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EX-31.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 302 - AMBAC FINANCIAL GROUP INCdex312.htm
EX-99.1 - PLAN OF OPERATIONS OF THE SEGREGATED ACCOUNT OF AMBAC ASSURANCE CORPORATION. - AMBAC FINANCIAL GROUP INCdex991.htm
EX-10.3 - AMENDMENT NO. 1 TO TAX SHARING AGREEMENT - AMBAC FINANCIAL GROUP INCdex103.htm
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 302 - AMBAC FINANCIAL GROUP INCdex311.htm
EX-10.2 - TAX SHARING AGREEMENT - AMBAC FINANCIAL GROUP INCdex102.htm
EX-32.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 906 - AMBAC FINANCIAL GROUP INCdex321.htm
EX-10.4 - AMENDMENT NO. 2 TO TAX SHARING AGREEMENT - AMBAC FINANCIAL GROUP INCdex104.htm
EX-10.1 - SETTLEMENT AGREEMENT - AMBAC FINANCIAL GROUP INCdex101.htm
EX-32.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 906 - AMBAC FINANCIAL GROUP INCdex322.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the Quarterly Period Ended June 30, 2010

 

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

Commission File Number: 1-10777

 

 

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

 

 

 

Delaware   13-3621676
(State of incorporation)  

(I.R.S. employer

identification no.)

One State Street Plaza

New York, New York

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

(212) 668-0340

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

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

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

As of August 4, 2010, 302,108,597 shares of Common Stock, par value $0.01 per share, (net of 5,908,167 treasury shares and 308,016,764 restricted nominee shares) of the Registrant were outstanding.

 

 

 


Table of Contents

Ambac Financial Group, Inc. and Subsidiaries

INDEX

 

 

     PAGE

PART I FINANCIAL INFORMATION

  

Item1.

   Financial Statements of Ambac Financial Group, Inc. and Subsidiaries   
   Consolidated Balance Sheets – June 30, 2010 (unaudited) and December 31, 2009    3
   Consolidated Statements of Operations (unaudited) – three and six months ended June 30, 2010 and 2009    4
   Consolidated Statements of Stockholders’ Equity (unaudited) – six months ended June 30, 2010 and 2009    5
   Consolidated Statements of Cash Flows (unaudited) – six months ended June 30, 2010 and 2009    6
   Notes to Unaudited Consolidated Financial Statements    7

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    78

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    126

Item 4.

   Controls and Procedures    131

PART II OTHER INFORMATION

  
Item 1.    Legal Proceedings    132
Item 1A.    Risk Factors    140
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds    145
Item 6.    Exhibits    146

SIGNATURES

   147

INDEX TO EXHIBITS

   148


Table of Contents

PART 1 – FINANCIAL INFORMATION

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

Ambac Financial Group Inc. and Subsidiaries

Consolidated Balance Sheets

 

(Dollars in Thousands)

   June 30,
2010
    December 31,
2009
 
     (unaudited)        

Assets:

    

Investments:

    

Fixed income securities, at fair value (amortized cost of $5,668,300 in 2010 and $7,605,565 in 2009)

   $ 5,925,170      $ 7,572,570   

Fixed income securities pledged as collateral, at fair value (amortized cost of $123,766 in 2010 and $164,356 in 2009)

     127,432        167,366   

Short-term investments, (amortized cost of $514,780 in 2010 and $962,007 in 2009)

     514,780        962,007   

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

     100        1,278   
                

Total investments

     6,567,482        8,703,221   

Cash and cash equivalents

     56,677        112,079   

Receivable for securities sold

     14,481        3,106   

Investment income due and accrued

     47,995        73,062   

Premium receivables

     2,789,353        3,718,158   

Reinsurance recoverable on paid and unpaid losses

     121,715        78,115   

Deferred ceded premium

     386,665        500,804   

Subrogation recoverable

     1,046,610        902,612   

Deferred taxes

     —          11,250   

Current taxes

     —          421,438   

Deferred acquisition costs

     263,258        279,704   

Loans

     70,849        80,410   

Derivative assets

     504,125        496,494   

Other assets

     173,270        229,299   

Variable interest entity assets:

    

Fixed income securities, at fair value

     1,801,557        525,947   

Restricted cash

     1,977        1,151   

Investment income due and accrued

     3,866        4,133   

Loans (includes $15,992,650 and $2,428,352 at fair value)

     16,189,761        2,635,961   

Derivative assets

     4,546        109,411   

Other assets

     11,598        12   
                

Total assets

   $ 30,055,785      $ 18,886,367   
                

Liabilities and Stockholders’ Deficit:

    

Liabilities:

    

Unearned premiums

   $ 4,714,527      $ 5,687,114   

Losses and loss expense reserve

     5,221,886        4,771,684   

Ceded premiums payable

     224,740        291,843   

Obligations under investment and payment agreements

     879,381        1,177,406   

Obligations under investment repurchase agreements

     113,296        113,527   

Current taxes

     22,384        —     

Long-term debt

     1,815,017        1,631,556   

Accrued interest payable

     58,345        47,125   

Derivative liabilities

     452,136        3,536,858   

Other liabilities

     140,999        248,655   

Payable for securities purchased

     24,151        2,074   

Variable interest entity liabilities:

    

Accrued interest payable

     3,307        3,482   

Long-term debt (includes $16,310,370 and $2,789,556 at fair value)

     16,518,312        3,008,628   

Derivative liabilities

     1,277,302        —     

Other liabilities

     12,681        60   
                

Total liabilities

     31,478,464        20,520,012   
                

Stockholders’ deficit:

    

Ambac Financial Group, Inc.:

    

Preferred stock

     —          —     

Common stock

     3,080        2,944   

Additional paid-in capital

     2,185,134        2,172,656   

Accumulated other comprehensive income (loss)

     219,939        (24,827

Accumulated deficit

     (4,031,055     (3,878,015

Common stock held in treasury at cost

     (454,203     (560,543
                

Total Ambac Financial Group, Inc. stockholders’ deficit

     (2,077,105     (2,287,785

Noncontrolling interest

     654,426        654,140   
                

Total stockholders’ deficit

     (1,422,679     (1,633,645
                

Total liabilities and stockholders’ deficit

   $ 30,055,785      $ 18,886,367   
                

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

3


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

 

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

(Dollars in Thousands, Except Share Data)

   2010     2009     2010     2009  

Revenues:

        

Financial Guarantee:

        

Net premiums earned

   $ 167,005      $ 177,732      $ 292,236      $ 374,544   

Net investment income

     69,028        125,506        186,598        226,381   

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     (7,777     (675,394     (41,245     (1,420,135

Portion of loss recognized in other comprehensive income

     290        —          2,409        —     
                                

Net other-than-temporary impairment losses recognized in earnings

     (7,487     (675,394     (38,836     (1,420,135
                                

Net realized investment gains

     18,281        7,710        73,420        6,159   

Change in fair value of credit derivatives:

        

Realized (losses) gains and other settlements

     (2,777,295     (5,053     (2,767,371     1,570   

Unrealized gains

     2,979,476        6,016        2,802,413        1,545,243   
                                

Net change in fair value of credit derivatives

     202,181        963        35,042        1,546,813   

Other (loss) income

     (30,243     39,221        (86,146     40,944   

(Loss) income on variable interest entities

     (38,546     33        (531,250     44   

Financial Services:

        

Investment income

     8,861        19,004        18,129        39,888   

Derivative products

     (70,957     (44,219     (129,184     (58,418

Other-than-temporary impairment losses:

        

Total other-than-temporary impairment losses

     (3,079     (186,708     (3,079     (272,198

Portion of loss recognized in other comprehensive income

     —          —          —          —     
                                

Net other-than-temporary impairment losses recognized in earnings

     (3,079     (186,708     (3,079     (272,198
                                

Net realized investment gains (losses)

     65,832        (2,310     67,242        114,236   

Net change in fair value of total return swap contracts

     —          22,052        —          11,671   

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

     (11,556     7,529        (14,295     7,690   

Corporate and Other:

        

Other income

     1,157        32,000        1,461        32,216   

Net realized gains

     10,693        —          10,693        33   
                                

Total revenues

     381,170        (476,881     (117,969     649,868   
                                

Expenses:

        

Financial Guarantee:

        

Losses and loss expenses

     323,326        1,230,847        412,478        1,970,677   

Underwriting and operating expenses

     58,931        48,842        109,427        105,454   

Interest expense

     6,886        —          6,886        —     

Financial Services:

        

Interest from investment and payment agreements

     4,357        8,311        9,791        21,100   

Other expenses

     3,124        3,541        6,751        7,492   

Corporate and Other:

        

Interest

     29,597        29,837        59,756        59,683   

Other expenses

     12,645        (3,337     24,593        684   
                                

Total expenses

     438,866        1,318,041        629,682        2,165,090   
                                

Pre-tax loss from continuing operations

     (57,696     (1,794,922     (747,651     (1,515,222

(Benefit) provision for income taxes

     (122     573,861        (15     1,245,761   
                                

Net loss

   $ (57,574   $ (2,368,783   $ (747,636   $ (2,760,983

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

     (15     11        (26     (2
                                

Net loss attributable to Ambac Financial Group, Inc.

   $ (57,559   $ (2,368,794   $ (747,610   $ (2,760,981
                                

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

   $ (0.20   $ (8.24   $ (2.59   $ (9.60

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

   $ (0.20   $ (8.24   $ (2.59   $ (9.60

Weighted-average number of common shares outstanding:

        

Basic

     290,050,931        287,639,234        289,147,236        287,602,413   

Diluted

     290,050,931        287,639,234        289,147,236        287,602,413   

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

4


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

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

Cost
    Noncontrolling
Interest
 

Balance at January 1, 2010

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

Comprehensive loss:

                     

Net loss

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

Other comprehensive loss:

                     

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

     277,271        277,271          277,271                

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

     (752     (752       (752             

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

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

Other comprehensive gain

     242,281        242,281                    
                                 

Total comprehensive loss

   $ (505,355   $ (505,355                 
                                 

Adjustment to initially apply ASU 2009-17

     705,046          702,042        3,004                

Dividends declared – subsidiary shares to non-controlling interest

     (816       (816               

Issuance of stock

     9,618                 136      9,482     

Stock-based compensation

     (103,867       (106,656     (207           2,996     

Cost of shares acquired

     (316                    (316  

Shares issued under equity plans

     106,656                       106,656     
                                                               

Balance at June 30, 2010

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

Balance at January 1, 2009

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

Sale of subsidiary shares to noncontrolling interest

     100,000                         100,000   

Retirement of shares issued to noncontrolling interest

     (1,806                 20,769        (22,575

Comprehensive loss:

                     

Net loss

     (2,760,983   $ (2,760,983     (2,760,981                  (2
                                 

Other comprehensive loss:

                     

Unrealized losses on securities, net of deferred income taxes of $736,606

     1,470,047        1,470,047          1,470,047                

Gain on derivative hedges, net of deferred income taxes of $294

     546        546          546                

Gain on foreign currency translation, net of deferred income taxes of $36,203

     78,314        78,314          77,005                   1,309   
                                 

Other comprehensive loss

     1,548,907        1,548,907                    
                                 

Total comprehensive loss

   $ (1,212,076   $ (1,212,076                 
                                 

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

     (381,716       (381,716               

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

     —            102,065        (102,065             

Dividends declared – subsidiary shares to non-controlling interest

     (10,254       (10,254               

Stock-based compensation

     (19,884       (28,393             8,509     

Cost of shares acquired

     (97)                       (97)     

Shares issued under equity plans

     28,511                       28,511     
                                                               

Balance at June 30, 2009

   $ (4,586,444     $ (6,630,047   $ (224,665   $ —      $ 2,944    $ 2,059,309    $ (565,904   $ 771,908   
                                                               

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

5


Table of Contents

Ambac Financial Group Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

     Six Months Ended
June 30,
 

(Dollars in Thousands)

   2010     2009  
    

Cash flows from operating activities:

    

Net loss attributable to common shareholders

   $ (747,610   $ (2,760,981

Noncontrolling interest in subsidiaries’ earnings

     (26     (2
                

Net loss

     (747,636     (2,760,983

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

    

Depreciation and amortization

     1,718        1,454   

Amortization of bond premium and discount

     (78,607     (71,569

Share-based compensation

     3,012        8,510   

Current income taxes

     443,822        2,174   

Deferred income taxes

     —          1,243,586   

Deferred acquisition costs

     16,446        (10,851

Unearned premiums, net

     (858,448     (353,575

Loss and loss expense, net

     262,604        1,305,316   

Ceded premiums payable

     (67,103     (102,440

Investment income due and accrued

     25,067        34,929   

Premium receivables

     928,805        262,178   

Accrued interest payable

     11,220        (31,874

Net mark-to-market (gains) losses

     (2,788,118     (1,564,604

Net realized investment gains

     (151,355     (120,428

Other-than-temporary impairment charges

     41,915        1,692,333   

Variable interest entity activities

     531,250        —     

Other, net

     72,175        (253,398
                

Net cash (used in) operating activities

     (2,353,233     (719,242
                

Cash flows from investing activities:

