpose entities and certain investments in fixed income securities. Additionally, Level 3 assets and liabilities generally include fixed income securities and loan receivables, as well as certain long-term debt of variable interest entities consolidated under ASC Topic 810.

 

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Table of Contents

The following table sets forth the carrying amount and fair value of Ambac’s financial assets and liabilities as of June 30, 2012 and December 31, 2011, including the level within the fair value hierarchy at which fair value measurements are categorized. As required by ASC Topic 820, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

     Carrying
Amount
    Total Fair
Value
    Fair Value Measurements Categorized as:  
         Level 1      Level 2     Level 3  

June 30, 2012

           

Financial assets:

           

Fixed income securities:

           

Municipal obligations

   $ 1,935,583      $ 1,935,583      $ —         $ 1,935,583      $ —     

Corporate obligations

     1,102,695        1,102,695        —           1,099,229        3,466   

Foreign obligations

     68,842        68,842        —           68,842        —     

U.S. government obligations

     111,389        111,389        111,389         —          —     

U.S. agency obligations

     84,700        84,700        —           84,700        —     

Residential mortgage-backed securities

     1,274,524        1,274,524        —           1,274,524        —     

Collateralized debt obligations

     41,366        41,366        —           31,808        9,558   

Other asset-backed securities

     771,191        771,191        —           720,445        50,746   

Short term investments

     1,010,059        1,010,059        993,284         16,775        —     

Other investments

     100        100        —           —          100   

Fixed income securities, pledged as collateral:

           

U.S. government obligations

     285,838        285,838        285,838         —          —     

Residential mortgage-backed securities

     822        822        —           822        —     

Cash

     49,012        49,012        49,012         —          —     

Restricted cash

     2,500        2,500        2,500         —          —     

Loans

     10,153        8,353        —           —          8,353   

Derivative assets:

           

Interest rate swaps—asset position

     392,766        392,766        —           259,146        133,620   

Interest rate swaps—liability position

     (259,852     (259,852     —           (26     (259,826

Future contracts

     —          —          —           —          —     

Other assets

     15,792        15,792        —           —          15,792   

Variable interest entity assets:

           

Fixed income securities:

           

Corporate obligations

     2,162,062        2,162,062        —           —          2,162,062   

Restricted cash

     2,276        2,276        2,276         —          —     

Loans

     14,446,047        14,425,077        —           186,804        14,238,273   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial assets

   $ 23,507,865      $ 23,485,095      $ 1,444,299       $ 5,678,652      $ 16,362,144   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Financial liabilities:

           

Obligations under investment and repurchase agreements

   $ 443,116      $ 443,428      $ —         $ —        $ 443,428   

Liabilities subject to compromise

     1,622,189        306,778        —           306,778        —     

Long term debt

     144,036        680,054        —           —          680,054   

Derivative liabilities:

           

Credit derivatives

     211,617        211,617        —           —          211,617   

Interest rate swaps—asset position

     (582     (582     —           —          (582

Interest rate swaps—liability position

     182,713        180,713        —           10,350        170,363   

Future contracts

     1,541        1,541        1,541         —          —     

Currency swaps

     569        569        —           569        —     

Other contracts

     182        182        —           182        —     

Liabilities for net financial guarantees written

     8,204,848        4,495,614        —           —          4,495,614   

Variable interest entity liabilities:

           

Long-term debt

     14,376,872        14,342,928        —           11,996,868        2,346,060   

Derivative liabilities:

           

Interest rate swaps—liability position

     1,978,737        1,978,737        —           1,978,737        —     

Currency swaps—asset position

     —          —          —           —          —     

Currency swaps—liability position

     85,072        85,072        —           85,072        —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial liabilities

   $ 27,250,910      $ 22,726,651      $ 1,541      $ 14,378,556      $ 8,346,554   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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Table of Contents
     Carrying
Amount
    Total Fair
Value
    Fair Value Measurements Categorized as:  
         Level 1      Level 2     Level 3  

December 31, 2011

           

