Ambac Financial Group, Inc., headquartered in New York City, is a holding company incorporated in the state of Delaware. Ambac was incorporated on April 29, 1991. Ambac, through its subsidiaries, provides financial guarantees and financial services to clients in both the public and private sectors around the world. The long-term senior unsecured debt of Ambac is rated “BBB” with a negative outlook by Standard & Poor’s Ratings Service, a division of the McGraw-Hill Companies, Inc. (“S&P”), and Ba1 on review for possible downgrade by Moody’s Investors Services, Inc. (“Moody’s”). Ambac’s activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services.
Ambac Assurance has two financial guarantee insurance operating subsidiaries, Ambac UK and Everspan Financial Guarantee Corp. (previously Connie Lee Insurance Company) (“Everspan”). Ambac UK, insures a wide array of obligations in the international markets including infrastructure financings, asset-securitizations, CDOs, utility obligations, whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation) and other obligations, generally within Western Europe. Everspan is a financial guarantee insurance company that was purchased by Ambac Assurance in 1997 and placed into runoff. Ambac Assurance is seeking to capitalize and reactivate Everspan which would allow it to write new financial guarantee business in the U.S. public finance and regulated utility markets.
As an alternative to financial guarantee insurance, credit protection was provided by Ambac Credit Products LLC, a subsidiary of Ambac Assurance, in credit derivative format. Ambac Assurance insures the obligations of Ambac Credit Products under these transactions. 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, Ambac Credit Products is generally required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. In a small number of transactions, Ambac Credit Products is required to (i) make a payment equal to the difference between the par value and market value of the underlying obligation
The effectiveness of our internal control over financial reporting as of December 31, 2008 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein, which expresses an unqualified opinion on the effectiveness of Ambac’s internal control over financial reporting as of December 31, 2008.
We have audited Ambac Financial Group, Inc. and subsidiaries’ (the “Company” or “Ambac”) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, Ambac maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
As discussed in Note 16 to the consolidated financial statements, Ambac adopted SFAS No. 157, “Fair Value Measurements” in 2008.
Ambac Financial Group, Inc. is a holding company incorporated in the state of Delaware. Ambac, through its subsidiaries, provides financial guarantees and financial services to entities in both the public and private sectors around the world. As of March 11, 2009, the long-term senior unsecured debt of Ambac is rated BBB with a negative outlook by Standard & Poor’s Ratings Service, a division of the McGraw-Hill Companies, Inc. (“S&P”), and Ba1 on review for possible downgrade by Moody’s Investors Services, Inc. (“Moody’s”). Ambac’s principal financial guarantee operating subsidiary, Ambac Assurance Corporation, a guarantor of public finance and structured finance obligations, has an A financial enhancement rating with a negative outlook from S&P, and a Baa1 financial strength rating on review for possible downgrade from Moody’s. These ratings reflect significant downgrades in Ambac Assurance’s financial strength ratings during 2008 and are the result of the adverse impact on Ambac’s principal business activities from the persistent disruption in the global credit markets. These significant ratings downgrades reflect investor concern relative to the Company’s financial strength.
Ambac has not written measurable financial guarantee business since November 2007. Further, 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.
Ambac’s principal business strategy to preserve and grow our business is focused primarily on the reactivation of Everspan for purposes of writing financial guarantee insurance in the U.S. public finance market. Other initiatives that we are pursuing include mortgage servicing and consulting in various sectors of the credit markets. Management believes that Everspan will require substantially more capital, including third-party capital, and at least a AA S&P and A2 Moody’s rating in order to compete in the U.S. public finance market. As noted above, Ambac has suffered significant ratings downgrades and currently does not carry the ratings necessary for Everspan to compete in the U.S. public finance market. Further, the Company has not yet received permission from the OCI to capitalize Everspan at a level enabling it to compete in that market. The OCI has indicated that it will not approve an investment in Everspan by Ambac Assurance unless Everspan receives financial strength ratings of at least AA from S&P and A2 from Moody’s.
Receipt of financial strength ratings which are sufficiently high to enable Everspan to successfully compete in the U.S. public finance market is critical to Everspan’s business plan. There can be no assurance that the Company will achieve such ratings. As described above, the financial strength rating downgrades have adversely impacted Ambac’s ability to generate new business and will negatively impact Ambac’s future business,
Ambac Assurance is permitted to purchase up to $3,000,000 of investment securities presently owned by the investment agreement business;
Ambac Assurance is permitted to provide a revolving unsecured credit facility to the investment agreement business of up to $1,600,000 for the purpose of providing such affiliates liquidity for collateral postings or liquidation of investment agreements; and
There are two different accounting frameworks applicable to special purpose entities (“SPEs”); the qualifying SPE (“QSPE”) framework under Statement of Financial Accounting Standards (“SFAS”) No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, as amended; and the variable interest entity (“VIE”) framework under Financial Interpretation No. (“FIN”) 46R “Consolidation of Variable Interest Entities”. The applicable framework depends on the nature of the entity and Ambac’s relationship to that entity.
Under a separate transaction which closed during 2007, Ambac determined it was the primary beneficiary and therefore consolidated a VIE as a result of providing a financial guarantee. Refer to Note 10, Special Purpose Entities and Variable Interest Entities, for further discussion of this transaction.
On September 15, 2008, the FASB issued a revised Exposure Draft, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 (“SFAS 140 ED”). This is a revision of the version issued on August 11, 2005. Among other things, SFAS 140 ED proposed to eliminate the concept of QSPE. On September 15, 2008, the FASB also issued an Exposure Draft, Amendments to FASB Interpretation No. 46(R) (“FIN 46(R) ED”). FIN 46(R) ED proposed a new approach to determine which enterprise involves in a VIE shall be the primary beneficiary and shall consolidate the VIE. The comment period for both SFAS 140 ED and FIN 46(R) ED ended on November 14, 2008. The proposed effective date of SFAS 140 ED and FIN 46(R) ED is January 1, 2010 for Ambac. Ambac believes these Exposure Drafts in their current form could increase the number of SPEs Ambac is required to consolidate and thus have a material impact to Ambac’s financial statements. Ambac continues to monitor the status of these Exposure Drafts.
Cash and cash equivalents include cash and U.S. agency obligations maturing within ninety days.
Where securities in an unrealized loss position are not deemed to be credit-impaired, management performs additional analysis as part of its quarterly impairment review process to assess whether it has the intent and ability to hold each security for a period of time sufficient for a forecasted recovery of fair value. In some cases, particularly with respect to investments in Alt-A RMBS securities, the forecasted recovery period may be several years or close to the maturity of the securities. When management asserts its intent and ability to retain a security until recovery, that security is judged to be temporarily impaired.