    

Proceeds from sales of bonds

     2,339,636        1,326,295   

Proceeds from matured bonds

     386,191        320,845   

Purchases of bonds

     (661,755     (736,963

Change in short-term investments

     447,227        392,157   

Loans, net

     9,562        400,850   

Recoveries from impaired investments

     —          13   

Change in swap collateral receivable

     64,448        315,107   

Cash acquired in consolidation of variable interest activities

     —          1,013,260   

Other, net

     10,851        (2,052
                

Net cash provided by investing activities

     2,596,160        3,029,499   
                

Cash flows from financing activities:

    

Dividends paid – subsidiary shares to noncontrolling interest

     (817     (10,254

Proceeds from issuance of investment and payment agreements

     1,253        23,531   

Payments for investment and payment draws

     (213,106     (1,430,699

Proceeds from the issuance of subsidiary shares to noncontrolling interest

     —          100,000   

Retirement of subsidiary shares to noncontrolling interest

     —          (1,806

Capital issuance costs

     —          (297

Net cash collateral paid/received

     (85,659     31,716   
                

Net cash (used in) financing activities

     (298,329   $ (1,287,809
                

Net cash flow

     (55,402     1,022,448   

Cash at January 1

     112,079        107,811   
                

Cash at June 30

   $ 56,677      $ 1,130,259   
                

Supplemental disclosure of cash flow information:

    

Cash paid during the year for:

    

Income taxes

   $ —        $ —     

Interest expense on long-term debt

   $ 44,358      $ 56,658   

Interest on investment agreements

   $ 10,529      $ 27,587   

Supplement disclosure of noncash financing activities:

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

See accompanying Notes to Consolidated Unaudited Financial Statements.

 

6


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

(Dollars in thousands, except share amounts)

(1) Background and Basis of Presentation

Ambac Financial Group, Inc. (“Ambac” or the “Company”) is a holding company incorporated in the state of Delaware. Ambac, through its subsidiaries, provided financial guarantees and financial services to entities in both the public and private sectors around the world. The long-term senior unsecured debt of Ambac is rated CC with a negative outlook by Standard & Poor’s Ratings Service, a Standard & Poor’s Financial Services LLC business (“S&P”), and C by Moody’s Investors Services, Inc. (“Moody’s”). Ambac’s principal financial guarantee operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance”), a guarantor of public finance and structured finance obligations, has an R (Regulatory Intervention) financial strength rating by S&P, and a Caa2 financial strength rating on review for possible upgrade from Moody’s.

Ambac’s principal business strategy going forward is to increase the residual value of our financial guarantee business by mitigating losses on poorly performing transactions and maximizing the yield on its investment portfolio. The Company’s existing investment agreement and derivative product portfolios are in active runoff, which may result in transaction terminations, settlements, restructuring, assignments of and scheduled amortization of contracts. In the course of managing the inherent risks of these portfolios during runoff, the Financial Services segment may enter into new financial instrument transactions for hedging purposes to the extent we are able to do so.

The financial strength rating downgrades and regulatory actions taken to date with respect to Ambac Assurance have adversely impacted Ambac’s ability to generate new business and will negatively impact Ambac’s future business, operations and financial results. Further, given the liquidity concerns at Ambac, the constraints imposed upon Ambac Assurance by the covenants made for the benefit of the Segregated Account and the Counterparties to the Settlement Agreement (as described in Recent Developments below), and the authority of the rehabilitator of the Segregated Account to control the management of the Segregated Account, there can be no assurance that Ambac will be successful in realizing any of the foregoing strategies. 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, 2010 and December 31, 2009 and for the three and six months ended June 30, 2010 and 2009 are prepared assuming the Company continues as a going concern and do not include any adjustment that might result from its inability to continue as a going concern.

Recent Developments:

Ambac’s Financial Condition

Ambac’s liquidity and solvency, both on a near-term basis and a long-term basis, are largely dependent on dividends from Ambac Assurance and on the value of Ambac Assurance. Ambac’s principal uses of liquidity are for the payment of principal (including maturing principal in the amount of $122.2 million on its 9.375% senior notes due August 2011) and interest on its debt (including annual interest expense of approximately $86.8 million, after taking into account the deferral of interest on the DISCs), and its operating expenses. Further, other contingencies (e.g., an unfavorable outcome in the outstanding class action lawsuits against Ambac) could cause additional strain on its capital and liquidity. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future.

While management believes that Ambac will have sufficient liquidity to satisfy its needs into the second quarter of 2011, no guarantee can be given that it will be able to pay all of its operating expenses and debt service obligations, and its liquidity may run out prior to the second quarter of 2011. Ambac

 

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is currently pursuing raising additional capital and is also pursuing a restructuring of its outstanding debt through a prepackaged bankruptcy proceeding. There can be no assurance that any definitive agreement will be reached. If Ambac is unable to effectuate one of these strategic alternatives in the near term, then Ambac would likely need to seek relief under Chapter 11 of the United States Bankruptcy Code without agreement with major creditor groups concerning a plan of reorganization. Ambac may decide not to pay interest on its debt prior to filing a prepackaged bankruptcy or seeking other relief under the bankruptcy Code.

Segregated Account

On March 24, 2010, Ambac Assurance acquiesced to the request of the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”) to establish a segregated account pursuant to Wisc. Stat. §611.24(2) (the “Segregated Account”). Under Wisconsin insurance law, the Segregated Account is a separate insurer from Ambac Assurance for purposes of the Segregated Account Rehabilitation Proceedings (as defined and described below). The purpose of the Segregated Account is to segregate certain segments of Ambac Assurance’s liabilities. The Segregated Account will be operated in accordance with a Plan of Operation (the “Plan of Operation”) and certain operative documents relating thereto (which include the Secured Note, the Reinsurance Agreement, the Management Services Agreement and the Cooperation Agreement). These operative documents provide that the Segregated Account will act exclusively through the rehabilitator. Pursuant to the Plan of Operation, Ambac Assurance has allocated to the Segregated Account (1) certain policies insuring or relating to credit default swaps; (2) residential mortgage-backed securities (“RMBS”) policies; (3) certain Student Loan Policies (as defined below); and (4) other policies insuring obligations with substantial projected impairments or relating to transactions which have contractual triggers based upon Ambac Assurance’s financial condition or the commencement of rehabilitation, which triggers are potentially damaging (collectively, the “Segregated Account Policies”). The policies described in (4) above include (a) certain types of securitizations, including commercial asset-backed transactions, consumer asset-backed transactions and other types of structured transactions; (b) the policies relating to Las Vegas Monorail Company; (c) policies relating to debt securities purchased by, and the debt securities issued by, Juneau Investments, LLC and Aleutian Investments, LLC, which are both finance companies owned by Ambac Assurance; (d) policies relating to leveraged lease transactions; and (e) policies relating to interest rate, basis, and/or currency swap or other swap transactions. Ambac Assurance also allocated the following to the Segregated Account: (i) all remediation claims, defenses, offsets, and/or credits (except with respect to recoveries arising from remediation efforts or reimbursement or collection rights), if any, in respect of the Segregated Account Policies, (ii) Ambac Assurance’s disputed contingent liability, if any, under the long-term lease with One State Street, LLC, and its contingent liability (as guarantor), if any, under the Ambac Assurance UK Limited (“Ambac UK”) lease with British Land, (iii) Ambac Assurance’s limited liability interests in Ambac Credit Products, LLC (“ACP”), Ambac Conduit Funding LLC, Aleutian Investments, LLC (“Aleutian”) and Juneau Investments, LLC (“Juneau”) and (iv) all of Ambac Assurance’s liabilities as reinsurer under reinsurance agreements (except for reinsurance assumed from Everspan). Net par exposure allocated to the Segregated Account is $57,610,863 as of June 30, 2010, which is inclusive of net par exposures assumed under reinsurance contracts, primarily from Ambac UK, in an aggregate amount of $20,973,633.

On March 24, 2010, the OCI commenced rehabilitation proceedings with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit the OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. The rehabilitator of the Segregated Account is Sean Dilweg, the Commissioner of Insurance of the State of Wisconsin. On March 24, 2010, the rehabilitation court also issued an injunction effective until further order of the court enjoining certain actions by Segregated Account policyholders and other counterparties, including the

 

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assertion of damages or acceleration of losses based on early termination and the loss of control rights in insured transactions. Certain Segregated Account policyholders have filed lawsuits challenging the Segregated Account Rehabilitation Proceedings (see “Legal Proceedings”).

Pursuant to the Verified Petition filed in Wisconsin in connection with such proceedings, the OCI has stated that it will seek the approval of the rehabilitation court for a plan of rehabilitation with respect to the Segregated Account (the “Segregated Account Rehabilitation Plan”). The Verified Petition states that the Segregated Account Rehabilitation Plan will, if approved, provide, among other things, that the holders of Segregated Account Policies shall receive in respect of claims made a combination of (i) cash and (ii) surplus notes (the “Segregated Account Surplus Notes”) with the same terms as the Ambac Assurance Surplus Notes (as defined below). Until the Segregated Account Rehabilitation Plan is approved, which OCI has indicated will be filed approximately six months after the rehabilitation proceedings were commenced, it is anticipated that no claims will be paid on Segregated Account Policies, except as approved by the rehabilitation court. In July 2010, the Segregated Account issued $50,000 of Segregated Account Surplus Notes in connection with a commutation of an insurance policy allocated to the Segregated Account.

Ambac Assurance has issued a $2,000,000 secured note due in 2050 (the “Secured Note”) to the Segregated Account. The Segregated Account has the ability to demand payment from time to time to pay claims and other liabilities. The balance of the secured note is $1,982,885 at June 30, 2010, inclusive of capitalized interest since the date of issuance. In addition, once the Secured Note has been exhausted, the Segregated Account has the ability to demand payment from time to time under an aggregate excess of loss reinsurance agreement provided by Ambac Assurance (the “Reinsurance Agreement”) to pay claims and other liabilities. Ambac Assurance is not obligated to make payments on the Secured Note or under the Reinsurance Agreement if its surplus as regards to policyholders is (or would be) less than $100,000, or such higher amount as the OCI permits pursuant to a prescribed accounting practice (the “Minimum Surplus Amount”). As long as the surplus as regards to policyholders is not less than the Minimum Surplus Amount, payments by the general account of Ambac Assurance (the “General Account”) to the Segregated Account under the Reinsurance Agreement are not capped. In addition, the Plan of Operation (as defined below) provides that the General Account may issue surplus notes directly to holders of Segregated Account Policies to satisfy the portion of claim liability not paid by the Segregated Account in cash or in Segregated Account Surplus Notes. There is no Wisconsin insurance fund available to pay claims.

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

The Secured Note will be subject to mandatory prepayment on demand in an amount equal to (i) the cash portion of claim liabilities, loss settlements, commutations and purchases of Segregated Account Policies (or related insured obligations) due and payable by the Segregated Account (“Segregated Account Policy Cash Payments”), amounts due and payable by the Segregated Account arising out of the non-policy obligations allocated thereto, and any cash interest payment and cash principal repayment under any Segregated Account Surplus Notes in connection with any of the foregoing, provided in each case such amounts due and payable are in accordance with the Segregated

 

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Account Rehabilitation Plan (as defined below) and not otherwise disapproved by the rehabilitator of the Segregated Account plus (ii) amounts due and payable by the Segregated Account in respect of specified administrative expenses of the Segregated Account plus (iii) other amounts directed to be paid by the rehabilitator of the Segregated Account in conjunction with the rehabilitation proceeding, minus (iv) the amount of the Segregated Account’s liquid assets as determined by the Segregated Account. In addition, if an event of default occurs under the Secured Note, the Segregated Account is entitled to accelerate the outstanding principal amount due under the Secured Note.

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

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

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

During the Segregated Account Rehabilitation Proceedings, the rehabilitator of the Segregated Account has the authority to control the management of the Segregated Account. Ambac Assurance will provide certain management and administrative services to the Segregated Account and the rehabilitator pursuant to a Management Services Agreement (the “Management Services Agreement”), including information technology services, credit exposure management, treasury, accounting, tax, management information, risk management, loss management, internal audit services and business continuity services. Services will be provided at cost, subject to mutual agreement of the Segregated Account and Ambac Assurance. Either party may terminate the Management Services Agreement for cause upon 120 days written notice (or such shorter period as the rehabilitator may determine) and the Segregated Account

 

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may terminate without cause at any time upon at least 30 days prior notice. If the Segregated Account elects to terminate the Management Services Agreement, Ambac Assurance will not have the right to consent to the replacement services provider.