Financial assets:

           

Fixed income securities:

           

Municipal obligations

   $ 2,002,999      $ 2,002,999      $ —         $ 2,002,999      $ —     

Corporate obligations

     1,127,500        1,127,500        —           1,119,570        7,930   

Foreign obligations

     94,795        94,795        —           94,795        —     

U.S. government obligations

     111,562        111,562        111,562         —          —     

U.S. agency obligations

     86,871        86,871        —           85,647        1,224   

Residential mortgage-backed securities

     1,412,517        1,412,517        —           1,412,517        —     

Collateralized debt obligations

     46,237        46,237        —           33,755        12,482   

Other asset-backed securities

     947,808        947,808        —           871,922        75,886   

Short term investments

     783,071        783,071        769,204         13,867        —     

Other investments

     100        100        —           —          100   

Fixed income securities, pledged as collateral:

           

U.S. government obligations

     260,802        260,802        260,802         —          —     

Residential mortgage-backed securities

     2,728        2,728        —           2,728        —     

Cash

     15,999        15,999        15,999         —          —     

Restricted cash

     2,500        2,500        2,500         —          —     

Loans

     18,996        16,934        —           —          16,934   

Derivative assets:

           

Interest rate swaps—asset position

     411,652        411,652        —           260,851        150,801   

Interest rate swaps—liability position

     (242,500     (242,500     —           (53     (242,447

Future contracts

     —          —          —           —          —     

Call options on long-term debt

     6,055        6,055        —           —          6,055   

Other assets

     16,779        16,779        —           —          16,779   

Variable interest entity assets:

           

Fixed income securities:

           

Corporate obligations

     2,199,338        2,199,338        —           —          2,199,338   

Restricted cash

     2,140        2,140        2,140         —          —     

Loans

     14,329,515        14,309,134        —           182,140        14,126,994   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial assets

   $ 23,637,464      $ 23,615,021      $ 1,162,207       $ 6,080,738      $ 16,372,076   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Financial liabilities:

           

Obligations under investment and repurchase agreements

   $ 546,546      $ 549,043      $ —         $ —        $ 549,043   

Liabilities subject to compromise

     1,622,189        112,233        —           112,233        —     

Long term debt

     223,601        562,043        —           —          562,043   

Derivative liabilities:

           

Credit derivatives

     190,653        190,653        —           —          190,653   

Interest rate swaps—asset position

     (30,859     (30,859     —           —          (30,859

Interest rate swaps—liability position

     251,303        251,303        —           9,913        241,390   

Futures contracts

     627        627        627         —          —     

Currency swaps

     2,423        2,423        —           2,423        —     

Other contracts

     361        361        —           361        —     

Liabilities for net financial guarantees written

     7,547,288        2,642,795        —           —          2,642,795   

Variable interest entity liabilities:

           

Long-term debt

     14,288,540        14,255,452        —           12,320,810        1,934,642   

Derivative liabilities:

           

Interest rate swaps—liability position

     2,023,974        2,023,974        —           2,023,974        —     

Currency swaps—asset position

     (27,779     (27,779     —           (27,779     —     

Currency swaps—liability position

     90,857        90,857        —           90,857        —     
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total financial liabilities

   $ 26,729,724      $ 20,623,126      $ 627       $ 14,532,792      $ 6,089,707   
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

25


Table of Contents

Determination of Fair Value:

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

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

Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, derivative instruments, most variable interest entity assets and liabilities and equity interests in Ambac sponsored special purpose entities. Valuation of financial instruments is performed by Ambac’s Finance group using methods approved by senior financial management with consultation from risk management and portfolio managers as appropriate. Preliminary valuation results are discussed with portfolio managers quarterly to assess consistency with market transactions and trends as applicable. Market transactions such as trades or negotiated settlements of similar positions, if any, are reviewed quarterly to validate fair value model results. However many of the financial instruments valued using significant unobservable inputs have very little or no observable market activity. Methods and significant inputs and assumptions used to determine fair values across portfolios are reviewed quarterly by senior financial management. Additionally, changes to fair value methods and assumptions are reviewed with the CEO and audit committee when such changes may be material to the company’s financial position or results. Other valuation control procedures specific to particular portfolios are described further below.