The evaluation of securities for impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition and/or future prospects, the performance of the underlying collateral, the effects of changes in interest rates or credit spreads and the expected recovery period. Ambac’s assessment of a decline in value reflects management’s current judgment regarding facts and circumstances specific to a security and the factors noted above, including whether Ambac will continue to have the intent and ability to hold temporarily impaired securities until recovery. If that judgment changes, Ambac may ultimately record a charge for other-than-temporary impairment in future periods.
Securities purchased under agreements to resell and securities sold under agreements to repurchase, represent short-term collateralized financing transactions and are recorded at their contracted amounts, plus accrued interest. Ambac nets securities purchased under agreements to resell and securities sold under agreements to repurchase that are executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria. Ambac takes possession of securities purchased under agreements to resell, makes delivery of securities sold under agreements to repurchase, monitors the market value of these securities on a daily basis and delivers or obtains additional collateral as appropriate. There were no securities purchased under agreements to resell and securities sold under agreements to repurchase outstanding at December 31, 2008. At December 31, 2007, collateral underlying securities purchased under agreements to resell had an average credit rating of triple-A and a weighted-average maturity of 5 days.
Financial guarantee insurance costs that vary with and are primarily related to the production of business have been deferred. Ambac periodically conducts a study to determine the amount of operating costs that vary with and primarily relate to the acquisition of business and qualify for deferral. These costs include compensation of employees and certain other underwriting expenses, net of reinsurance ceding commissions. Given the negligible amount of new business underwritten during 2008, the amount of acquisition costs eligible for deferral has decreased significantly from prior years. Premium taxes and reinsurance commissions are deferred in their entirety. Costs associated with credit derivatives are expensed as incurred. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned. Amortization of deferred acquisition costs amounted to $32,798, $46,104 and $38,221 for 2008, 2007 and 2006, respectively, and is adjusted to reflect acceleration of premium revenue due to refundings or calls and to reflect changes in the estimated lives of certain insured obligations. A premium deficiency exists if the sum of the expected loss and loss expenses and unamortized deferred acquisition costs exceed the related unearned premiums and anticipated investment income. Ambac includes anticipated investment income when determining whether a premium deficiency exists, as permitted under US GAAP. If a premium deficiency was to exist the unamortized deferred acquisition costs would be reduced by a charge to expense and a liability would be established for any remaining deficiency.
Based upon Ambac’s experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The trustee, on behalf of the insured party, named beneficiary, or custodian has the right to make a claim under Ambac’s financial guarantee insurance policy at the first scheduled debt service date of the defaulted obligation.
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.
Monetary default or claims payment has occurred or is expected imminently. If a default has occurred, case basis reserves will be established.
The credit has defaulted, payments have occurred or will occur, and any recoveries or salvage has been received. The claim payments are scheduled and known, and reserves have been established to fully cover such claims.
The active credit reserve is established through a process that begins with estimates of probable losses inherent in the adversely classified credit portfolio. These estimates are based upon: (i) Ambac’s internal system of credit ratings, which are analogous to the risk ratings of the major rating agencies; (ii) internally developed historical default information (taking into consideration ratings and average life of an obligation); (iii) internally developed loss severities; and (iv) the net par outstanding on the adversely classified credit. The loss severities and default information are based on rating agency information and are specific to each bond type and are established and approved by Ambac’s Enterprise Risk Management Committee. The Enterprise Risk Management Committee is comprised of Ambac’s senior risk management professionals and other senior management. For certain adversely-classified credit exposures, Ambac’s additional monitoring and loss remediation efforts may provide information relevant to the estimate of the active credit reserve.
Ambac may use market accepted software tools when a more precise view of expected claim payment cash flows can be derived. We have utilized this approach for residential mortgage-backed 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. Ambac discounts these estimated net claim payments using discount rates that approximate the average taxable equivalent yield on our investment portfolio at December 31, 2008 and 2007.
Additional remediation activities applied to adversely classified credits can include various actions by Ambac. The most common actions include obtaining detailed appraisal information on collateral, more 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. In estimating the active credit reserve, Ambac uses relevant credit-specific information obtained from its remediation efforts to supplement the statistical approach discussed above. Senior management meets at least quarterly 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. Active credit reserves were $969,219 and $363,372 at December 31, 2008 and 2007, respectively. The active credit reserves at December 31, 2008 and 2007 were comprised of 120 credits with net par of $14,779,793 and 45 credits with net par outstanding of $6,512,515, respectively. Included in the calculation of active credit reserves at December 31, 2008 and 2007 was the consideration of $49,819 and $13,364, respectively, of reinsurance which would be due to Ambac from reinsurers, upon default of the insured obligation.
Ambac provides information on the classification of its loss reserve between active credit reserve and case basis credit reserve for the purpose of disclosing the components of the total reserve that relate to exposures that have not yet defaulted and those that have defaulted. The total reserve (active credit and case basis) was $2,265,860 and $484,276 at December 31, 2008 and 2007, respectively. Due to the relatively large size of certain insured obligations comprising the active and case basis credit reserves, improvements or further deterioration in any one credit may significantly impact our loss provision in a given period. The provision for losses and loss expenses in the accompanying Consolidated Statements of Operations represents the expense recorded to bring the total reserve to a level determined by management to be adequate for losses inherent in the non-derivative financial guarantee insurance portfolio. Ambac’s management believes that the reserves for losses and loss expenses are adequate to cover the ultimate net cost of claims, but the reserves are based on estimates and there can be no assurance that the ultimate liability for losses will not exceed such estimates.
Our liabilities for credit losses are based in part on the short-duration accounting guidance in SFAS 60, “Accounting and Reporting by Insurance Enterprises.” The trustee (on behalf of the insured party), named beneficiary or custodian has a right to a claim payment under the financial guarantee insurance policy at the date of the first scheduled debt service payment of a defaulted security in the amount equal to the payment shortfall. We believe a loss event occurs for financial guarantee insurance products at the time the issuers’ financial condition deteriorates to an impaired credit status rather than at the time the insured party has a right to a claim payment. Because of this belief and the ambiguities discussed below in the application of SFAS 60 to the
Ambac is aware that there are certain differences regarding the measurement of liabilities for credit losses among participants in the financial guarantee industry. Difficulties in applying the existing insurance accounting literature, such as the classification of the insurance contracts as either short-duration or long-duration to the attributes of financial guarantee insurance, different measurement models and assumptions utilized, regulatory guidance provided to certain entities, and the existence of accounting literature providing guidance with respect to liability recognition for loan guarantees, are the reasons for differences among the industry participants.