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

Settlement Agreement

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

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

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

Pursuant to a commutation agreement entered into with each of the Counterparties that is a party to credit default swaps written by ACP with respect to certain CDO of ABS obligations and related financial guaranty insurance policies written by Ambac Assurance with respect to ACP’s obligations thereunder, Ambac Assurance and ACP have commuted all of such obligations (the “Commuted CDO of

 

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

At June 30, 2010, the Ambac Assurance Surplus Notes are reported in long-term debt on the consolidated balance sheet with a carrying value of $200,086 based on an imputed interest rate of 53.9% at the date of issuance and have a scheduled maturity of June 7, 2020. Interest on the Ambac Assurance Surplus Notes is payable annually at the rate of 5.1% on the unpaid principal balance outstanding. All payments of principal and interest on the Ambac Assurance Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the Ambac Assurance Surplus Notes, such interest will accrue and compound annually until paid. The Ambac Assurance Surplus Notes were issued pursuant to a Fiscal Agency Agreement entered into on June 7, 2010 with The Bank of New York Mellon, as fiscal agent (the “Fiscal Agency Agreement”).

Ambac Assurance has entered into call options with certain of the Counterparties pursuant to which, with the prior consent of OCI, Ambac Assurance may repurchase Ambac Assurance Surplus Notes from such Counterparties. As of the date hereof, Ambac Assurance has options to call an aggregate of $940,000 in principal amount of Ambac Assurance Surplus Notes at a weighted average call price of $0.22 per $1.00 face amount. At June 30, 2010, these options have a weighted average maturity of approximately 29 months.

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

Ambac UK

Pursuant to the Amended and Restated 1997 Reinsurance Agreement between Ambac UK and Ambac Assurance (the “AUK Reinsurance Agreement”), Ambac Assurance reinsures on a quota share basis 90% of the liabilities under policies issued by Ambac UK, and reinsures on an excess of loss basis Ambac UK policy liabilities in excess of £500,000 per anum. Ambac UK has sent Ambac Assurance notices of termination with respect to the AUK Reinsurance Agreement in which Ambac UK demands payment of unearned premium reserves, loss reserves and loss adjustment expense reserves related to the reinsured policies, less ceding commissions and certain adjustments. Ambac Assurance has not agreed or accepted that the purported termination of the AUK Reinsurance Agreement was valid.

Pursuant to the Segregated Account Rehabilitation Proceedings, the liabilities of Ambac Assurance under the AUK Reinsurance Agreement have been allocated to the Segregated Account; as such, the rehabilitator of the Segregated Account will determine the actions, if any, to be taken in respect of the AUK Reinsurance Agreement.

 

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Impact of Settlement Agreement and Segregated Account Rehabilitation Proceeding on Ambac

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

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

Tax Treatment of Surplus Notes

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

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

If the Surplus Notes are characterized as equity of Ambac Assurance and it is determined the

 

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

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

Reclassifications:

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

(2) Net income per Share

ASC Paragraph 260-10-65-2 of ASC Topic 260, Earnings Per Share, effective for fiscal years beginning after December 15, 2008, clarified that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method, which Ambac adopted in 2009. Retrospective application is required. Ambac had participating securities consisting of nonvested common stock with the same voting and dividend rights as our common stock. These shares of common stock vested in January 2010. Basic net income per share is computed by dividing net income available to common stockholders less income allocated to participating securities, by the weighted-average number of common shares outstanding during the period. No income was allocated to participating securities outstanding during the three and six months ended June 30, 2010 or three and six months ended June 30, 2009. Common shares outstanding includes common stock issued less treasury shares plus restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding during the period, plus all dilutive potential common shares outstanding during the period. All dilutive potential common shares outstanding consider common stock deliverable pursuant to stock options, nonvested restricted stock units, nonvested common shares, and stock purchase contracts. There were no dilutive effects for the three and six months ended June 30, 2010 and 2009. The following table presents securities outstanding that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because they were antidilutive for the three and six months ended June 30, 2010 and 2009:

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009

Stock options

   2,843,528    3,853,423    2,908,148    3,960,834

Restricted stock and units

   2,194,464    3,412,015    2,259,637    3,280,114

Stock purchase contracts

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

 

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

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

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

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

Ambac has engaged in transactions with special purpose entities, including VIEs, in various capacities. Ambac has provided financial guarantees, including credit derivative contracts for various debt obligations issued by various entities, including VIEs. Ambac has also sponsored two special purpose entities that issue medium-term notes to fund the purchase of certain financial assets. Finally,

 

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

 

Ambac is an investor in mortgage-backed and other asset-backed securities issued by VIEs and its ownership interest is generally insignificant to the VIE and/or Ambac does not have rights that direct the activities that are most significant to such VIE.

Financial Guarantees:

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

We determined that Ambac generally has the obligation to absorb the VIE’s expected losses given that we have issued financial guarantees supporting the liabilities (and in certain cases assets) of a VIE. We also determined for certain transactions that experienced the aforementioned performance deterioration, that we had the power, through voting rights or similar rights, to direct the activities of certain VIEs that most significantly impact the VIE’s economic performance because: a) certain triggers had been breached in these transactions resulting in Ambac having the ability to exercise certain loss remediation activities, or b) due to the passive nature of the VIEs’ activities, Ambac’s contingent loss remediation rights upon a breach of certain triggers in the future is considered to be the power to direct the activities that most significantly impact the VIEs’ economic performance.

Ambac Sponsored VIEs:

A subsidiary of Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These special purpose entities are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve these entities. The permitted activities of these entities are limited to those outlined below. As a result of the adoptions of both ASU-2009-16 and ASU 2009-17 on January 1, 2010, Ambac was required to consolidate these VIEs on January 1, 2010. As mentioned below, effective March 24, 2010, Ambac was required to deconsolidate these entities because Ambac’s policies issued to these entities have been allocated to the Segregated Account of Ambac Assurance. The consolidation of these entities did not have any effects on Ambac’s beginning retained earnings as these entities were accounted for at fair value before initial consolidation. Prior to 2010 and upon deconsolidation, Ambac has elected to account for its equity interest in these entities at fair value under the fair value option in accordance with ASC Topic 825, Financial Instruments. We believe that the fair value of these investments in these entities provides for greater transparency for recording profit or loss as compared to the equity method under ASC Topic 323,

 

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

 

Investments – Equity Method in Joint Ventures. At June 30, 2010 and December 31, 2009 the fair value of these entities is $20,512 and $18,843, respectively, and is reported within Other Assets within the Consolidated Balance Sheets. The change in fair value of these entities for the three months ended June 30, 2010 and June 30, 2009, is $3,585 and ($360), respectively, and is included within Other Income on the Consolidated Statements of Operations. The change in fair value of these entities for the six months ended June 30, 2010 and June 30, 2009, is ($1,668) and ($902), respectively.

As of June 30, 2010, there have been 15 individual transactions with these entities, of which 7 are outstanding. In each case, Ambac sold fixed income debt obligations to these entities. The fixed income debt obligations are composed of asset-backed securities and utility obligations with a weighted average rating of BBB+ and weighted average life of 6.6 years at June 30, 2010. The purchase by these entities is financed through the issuance of medium-term notes (“MTNs”), which are cross-collateralized by the purchased assets. The MTNs have the same expected weighted average life as the purchased assets. Derivative contracts (interest rate and currency swaps) may be used within the entities for economic hedging purposes only. Hedges are established at the time MTNs are issued to purchase financial assets. The activities of these entities are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued and/or the related derivative contracts. As of June 30, 2010, Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities.

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

There were no assets sold to these entities during the six months ended June 30, 2010 and the year ended December 31, 2009. Ambac Assurance received premiums for issuing the financial guarantee policies on the assets, MTNs and derivative contracts of $719 and $1,319 for the three months ended June 30, 2010 and 2009, respectively; and $1,536 and $2,640 for the six months ended June 30, 2010 and 2009, respectively. Ambac paid claims to these entities of $0 and $27,071 for the three months ended June 30, 2010 and 2009, respectively, and $24,411 and $42,588 for the six months ended June 30, 2010 and 2009, respectively, under these financial guarantee contracts. Ambac also received fees for providing other services amounting to $20 and $62 for the three months ended June 30, 2010 and 2009, respectively, and $37 and $108 six months ended June 30, 2010 and 2009, respectively.

Derivative contracts are provided by Ambac Financial Services to these entities. Consistent with other non-hedging derivatives, Ambac Financial Services accounts for these contracts on a trade date basis at fair value. Ambac Financial Services received $5,161, and $4,502 for the three months ended June 30, 2010 and 2009, respectively; and $6,310 and $1,550 six months ended June 30, 2010 and 2009, respectively, under these derivative contracts.

 

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

 

Consolidation of VIEs:

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

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

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

As a result of adopting ASU 2009-17, a cumulative effect gain adjustment of $705,046 was recorded as a net increase to total equity as of January 1, 2010 (increase in assets of $21,960,991 offset by an increase in liabilities of $21,255,945), which includes changes to the opening balance of retained earnings and accumulated other comprehensive loss, net of taxes as Ambac was required to consolidate 83 additional VIEs. The types of entities that Ambac was required to consolidate included: (i) RMBS securitization trusts as a result of financial guarantee insurance policies on the senior debt of such trusts; (ii) collateralized debt obligation trusts as a result of credit derivative contracts issued to investors of the debt of such trust; (iii) international and other asset-backed securitizations as a result of insurance policies guarantying the debt of such financing entities; and (iv) other transactions, including the Ambac sponsored special purpose entities, Juneau and Aleutian. The net impact of consolidating these VIEs on Ambac’s balance sheet at adoption of ASU 2009-17 and ASU 2009-16 was as follows:

 

   

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

 

   

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

 

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

 

   

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

 

   

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

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

 

Addition of VIE assets

   $ 22,839,549   

Addition of VIE liabilities

     (22,525,422
        

Net VIE assets added upon adoption

     314,127   
  

Elimination of insurance assets

     (833,716

Elimination of insurance liabilities

     1,269,477   
        

Net insurance liabilities eliminated upon adoption

     435,761   
  

Elimination of intercompany invested assets

     (44,842
        

Net decrease of Shareholders’ deficit upon adoption

   $ 705,046   
        

As a result of the establishment of the Segregated Account and the rehabilitation proceedings with respect to the Segregated Account as discussed in Note 1, including the terms of the management agreement which permit OCI to terminate the agreement with Ambac at any point in time, Ambac no longer has the unilateral power to direct the activities of the VIEs that most significantly impact the entity’s economic performance for those insurance policies that were allocated to the Segregated Account. Accordingly, Ambac deconsolidated 49 VIEs, including 43 RMBS securitization trusts and certain other entities including the Ambac sponsored VIEs, Juneau and Aleutian, effective March 24, 2010. Juneau and Aleutian are related parties of Ambac. While the RMBS securitization and other trusts are not related parties of Ambac, the company continues to provide financial guarantee policies on the senior debt or assets of such trusts upon deconsolidation. The effect of this deconsolidation was to reverse a significant portion of the transition adjustment to adopt ASU 2009-17 on January 1, 2010 and to deconsolidate one additional VIE which was consolidated as of December 31, 2009, effectively re-establishing insurance accounting for such transactions.

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

 

   

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

 

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

 

   

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

As a result of the Settlement Agreement that Ambac Assurance entered into with Counterparties to credit default swaps, as discussed in Note 1, Ambac commuted certain CDO of ABS obligations and related financial guaranty insurance policies written by Ambac Assurance with respect to ACP’s obligations thereunder. Such obligations were Ambac’s only variable interests in the associated VIEs. Accordingly, Ambac no longer has the unilateral power to direct the activities of the VIEs that most significantly impact the entities’ economic performance, or any further involvement in these VIEs, and deconsolidated 17 VIEs during the second quarter of 2010. The deconsolidation of these VIEs has no impact on Ambac’s Consolidated Statements of Operations. However, VIE assets and liabilities are lower by $3,002,000 at June 30, 2010 compared to March 31, 2010, due to these CDS commutations.

As of June 30, 2010, consolidated VIE assets and liabilities relating to 24 consolidated entities were $18,013,305 and $17,811,602, respectively. As of December 31, 2009, consolidated VIE assets and liabilities were $3,276,615 and $3,012,170, respectively. Ambac is not primarily liable for the debt obligations issued by the VIEs. Ambac would only be required to make payments on these debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of the VIEs. Ambac evaluates the net income statement effects and earnings per share effects to determine attributions between Ambac and non-controlling interests as a result of consolidating a VIE. Ambac has determined that the net changes in fair value of most consolidated VIE assets and liabilities are attributable to Ambac due to Ambac’s interest through financial guarantee premium and loss payments with the VIE. VIE activities related to entities that remain consolidated as of June 30, 2010 resulted in a loss of $38,546 and $36,173 which is included in Financial Guarantee: (Loss) income on variable interest entities for the three and six months ended June 30, 2010, respectively.