We reflect Ambac’s own creditworthiness in the fair value of financial liabilities by including a credit valuation adjustment (“CVA”) in the determination of fair value. A decline (increase) in Ambac’s creditworthiness as perceived by market participants will generally result in a higher (lower) CVA, thereby lowering (increasing) the fair value of Ambac’s financial liabilities as reported.

Fixed Income Securities:

The fair values of fixed income investment securities held by Ambac and its operating subsidiaries are based primarily on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes generally consider a variety of factors, including recent trades of the same and similar securities. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and yield curves for asset-type and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. Longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value. Generally, lower credit ratings or longer expected maturities will be accompanied by higher yields used to value a security. At June 30, 2012, approximately 7%, 92%, and 1% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively. At December 31, 2011, approximately 8%, 91%, and 1% of the investment portfolio (excluding variable interest entity investments) was valued using dealer quotes, alternative pricing sources with reasonable levels of price transparency and internal valuation models, respectively.

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.

 

26


Table of Contents

Third party quotes represent the only input to the reported fair value of Level 2 fixed income securities. Information about the valuation inputs for fixed income securities classified as Level 3 is included below:

Corporate obligations: These securities represent interest only strips of investment grade corporate obligations. The fair value of such securities classified as Level 3 was $3,466 and $7,930 at June 30, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with the discount rate determined from the yields of corporate bonds from the same issuers. During the second quarter of 2012, one fixed-rate investment-grade corporate obligation was transferred out of level 3 and into level 2. Significant inputs for the interest only strips valuation at June 30, 2012 and December 31, 2011 include the following weighted averages:

June 30, 2012

 

  a. Coupon rate: 0.35%

 

  b. Maturity: 21.89 years

 

  c. Yield: 6.86%

December 31, 2011

 

  a. Coupon rate: 0.60%

 

  b. Maturity: 21.44 years

 

  c. Yield: 7.20%

U.S. agency obligations: These notes are secured by separate lease rental agreements with the U.S. Government acting through the General Services Administration. There were no U.S. agency obligations classified as Level 3 at June 30, 2012. The fair value of such securities classified as Level 3 was $1,224 at December 31, 2011. Fair value was calculated using a discounted cash flow approach with the yield based on comparable U.S. agency securities. Significant inputs for the valuation at December 31, 2011 include the following weighted averages:

 

  a. Coupon rate: 6.91%

 

  b. Maturity: 1.33 years

 

  c. Yield: 2.13%

Collateralized debt obligations (“CDO”): Securities are floating rate senior notes with the underlying securities of the CDO consist of subordinated bank perpetual preferred securities. The fair value of such securities classified as Level 3 was $9,558 and $12,482 at June 30, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at June 30, 2012 and December 31, 2011 include the following weighted averages:

June 30, 2012

 

  a. Coupon rate: 1.13%

 

  b. Maturity: 1.44 years

 

  c. Yield: 10.39%

December 31, 2011

 

  a. Coupon rate: 0.86%

 

  b. Maturity: 1.55 years

 

  c. Yield: 11.79%

 

27


Table of Contents

Other asset-backed securities: These securities are floating rate investment grade notes collateralized by various asset types. The fair value of such securities classified as Level 3 was $50,746 and $75,886 at June 30, 2012 and December 31, 2011, respectively. Fair value was calculated using a discounted cash flow approach with expected future cash flows discounted using a yield curve consistent with the security type and rating. Significant inputs for the valuation at June 30, 2012 and December 31, 2011 include the following weighted averages:

June 30, 2012

 

  a. Coupon rate: 0.87%

 

  b. Maturity: 8.18 years

 

  c. Yield: 7.50%

December 31, 2011

 

  a. Coupon rate: 1.41%

 

  b. Maturity: 3.00 years

 

  c. Yield: 4.50%

Derivative Instruments:

Ambac’s derivative instruments primarily comprise interest rate and credit default swaps, exchange traded futures contracts and call options to repurchase Ambac Assurance surplus notes. All call options to repurchase surplus notes were exercised or expired in June 2012. Fair value is determined based upon market quotes from independent sources, when available. When independent quotes are not available, fair value is determined using valuation models. These valuation models require market-driven inputs, including contractual terms, credit spreads and ratings on underlying referenced obligations, yield curves and tax-exempt interest ratios. 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. Under ASC Topic 820, Ambac is required to consider its own credit risk when measuring the fair value of derivative and other liabilities. The fair value of net credit derivative liabilities was reduced by $393,276 at June 30, 2012 and $572,523 at December 31, 2011, as a result of incorporating a CVA on Ambac Assurance into the valuation model for these transactions. Interest rate swaps and other derivative liabilities may also require an adjustment to fair value to reflect Ambac Assurance’s credit risk. Factors considered in estimating the amount of any Ambac CVA on such contracts include collateral posting provisions, right of set-off with the counterparty, the period of time remaining on the derivatives and the pricing of recent terminations and amendments. Derivative liabilities were reduced by $160,548 at June 30, 2012 and $166,868 at December 31, 2011, as a result of Ambac CVA adjustments to derivative contracts other than credit derivatives.

As described further below, certain valuation models require other inputs that are not readily observable in the market. The selection of a model to value a derivative depends on the contractual terms of, and specific risks inherent in the instrument as well as the availability of pricing information in the market.

For derivatives that are less complex and trade in liquid markets or may be valued primarily by reference to interest rates and yield curves that are observable and regularly quoted, such as interest rate and currency swaps, we utilize vendor-developed models. These models provide the net present value of the derivatives based on contractual terms and observable market data. Downgrades of Ambac Assurance, as guarantor of the financial services derivatives, beginning 2008 have increased collateral requirements and triggered termination provisions in certain interest rate and currency swaps. Increased termination activity since the initial rating downgrades of Ambac Assurance has provided additional information about the current replacement and/or exit value of our financial services derivatives, which may not be fully reflected in our vendor-models but has been incorporated into the fair value of these derivatives at June 30, 2012 and December 31, 2011. These fair value adjustments are applied to individual groups of derivatives based on common attributes such as counterparty type and credit condition, term to maturity, derivative type and net present value. Generally, the need for counterparty (or Ambac) CVAs is mitigated by the existence of collateral posting agreements under which adequate collateral has been posted. Derivative contracts entered into with financial guarantee customers are not typically subject to collateral posting agreements. Counterparty credit risk related to such customer derivative assets is included in our fair value adjustments.

For derivatives that do not trade, or trade in less liquid markets such as credit derivatives, a proprietary model is used because such instruments tend to be unique, contain complex or heavily modified and negotiated terms, and pricing information is not readily available in the market. Derivative fair value models and the related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based on improvements in modeling techniques. Ambac has not made any significant changes to its modeling techniques or related model inputs for the periods presented.

 

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Credit Derivatives (“CDS”):

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

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

Broker quotes on the reference obligations named in our CDS contracts represent an input to determine the estimated fair value of the CDS contract. Broker quotes are indicative values for the reference obligation and generally do not represent a bid or doing-business quote for the reference instrument. Such quotes follow methodologies that are generally consistent with those used to value similar assets on the quote providers’ own books. Methodologies may differ among brokers but are understood to reflect observable trading activity (when available) and modeling that relies on empirical data and reasonable assumptions. For certain CDS contracts referencing unsecuritized pools of assets, we will obtain counterparty quotes on the credit derivative itself. Such quotes are adjusted to reflect Ambac’s own credit risk when determining the fair value of credit derivative liabilities. Third party reference obligation values or specific credit derivative quotes were used in the determination of CDS fair values related to transactions representing 83% of CDS gross par outstanding and 83% of the CDS derivative liability as of June 30, 2012.