In January and February of 2005, the SEC staff discussed with the financial guarantee industry participant’s differences in loss reserve recognition practices among those participants. In September 2005, the Financial Accounting Standards Board (“FASB”) added a project to its agenda to consider the accounting by financial guarantee insurers for claims liability recognition, premium recognition and deferred acquisition costs. The proposed guidance was issued on April 18, 2007 and the final standard SFAS 163, “Accounting for Financial Guarantee Insurance Contracts”, was issued on May 23, 2008. The provisions of SFAS 163 are effective January 1, 2009. Certain disclosure requirements are however effective September 30, 2008 and shall be based on the insurance enterprise’s existing accounting policies that may or not be consistent with the principles of SFAS 163 at this earlier effective date. See Future Application of Accounting Standards section below for further information.
* Excludes $33,836 gross of reinsurance and $33,580 net of reinsurance, of loss and loss adjustment expense reserves.
Under certain circumstances, such as in the event of financial guarantor rating downgrades or upon negotiation among the parties, investment agreements may be settled for an amount different than the carrying value of the obligation. Any difference between final settlement payment and carrying value of the terminated investment agreement obligation is reported in Financial Services: Net realized gains and losses on the Consolidated Statements of Operations.
Gross premiums are received either upfront (typical of public finance obligations) or in installments (typical of structured finance obligations). Up-front insurance premiums written are received for an entire bond issue, which may contain several maturities, and are recorded as unearned premiums. The premium is allocated to each bond maturity proportionately based on total principal amount guaranteed and is recognized as premiums on a straight-line basis over the term of each maturity. Installment insurance premiums written are recognized as premiums earned over each installment period, typically one year or less, on a straight-line basis. Premium earnings under both the upfront and installment revenue recognition methods are in proportion to the principal amount guaranteed and result in higher premium earnings during periods where guaranteed principal is higher. When an issue insured by Ambac Assurance has been refunded or called, the remaining unrecognized premium (net of refunding credits, if any) is recognized at that time. As discussed in Future Application of Accounting Standards section below, the GAAP accounting for net premiums earned will change in 2009.
Interest rate, currency swaps and total return swaps - Ambac provided interest rate and currency swaps principally to states, municipalities and their authorities and asset-backed issuers in connection with their financings. Ambac also entered into total return swaps, which contain contractual provisions similar to credit default swaps, with various financial institutions. All interest rate, currency and total return swap revenues are accounted for as “Derivative Contracts Classified as Held for Trading Purposes,” which is discussed in the Derivatives Contracts section below.
Until the third quarter of 2007, Ambac 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 purchases credit protection on a portion of the risk written, from reinsurance companies or other financial companies. Management views credit derivative contracts as part of its financial guarantee business, under which Ambac intends to hold its written and purchased positions for the entire term of the related contracts.
There are less than 30 transactions which are not “pay-as-you-go” with a combined notional of approximately $3.9 billion and a net liability fair value of $159 million as of December 31, 2008. All of these deals carry an internal rating of A- or better. These transactions are primarily in the form of CLOs written between 2002 and 2005 and other pooled corporate risks.
with adequate capacity to pay interest and repay principal. Certain protective elements and margins may weaken under adverse economic condition and changing circumstances. These bonds are more likely than higher rated bonds to exhibit unreliable protection levels over all cycles. Ambac’s below investment grade (“BIG”) internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions. The following table summarizes the net par outstanding for CDS contracts, by Ambac rating, for each major category as of December 31, 2008:
The table below summarizes information by major category as of December 31, 2008:
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 10, Special Purpose Entities and Variable Interest Entities.
Ambac’s credit derivative contracts are accounted for at fair value since they do not qualify for the financial guarantee scope exception under SFAS 133. 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
Although CDS contracts are accounted for at fair value in accordance with SFAS 133, 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 in Losses and Loss Expenses section. The table below summarizes information related to CDS contracts currently on Ambac’s adversely classified credit listing:
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. Ambac Capital Services entered into total return swaps with professional counterparties. Total return swaps are primarily referenced to fixed income obligations, which meet Ambac Assurance’s financial guarantee credit underwriting criteria. These contracts are recorded on trade date at fair value. Changes in fair value are recorded in the Consolidated Statements of Operations. The change in fair value of interest rate and currency swaps are reflected in “Derivative products” revenues and the change in fair value of total return swaps are reflected in “Net mark-to-market losses on total return swap 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.
The Ambac 1997 Equity Plan (the “Equity Plan”), as amended, provides for the granting of stock options, stock appreciation rights, restricted stock units (“RSUs”), performance units and other awards that are valued or determined by reference to the common stock. Ambac generally expects to deliver shares to employees under this plan from its treasury stock. Ambac also maintains the Ambac 1997 Non-employee Directors Equity Plan, which provides similar awards to non-employee members of Ambac’s Board of Directors. The number of shares awarded to each non-employee director under the Directors Equity Plan are determined by formula. As of December 31, 2008, approximately 9,657,364 shares were available for future grant under the Equity Plan and the Directors Equity Plan.
Effective January 1, 2006, Ambac adopted SFAS 123-R, “Share-Based Payment”, by using the modified prospective approach to all employee awards granted after the effective date. Beginning with the effective date, SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date and for all awards granted to employees prior to the effective date of SFAS 123-R that remain unvested on the effective date using the fair-value measurement method and estimating forfeitures for all unvested awards. Under the fair-value measurement method, a share-based award is generally measured based on the grant-date fair value of the award. SFAS 123-R requires the grant date expensing of share-based awards granted to retirement-eligible employees. Based on interpretative guidance under SFAS 123-R, Ambac must elect to continue to expense awards to retirement eligible employees on the grant date or accrue in the year prior to the grant date (service period). Ambac elected to accrue the estimated cost of future stock-compensation grants to retirement-eligible employees over the service period. The fair value of share-based awards that only require future service are amortized over the relevant service period. For an award with only service conditions that has a graded vesting schedule, the fair value of the award is attributed on a straight-line basis over the requisite service period for each separately vested portion of the award as if the award was, in-substance, multiple awards. The fair value of the market condition based stock option awards are attributed over the shorter of the derived vesting periods based on the output of the valuation model or the service period. RSU awards are attributed over the shorter of the vesting or service period.
Foreign currency transaction gains and losses of Ambac’s U.S. dollar functional currency subsidiaries’, arising primarily from sales of long-term foreign denominated investment securities, short-term investment securities and cash denominated in foreign currencies, are reflected in net (loss) income. The Consolidated Statements of Operations include pre-tax gains from such foreign exchange items of $1,933, $14,496 and $8,724 for 2008, 2007 and 2006, respectively.
Ambac files a consolidated Federal income tax return with its subsidiaries. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.