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

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

 

     June 30, 2010    December 31, 2009

Investments:

     

Corporate obligations

   $ 1,801,557    $ 160,518

Residential mortgage-backed securities

     —        173,066

Other asset-backed securities

     —        192,363

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

 

     Estimated fair value    Unpaid principal balance

June 30, 2010:

     

Loans

   $ 15,992,650    $ 17,075,575

Long-term debt

   $ 16,310,370    $ 18,422,892

December 31, 2009:

     

Loans

   $ 2,428,352    $ 2,459,003

Long-term debt

   $ 2,789,556    $ 3,547,842

 

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

 

Loans at June 30, 2010 included loans receivable that are 90 or more past due, which had an aggregate unpaid principal balance of $30,677 and fair value of $11,786. See Note 11, Fair Value Measurements for disclosures about the valuation methodologies used to determine fair value of VIE assets and liabilities.

The total unpaid principal amount of variable interest entity notes outstanding were $18,630,834 and $3,766,914 as of June 30, 2010 and December 31, 2009, respectively. The range of final maturity dates of the variable interest entity notes outstanding is July 2010 to December 2047 as of June 30, 2010. As of June 30, 2010, the interest rates on the variable interest entity notes ranged from 0.72% to 12.63%.

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, 2010:

 

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

Global Structured Finance:

           

Collateralized debt obligations

   $ 23,717,893    $ 61,070    $ 139,114    $ 198,383

Mortgage-backed – residential

     39,950,909      1,115,639      3,806,575      345

Mortgage-backed – commercial

     886,122      —        —        7,280

Other consumer asset-backed

     14,409,156      161,390      774,395      11,342

Other commercial asset-backed

     23,870,425      954,814      918,504      7,124

Other

     9,853,819      146,118      619,194      1,672
                           

Total Global Structured Finance

     112,688,324      2,439,031      6,257,782      226,146

Global Public Finance

     40,567,359      637,137      855,691      9,935
                           

Total

   $ 153,255,683    $ 3,076,168    $ 7,113,473    $ 236,081
                           

 

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

(4) Net Premiums Earned

Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). For premiums received upfront, an unearned premium revenue (“UPR”) liability is established, which is initially recorded as the cash amount received. For installment premium transactions, a premium receivable asset and offsetting UPR liability is initially

 

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

 

established in an amount equal to: (i) the present value of future contractual premiums due (the “contractual” method) or, (ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable (the “expected” method), the present value of premiums to be collected over the expected life of the transaction. An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in a foreign currency are discounted using the appropriate risk-free rate for the respective currency. The weighted average risk-free rate and weighted average period of future premiums used to estimate the premium receivable at June 30, 2010 and December 31, 2009 is 3.1% and 2.7%, respectively, and 10.8 years and 10.2 years, respectively. Insured obligations consisting of homogeneous pools for which Ambac uses expected future premiums to estimate the premium receivable and UPR include residential mortgage-backed securities and consumer auto loans. As prepayment assumptions change for homogenous pool transactions, or if there is an actual prepayment for a “contractual” method installment transaction, the related premium receivable and UPR are adjusted in equal and offsetting amounts with no immediate effect on earnings using new premium cash flows and the then current risk free rate.

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

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

 

     June 30,
2010
    December 31,
2009
 

Premium receivable at December 31, 2009

   $ 3,718,158     

Impact of adoption of ASU 2009-17(1)

     (670,997  
          

Premium receivable at January 1, 2010 and 2009

     3,047,161      $ 4,622,858   

Premium payments received

     (145,667     (416,280

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

     (234,657     (628,421

Accretion of premium receivable discount

     43,538        111,587   

Deconsolidation of certain VIEs( 1)

     148,213        —     

Other adjustments (including foreign exchange)

     (69,235     28,414   
                

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

   $ 2,789,353      $ 3,718,158   
                

 

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

Similar to gross premiums, premiums ceded to reinsurers are paid either upfront or in installments. For premiums paid upfront, a deferred ceded premium asset is established which is initially recorded as the cash amount paid. For installment premiums, a ceded installment premiums payable liability and offsetting deferred ceded premium asset are initially established in an amount equal to: i) the present value of future contractual premiums due or, ii) if the underlying insured obligation is a homogenous pool of assets which are contractually prepayable, the present value of premiums to be paid

 

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

 

over the life of the transaction. An appropriate risk-free rate corresponding to the weighted average life of each policy and exposure currency is used to discount the future premiums contractually due or expected to be collected. Premiums ceded to reinsurers reduce the amount of premiums earned by Ambac from its financial guarantee insurance policies. For both up-front and installment premiums, ceded premiums written are primarily recognized in earnings in proportion to and at the same time the related gross premium revenue is recognized. For premiums paid to reinsurers on an installment basis, Ambac records the present value of future ceding commissions as an offset to ceded premiums payable, using the same assumptions noted above for installment premiums. The ceding commission revenue associated with the ceding premiums payable is deferred (as an offset to deferred acquisition cost) and recognized in income in proportion to ceded premiums.

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

 

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

Three months ended:

     

September 30, 2010

   $ 62,750    $ 90,978

December 31, 2010

     68,666      88,967

Twelve months ended:

     

December 31, 2011

     248,787      336,977

December 31, 2012

     229,962      308,605

December 31, 2013

     215,494      282,012

December 31, 2014

     204,869      260,842

Five years ended:

     

December 31, 2019

     880,242      1,071,073

December 31, 2024

     742,468      799,755

December 31, 2029

     614,308      577,853

December 31, 2034

     388,006      332,616

December 31, 2039

     147,678      128,140

December 31, 2044

     40,032      37,293

December 31, 2049

     10,485      10,572

December 31, 2054

     1,176      2,175

December 31, 2059

     5      3
             

Total

   $ 3,854,928    $ 4,327,861
             

 

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

When an issue insured by Ambac Assurance has been retired, including those retirements due to refunding or calls, the remaining unrecognized premium is recognized at that time to the extent the financial guarantee contract is legally extinguished. Accelerated premium revenue for retired obligations for the three and six months ended June 30, 2010 was $54,308 and $66,446, respectively. Accelerated

 

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

 

premium revenue for retired obligations for the three and six months ended 2009 was $33,797 and $74,801, respectively. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow (a pre-refunding). The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date or a specified call date. Ambac has evaluated the provisions in certain financial guarantee insurance policies issued on legally defeased obligations and determined those policies have not been legally extinguished and, therefore, premium revenue recognition has not been accelerated.

The table below shows premiums written on a gross and net basis for the three and six month periods ended June 30, 2010 and 2009:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Revenues:

        

Financial Guarantee:

        

Gross premiums written

   $ (41,735   $ (118,420   $ (191,135   $ (157,671

Ceded premiums written

     (1,678     158,511        16,938        187,546   
                                

Net premiums written

   $ (43,413   $ 40,091      $ (174,197   $ 29,875   
                                

(5) Losses and Loss Expenses

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

Ambac’s loss reserves are based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac’s surveillance group to track credit migration of insured obligations from period to period and update internal classifications and credit ratings for each transaction. Non-adversely classified credits are assigned a Class I or Survey List (“SL”) rating while adversely classified credits are assigned a rating of Class IA through Class V. The criteria for an exposure to be assigned an adversely classified credit rating includes the deterioration of an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), poor performance by the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of an insured securitization transaction is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related issue. For example, a servicer of a

 

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mortgage-backed securitization that does not remain current in its collection efforts could cause an increase in the delinquency and potential default of the underlying obligation. Similarly, loss severities increase when a servicer does not effectively handle loss mitigation activities such as (i) the advancing of delinquent principal and interest and of default related expenses which are deemed to be recoverable by the servicer, (ii) pursuit of loan charge-offs which maximize cash flows from the mortgage loan pool, and (iii) foreclosure and real estate owned disposition strategies and timelines.

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

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

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

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

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

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

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

CLASS II – “Substandard Requiring Intervention”

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

CLASS III – “Doubtful with Clear Potential for Loss”

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

 

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CLASS IV – “Imminent Default or Defaulted”

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

CLASS V – “Fully Reserved”

The credit has defaulted and payments have occurred. The claim payments are scheduled and known, reserves have been established to fully cover such claims, and no claim volatility is expected.

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

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

The discount factor applied to both of the above described approaches is based on a risk-free discount rate corresponding to the remaining expected weighted-average life of the exposure and the exposure currency. The discount factor is updated for the current risk-free rate each reporting period. The weighted average risk-free rate used to discount loss reserves at June 30, 2010 was 2.54%.

Additional surveillance activities applied to adversely classified credits can include various actions by Ambac. The most common actions include obtaining detailed appraisal information on collateral, more

 

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frequent meetings with the issuer’s or servicer’s management to review operations, financial condition and financial forecasts and more frequent analysis of the issuer’s financial statements. Senior management meets frequently with the surveillance group to review the status of their work to determine the adequacy of Ambac’s loss reserves and make any necessary adjustments.

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

 

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

 

Surveillance Categories  
     I/SL     IA     II     III     IV     V     Total  

Number of policies

   24      10      39      69      113      1      256   

Remaining weighted-average

contract period (in years)

   23      13      15      12      8      10      11   

Gross insured contractual payments outstanding:

              

Principal

   2,073,329      498,443      3,483,083      12,016,589      14,017,315      47      32,088,806   

Interest

   405,027      237,202      2,029,672      4,958,975      3,955,015      27      11,585,918   
                                          

Total

   2,478,356      735,645      5,512,755      16,975,564      17,972,330      74      43,674,724   
                                          

Gross undiscounted claim liability

   25,021      30,470      159,492      2,735,456      6,566,218      74      9,516,731   

Discount, gross claim liability

   (989   (10,003   (24,154   (379,635   (1,472,098   (26   (1,886,905
                                          

Gross claim liability before all subrogation and before reinsurance

   24,032      20,467      135,338      2,355,821      5,094,120      48      7,629,826   
                                          

Less:

              

Gross RMBS subrogation(1)

   —        —        —        —        (2,333,972   —        (2,333,972

Discount, RMBS subrogation

   —        —        —        —        82,990      —        82,990   
                                          

Discounted RMBS subrogation, before reinsurance

   —        —        —        —        (2,250,982   —        (2,250,982
                                          

Less:

              

Gross other subrogation(2)

   —        (2,685   (41   (690,439   (796,290   —        (1,489,455

Discount, other subrogation

   —        1,178      10      250,333      304,079      —        555,600   
                          

Discounted other subrogation, before reinsurance

   —        (1,507   (31   (440,106   (492,211   —        (933,855
                                          

Gross claim liability, net of all subrogation, before reinsurance

   24,032      18,960      135,307      1,915,715      2,350,927      48      4,444,989   
                                          

Less: Unearned premium reserves

   (11,517   (9,757   (48,054   (186,952   (157,474   —        (413,754

Plus: Loss adjustment expenses reserves

   —        —        —        —        116,420      —        116,420   
                                          

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

   12,515      9,203      87,253      1,728,763      2,309,873      48      4,147,655   
                                          

Reinsurance recoverable reported on Balance Sheet

   928      121      12,297      64,886      43,475      —        121,707   
                                          

 

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(1)    RMBS subrogation represents Ambac’s estimate of subrogation recoveries from RMBS transaction sponsors for representations and warranty breaches. Please see “Representation and Warranty Breaches by RMBS Transaction Sponsors” below for detailed discussion.
(2)    Represents subrogation other than RMBS subrogation as defined in (1) above.     
(3)    Claim liability reported is included in the Consolidated Balance Sheets as follows:     
   Loss and loss expense reserve (net of potential remediation subrogation of $441,959)    $ 5,221,886     
   Subrogation recoverable (includes gross potential remediation of $1,809,023)      (1,046,610  
   Other assets (within)      (27,619  
               
      $ 4,147,657     
               

Loss reserves on non-defaulted credits were $2,081,179 and $2,646,517 at June 30, 2010 and December 31, 2009, respectively. These loss reserves were comprised of 145 credits with net par of $17,162,233 at June 30, 2010 and 130 credits with net par of $21,424,301 at December 31, 2009. Loss reserves on defaulted credits were $1,846,050 and $1,098,352 at June 30, 2010 and December 31, 2009, respectively, comprising 110 credits with net par outstandings of $12,914,892 at June 30, 2010 and 85 credits with net par outstanding of $11,345,697 at December 31, 2009. Included in loss reserves at June 30, 2010 are $655,468 of claims that were presented and not paid under the claim moratorium on the Segregated Account, as required by the OCI. Loss expense reserves were also established for significant surveillance and mitigation expenses associated with adversely classified credits. Total loss expense reserves were $114,201 and $32,452 at June 30, 2010 and December 31, 2009, respectively. Loss reserves ceded to reinsurers at June 30, 2010 and December 31, 2009 were $106,570 and $64,311, respectively. Amounts were included in reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet.