When broker quotes for reference obligations are not available, reference obligation prices used in the valuation model are estimated internally based on averages of the quoted prices for other transactions of the same bond type and Ambac rating as well as changes in published credit spreads for securities with similar collateral and ratings characteristics. When price quotes of a similar bond type vary significantly or the number of similar transactions is small, management will consider additional factors, such as specific collateral composition and performance and contractual subordination, to identify similar transactions. Reference obligation prices derived internally as described above were used in the determination of CDS fair values related to transactions representing 17% of CDS gross par outstanding and 17% of the CDS derivative liability as of June 30, 2012.

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

The amount of expected loss on a reference obligation is a function of the probability that the obligation will default and severity of loss in the event of default. Ambac’s CDS transactions were all originally underwritten with extremely low expected losses. Both the reference obligation spreads and Ambac’s CDS fees at the inception of these transactions reflect these low expected losses. When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and, therefore, an increase in expected loss. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread (over LIBOR) which would be captured as a CDS fee (“relative change ratio”) at the valuation date, resulting in a higher mark-to-market loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. For example, if the credit spread of an underlying reference obligation was 80 basis points at the inception of a transaction and Ambac

 

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

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

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

Ambac incorporates its own credit risk into the valuation of its CDS liabilities by applying a CVA to the calculations described above. Under our methodology, determination of the CDS fair value requires estimating hypothetical financial guarantee CDS fees for a given credit at the valuation date and estimating the present value of those fees. Our approach begins with pricing in the risk of default of the reference obligation using that obligation’s credit spread. The widening of the reference obligation spread results in a mark-to-market loss to Ambac, as the credit protection seller, and a gain to the credit protection buyer because the cost of credit protection on the reference obligation (ignoring CDS counterparty credit risk) will be greater than the amount of the actual contractual CDS fees. The Ambac CVA is a percentage applied to the estimated CDS liability fair value otherwise calculated as described above. The Ambac CVA is estimated using relevant data points, including quoted prices of securities guaranteed by Ambac Assurance which indicate the value placed by market participants on Ambac Assurance’s insurance obligations and the fair value of Ambac Assurance surplus notes. The resulting Ambac CVA percentage used in the valuation of CDS liabilities was 65% and 75% as of June 30, 2012 and December 31, 2011, respectively. In instances where narrower reference obligation spreads result in a CDS asset to Ambac, those hypothetical future CDS fees are discounted at a rate which incorporates our counterparty’s credit spread (i.e. the discount rate used is LIBOR plus the current credit spread of the counterparty).

In addition, when there are sufficient numbers of new observable transactions, negotiated settlements or other market indications of a general change in market pricing trends for CDS on a given bond type, management will adjust its assumptions about the percentage of reference obligation spreads captured as CDS fees to match the current market. No such adjustments were made during the periods presented. Ambac is not transacting CDS business currently and other guarantors have stated they have exited this product. Additionally, there have been no negotiated settlements of CDS contracts during the periods presented.

Key variables which impact the “Realized gains and losses and other settlements” component of “Net change in fair value of credit derivatives” in the Consolidated Statements of Total Comprehensive Income are the most readily observable variables since they are based solely on the CDS contractual terms and cash settlements. Those variables include premiums received and accrued and losses paid and payable on written credit derivative contracts for the appropriate accounting period. Losses paid and payable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under

 

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the contract terms has occurred or in connection with a negotiated termination of a contract. The remaining key variables described above impact the “Unrealized gains (losses)” component of “Net change in fair value of credit derivatives.” The net notional outstanding of Ambac’s CDS contracts were $12,884,416 and $14,166,612 at June 30, 2012 and December 31, 2011, respectively.