SFAS 163 requires the recognition and measurement of a claim liability based on the present value of expected net cash outflows to be paid, using a risk-free rate, in excess of the unearned premium revenue. Expected net cash outflows under SFAS 163 are probability-weighted cash flow scenarios that reflect the likelihood of all possible outcomes for net claim payments under an insurance contract. This differs from Ambac’s current claim liability approach which we recognize the full amount of estimated net cash outflows based, in many cases, on a single scenario discounted at a rate which approximates our investment portfolio yield.
SFAS 163 will be applied to existing financial guarantee insurance contracts in effect on January 1, 2009 and the cumulative effect of initially applying this Statement will be recorded as an adjustment to the opening balance of retained earnings. Ambac believes that the cumulative effect of initially applying the provisions of SFAS 163 could be material to our financial statements however the impact upon adoption is still not known. The provisions of SFAS 163 are complex and its implementation has presented significant challenges as a result of the short implementation time frame, resolution of difficult interpretational issues and significant changes to our internal accounting and reporting systems. Ambac continues to evaluate the impact of the standard with regard to revenue recognition, claim liabilities and deferred acquisition costs on its financial statements.
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. Management has determined that the unrealized losses reflected in the table above are temporary in nature as of December 31, 2008 and 2007 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; and (iii) Ambac’s ability and current intent to hold these securities until a recovery in fair value or maturity. See Note 2 for a more detailed discussion on Ambac’s impairment review process.
At December 31, 2008 and 2007, there were 428 and 332 individual fixed income securities, respectively where the aggregate amortized cost exceeded fair value. Unrealized losses on these securities as a percentage of amortized cost was 53% and 7%, as of December 31, 2008 and 2007, respectively. The unrealized losses in fixed income securities at December 31, 2008 and 2007 were concentrated in Alt-A residential mortgage backed securities.
As part of the quarterly impairment review process, management has analyzed the cash flows of all Alt-A securities held based on the default, prepayment and severity loss assumptions specific to each security’s underlying collateral. Management has contracted an external consultant to model each of the securities in our portfolio. The model estimates cash flows from the underlying mortgage loans and distributes those cash flows to various tranches of securities, considering the transaction structure and any subordination and credit enhancements that exist in that structure. The cash flow model incorporates actual cash flows on the mortgage-backed securities 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. Management considered this analysis in making our determination that a credit loss is not probable on these transactions.
temporary impairments in the future. Although our analysis indicates that at this time credit losses are not probable, expected collateral cash flows are closer to resulting in projected shortfalls of principal or interest on these securities relative to our other Alt-A holdings. Therefore, deterioration in the expected performance of collateral, changes in interest rates, or other factors that impact performance is more likely to result in an other-than-temporary impairment in the future.
The increase in gross unrealized losses on municipal obligations during the year-ended December 31, 2008 was a result of credit spreads widening across the spectrum since the onset of the credit crisis and particularly since the downgrades of the financial guarantors occurred. The Company does not have credit concerns with the municipal securities since many of the underlying credits are highly rated in the AA category and the Company believes that receipt of all principal and interest on these securities is probable.
The following table details amounts included in net realized gains (losses) by segment:
Also during its quarterly impairment evaluations, management identified certain investment securities to potentially sell in order to satisfy additional collateral posting requirements, investment agreement terminations or other near term liquidity needs. Management recorded other-than-temporary impairment charges of $186,932 for the year ended December 31, 2008 for the securities identified at each quarterly evaluation date that were in an unrealized loss position because management did not have the intent to hold the securities for a period of time sufficient to allow for recovery in market value to amortized cost. Other-than-temporary impairment charges in 2007 of $40,080 were a result of management’s intent to sell specific securities to meet potential liquidity needs.
(1) Securities purchased under agreements to resell (repurchase agreements) - In the normal course of business, Ambac holds securities under repurchase agreements with various counterparties. A portion of these securities has been pledged to Ambac’s investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). Such securities may not then be repledged by the investment agreement counterparty to another entity. Securities purchased under agreements to resell have also been pledged to certain interest rate swap and credit derivative counterparties. Under the terms of these derivative agreements, Ambac and its counterparties may be required to pledge collateral to the other resulting from changes in the estimated fair value of those agreements. Both Ambac and the counterparties have identical rights to pledge or rehypothecate the securities received under these derivative agreements.
(2) Securities held in Ambac’s investment portfolio - Ambac pledges investments it holds in its investment portfolio to (a) investment and investment repurchase agreement counterparties; (b) repurchase agreement counterparties in accordance with the terms and conditions described in (1) above; and (c) a non-U.S. domiciled insurance company which has ceded insurance risks to Ambac. Securities pledged to investment and investment repurchase agreement counterparties as well as non-U.S. domiciled insurers may not then be re-pledged to another entity. Ambac has also sold securities in its Financial Services investment portfolio under agreements to repurchase (reverse repurchase agreements). Ambac’s counterparties under derivative agreements and reverse repurchase agreements have the right to pledge or rehypothecate the securities and as such, are separately classified on the Consolidated Balance Sheets as “Fixed income securities pledged as collateral, at fair value”.
(3) Cash and Securities pledged to Ambac under derivative agreements - Ambac may repledge securities it holds from certain derivative counterparties as described in (1) above, to other derivative counterparties in accordance with its rights and obligations under those agreements.
Ambac Assurance’s reinsurance assets, including prepaid reinsurance and reinsurance recoverables on losses amounted to $450,464 at December 31, 2008. This credit exposure existed at December 31, 2008 with respect to reinsurance recoverables to the extent that any reinsurer may not be able to reimburse Ambac Assurance under the terms of these reinsurance arrangements. Ambac Assurance requires certain reinsurers to maintain bank letters of credit or establish trust accounts to cover liabilities ceded to such reinsurers under reinsurance contracts. The collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance (i) monitors the financial condition of its reinsurers, (ii) is entitled to receive collateral from its reinsurance counterparty in certain reinsurance contracts, and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade (S&P or Moody’s) of a reinsurer. Given the financial strength of its reinsurers at the inception of each reinsurance contract, Ambac Assurance requires collateral from reinsurers primarily to (i) receive statutory credit for the reinsurance for foreign reinsurers, (ii) provide liquidity to Ambac Assurance in the event of claims on the reinsured exposures, and (iii) enhance rating agency credit for the reinsurance. Ambac Assurance held letters of credit and collateral amounting to approximately $627,190 from its reinsurers at December 31, 2008. The largest reinsurer accounted for 5.8% of gross par outstanding at December 31, 2008.