Representation and Warranty Breaches by RMBS Transaction Sponsors:

In an effort to better understand the unprecedented levels of mortgage delinquencies, Ambac engaged consultants with significant mortgage lending experience to review the underwriting documentation for mortgage loans underlying certain insured RMBS transactions. These transactions which have exhibited exceptionally poor performance were chosen for further examination of the underwriting documentation supporting the underlying loans. Factors Ambac believes to be indicative of this poor performance include (i) increased levels of early payment defaults, (ii) the significant number of loan liquidations or charge-offs and resulting high level of losses, and (iii) the rapid elimination of credit protections inherent in the transactions’ structures. With respect to item (ii), “loan liquidations” refers to loans for which the servicer has liquidated the related collateral and the securitization has realized losses on the loan; “charge-offs” refers to loans which have been written off as uncollectible by the servicer, thereby generating no recoveries to the securitization, and may also refer to the unrecovered balance of liquidated loans. In either case, the servicer has taken such actions as it has deemed viable to recover against the collateral, and the securitization has incurred losses to the extent such actions did not fully repay the borrower’s obligations. Generally, the sponsor of the transaction provides representations and warranties with respect to the securitized loans including the loan characteristics, the absence of fraud or other misconduct in the origination process, including those attesting to the compliance of home loans with the prevailing underwriting policies. Per the transaction documents, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute any loan that breaches the representations and warranties. Substitution is generally limited to two years from the closing of the transaction and the cure remedy is permitted only to the extent cure is possible.

Subsequent to the forensic exercise of examining loan files to ascertain whether the loans conformed to the representations and warranties, we submit nonconforming loans to the sponsor for repurchase. For all of the transactions reviewed by Ambac, the substitution remedy is no longer available (i.e., more than two years have lapsed since the closing of the transaction). To effect a repurchase,

 

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

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

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

 

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

Due to the nature of the sampling methodology used, the subrogation recovery estimate we have recorded based on the above-described random sample approach includes all breached loans which we believe the sponsor is contractually required to repurchase, including extrapolation to a loan pool which includes loans which we do not anticipate defaulting (i.e. performing loans). In theory, a performing loan should have little or no effect on Ambac’s anticipated claim payments, regardless of whether or not the sponsor repurchases the loan. In other words, since there will be sufficient cash flows to service the notes in either situation (i.e. whether cash is received from a sponsor loan repurchase or whether cash is received from the underlying performing loan), there should be no claim payment under Ambac’s insurance policy. Nonetheless, we have recorded a subrogation recovery for certain performing loans because we believe the breaches of representations and warranties are so pervasive that a judicial court would deem it impractical to have the sponsor re-underwrite every loan in a given transaction and repurchase only individual loans that have breached. Rather, we believe there is established precedent for the utilization of a statistical sampling and extrapolation methodology across a population to prove liability and damages where it would be impractical to make a determination on an individual loan basis. We believe the court would likely require a monetary settlement based on a reasonable methodology, such as our random sample approach, and limit such a settlement to Ambac’s ever-to-date paid losses plus the present value of expected future paid losses for each policy. That is, the settlement monies would be either remitted directly to Ambac, placed in the securitization trust, or otherwise held under an arrangement for the benefit of the securitization trust; however, individual loans would not be repurchased from the trust. In either case those settlement monies would offset past and future Ambac claim payments. Consequently, since the sponsor is contractually obligated to repurchase those loans which breach representations and warranties regardless of whether they are current or defaulted, we believe the appropriate measure in estimating subrogation recoveries is to apply the breach rate to both performing and defaulted loans.

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

 

  (i) There is no extrapolation to the CULPB and realized losses under the adverse sample approach. At June 30, 2010, the adverse sample approach is used for 14 transactions that are with the same sponsor, who has limited our access to the underlying loan files and, therefore, a statistically valid random sample from the entire loan pool cannot be selected. This is in contrast to the transactions subject to the random sample approach where Ambac’s access to individual loan files has not been limited and the Company, therefore, has been able to develop a statistically valid representative sample.

 

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

 

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

Ambac has updated its estimated subrogation recoveries from $2,046.8 million ($2,026.3 million net of reinsurance) at December 31, 2009 to $2,251.0 million ($2,227.2 million net of reinsurance) at June 30, 2010. The balance of subrogation recoveries and the related claim liabilities at June 30, 2010 and December 31, 2009 are as follows:

 

($ in millions)

                       
      June 30, 2010  

Method

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

Adverse samples

   14 (2)    $ 1,497.2    $ (610.7   $ 886.5   

Random samples

   12 (3)      857.1      (1,640.3     (783.2
                             

Totals

   26      $ 2,354.3    $ (2,251.0   $ 103.3   
                             

 

($ in millions)

                      
      December 31, 2009  

Method

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

Adverse samples

   10    $ 759.4    $ (460.6   $ 298.8   

Random samples

   9      937.3      (1,586.2     (648.9
                            

Totals

   19    $ 1,696.7    $ (2,046.8   $ (350.1
                            

 

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

 

(1) The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the projected future paid losses for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than projected future paid losses, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability. Of the $2,251.0 million of subrogation recoveries recorded at June 30, 2010, $1,809.0 million was included in “Subrogation recoverable” and $442.0 million was included in “Loss and loss expense reserves.”
(2) Of these 14 transactions, 9 contractually require the sponsor to repurchase loans at the unpaid principal balance and 5 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest. However, for reasons discussed above in the description of the adverse sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor’s contractual repurchase obligation.
(3) Of these 12 transactions, 3 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest and 9 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest plus servicer advances/expense and/or trustee expenses. However, for reasons discussed above in the description of the random sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor’s contractual repurchase obligation.

While the obligation by sponsors to repurchase loans with material breaches is clear, generally the sponsors have not yet honored those obligations. Ambac’s approach to resolving these disputes has included negotiating with individual sponsors at the transaction level and in some cases at the individual loan level and has resulted in the repurchase of some loans. Ambac has utilized the results of the above described loan file examinations to make demands for loan repurchases from sponsors or their successors and, in certain instances, as a part of the basis for litigation filings. Ambac has initiated and will continue to initiate lawsuits seeking compliance with the repurchase obligations in the securitization documents. Ambac estimates that it will take approximately three years from the initiation of litigation with the sponsor to ultimate resolution. Based on this estimate as a basis for projecting the future subrogation cash flows, Ambac assumes, on average, approximately three and a half years to collect recoveries, discounted at a risk-free rate of 2.0%. Estimated recoveries will continue to be revised and supplemented as the scrutiny of the mortgage loan pools progresses.

We have performed the above-mentioned, detailed examinations on a variety of second-lien transactions and five first-lien transactions that have experienced exceptionally poor performance. However, the loan file examinations and related estimated recoveries we have reviewed and recorded to date have been limited to only those transactions whose sponsors (or their successors) are subsidiaries of large financial institutions, all of which carry an investment grade rating from at least one nationally recognized rating agency. A total of seven sponsors represent the 26 transactions which have been reviewed as of June 30, 2010. While our contractual recourse is generally to the sponsor/subsidiary, rather than to the financial institutional parent, each of these financial institutions has significant financial resources and an ongoing interest in mortgage finance, and we therefore believe that the financial institution/parent would not seek to disclaim financial responsibility for these obligations if the sponsor/subsidiary is unable to honor its contractual obligations or pay a judgement that we may obtain in litigation. Additionally, in the case of successor institutions, we are not aware of any provisions that explicitly preclude or limit the successors’ obligations to honor the obligations of the original sponsor. As a result, we did not make any significant adjustments to our estimated subrogation recoveries with respect to the credit risk of these sponsors (or their successors). We believe that focusing our loan remediation efforts on large financial institutions first will provide the greatest economic benefit to

 

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

 

Ambac. Ambac retains the right to review all RMBS transactions for representations and warranties breaches. Since a significant number of other second-lien and first-lien transactions are also experiencing poor performance, management is considering expanding the scope of this effort.

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

 

($ in millions)

   Random sample     # of
deals
   Adverse
Sample
    # of
deals

Rollforward:

         

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

   $ (1,586.2   9    $ (460.6   10
                         

Changes recognized in 2010:

         

Additional transactions reviewed

     (80.1   3      (87.5   4

Additional adverse sample loans reviewed

     —        n/a      (48.6   n/a

Loans repurchased by the sponsor

     —        n/a      9.5      n/a
                         

Subtotal of changes recognized in current period

     (80.1   12      (126.6   4
                         

Changes from re-estimation of opening balance:

         

Increase in estimated time to recovery

     7.4      n/a      18.0      n/a

Change in pre-recovery loss reserves

     21.1      n/a      (24.0   n/a

Other

     (2.5   n/a      (17.5   n/a
                         

Subtotal of changes from re-estimation of opening balance

     26.0      —        (23.5   —  
                         

Discounted RMBS subrogation (gross of reinsurance) at 6/30/10

   $ (1,640.3   12    $ (610.7   14
                         

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

 

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

 

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

 

($ in millions)    Six Months
Ended
June 30, 2010
 

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

   $ 3,777.3   

Impact of adopting ASU 2009-17(1)

     (503.8
        

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

     3,273.5   

Changes in the loss reserves due to:

  

Current year:

  

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

     141.0   

Claim payments, net of subrogation and reinsurance

     4.2   

Establishment of subrogation recoveries, net of reinsurance

     (82.4
        

Total current year

     62.8   

Prior year:

  

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

     472.3   

Change in previously established subrogation recoveries, net of reinsurance

     (118.5

Claim payments, net of subrogation recoverable and reinsurance

     (195.4
        

Total prior year

     158.4   

Changes in loss reserves

     221.2   

Deconsolidation of certain VIEs( 1)

     546.7   
        

Ending loss reserves, net of subrogation recoverable and reinsurance

   $ 4,041.4   
        

 

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

(6) Derivative Contracts

ASC Topic 815, Derivatives and Hedging, establishes accounting and reporting standards for derivative instruments. All derivatives, whether designated for hedging relationships or not, are required to be recorded on the Consolidated Balance Sheets at fair value. Methodologies used to determine fair value of derivative contracts, including model inputs and assumptions where applicable, are described further in Note 11, Fair Value Measurements. ASC Topic 815 requires enhanced qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The enhanced disclosures have been included in the discussion below.

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

 

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

 

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

All derivative contracts are recorded on the Consolidated Balance Sheets at fair value on a gross basis; assets and liabilities are netted by customer only when a legal right of offset exists. Ambac elects to not offset fair value amounts recognized for the right to reclaim cash collateral or futures margin or the obligation to return cash collateral against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement. The amounts representing the right to reclaim cash collateral and posted margin, recorded in “Other assets” were $71,209 and $119,456 as of June 30, 2010 and December 31, 2009, respectively. The amounts representing the obligation to return cash collateral, recorded in “Other liabilities” were $4,350 and $90,009 as of June 30, 2010 and December 31, 2009, respectively. The following tables summarize the location and fair values of individual derivative instruments reported in the Consolidated Balance Sheets as of June 30, 2010 and December 31, 2009. Amounts are presented gross of the effect of offsetting balances even where a legal right of offset exists:

 

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

June 30, 2010:

           

Derivatives held for trading

           

Credit derivatives

   Derivative assets    $ 209,619    Derivative liabilities    $ 241,009

Interest rate swaps

   Derivative assets      413,907    Derivative liabilities      194,339
   Derivative liabilities      1,856    Derivative assets      124,411

Currency swaps

   Derivative assets      7,262    Derivative liabilities      8,524
   Derivative liabilities      —      Derivative assets      2,253

Futures contracts

   Derivative assets      —      Derivative liabilities      9,820

Other contracts

   Derivative assets      —      Derivative liabilities      300
                   

Total derivatives held for trading

        632,644         580,656
                   

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

           

Interest rate swaps

   Derivative liabilities      —      Derivative liabilities      —  
                   

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

        —           —  
                   

Total derivatives

      $ 632,644       $ 580,656
                   

Variable Interest Entities

   Derivative assets    $ 4,546    Derivative liabilities    $ 1,277,302
                   

December 31, 2009:

           

Derivatives held for trading

           

Credit derivatives

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

Interest rate swaps

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

Currency swaps

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

Futures contracts

   Derivative assets      10,125    Derivative liabilities      —  

Other contracts

   Derivative assets      —      Derivative liabilities      717
                   

Total derivatives held for trading

        638,643         3,691,359
                   

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

           

Interest rate swaps

   Derivative assets      12,352    Derivative liabilities      —  
                   

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

        12,352         —  
                   

Total derivatives

      $ 650,995       $ 3,691,359
                   

Variable Interest Entities

   Derivative assets    $ 109,411    Derivative liabilities    $ —  
                   

 

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

 

Derivative Contracts Classified as Held for Trading Purposes:

Financial Guarantee Credit Derivatives:

Until the third quarter of 2007, Ambac’s subsidiary, Ambac Credit Products (“ACP”) sold credit protection by entering into credit derivatives, primarily in the form of credit default swap contracts (“CDS contracts”), with various financial institutions. In a limited number of contracts, the Company purchased credit protection on a portion of the risk written from reinsurance companies or other financial companies. Credit derivative assets included in the Consolidated Balance Sheets as of June 30, 2010 arose from such purchased credit default swaps.