Credit derivative liabilities at June 30, 2012 and December 31, 2011 had a combined fair value of $211,617 and $190,653, respectively, and related to underlying reference obligations that are classified as either collateralized loan obligations (“CLOs”) or Other. Information about the above described model inputs used to determine the fair value of each class of credit derivatives as of June 30, 2012 and December 31, 2011 is summarized below:

 

As of June 30, 2012

    
     CLOs     Other(1)  

Notional outstanding

   $ 7,586,414      $ 3,681,319   

Weighted average reference obligation price

     94.6        84.6   

Weighted average life (WAL) in years

     2.3        4.7   

Weighted average credit rating

     AA-        A   

Weighted average relative change ratio

     34.4     38.3

CVA percentage

     65     65

Fair value of derivative liabilities

   $ (51,166   $ (105,411

 

As of December 31, 2011

    
     CLOs     Other(1)  

Notional outstanding

   $ 8,228,577      $ 4,099,766   

Weighted average reference obligation price

     92.5        84.3   

Weighted average life (WAL) in years

     2.7        4.7   

Weighted average credit rating

     AA-        A   

Weighted average relative change ratio

     34.4     38.5

CVA percentage

     75     75

Fair value of derivative liabilities

   $ (54,320   $ (86,526

 

(1) Excludes contracts for which fair values are based on credit derivative quotes rather than reference obligation quotes. Such contracts have a combined notional outstanding of $1,616,683, WAL of 8.4 years and liability fair value of ($55,040) as of June 30, 2012. Other inputs to the valuation of these transactions at June 30, 2012 include weighted average quotes of 10% of notional, weighted average rating of A and Ambac CVA percentage of 65%. As of December 31, 2011, these contracts had a combined notional outstanding of $1,838,269, WAL of 9.0 years and liability fair value of ($49,807). Other inputs to the valuation of these transactions at December 31, 2011 include weighted average quotes of 11% of notional, weighted average rating of A+ and Ambac CVA percentage of 75%.

Significant unobservable inputs for credit derivatives include WAL, credit rating, relative change ratio and CVA percentage. A longer (shorter) WAL, lower (higher) reference obligation credit rating, higher (lower) relative change ratio or lower (higher) CVA percentage, in isolation, would result in an increase (decrease) in the fair value liability measurement. A change in credit rating of a reference obligation in our model will generally result in a directionally opposite change in the relative change ratio. Also, a shorter (longer) WAL will generally correspond with a lower (higher) CVA percentage.

Call options on long-term debt:

The fair value of Ambac Assurance’s options to repurchase Ambac Assurance surplus notes at a discount to par was estimated based on a combination of internal discounted cash flow analysis and market observations. The discounted cash flow analysis uses multiple discount rate scenarios to determine the present value of the surplus notes assuming exercise and non-exercise of the options, with the difference representing the option value under that scenario. The results are probability weighted to determine the recorded option value. All options to repurchase Ambac Assurance surplus notes that were stand-alone derivatives and reported at fair value on the Consolidated Balance Sheets were exercised in June 2012. The weighted average discount rate used to value such options was 36.57% at December 31, 2011.

Financial Guarantees:

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

 

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This fair value estimate of financial guarantees is presented on a net basis and includes direct and assumed contracts written, which represent our liability, net of ceded reinsurance contracts, which represent our asset. The fair value estimate of direct and assumed contracts written is based on the sum of the present values of (i) unearned premium reserves; and (ii) loss and loss expense reserves, including claims presented and not paid as a result of the claim moratorium imposed by the Rehabilitation Court on March 24, 2010. The fair value estimate of ceded reinsurance contracts is based on the sum of the present values of (i) deferred ceded premiums net of ceding commissions; and (ii) reinsurance recoverables on paid and unpaid losses.