As of December 31, 2008, the aggregate amount of insured par ceded by Ambac to reinsurers under reinsurance agreements was $63,650,079. The following table represents the percentage ceded to reinsurers and reinsurance recoverable at December 31, 2008 and its rating levels as of February 28, 2009:
(1) Reinsurer was downgraded in 2008 by S&P and/or Moody’s. According to the terms of the reinsurance agreement, Ambac Assurance has certain cancellation rights that can be exercised.
(3) Represents ceded case loss and loss expense reserves and reinsurance recoverables on ceded paid losses and loss expenses, net of ceded premium payables due to reinsurers, letters of credit, and collateral posted for the benefit of the Company.
Under reciprocal reinsurance agreements with various financial guarantor competitors, Ambac Assurance has assumed exposures. Ambac and MBIA have had such a reciprocal reinsurance agreement since 1995 when the two companies created an unincorporated international joint venture. In 2004, Ambac Assurance entered into reciprocal reinsurance agreements with FSA Guarantee for healthcare and international PFI transactions. Additionally, Ambac Assurance’s portfolio has assumed transactions that it obtained in connection with its purchase of Everspan in 1998. Under the provisions of each of these reinsurance agreements, the ceding company has certain cancellation rights that became exercisable upon the rating downgrades of Ambac Assurance in 2008 and accordingly, the ceding insurer has the ability to terminate and recapture the reinsured exposures. The cost of such termination is based on the provisions of each reinsurance contract and amounts would be higher than the amount of liabilities (loss reserves and unearned premium reserves) included in the financial statements. Certain contracts require an increase in ceding commission if termination is not elected by the primary insurer.
The provision for losses of $2,227,583 is the amount recorded as loss and loss expenses in the Consolidated Statements of Operations. The provision for losses and loss expenses represents the expense recorded for losses
inherent in the non-derivative financial guarantee insurance portfolio as of the reporting date. The 2008 loss and loss expenses were primarily driven by provisions for losses on deteriorating mortgage-backed security exposures, partially due to deterioration in credit underwriting standards by mortgage originators. Ambac has established subrogation recoveries of $859,529 for substantiated representation and warranty breaches by certain transaction sponsors.
Ambac establishes an active credit reserve to reflect probable and estimable losses due to credit deterioration on insured credits that have not yet defaulted or been reported as of the reporting date. The active credit reserve is generally established through a process that estimates probable losses inherent in the adversely classified credit portfolio. Provisions are recognized through the active credit reserve based on the ongoing analysis of the portfolio as discussed in Note 2. Upon default of the underlying credit, the reserve is transferred from active credit reserves to case basis credit reserves.
Case basis credit reserves are established for losses on insured obligations that have already defaulted. We believe our definition of case basis credit reserves differs from other financial guarantee industry participants. Our case reserves represent the present value of anticipated loss and loss expense payments expected over the estimated period of default. Loss and loss expenses consider defaulted debt service payments, estimated expenses associated with settling the claims and estimated recoveries under collateral, contractual and subrogation rights.
During 2008, 2007 and 2006, gross losses paid were $638,194, $30,417 and $126,183, respectively. During 2008, 2007 and 2006, other recoveries (under subrogation rights) of losses were $11,719, $27,875 and $16,711, respectively.
In 2007, Ambac issued in a public offering $400,000 of Directly-Issued Subordinated Capital Securities due 2087 (the DISCSsm) and bears interest of 6.15%, payable semi-annually in arrears on February 15 and August 15 of each year beginning August 15, 2007. The DISCS may be redeemed in whole or in part at Ambac’s option, or in whole upon the occurrence of certain tax or rating agency events, at the applicable redemption price. Ambac used the proceeds from the offering to repurchase $400,000 of its common stock pursuant to an accelerated share repurchase program.
The total effect of income taxes on income and stockholders’ equity for the years ended December 31, 2008 and 2007 was as follows:
The addition to tax reserves in 2008, 2007 and 2006 relates to the accrual of interest on existing tax reserves. The release of tax reserves in 2008 relates to the settlement of an Internal Revenue Service audit.
The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 2008 and 2007 are presented below:
Aside from an additional accrual for interest and penalties, it is not likely that the uncertain tax position will change in the next 12 months.
Beginning in 2005, Ambac CDS contracts were significantly altered to adopt a “pay as you go” approach. The contracts call for the seller to make cash settlements to buyer in the event of failure of the referenced obligation to make any of a number of scheduled future payments. Cash settlement follows the payment schedule of the reference obligation in terms of amount and timing and does not terminate the contract. The conditions of settlement may be satisfied on any number of occasions. Buyer does not at anytime have any obligation to hold any part of the reference obligation, and is not required to transfer any obligation to seller at settlement. As such, the facts would indicate that “pay as you go” contracts should be characterized as notional principal contracts.
Prior to 2007, the Company had an established history of increasing profitability in both pre tax GAAP earnings and taxable income before special deductions, which were $1,210,213 and $1,008,090 respectively in 2006. The primary differences between the GAAP earnings and taxable income were the timing of recognition of premium and losses and tax exempt investment income.
Over the past 2 years, the Company experienced significant mark to market losses on its CDS portfolio, incurred significant losses on its RMBS (real estate mortgage backed securities) and significant increases in the unrealized losses on its investment portfolio, which resulted in overall net losses on both a GAAP and tax basis. The extent of these losses was much greater than originally anticipated and it is reasonably possible that these losses may continue to develop in future periods.
As of December 31, 2008, the Company established a gross deferred tax operating asset of $3,123,473 and a gross deferred tax capital asset of $1,057,026, resulting in a total deferred tax asset of $4,180,499. In accordance with SFAS 109, “Accounting for Income Taxes” the Company evaluated our deferred income taxes quarterly to determine if valuation allowances are required. SFAS 109 requires that companies assess whether valuation allowances should be established against their deferred tax assets based on the consideration of all available
Ambac has not established a valuation allowance in connection with the capital loss portion of its deferred tax asset which is comprised of $891,033 relating to SFAS No. 115 securities for which management has the ability and intent to hold such securities to maturity and $172,205 relating to other-than-temporary impairment charges taken on the remaining investment portfolio. Ambac’s conclusion that no valuation allowance is needed on the capital loss portion of the deferred tax asset is based on Ambac’s ability and intent to hold the SFAS No. 115 securities until maturity and because it is more likely than not that Ambac will have sufficient capital gains in the three year carry back and five year carry forward period to fully validate the deferred tax asset related to capital losses on the other-than-temporary investments impairment charges recorded in the consolidated statement of operations. Consistent with the Company’s assessment of future taxable income, it is the Company’s intent and ability to hold the investment securities with unrealized losses through recovery. It is reasonably possible that the intent and ability to hold may be changed if unanticipated changes in the Company occur, which would result in the Company recording a valuation allowance against the capital loss portion of the deferred tax asset.