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

In a small number of transactions, ACP is required to (i) make a payment equal to the difference between the par value and market value of the underlying obligation or (ii) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation. There are less than 25 transactions, which are not “pay-as-you-go”, with a combined notional of approximately $1,959,973 and a net liability fair value of $11,170 as of June 30, 2010. All except one deal carry an internal rating of A or better. These transactions are primarily in the form of CLOs written between 2002 and 2005.

Substantially all of ACP’s credit derivative contracts relate to structured finance transactions. Credit derivatives issued by ACP are insured by Ambac Assurance. None of our outstanding credit derivative transactions at June 30, 2010 include ratings based collateral-posting triggers or otherwise require Ambac to post collateral regardless of Ambac’s ratings or the size of the mark to market exposure to Ambac.

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

 

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

 

The following table summarizes the net par outstanding for CDS contracts, by Ambac rating, for each major category as of June 30, 2010:

 

Ambac Rating

   CLO    Other(1)    Total

AAA

   $ 808,075    $ 3,221,536    $ 4,029,611

AA

     9,190,133      907,664      10,097,797

A

     2,434,520      2,917,667      5,352,187

BBB

     43,094      825,789      868,883

Below investment grade

     132,171      —        132,171
                    
   $ 12,607,993    $ 7,872,656    $ 20,480,649
                    

 

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

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

June 30, 2010

 

     CDO of ABS    CLO     Other     Total  

Number of CDS transactions

     —        64        32        96   

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

     —        3.7        4.4        3.9   

Gross principal notional outstanding

   $ —      $ 12,607,993      $ 7,872,656      $ 20,480,649   

Hedge principal notional outstanding

   $ —        —          —          —     

Net derivative assets (liabilities) at fair value

   $ 209,619    $ (81,336   $ (159,673   $ (31,390

December 31, 2009

 

     CDO of ABS     CLO     Other     Total  

Number of CDS transactions

     19        76        37        132   

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

     25.3        4.2        4.8        12.5   

Gross principal notional outstanding

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

Hedge principal notional outstanding

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

Net derivative assets (liabilities) at fair value

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

The maximum potential amount of future payments under Ambac’s credit derivative contracts written on a “pay-as-you-go” basis is generally the gross principal notional outstanding amount included in the above table plus future interest payments payable by the derivative reference obligations. For contracts that are not written with pay-as-you-go terms, the maximum potential future payment is represented by the principal notional only. Since Ambac’s credit derivatives typically reference obligations of or assets held by SPEs that meet the definition of a VIE, the amount of maximum potential future payments for credit derivatives is included in the table in Note 3, Application of the New Consolidation Accounting Standard on Special Purpose Entities, including Variable Interest Entities.

Amounts paid under our written credit derivative contracts may be recoverable as a result of future payments of previously missed principal or interest payments by the reference obligation payor or purchased credit derivatives that hedge Ambac’s gross exposure to a written contract or future recoveries from reference obligation collateral acquired in connection with credit derivative settlements. Such collateral typically comprises securities and/or loans owned or referenced in the securitization structure on which Ambac provided senior credit protection. The fair value of purchased credit derivatives

 

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

 

included in net fair value of credit derivatives was $209,619 and $212,402 at June 30, 2010 and December 31, 2009, respectively. The credit derivative assets at June 30, 2010 represent the amount due under hedge contracts on certain of the company’s written credit derivative exposures that were commuted under the Settlement Agreement effective June 7, 2010 (as further described in Note 1).

Ambac’s credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under ASC Topic 815. Changes in fair value are recorded in “Net change in fair value of credit derivatives” on the Consolidated Statements of Operations. The “Realized gains and losses and other settlements” component of this income statement line includes (i) premiums received and accrued on written credit derivative contracts, (ii) premiums paid and accrued on purchased credit derivative contracts, (iii) losses paid and payable on written credit derivative contracts and (iv) paid losses recovered and recoverable on purchased credit derivative contracts for the appropriate accounting period. Losses paid and payable and losses recovered and recoverable reported in “Realized gains and losses and other settlements” include those arising after a credit event that requires a payment under the contract terms has occurred or in connection with a negotiated termination of a contract. Paid losses included in realized gains and losses and other settlements were $2,994,794 and $2,994,532 for the three and six months ended June 30, 2010, respectively, and $17,248 and $23,784 for the three and six months ended June 30, 2009, respectively. The “Unrealized gains (losses)” component of this income statement line includes all other changes in fair value, including reductions in the fair value of liabilities as they are paid or settled. Refer to Note 11 for a detailed description of the components of our credit derivative contracts’ fair value.

Although CDS contracts are accounted for at fair value in accordance with ASC Topic 815, they are surveilled similar to non-derivative financial guarantee contracts. As with financial guarantee insurance policies, Ambac’s surveillance group tracks credit migration of CDS contracts’ reference obligations from period to period. Adversely classified credits are assigned risk classifications by the surveillance group using the guidelines described above. As a result of the Settlement Agreement described in Note 1, there are no CDS contracts on Ambac’s adversely classified credit listing as of June 30, 2010.

Financial Services Derivative Products:

Ambac, through its subsidiary Ambac Financial Services, provided interest rate and currency swaps to states, municipalities and their authorities, asset-backed issuers and other entities in connection with their financings. The interest rate swaps provided typically require Ambac Financial Services to receive a fixed rate and pay either a tax-exempt index rate or an issue-specific bond rate on a variable-rate bond. Ambac Financial Services manages its interest rate swaps business with the goal of being market neutral to changes in benchmark interest rates while retaining some basis risk and some excess interest rate sensitivity as an economic hedge against the effects of rising interest rates on Ambac’s financial guarantee exposures. Within the trading derivatives portfolio, Ambac Financial Services enters into interest rate and currency swaps with professional counterparties and uses exchange traded U.S. Treasury futures with the objective of managing overall exposure to benchmark interest rates and currency risk exposure. Basis risk in the portfolio arises primarily from (i) variability in the ratio of benchmark tax-exempt to taxable interest rates, (ii) potential changes in the counterparty bond issuers’ bond-specific variable rates relative to taxable interest rates, and (iii) variability between Treasury and swap rates. The derivative portfolio also includes an unhedged Sterling-denominated exposure to Consumer Price Inflation in the United Kingdom. Ambac has economically hedged the risk of interest rate increases through Ambac Financial Service’s trading derivatives portfolio to mitigate floating rate obligations elsewhere in the Company, including in the credit derivative portfolio.

 

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

 

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

 

Type of derivative

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

Interest rate swaps—receive-fixed/pay-variable

   $ 1,663,796    $ 2,040,984

Interest rate swaps—pay-fixed/receive-variable

     2,940,118      2,862,866

Interest rate swaps—basis swaps

     231,250      641,370

Currency swaps

     117,390      1,165,213

Futures contracts

     378,000      394,200

Other contracts

     154,470      241,641

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

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

 

    

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

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

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

months ended
June 30, 2010
 

Financial Guarantee:

       

Credit derivatives

  

Net change in fair value of credit derivatives

   $ 202,182      $ 35,042   

Financial Services derivatives products:

       

Interest rate swaps

   Derivative products      (37,336     (15,707

Currency swaps

   Derivative products      1,875        (70,238

Futures contracts

   Derivative products      (35,184     (43,424

Other derivatives

   Derivative products      (372     102   
                   

Total Financial Services derivative products

        (71,017     (129,267
                   

Total derivative contracts held for trading purposes

      $ 131,165      $ (94,225
                   

 

40


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

 

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

 

    

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

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

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

months ended
June 30, 2009
 

Financial Guarantee:

       

Credit derivatives

  

Net change in fair value of credit derivatives

   $ 963      $ 1,546,813   

Financial Services derivatives products:

       

Interest rate swaps

  

Derivative products

     (48,417     (63,070

Currency swaps

  

Derivative products

     (4,551     (4,838

Total return swaps

  

Net change in fair value of total return swap contracts

     22,052        11,671   

Futures contracts

  

Derivative products

     8,460        8,460   

Other derivatives

  

Derivative products

     265        680   
                   

Total Financial Services derivative products

        (22,191     (47,097
                   

Total derivative contracts held for trading purposes

      $ (21,228   $ 1,499,716   
                   

Derivative Contracts used for Non-Trading and Hedging Purposes:

Interest rate and currency swaps are used to manage the risk of changes in fair value or cash flows caused by variations in interest rates and foreign currency exchange rates. These risks exist within the investment agreement business primarily related to differences in coupon interest terms between investment agreement contracts and invested assets that support those contracts. In order to qualify for hedge accounting, a derivative must be considered highly effective at reducing the risk associated with the exposure being hedged. Each derivative must be designated as a hedge, with documentation of the risk management objective and strategy, including identification of the hedging instrument, the hedged item, the risk exposure, and how effectiveness will be assessed prospectively and retrospectively. The extent to which a hedging instrument is effective at achieving offsetting changes in fair values or cash flows must be assessed at least quarterly. Any ineffectiveness must be reported in net income. Derivatives may be used for non-trading and hedging purposes, even if they do not meet the technical requirements for hedge accounting under ASC Topic 815. The number of designated hedges under ASC Topic 815 has been declining with the runoff of the investment agreement portfolio and, as of December 31, 2009, no accounting hedges remain in the company’s portfolio. In the second quarter 2010, all remaining derivatives of the investment agreement business were terminated.

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

 

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

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

     

Interest rate swaps

   $ —      $ 150,982

Interest rate and currency swaps are utilized to hedge exposure to changes in fair value of assets or liabilities resulting from changes in interest rates and foreign exchange rates, respectively. These interest rate and currency swap hedges are referred to as “fair value” hedges. If the provisions of the derivative contract meet the technical requirements for fair value hedge accounting under ASC Topic 815,

 

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

 

the change in fair value of the derivative contract, excluding accrued interest, is recorded as a component of “Net mark-to-market (losses) gains on non-trading derivative contracts” in the Consolidated Statements of Operations. The change in fair value of the hedged asset or liability attributable to the hedged risk adjusts the carrying amount of the hedged item and is recorded as a component of “Net mark-to-market (losses) gains on non-trading derivative contracts.” Changes in the accrued interest component of the derivative contract are recorded as an offset to changes in the accrued interest component of the hedged item. As noted above, all designated hedge relationships under ASC Topic 815 were terminated by December 31, 2009. There were no designated accounting hedges in 2010.

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

Three months ended June 30, 2009:

 

Derivatives in ASC Topic 815 Fair Value Hedging
Relationships

  

Location of Gain or (Loss)
Recognized in

Consolidated Statement of
Operations

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

Interest rate swaps

  

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

   $ (41,678   $ 42,400      $ 722   
  

Financial Services: Interest from investment and payment agreements

     2,678        (2,795     (117

Currency swaps

  

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

     302        (303     (1
  

Financial Services: Interest from investment and payment agreements

     8        (18     (10
                           

Total

      $ (38,690   $ 39,284      $ 594   
                           

Six months ended June 30, 2009:

 

         

Interest rate swaps

  

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

   $ (64,095   $ 64,949      $ 854   
  

Financial Services: Interest from investment and payment agreements

     5,268        (5,554     (286

Currency swaps

  

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

     (94     92        (2
  

Financial Services: Interest from investment and payment agreements

     35        (54     (19
                           

Total

      $ (58,886   $ 59,433      $ 547   
                           

Interest rate swaps are also utilized to hedge the exposure to changes in cash flows caused by variable interest rates of assets or liabilities. These interest rate swap hedges are referred to as “cash flow” hedges. The effective portion of the gains and losses on interest rate swaps that meet the technical requirements for cash flow hedge accounting under ASC Topic 815 is reported in “Accumulated Other Comprehensive Loss” in Stockholders’ Deficit. If the cumulative change in fair value of the derivative contract exceeds the cumulative change in fair value of the hedged item, ineffectiveness is required to be recorded in net income. All designated hedge relationships under ASC Topic 815 were terminated by

 

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

 

December 31, 2009. There were no designated accounting hedges in 2010. In the first quarter of 2010, all remaining deferred gains on derivative instruments previously reported in Accumulated Other Comprehensive Loss have been reclassified to net income resulting in a gain of $1,156, included in “Net mark-to-market gains (losses) on non-trading derivative contracts” for the six months ended June 30, 2010.