Key variables are par amounts outstanding (including future periods for the calculation of future installment premiums), expected term, discount rate, and expected net loss and loss expense payments. Net par outstanding is monitored by Ambac’s Risk Group. With respect to the discount rate, ASC Topic 820 requires that the nonperformance risk of a financial liability be included in the estimation of fair value. This nonperformance risk would include considering Ambac Assurance’s own credit risk in the fair value of financial guarantees we have issued, thus the estimated fair value for direct contracts written included an Ambac CVA to reflect Ambac’s credit risk. The Ambac CVA was 65% and 75% as of June 30, 2012 and December 31, 2011, respectively. Refer to “Credit Derivatives” above for additional information on the determination of the CVA. Refer to Note 6 for additional information on factors which influence our estimate of loss and loss expenses. The estimated fair value of ceded reinsurance contracts factors in any adjustments related to the counterparty credit risk we have with reinsurers. Beginning with the June 30, 2012 reporting period, we further refined our fair value estimate to also consider an estimated profit margin on the expected loss and loss payments. This profit margin represents what another financial guarantee insurer would require to assume the financial guarantee contracts. Given the unique nature of financial guarantees and current inactive state of the industry there is a lack of observable market information to make this estimate. A profit margin of 20% was developed based on discussions with the third-party institutions with valuation expertise, discussions with industry participants and yields on Ambac Assurance surplus notes.

There are a number of factors that limit our ability to accurately estimate the fair value of our financial guarantees. The first limitation is the lack of observable pricing data points as a result of Ambac no longer writing new financial guarantee business. Additionally, although the fair value accounting guidance for liabilities requires a company to consider the cost to completely transfer its obligation to another party of comparable credit worthiness, our primary insurance obligation is irrevocable and thus there is no established active market for transferring such obligations. Variables which are not incorporated in our current fair value estimate of financial guarantees include the credit spreads of the underlying insured obligations, the underlying ratings of those insured obligations and assumptions about current financial guarantee premium levels relative to the underlying insured obligations’ credit spreads.

Liabilities Subject to Compromise:

The fair value of Ambac’s debt included in Liabilities Subject to Compromise is based on quoted market prices.

Long-term Debt:

The fair value of surplus notes issued by Ambac Assurance and classified as long-term debt is internally estimated considering market transactions when available and internally developed discounted cash flow models. Surplus notes were initially recorded at fair value at the date of issuance. In subsequent periods, surplus notes are carried at their face value less unamortized discount.

Other Financial Assets and Liabilities:

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

 

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Variable Interest Entity Assets and Liabilities:

The financial assets and liabilities of VIEs consolidated under ASC Topic 810 consist primarily of fixed income securities, loans receivable, derivative instruments and debt instruments and are generally carried at fair value. These consolidated VIEs are securitization entities which have liabilities and/or assets guaranteed by Ambac Assurance. 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 debt fair value is based on market prices received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. Such quotes are considered Level 2 and generally consider a variety of factors, including recent trades of the same and similar securities. For those VIE debt instruments where quotes were not available, the debt instrument fair values are considered Level 3 and are based on internal discounted cash flow models. Comparable to the sensitivities of investments in fixed income securities described above, longer (shorter) expected maturities or higher (lower) yields used in the valuation model will, in isolation, result in decreases (increases) in fair value liability measurement for VIE debt. VIE debt instruments considered Level 3 include fixed rate, floating rate and zero coupon notes secured by various asset types, primarily European ABS. Information about the valuation inputs for the various VIE debt categories classified as Level 3 is as follows:

European ABS transactions: The fair value of such obligations classified as Level 3 was $2,346,060 and $1,934,642 at June 30, 2012 and December 31, 2011, respectively. Fair values were calculated by using a discounted cash flow approach. The discount rates used were based on the rates implied from the third party quoted values (Level 2) for comparable notes from the same securitization. Significant inputs for the valuation at June 30, 2012 and December 31, 2011 include the following weighted averages:

June 30, 2012

 

  a. Coupon rate: 1.59%

 

  b. Maturity: 9.77 years

 

  c. Yield: 4.04%

December 31, 2011

 

  a. Coupon rate: 1.56%

 

  b. Maturity: 11.99 years

 

  c. Yield: 3.90%

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, foreign 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. VIE derivative fair value balances at June 30, 2012 and December 31, 2011 were developed using vendor-developed models and do not use significant unobservable inputs.