As of December 31, 2008 Ambac has a net operating tax carryforward of approximately $3,497,787, which if not utilized will expire in 2028.
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 structured finance obligations guaranteed by Ambac Assurance), the structure allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance 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.
As of December 31, 2008, Ambac is the primary beneficiary and, therefore, consolidated a VIE under one transaction as a result of providing a financial guarantee. The VIE is a bankruptcy remote special purpose financing entity created by the issuer of debt securities to facilitate the sale of notes guaranteed by Ambac Assurance. Ambac is not primarily liable for the debt obligations of the VIE. Ambac would only be required to make payments on these debt obligations in the event that the issuer defaults on any principal or interest due. Additionally, Ambac’s creditors do not have rights with regard to the assets of the VIE.
The following table provides supplemental information about the combined assets and liabilities associated with the VIE discussed above. The assets and liabilities of the VIE are consolidated into the respective Balance Sheet captions.
(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. The maximum exposure to loss is included in and not incremental to the gross financial guarantees in force disclosed in Note 15 “Guarantees Inforce”.
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. Refer to Note 2 Significant Accounting Policies-“Losses and Loss Expenses” and “Net Premiums Earned” sections for further information related to the accounting for financial guarantee insurance contracts.
As of December 31, 2008, there have been 15 individual transactions with the QSPEs, of which 9 are outstanding. In each case, Ambac sold fixed income debt obligations to the QSPEs. The fixed income debt obligations are composed of asset-backed securities and utility obligations with a weighted average rating of A- and weighted average life of 2.5 years at December 31, 2008. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. Additionally, Ambac’s creditors do not have any rights with regard to the assets of the QSPEs. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. The MTNs have the same weighted average life as the purchased assets. Derivative contracts (interest rate and currency swaps) may be used for hedging purposes only. Hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs 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 December 31, 2008, Ambac Assurance had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the QSPEs.
Derivative contracts are provided by Ambac Financial Services, a subsidiary of Ambac. Consistent with other non-hedging derivatives, Ambac Financial Services account for these contracts on a trade date basis at fair value. The change in fair value of interest rate and currency swaps are reflected in “Derivative products revenues” on Ambac’s Consolidated Statements of Operations. Ambac Financial Services received $10,905,
$33,830 and $31,603 for the years ended December 31, 2008, 2007 and 2006, respectively, under these derivative contracts. Methodologies used to determine fair value of derivative contracts, including model inputs and assumptions where applicable, are described further in Note 16 Fair Value Measurements.
Ambac has elected to account for its equity interest in the QSPEs at fair value under SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” Ambac previously accounted for its equity interest in the QSPEs using the equity method of accounting in accordance with ABP Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” We believe that the fair value of these investments in these QSPEs provides for greater transparency for recording profit or loss as compared to the equity method. Ambac reported a $7,020 cumulative-effect adjustment benefit to the opening balance of retained earnings as a result of the re-measurement to fair value. At December 31, 2008 the fair value of the QSPEs is $14,290 and is reported within Other Assets within the Consolidated Balance Sheets. The change in fair value of the QSPEs for the year ended December 31, 2008 is ($17), and is included within Other Income on the Consolidated Statements of Operations.
During 2006, the Compensation Committee of the Board of Directors approved an amendment to the Ambac Pension Plan that terminated the Plan effective December 31, 2006. Benefits under the Plan ceased to accrue as of December 31, 2006. Benefits were paid under the Plan in 2007 and the remaining plan assets were transferred to a trust to be used to fund other eligible retirement benefits. The remaining plan assets as of December 31, 2008 are disclosed as part of Short-term Investments in the Consolidated Balance Sheets.
The discount rate used in determining the projected benefit obligations for the postretirement plan is selected by reference to the year-end Moody’s corporate AA rate, as well as other high-quality indices with similar duration to that of the benefit plans. The rate used for the projected plan benefit obligations at the measurement date for 2008 and 2007 (December 31) were 5.75% and 6.25%, respectively.
Substantially all employees of Ambac are covered by a defined contribution plan (the “Savings Incentive Plan”). Ambac makes an employer matching contribution of 100% of the employee’s contributions up to 6% of such participants’ base compensation, subject to limits set by the Internal Revenue Code. Effective January 1, 2007, the Compensation Committee of the Board of Directors approved an increase to the matching contribution from 50% to 100% of the employees contribution up to 6%. Ambac may also make a Basic Profit Sharing contribution of 3% of base compensation and a Supplemental Profit Sharing contribution of an additional 3% of base compensation to eligible employees. The total cost of the Savings Incentive Plan was $4,393, $4,678 and $3,757 in 2008, 2007 and 2006, respectively.
The expected volatility considers the implied volatility in Ambac’s traded options and historical volatility levels on Ambac’s common stock over the contractual term (Monte Carlo simulation) or expected life (Black-Scholes) of the option. Applicable to the Monte Carlo simulation, the suboptimal factor represents the option holder’s expected exercise behavior, that is, the percentage multiplied by the option grant’s strike price results in the market price at which Ambac expects the holder to exercise their option. The determination of the suboptimal factor is based on the exercise history of Ambac’s previous grants considering management’s future expectation of exercise behavior. The expected dividend yield is based on historical dividend payments. The risk-free interest
rates reflect the yields on U.S. Treasuries over the contractual term (Monte Carlo simulation) or expected life (Black-Scholes) of the award. For the Monte Carlo simulation model, we have adjusted the contractual term of the option for the effect of retirement-eligible participants to arrive at the expected term assumption.
A summary of option activity for the period ending December 31, 2008 is as follows:
As of December 31, 2008, there was $8,719 of total unrecognized compensation costs related to unvested stock options granted. These costs are expected to be recognized over a weighted average period of 1.3 years. Gross stock option expense for 2008, 2007 and 2006 was $1,749, $15,345 and $15,079, respectively. The net income effect from stock options for 2008, 2007 and 2006 were $138, $7,033, and $5,692, respectively.
As of December 31, 2008, there was $19,251 of total unrecognized compensation costs related to unvested RSUs granted. These costs are expected to be recognized over a weighted average period of 1.79 years. The fair value for RSUs vested during 2008, 2007 and 2006 was $4,324, $25,842 and $8,511, respectively.