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

Three months ended June 30, 2009:

 

Derivatives in ASC Topic 815 Cash
Flow Hedge Relationships

   Amount of Gain
(Loss) Recognized
in OCI on
Derivatives
(Effective Portion)
    Location of Gain
(Loss) Reclassified
from AOCI into
Income (Effective
Portion)
   Amount of Gain
(Loss) Reclassified
from AOCI into
Income (Effective
Portion)
   Location of Gain or
(Loss) Recognized in
Income (Ineffective
Portion)
  Amount of Gain
(Loss) Recognized in
Income (Ineffective
Portion)

Interest rate swaps

   $ (458   Financial Services:
Investment income
   $ 874    Net mark-to-market
gains (losses) on
non-trading
derivative contracts
  $ 28

Six months ended June 30, 2009:

 

Derivatives in ASC Topic 815 Cash
Flow Hedge Relationships

   Amount of Gain
(Loss) Recognized
in OCI on
Derivatives
(Effective Portion)
    Location of Gain
(Loss) Reclassified
from AOCI into
Income (Effective
Portion)
   Amount of Gain
(Loss) Reclassified from
AOCI into Income
(Effective Portion)
    Location of Gain or
(Loss) Recognized in
Income  (Ineffective
Portion)
  Amount of Gain
(Loss) Recognized
in Income (Ineffective
Portion)

Interest rate swaps

   $ (1,057   Financial Services:
Investment income
   $ (1,715   Net mark-to-
market gains
(losses) on
non-trading
derivative
contracts
  $ 56

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

Ambac’s operating subsidiaries enter into non-trading derivative contracts for the purpose of economically hedging exposures to fair value or cash flow changes caused by fluctuations in interest rates and foreign currency rates. Such contracts include derivatives that do not meet the technical requirements for hedging under ASC Topic 815. Net gains (losses) recognized on such contracts recognized as part of net mark-to-market gains (losses) on non-trading derivative contracts was ($11,556) and $(15,451) for the three and six months ended June 30, 2010, respectively, and $6,780 and $6,782 for the three and six months ended June 30, 2009, respectively.

 

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

 

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

Contingent Features in Derivatives Related to Ambac Credit Risk:

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

As of June 30, 2010, the aggregate fair value of all derivative instruments with contingent features linked to Ambac’s own credit risk that are in a net liability position after considering legal rights of offset was $105,886 related to which Ambac had posted assets as collateral with a fair value of $177,260. All such ratings-based contingent features have been triggered as of June 30, 2010, requiring maximum collateral levels to be posted by Ambac and allowing counterparties to elect to terminate the contracts. Assuming all contracts terminated on June 30, 2010, settlement of collateral balances and net derivative liabilities would result in a net receipt of cash and/or securities by Ambac. If counterparties elect to exercise their right to terminate, the actual termination payment amounts will be determined in accordance with derivative contract terms, which may result in amounts that differ from market values as reported in Ambac’s financial statements.

(7) Income Taxes

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

 

Jurisdiction

   Tax Year

United States

   2005

New York State

   2008

New York City

   2000

United Kingdom

   2005

As of June 30, 2010 and December 31, 2009, the liability for unrecognized tax benefits is approximately $22,950 and $22,850, respectively. Included in these balances at June 30, 2010 and December 31, 2009 are $22,950 and $22,850, respectively, of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

Ambac accrues interest and penalties related to unrecognized tax benefits in the provision for income taxes. During the six months ended June 30, 2010 and 2009, Ambac recognized interest of approximately $100 and $2,050, respectively. During the three months ended June 30, 2010 and 2009,

 

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

 

Ambac recognized interest of approximately $50 and $1,025, respectively. Ambac had approximately $15,120 and $15,020 for the payment of interest accrued at June 30, 2010 and December 31, 2009, respectively.

As a result of the development of additional losses and the related impact on the Company’s cash flows, management believes it is more likely than not that the Company will not generate sufficient taxable income to recover the deferred tax operating asset. As of June 30, 2010 a full valuation allowance of $2,653,544 has been established against the deferred tax asset, including a reduction of $245,714 charged against equity for adoption of ASU 2009-17 and an increase of $140,488 resulting from post adoption reversals reflected in income. As of December 31, 2009, the company had a valuation allowance of $2,701,493.

(8) Investments

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

 

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

 

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

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair
Value
   Non-credit other-
than-temporary

Impairments(1)

June 30, 2010

              

Fixed income securities:

              

Municipal obligations

   $ 2,030,470    $ 90,267    $ 5,137    $ 2,115,600    $ —  

Corporate obligations

     882,579      42,282      29,556      895,305      —  

Foreign obligations

     108,583      6,359      —        114,942      —  

U.S. government obligations

     184,735      7,916      —        192,651      —  

U.S. agency obligations

     85,202      7,445      —        92,647      —  

Residential mortgage-backed securities

     1,307,396      221,432      53,698      1,475,130      2,323

Collateralized debt obligations

     42,598      24      16,386      26,236      —  

Other asset-backed securities

     1,026,737      37,188      51,266      1,012,659      —  

Short-term

     514,780      —        —        514,780      —  

Other

     100      —        —        100      —  
                                  
     6,183,180      412,913      156,043      6,440,050      2,323
                                  

Fixed income securities pledged as collateral:

              

U.S. government obligations

     110,252      2,814      —        113,066      —  

U.S. agency obligations

     —        —        —        —        —  

Residential mortgage-backed securities

     13,514      852      —        14,366      —  
                                  

Total collateralized investments

     123,766      3,666      —        127,432      —  
                                  

Total investments

   $ 6,306,946    $ 416,579    $ 156,043    $ 6,567,482    $ 2,323
                                  

December 31, 2009

Fixed income securities:

              

Municipal obligations

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

Corporate obligations

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

Foreign obligations

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

U.S. government obligations

     230,587      3,541      712      233,416      —  

U.S. agency obligations

     68,719      4,877      116      73,480      —  

Residential mortgage-backed securities

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

Collateralized debt obligations

     79,135      22      22,706      56,451      —  

Asset-backed securities

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

Short-term

     962,007      —        —        962,007      —  

Other

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

Fixed income securities pledged as collateral:

              

U.S. government obligations

     122,139      1,688      777      123,050      —  

U.S. agency obligations

     16,832      617      —        17,449      —  

Residential mortgage-backed securities

     25,385      1,482      —        26,867      —  
                                  

Total collateralized investments

     164,356      3,787      777      167,366      —  
                                  

Total investments

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

 

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

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

 

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

 

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

 

     Amortized
Cost
   Estimated
Fair Value

Due in one year or less

   $ 656,182    $ 657,408

Due after one year through five years

     804,056      841,783

Due after five years through ten years

     755,747      781,985

Due after ten years

     1,700,716      1,757,915
             
     3,916,701      4,039,091

Residential mortgage-backed securities

     1,320,910      1,489,496

Collateralized debt obligations

     42,598      26,236

Other asset-backed securities

     1,026,737      1,012,659
             
   $ 6,306,946    $ 6,567,482
             

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

Unrealized Losses:

The following table shows gross unrealized losses and fair values of Ambac’s investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at June 30, 2010 and December 31, 2009:

 

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

June 30, 2010:

                 

Fixed income securities:

                 

Municipal obligations.

   $ —      $ —      $ 72,185    $ 5,137    $ 72,185    $ 5,137

Corporate obligations

     75,155      6,370      168,847      23,186      244,002      29,556

Foreign obligations

     —        —        —        —        —        —  

U.S. government obligations

     —        —        —        —        —        —  

U.S. agency obligations

     —        —        —        —        —        —  

Residential mortgage-backed securities

     31,912      1,485      130,005      52,213      161,917      53,698

Collateralized debt obligations

     4,866      2,290      21,346      14,096      26,212      16,386

Other asset-backed securities

     36,449      3,020      520,692      48,246      557,141      51,266
                                         

Total temporarily impaired securities

   $ 148,382    $ 13,165    $ 913,075    $ 142,878    $ 1,061,457    $ 156,043
                                         

December 31, 2009:

                 

Fixed income securities:

                 

Municipal obligations

   $ 118,770    $ 4,073    $ 90,775    $ 11,303    $ 209,545    $ 15,376

Corporate obligations

     182,129      9,011      188,634      28,571      370,763      37,582

Foreign obligations

     21,037      471      4,938      744      25,975      1,215

U.S. government obligations

     68,073      1,489      —        —        68,073      1,489

U.S. agency obligations

     4,345      116      —        —        4,345      116

Residential mortgage-backed securities

     220,419      16,351      128,991      79,704      349,410      96,055

Collateralized debt obligations

     4,541      3,716      51,888      18,990      56,429      22,706

Other asset-backed securities

     380,426      43,029      735,190      162,611      1,115,616      205,640
                                         

Total temporarily impaired securities

   $ 999,740    $ 78,256    $ 1,200,416    $ 301,923    $ 2,200,156    $ 380,179
                                         

Ambac has a formal impairment review process for all securities in its investment portfolio. Ambac conducts a review each quarter to identify and evaluate investments that have indications of possible other than temporary impairment, including substantial or continuous declines in fair value

 

47


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

 

below amortized cost or declines in external credit ratings from the time the securities were purchased. Management has determined that the unrealized losses reflected in the table above are temporary in nature as of June 30, 2010 and December 31, 2009 based upon (i) no principal and interest payment defaults on these securities; (ii) analysis of the creditworthiness of the issuer and financial guarantor, as applicable, and analysis of projected defaults on the underlying collateral; (iii) management has no intent to sell these investments in debt securities; and (iv) it is not more likely than not that Ambac will be required to sell these debt securities before the anticipated recovery of its amortized cost basis. The assessment under (iv) is based on a comparison of future available liquidity from the fixed income investment portfolio against the projected net cash outflow from operating activities and debt service. For purposes of this assessment, available liquidity from the fixed income investment portfolio is comprised of the fair value of securities for which management has asserted its intent to sell plus the scheduled maturities and interest payments from the remaining securities in the portfolio. As of June 30, 2010, management had the intent to sell securities with a total fair value of $2,119,111, which is considered to be immediately available for liquidity needs in our analysis. To the extent that securities that management intends to sell are in an unrealized loss position, they would have already been considered other-than-temporarily impaired with the amortized cost written down to fair value. Because the above-described assessment indicates that future available liquidity exceeds projected net cash outflow, it is not more likely than not that we would be required to sell additional securities, other than those already identified for sale, before the recovery of their amortized cost basis. In the liquidity assessment described above, principal payments on securities pledged as collateral are not considered to be available for other liquidity needs until the collateralized positions are projected to be settled. Projected interest receipts on securities pledged as collateral generally belong to Ambac and are considered to be sources of available liquidity from the investment portfolio. As of June 30, 2010, for securities that have indications of possible other-than-temporary impairment but which management does not intend to sell and will not more likely than not be required to sell, management compared the present value of cash flows expected to be collected to the amortized cost basis of the securities to assess whether the amortized cost will be recovered. Cash flows were discounted at the effective interest rate implicit in the security at the date of acquisition. For floating rate securities, future cash flows and the discount rate used were both adjusted to reflect changes in the index rate applicable to each security as of the evaluation date.

Of the securities that were in a gross unrealized loss position at June 30, 2010, $77,094 of the total fair value and $10,587 of the unrealized loss related to below investment grade securities and non-rated securities. These included residential mortgage-backed securities that were rated below investment grade which had a total fair value of $32,951 and unrealized loss balance of $1,617. Of the securities that were in a gross unrealized loss position at December 31, 2009, $114,391 of the total fair value and $34,987 of the unrealized loss related to below investment grade securities and non-rated securities. These included residential mortgage-backed securities that were rated below investment grade which had a total fair value of $63,088 and unrealized loss balance of $16,343.

Corporate obligations:

The decrease in gross unrealized losses on corporate obligations during the six months ended June 30, 2010 is the result of lower interest rates, partially offset by credit spread widening. Of the $23,186 of unrealized losses on corporate obligations greater than 12 months, one security comprises $11,113 of the total. This security, which is a closed-block life insurance issuance that is insured by Assured Guaranty Municipal Corporation, has been in an unrealized loss position for 30 months. The unrealized loss on this security is the result of general credit spread widening on life insurers. Given the insured rating of AA- and Investment Grade underlying rating, management believes that timely receipt of all principal and interest is probable.