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. Our valuation of VIE assets (fixed income securities or loans), therefore, are derived from the fair value of notes and derivatives, as described above, adjusted for the fair value of cash flows from Ambac’s 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 discounted at a rate that includes Ambac’s own credit risk. Excluding changes in estimated financial guarantee cash flows, changes in the fair value of VIE assets will be accompanied by corresponding and offsetting changes in the fair value of VIE liabilities plus VIE derivatives. Higher (lower) estimated future premiums or lower (higher) estimated loss payments on financial guarantee policies in isolation will result in increases (decreases) in the fair value measurement of VIE assets. Changes in financial guarantee estimated premiums and loss payments are generally independent. A higher CVA will reduce the fair value of expected claim payments and therefore increase VIE asset measures. The amount of CVA is generally independent of other significant inputs to the calculation of VIE assets. Estimated future premium payments to be paid by the VIEs were discounted at a weighted average rate of 7.6% and 8.4% at June 30, 2012 and December 31, 2011, respectively. The value of future loss payments to be paid by Ambac to the VIEs was adjusted to include an Ambac CVA appropriate for the term of expected Ambac claim payments.

 

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The following tables present the changes in the Level 3 fair value category for the three and six months ended June 30, 2012 and 2011. Ambac classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs.

Level-3 financial assets and liabilities accounted for at fair value

 

                      VIE Assets and Liabilities        

Three months ended

June 30, 2012

  Investments     Other
assets
    Derivatives     Investments     Loans     Derivatives     Long-term
debt
    Total  

Balance, beginning of period

  $ 161,450      $ 16,023      $ (355,616   $ 2,184,665      $ 14,460,077        —        $ (2,786,644   $ 13,679,955   

Additions of VIEs consolidated

    —          —          —          —          —          —          —          —     

Total gains/(losses) realized and unrealized:

               

Included in earnings

    88        (231     (81,290     20,103        131,807        —          21,235        91,712   

Included in other comprehensive income

    (1,588     —          —          (42,706     (267,190     —          54,510        (256,974

Purchases

    —          —          —          —          —          —          —          —     

Issuances

    —          —          —          —          —          —          —          —     

Sales

    —          —          —          —          —          —          —          —     

Settlements

    (89,879     —          (70,698     —          (86,421     —          19,863        (227,135

Transfers in Level 3

    —          —          —          —          —          —          (312,083     (312,083

Transfers out of Level 3

    (6,301     —          —          —          —          —          657,059       650,758   

Deconsolidation of VIEs

    —          —          —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

  $ 63,770      $ 15,792      $ (507,604   $ 2,162,062      $ 14,238,273      $ —        $ (2,346,060   $ 13,626,233   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The amount of total gains/(losses) included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the reporting date

  $ —        $ (231   $ (118,474   $ 20,103      $ 131,807      $ —        $ 21,235      $ 54,440   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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                      VIE Assets and Liabilities        

Six months ended

June 30, 2012

  Investments     Other
assets
    Derivatives     Investments     Loans     Derivatives     Long-term
debt
    Total  

Balance, beginning of period

  $ 97,522      $ 16,779      $ (486,775   $ 2,199,338      $ 14,126,994        —        $ (1,934,642   $ 14,019,216   

Additions of VIEs consolidated

    —          —          —          —          —          —          —          —     

Total gains/(losses) realized and unrealized:

              —         

Included in earnings

    40        (987     41,037        (62,713     298,472        —          (115,328     160,521   

Included in other comprehensive income

    6,225        —          —          25,437        148,667        —          (8,695     171,634   

Purchases

    —          —          —          —          —          —          —          —     

Issuances

    —          —          —          —          —          —          —          —     

Sales

    —          —          —          —          —          —          —          —     

Settlements

    (92,621     —          (61,866     —          (335,860     —          32,893        (457,454

Transfers in Level 3

    58,905        —          —          —          —          —          (977,347     (918,442

Transfers out of Level 3

    (6,301     —          —          —          —          —          657,059        650,758   

Deconsolidation of VIEs

    —          —          —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

  $