Ambac is responsible for leases on the rental of office space. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:
Ambac Financial Group, Inc, and certain of its present and former officers and directors have been named in lawsuits that allege violations of the federal securities laws and/or state law. Various putative class action suits alleging violations of the federal securities laws have been filed against the Company and certain of its present or former directors and officers. These suits include four class actions filed in January and February of 2008 in the United States District Court for the Southern District of New York that were consolidated on May 9, 2008 under the caption In re Ambac Financial Group, Inc. Securities Litigation, Lead Case No. 08 CV 411. On July 25, 2008, another suit, Painting Industry Insurance and Annuity Funds v. Ambac Assurance Corporation, et al., case No. 08 CV 6602, was filed in the United States District for the Southern District of New York. On or about August 22, 2008, a consolidated amended complaint was filed in the consolidated action. The consolidated amended complaint includes the allegations presented by the original four class actions, the allegations presented by the Painting Industry action, and additional allegations. The consolidated amended complaint purports to be brought on behalf of purchasers of Ambac’s common stock from October 25, 2006 to April 22, 2008, on behalf of purchasers of Ambac’s Directly-Issued Subordinated Capital Securities (“DISCS”), issued in February of 2007, and on behalf of purchasers of equity units and common stock in Ambac’s March 2008 offerings. The suit names as defendants the Company, the underwriters for the three offerings, KPMG and certain present and former directors and officers of the Company. The complaint alleges, among other things, that the defendants issued materially false and misleading statements regarding Ambac’s business and financial results and guarantees of CDO and MBS transactions and that the Registration Statements pursuant to which the three offerings were made contained material misstatements and omissions in violation of the securities laws. On October 21, 2008, the Company and the individual defendants named in the consolidated securities action moved to dismiss the consolidated amended complaint.
Various shareholder derivative actions have been filed against certain present and former officers and directors of Ambac, and against Ambac as a nominal defendant. These suits, which are brought purportedly on behalf of the Company, are in many ways similar and allege violations of law for conduct occurring between October 2005 and the present regarding, among other things, our guarantees of CDO and MBS transactions, Ambac’s public disclosures regarding such guarantees and Ambac’s financial condition, and certain defendants’ alleged insider trading on non-public information. The suits include (i) three actions filed in the United States District Court for the Southern District of New York that have been consolidated under the caption In re Ambac Financial Group, Inc. Derivative Litigation, Lead Case No. 08 CV 854; on June 30, 2008, plaintiffs filed a consolidated and amended complaint that asserts violations of state and federal law, including breaches of fiduciary duties, waste of corporate assets, unjust enrichment and violations of the federal securities laws; on
Ambac has been named in a lawsuit filed by the City of New Orleans (“New Orleans”) in connection with its participation in a New Orleans bond issue. New Orleans issued variable rate demand obligations (“VRDOs”), which were insured by Ambac Assurance, and entered into an interest rate swap agreement with PaineWebber, Inc. in order to “synthetically fix” its interest rate on the VRDOs. PaineWebber in turn entered into an interest rate swap agreement with Ambac Financial Services, LLC (“AFS”) with terms that mirrored those of the New Orleans/Paine Webber swap. New Orleans alleges that, (1) as a result of the loss of its triple-A ratings, Ambac Assurance is unable to perform its obligations under its financial guarantee insurance policy and that this alleged
inability to perform has cost New Orleans additional interest costs on the bonds and (2) AFS improperly directed PaineWebber to adjust the floating rate paid by PaineWebber under the interest rate swap agreement to an index rate, thereby increasing the interest cost of the bond issue to New Orleans.
During 2008, Ambac raised $1,500,000 of capital. This transaction included 185,185,186 common shares (public and private offerings) for $1,250,000 and the issuance of $250,000 of equity units pursuant to which we are obligated to sell, and the holders are obligated to purchase, common shares in 2011. Refer to Note 7 for further information on the equity units issued. Approximately $1,300,000 of the capital proceeds was contributed to Ambac Assurance to support its financial strength ratings.
On July 2, 2008, Ambac’s Board of Directors authorized up to $50,000 for share repurchases of its common stock under a new Stock Repurchase Program upon the condition of the completion of the offering of shares by the underwriters of its March 2008 offering. As a result of Moody’s rating actions, Ambac has suspended this program.
Dividends declared per share amounted to $0.10, $0.78, and $0.66 in 2008, 2007, and 2006, respectively.
The par amount of financial guarantees outstanding were $497,960,000 and $612,075,000 at December 31, 2008 and 2007, respectively. The par amount of financial guarantees outstanding, net of reinsurance, was $434,310,000 and $524,025,000 at December 31, 2008 and 2007, respectively. As of December 31, 2008 and 2007, the guarantee portfolio was diversified by type of guaranteed bond as shown in the following table:
In the United States, California and New York were the states with the highest aggregate net par amounts in force, accounting for 10.4% and 6.0% of the total at December 31, 2008. No other state accounted for more than five percent. The highest single insured risk represented 0.7% of the aggregate net par amount guaranteed.
In connection with its financial guarantee business, Ambac has outstanding commitments to provide guarantees of $19,031,000 at December 31, 2008. These commitments relate to potential future debt issuances or increases in funding levels for existing insurance or credit derivative transactions. Commitments generally have fixed termination dates and are contingent on the satisfaction of all conditions set forth in the contract. These commitments may expire unused or be reduced or cancelled at the counterparty’s request. Additionally, approximately 50% of the total commitment amount represents commitments that contain one or more of the following provisions: (i) the commitment may be terminated at the Company’s election upon a material adverse change, (ii) in order for the funding levels to be increased, certain asset eligibility requirements must be met, or (iii) for commitments to provide protection in credit derivative form, the commitment may not be exercised upon an event of default or after the reinvestment period. Accordingly, the $19,031,000 of commitments outstanding at December 31, 2008 does not necessarily reflect actual future amounts.
net exposure under this commitment as of December 31, 2008 was $2,884,000. Ambac has a below investment grade internal credit rating for this commitment.
On January 1, 2008, Ambac adopted the provisions of SFAS 157, “Fair Value Measurements”. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement applies to amounts measured at fair value under other accounting pronouncements that require or permit fair value measurements. SFAS 157 supersedes certain accounting guidance, which prohibited the recognition of day one gains on certain derivative transactions. The provisions of SFAS 157 are to be applied prospectively, except that any remaining reserves for day one gains will be reflected as a cumulative effect adjustment to the opening balance of retained earnings. Ambac adopted SFAS 157 as of the beginning of 2008. The transition adjustment to beginning retained earnings was an after-tax gain of $13,031. Additionally, the requirement under SFAS 157 to incorporate Ambac’s own creditworthiness in the measurement of fair value of liabilities resulted in an increase to pre-tax income of $10,246,697 for the year ended December 31, 2008. We reflect Ambac’s own creditworthiness in the fair value by increasing the discount rate used by observable credit spreads on Ambac Assurance.
SFAS 157 specifies a fair value hierarchy based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company-based market assumptions. In accordance with SFAS 157, the fair value hierarchy prioritizes model inputs into three broad levels as follows:
Quoted prices for identical instruments in active markets. Assets and liabilities classified as Level 1 include US treasury securities, money market funds and mutual funds.
