Ambac has historically provided financial guarantee insurance for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation (“Ambac Assurance”). Ambac Assurance’s financial strength ratings were downgraded during 2008; it now has a Baa1 financial strength rating on review for possible downgrade from Moody’s and is rated A with a negative outlook from S&P. As a result of these rating agency actions, as well as investor concern with respect to these actions, Ambac Assurance and its operating subsidiaries have been able to originate only a de minimis amount of new financial guarantee business since November 2007.
operations and financial results. Although Ambac is considering various strategic alternatives, there can be no assurance that any actions taken by Ambac will improve its financial strength ratings, that further ratings downgrades will not occur, or that Ambac, through Everspan, will be able to effectively compete in the U.S. public finance market.
losses on the Consolidated Statements of Operations equal to the difference between the fair value and amortized cost basis of the security. In addition, for securities expected to be sold, an other-than-temporary impairment charge is recognized if management does not expect the fair value of the security to recover to amortized cost prior to the expected date of sale. The fair value of the other-than-temporarily impaired investment becomes its new cost basis. For fixed income securities, Ambac accretes the new cost basis to par or to the estimated future cash flows to be recovered over the expected remaining life of the security by adjusting the security’s yield. Ambac has a formal process to identify and evaluate investments that have indications of possible impairment. Factors considered when assessing impairment include: (i) debt securities whose fair values have declined by 20% or more below amortized cost; (ii) debt securities whose market values have declined by 5% or more but less than 20% below amortized cost for a continuous period of at least six months; (iii) recent downgrades by rating agencies; (iv) the financial condition of the issuer and financial guarantor as applicable and analysis of projected defaults on the underlying collateral; (v) whether scheduled interest payments are past due; and (vi) whether Ambac has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. As a result of significant price declines of certain “Alt-A” residential mortgage backed securities in our investment portfolio, combined with general market concerns regarding housing prices and the delinquency and default rates on mortgage loans underlying such securities, our impairment evaluation includes additional analysis. Using default, prepayment and severity loss assumptions tailored to the underlying loans in each Alt-A transaction, the securities are modeled to determine if our best estimate of the underlying cash flows would result in a probable loss to such security. If the modeling results indicate an “expected loss” to the tranche we hold, the security would be deemed to be other-than-temporarily impaired, which would result in the recognition of a realized loss in the Statements of Operations. For purposes of assessing other-than-temporary impairments, an “expected loss” has occurred when management has determined that it is no longer probable that we will receive all contractual principal and interest payments or the future payments estimated at the time the security was last found to be other-than-temporarily impaired. In evaluating Alt-A securities for other-than-temporary impairment and making our final determination, management considered analyses prepared by an outside consultant specializing in RMBS structures for the majority of 2008 as further described in Note 3.
financial guarantee industry, Ambac does not believe that SFAS 60 alone provides sufficient guidance. As a result, Ambac supplements the guidance in SFAS 60 with the guidance in SFAS 5, “Accounting for Contingencies,” which calls for a loss to be accrued if it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Ambac also relies by analogy on EITF Issue 85-20, “Recognition of Fees for Guaranteeing a Loan,” which states that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS 5, “Accounting for Contingencies.”
Investment agreements - Ambac provided investment agreements and investment repurchase agreements principally to asset-backed and structured finance issuers, states, municipalities and municipal authorities, whereby Ambac agrees to pay an agreed-upon return based on funds deposited. Proceeds from these investment agreement and investment repurchase agreement obligations are used to invest in fixed income investments. Interest income from these investments is included in Financial Services revenues.
None of our outstanding credit derivative transactions includes 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.
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 SFAS 133 is reported in “Accumulated Other Comprehensive Losses” in Stockholders’ Equity. 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. At December 31, 2008, $102 was recorded as hedge ineffectiveness on cash flow hedges in “Net mark-to-market losses on non-trading derivatives.” As of December 31, 2008, $2,599 of pre-tax deferred gains on derivative instruments reported in Accumulated Other Comprehensive Income are expected to be reclassified to net income during the next twelve months. Transactions and events expected to occur over the next twelve months that will necessitate reclassifying these derivative gains include the repricing of variable-rate assets.
Ceded Reinsurance: Ambac Assurance ceded exposures under various reinsurance contracts primarily designed to diversify risk, increase underwriting capacity, manage capital needs and strengthen financial ratios. Ceded premiums are considered prepaid reinsurance premiums and are amortized into income in proportion to the protection received.
Ambac used the Black-Scholes model to value the 2008 service condition based stock options. Upon the adoption of SFAS No. 123-R, Ambac used a Monte Carlo simulation model for the 2007 and 2006 market condition based stock option grants. The model utilizes multiple input variables that determine the probability of satisfying each market condition stipulated in the option grant and calculates the fair market value for each option granted based on certain assumptions. The assumptions for the 2008, 2007 and 2006 stock option grants are as follows:
Ambac has an outstanding commitment to provide a financial guarantee on a static pool of primarily High Grade and Mezzanine CDO of ABS securities, comprised of underlying CDO and MBS and other securitizations. The commitment was structured such that Ambac would issue an insurance policy on investment securities remaining in the pool after a first loss coverage amount was depleted. Due to the particular provisions of this commitment, we have concluded that it meets the definition of a derivative under SFAS 133. Accordingly, the fair value of the transaction is included in Derivative liabilities and changes in fair value are included in Net change in fair value of credit derivatives. The initial pool size was approximately $4,000,000 with 25% of first loss coverage. As of December 31, 2008, the gross investment pool balance was $3,745,000 with $869,000 of remaining first loss. We expect the gross investment pool balance and the first loss amount to be reduced by losses associated with credit events that have occurred and are subject to cash settlement. Ambac’s approximate
the credit markets and recent rating agency actions, both of which have significantly limited the amount of new financial guarantee business written by Ambac. Additionally, the fair value concepts of SFAS 157, as they relate to valuing liabilities, requires a company to consider the cost to completely transfer its obligation to another party of comparable credit worthiness. However, our primary insurance obligation is irrevocable and thus there is no established active market for transferring such obligations. Finally, as a result of the breadth, volume and geographic diversification of our financial guarantee exposures, we may need to enhance our model to more accurately incorporate other key variables that may influence the fair value estimate. Variables which are not incorporated in our current fair value estimate of financial guarantees include the credit spreads of the underlying insured obligations, the underlying ratings of those insured obligations and assumptions about current financial guarantee premium levels relative to the underlying insured obligations’ credit spreads.
(1) Excludes a $10,000 investment which is carried in the Consolidated Balance Sheets at cost.