 

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

 

Residential mortgage-backed securities:

The gross unrealized loss on mortgage-backed securities as of June 30, 2010 is primarily related to Alt-A residential mortgage-backed securities. Of the $52,213 of unrealized losses on mortgage-backed securities for greater than 12 months, $51,239 or 98.1%, is attributable to 16 individual Alt-A securities. These individual securities have been in an unrealized loss position for 30 months. Each of these Alt-A securities have very similar characteristics such as vintage of the underlying collateral (2004-2007) and placement in the structure (generally class-A tranche rated triple-A at issuance). The significant declines in fair value relate to the actual and potential effects of declining U.S. housing prices and the current recession in general on the performance of collateral underlying residential mortgage backed securities. This has been reflected in decreased liquidity for RMBS securities and increased risk premiums demanded by investors resulting in a required return on investment that is significantly higher than historically experienced.

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

Other asset-backed securities:

The decrease in gross unrealized losses on other asset-backed securities during the six months ended June 30, 2010 is the result of sales of other asset-backed securities as well as the effect of improved market liquidity for certain higher quality, shorter term consumer asset-backed securities. Of the $48,246 of unrealized losses on other asset-based securities greater than 12 months, two credit card positions comprise $8,008 of the total. These individual securities have been in an unrealized loss position for 21 months. As part of the quarterly impairment review process, management monitors each deal’s performance metrics and other available qualitative and fundamental information in developing an analytical opinion. Ambac determined that there is sufficient credit enhancement to mitigate recent market stresses. Management believes that the timely receipt of all principal and interest from other asset-backed securities is probable.

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

The following table details amounts included in net realized investment gains (losses) and other-than-temporary impairments included in earnings for the three and six months ended June 30, 2010 and 2009:

 

     Three-months ended
June 30,
    Six-months ended
June 30,
 
     2010     2009     2010     2009  

Gross realized gains on securities

   $ 22,128      $ 28,907      $ 152,653      $ 48,333   

Gross realized losses on securities

     (10,870     (45,451     (85,870     (51,888

NCFE recoveries

     —          —          —          13   

Net gain on investment agreement terminations

     73,511        18,018        73,516        120,815   

Foreign exchange (losses) gains

     (656     3,926        363        3,155   
                                

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

     84,113        5,400        140,662        120,428   

Net other-than-temporary impairments(1)

     (10,566     (862,102     (41,915     (1,692,333

Gain on extinguishment of debt

     10,693        —          10,693        —     
                                

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

   $ 84,240      $ (856,702   $ 109,440      $ (1,571,905
                                

 

(1) Other-than-temporary impairments since April 1, 2009 exclude impairment amounts recorded in other comprehensive income under ASC Paragraph 320-10-65-1, which comprise non-credit related amounts on securities that are credit impaired but which management does not intend to sell and it is not more likely than not that the company will be required to sell before recovery of the amortized cost basis.

 

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Other-than-temporary impairments for the six months ended June 30, 2010 included charges of $17,147 to write-down the amortized cost basis of tax-exempt municipal bonds and student loan securities to fair value at their respective impairment dates as a result of management’s intent to sell securities in connection with plans to reposition the investment portfolio and to meet general liquidity needs. Additionally, other-than-temporary impairment charges to earnings in 2010 included $24,768 in credit losses on securities guaranteed by Ambac Assurance. As further described in Note 1, on March 24, 2010, the OCI commenced 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. As a result of actions taken by OCI, financial guarantee payments on securities guaranteed by Ambac Assurance which have been placed in the Segregated Account are no longer under the control of Ambac management. Accordingly, estimated cash flows on such securities have been adversely impacted resulting in credit losses. Other-than-temporary impairment charges were $862,102 and $1,692,333 for the three and six month period ended June 30, 2009, respectively. Charges in 2009 included $0 and $830,231 for the three and six months ended June 30, respectively, related to write-downs of certain securities that were believed to be credit impaired and $862,102 for the three and six months ended June 30, 2009, related to securities that management had the intent to sell primarily to meet financial services liquidity needs at that time.

Credit losses on Ambac-guaranteed securities which are included in other-than-temporary impairments for the three and six months ended June 30, 2010 were estimated using market accepted cash flow models and inputs consistent with those used to develop loss reserves described in Note 5. These credit losses relate primarily to Ambac-guaranteed RMBS senior bonds collateralized by either first or second lien mortgage products. Pool cash flows are run through a market accepted deal model library based on either loan level or pool level assumptions for underlying collaterals to project cash flows on the bond level. Each RMBS transaction structural features are modeled, including loss allocations, triggers, prepayment penalty allocations, and interest-rate hedges. Through the deal model waterfalls we generate principal and interest cash flow vectors for each tranche in the portfolio. For investments collateralized by first-lien mortgages, we employ a loan-level model which uses regression analysis derived from a subset of two million mortgages from a proprietary database to estimate the effect of projected Home Price Appreciation, unemployment, and interest rates on individual mortgages based on their individual characteristics. Variable values and loan conditions are updated monthly. The model runs 300 simulations for each transaction. The heart of the framework, the discrete choice credit module, estimates the probability of monthly loan level credit performance evolutions through time across eight possible status states (current, 30 day delinquent, 60 day delinquent, 90 + day delinquent, foreclosure, REO, prepay, and default). Specific inputs used include: property type; occupancy; purpose; documentation; lien type; time to payment shock; effective LTV; change of monthly LTV; FICO score; debt to income ratio; mortgage rate; initial spread; loan age; delinquency history; and macroeconomic factors including interest rates, unemployment rate, HPA rate, loan modification program and government rescue plan. Our loss estimates for the second lien products in the RMBS portfolio were based on pool level assumptions. A monthly roll-rate methodology was applied to project future prepayment, default, and severity vectors on a pool-specific basis. We examined the historical rate at which delinquent loans in each transaction rolled into later delinquency categories (i.e. 30-59 days, 60-89 days, 90+ days, and default) and used this data along with the most recent delinquency information to project a default curve for the life of the transaction. Lifetime prepayment and loss severity factors were also projected by

 

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

 

examining historical data. Specific inputs we used were: roll rates; initial delinquencies; prepayment rates; loss severity and burnout. These modeling results on the underlying bonds are used along with assumptions about future guarantor claim payments as described below to determine credit losses. Under the Segregated Account Rehabilitation Plan, management anticipates that future claim payments made by Ambac Assurance on these securities would be approximately 25% in cash and 75% in surplus notes. All future cash payments on the surplus notes are subject to approval of OCI. The calculation of partial cash payments by the guarantor is highly subjective and not readily available through market standard cash flow tools. To consider the uncertainty of guarantor cash payments, particularly on the surplus notes, our analysis of credit impairment of Ambac-guaranteed securities in our investment portfolio reflects a weighted average of estimated future cash flows under two scenarios: (i) the “with guarantor” scenario in which Ambac Assurance pays 100% of its claims in cash (weighted 30%) and (ii) the “without guarantor” scenario that fully excludes payments from Ambac Assurance (weighted 70%). Although the Segregated Account Rehabilitation Plan contemplates payments of 25% of claims in cash, we have applied 30% weight to the “with guarantor” scenario to reflect assumed market participants’ expectations of future cash payments from the surplus notes.

The following table presents a roll-forward of Ambac’s cumulative credit impairments that were recognized in earnings on securities held as of June 30, 2010:

 

     Credit
Impairment
 

Balance as of January 1, 2010

   $ 98,654   

Additions for credit impairments recognized on(1):

  

Securities not previously impaired

     15,909   

Securities previously impaired

     8,859   

Reductions for credit impairments previously recognized on:

  

Securities that matured or were sold during the period

     (1,296
        

Balance as of June 30, 2010

   $ 122,126   
        

 

(1) These additions are included in the Financial Guarantee net other-than-temporary impairment losses recognized in earnings of $41,915 in the Consolidated Statements of Operations, as well as impairments on securities for which Ambac intended to sell.

    Collateral and Deposits with Regulators:

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

 

  (1) Cash and securities held in Ambac’s investment portfolio – Ambac pledges assets it holds in its investment portfolio to (a) investment and payment agreement counterparties; and (b) derivative counterparties. Securities pledged to investment and payment agreement counterparties may not then be re-pledged to another entity. Ambac’s counterparties under derivative agreements have the right to pledge or rehypothecate the securities and as such, pledged securities are separately classified on the Consolidated Balance Sheets as “Fixed income securities pledged as collateral, at fair value”.

 

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

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
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The following table presents (i) the sources of collateral either received from various counterparties where Ambac is permitted to sell or re-pledge or directly held in the investment portfolio and (ii) how that collateral was pledged to various investment and payment agreement, derivative and repurchase agreement counterparties at June 30, 2010 and December 31, 2009:

 

     Fair Value of
Cash and
Underlying
Securities
   Fair Value of  Cash
and Securities
Pledged to
Investment and
Payment Agreement
Counterparties
   Fair Value of
Cash and
Securities
Pledged to
Derivative
Counterparties

June 30, 2010

        

Sources of Collateral:

        

Cash and securities pledged directly from the investment portfolio

   $ 1,187,657    $ 993,366    $ 194,291

Cash and securities pledged from its derivative counterparties

     4,350      —        4,350

December 31, 2009

        

Sources of Collateral:

        

Cash and securities pledged directly from the investment portfolio

   $ 1,322,341    $ 1,125,528    $ 196,813

Cash and securities pledged from its derivative counterparties

     90,009      —        90,009

Securities carried at $6,469 and $7,069 at June 30, 2010 and December 31, 2009, respectively, were deposited by Ambac Assurance and Everspan with governmental authorities or designated custodian banks as required by laws affecting insurance companies.

(9) Stockholders’ Equity

Effective January 1, 2009, ASC Topic 810 requires that the carrying value of noncontrolling interests (previously referred to as minority interests) be removed from liability or mezzanine sections of the balance sheet and reclassified as equity; and consolidated net income (loss) to be recast to include net income attributable to the noncontrolling interest, retrospectively for all periods presented. Non-controlling interests includes primarily the preferred stock of Ambac Assurance. In the first six months of 2009, Ambac Assurance sold an additional $100,000 of preferred stock. Also, in the first six months of 2009, Ambac Assurance retired 903 shares of preferred stock for $1,806.

 

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Item 1. Notes to Unaudited Consolidated Financial Statements
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The following schedule presents the effects of changes in Ambac Financial Group, Inc.’s ownership interest in Ambac Assurance on the equity attributable to Ambac Financial Group, Inc.:

Net Income Attributable to Ambac Financial Group, Inc.

Transfers (to) from the noncontrolling interest

 

     Three Months Ended
June 30,
    Six Months Ended
June  30,
 
     2010     2009     2010     2009  

Net income attributable to Ambac Financial Group, Inc.

   $ (57,559   $ (2,368,794   $ (747,610   $ (2,760,981

Transfers (to) from the noncontrolling interest:

        

Increase in Ambac Financial Group, Inc’s paid-in-capital from retirement of 903 shares of preferred stock

     —          —          —          20,769   
                                

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

   $ (57,559   $ (2,368,794   $ (747,610   $ (2,740,212
                                

In June 2010, Ambac entered into a series of debt for equity exchanges with certain holders of Ambac’s 9.375% debentures, due August 2011. Ambac has issued an aggregate of 13,638,482 shares of its common stock in exchange for $20,311 in aggregate principal amount of the 2011 debentures. Ambac recognized a gain on the extinguishment of these debentures in the amount of $10,693, which was the difference between the fair value of the new shares issued less than the net carrying value of the debentures.

(10) Segment Information

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

Transactions between the financial guarantee and financial services segment include (i) premiums for Ambac’s financial guarantee of the swap and investment agreement obligations of its Financial Services subsidiaries; (ii) interest on loans that Ambac Assurance provides to the Financial Services businesses; (iii) interest rate swaps between Ambac Assurance and its Financial Services subsidiary to hedge floating rate exposures in the insured portfolio; (iv) interest rate swaps between consolidated VIEs and the Financial Services business; and (v) fees relating to advisory services provided by RangeMark to Ambac Assurance.

Information provided below for “Corporate and Other” relates to (i) investment advisory services to the structured credit markets and (ii) corporate activities, including interest expense on debentures. On July 16, 2010 Ambac completed the sale of RangeMark, its advisory services subsidiary. Corporate and other revenue from unaffiliated customers consists primarily of income from investments. Inter-segment revenues consist of dividends received.

 

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

 

The following table is a summary of financial information by reportable segment as of and for the three and six months ended June 30, 2010 and 2009:

 

     Financial     Financial     Corporate     Inter-
segment
       

Three months ended June 30,

   Guarantee     Services     and Other     Eliminations     Consolidated  

2010:

          

Revenues:

          

Unaffiliated customers

   $ 380,219      $ (10,899   $ 11,850      $ —        $ 381,170   

Inter-segment

     (217,728     217,815        2,808        (2,895     —     
                                        

Total revenues

   $ 162,491      $ 206,916      $ 14,658      $ (2,895   $ 381,170   
                                        

Income before income taxes:

          

Unaffiliated customers

   $ (8,924   $ (18,380