The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. The current market disruptions make valuation even more difficult and subjective. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. We believe the potential for differences in third-party pricing levels is particularly significant with respect to residential mortgage backed and certain other asset-backed securities held in our investment portfolio and referenced in our credit derivative portfolio, due to the very low levels of recent trading activity for such securities. In addition, the use of internal valuation models for certain highly structured instruments such as credit default swaps, require assumptions about markets in which there has been a negligible amount of trading activity for over one year. As a result of these factors, in the current market environment, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position by Ambac, may be significantly different from its recorded fair value.
Ambac’s financial instruments carried at fair value are mainly comprised of investments in fixed income securities, derivative instruments and equity interest in QSPEs.
When broker quotes for reference obligations are not available, reference obligation prices used in the valuation model are estimated internally based on averages of the quoted prices for other transactions of the same bond type and Ambac rating as well as changes in published credit spreads for securities with similar collateral and ratings characteristics. When price quotes of a similar bond type vary significantly or the number of similar transactions is small, as has been observed with CDO of ABS transactions, management will consider additional factors, such as specific collateral composition and performance and contractual subordination, to identify similar transactions. Published credit spreads were primarily used to update recently received price quotes for certain CLO transactions where quotes were not received as of December 31, 2008. Reference obligation prices derived internally as described above were used in the determination of CDS fair values related to transactions representing 15% of CDS net par outstanding and 22% of the CDS derivative liability as of December 31, 2008.
The amount of expected loss on a reference obligation is a function of the probability that the obligation will default and severity of loss in the event of default. Ambac’s CDS transactions were all written with extremely low expected losses. Both the reference obligation spreads and Ambac’s CDS fees at the inception of these transactions reflect these low expected losses. When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and, therefore, an increase in expected loss. The effects of credit deterioration on financial guarantee CDS fees cannot be observed in the market through new transactions, secondary market transactions or by other means as there have been no such transactions. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread (over LIBOR) which would be captured as a CDS fee (“relative change ratio”) at the valuation date, resulting in a higher mark-to-market loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. For example, if the credit spread of an underlying reference obligation was 80 basis points at the inception of a transaction and Ambac received a 20 basis point fee for issuing a CDS on that obligation, the “relative change ratio”, which represents the CDS fee to cash market spread Ambac would utilize in its valuation calculation, would be 25%. If the reference obligation spread increased to 100 basis points in the current reporting period, absent any observable changes in financial guarantee CDS market pricing or credit deterioration, Ambac’s current period CDS fee would be computed by multiplying the current reference obligation spread of 100 basis points by the relative change ratio of 25%, resulting in a 25 basis point fee. Thus, the model indicates we would need to receive an additional 5 basis points (25 bps currently less the 20bps we received at inception) for issuing a CDS in the current reporting period for this reference obligation. We would then discount the product of the notional amount of the CDS and the 5 basis point hypothetical CDS fee increase, over the weighted average life of the reference obligation to compute the current period mark-to-market loss. Using the same example, if the reference obligation spread increased to 100 basis points and there was credit deterioration as evidenced by an internal rating downgrade which increased the relative change ratio from 25% to 35%, we would estimate a 15 basis point hypothetical CDS fee increase in our model (35% of 100 basis point reference obligation spread, or 35 bps currently, less the 20 bps contractually received). Therefore, we would record a higher mark-to-market loss based on the computations described above absent any observable changes in financial guarantee CDS market pricing.
purchased contracts, (iii) losses and settlements paid on written credit derivative contracts and (iv) paid losses and settlements recovered and recoverable on purchased credit derivative contracts for the appropriate accounting period. The remaining key variables described above impact the “Unrealized gains (losses)” component of “Net change in fair value of credit derivatives.” The net notional outstanding of Ambac’s CDS contracts is $56,801,198 and $67,922,299 at December 31, 2008 and 2007 respectively.
The amount of credit derivative assets included in “Derivative assets” is $321,007 and $156,900 as of December 31, 2008 and 2007. Credit derivative assets included in the Consolidated Balance Sheets as of December 31, 2008 and 2007 arose from widening credit spreads on reference obligations of purchased credit default swaps and, at year end 2007, narrower reference obligation credit spreads on a small number of credit default swap transactions compared to spreads at the time those CDS contracts were written. The aggregate notional amount of credit default swap protection purchased from financial institutions, including insurance enterprises, is approximately $820,305 and $1,933,104 with an aggregate fair value asset of $321,007 and $156,786 as of December 31, 2008 and 2007, respectively.
This fair value estimate of financial guarantees is presented in the table immediately following the first paragraph of this Note 16 on a net basis and includes direct contracts written, which represent our liability, net of ceded reinsurance contracts, which represent our asset. The fair value estimate of direct contracts written is based on the sum of the present values of (i) unearned premium reserves; (ii) loss and loss expense reserves; and (iii) estimated future installment premiums. The fair value estimate of ceded reinsurance contracts is based on the sum of the present values of (i) prepaid reinsurance, net of ceding commissions (ii) reinsurance recoverables on losses; and (iii) estimated future installment premiums ceded, net of ceding commissions.
Under our current financial guarantee model, the key variables are par amounts outstanding (including future periods for the calculation of future installment premiums), expected term, discount rate, and expected net loss and loss expense payments. Net par outstanding is monitored by Ambac’s surveillance group. Estimates of future installment premiums received and ceded are based on contractual premium rates and estimates of the expected terms of these contracts. With respect to the discount rate, SFAS 157 requires that the nonperformance risk of a financial liability be included in the estimation of fair value. This nonperformance risk would include considering Ambac’s own credit risk in the fair value of financial guarantees we have issued, thus the estimated fair value for direct contracts written was discounted at LIBOR plus Ambac’s current credit spread. The credit spread used to estimate the nonperformance risk component of the fair value of financial guarantees as of December 31, 2008 was 1,687 basis points. As Ambac adopted SFAS 157 effective January 1, 2008, this nonperformance risk was not incorporated into the financial guarantee fair value estimate reported in Ambac’s December 31, 2007 10-K. Please refer to Note 6, Loss and Loss Expenses, for additional information on factors which influence our estimate of loss and loss expenses. The estimated fair value of ceded reinsurance contracts factors in any adjustments related to the counterparty credit risk we have with reinsurers.
There are a number of factors that limit our ability to accurately estimate the fair value of our financial guarantees. The first limitation is the lack of observable pricing data points as a result of the current disruption in
The carrying values of Cash, Investment income due and accrued and Accrued interest payable approximates fair value. The fair values of Ambac’s equity interest in QSPEs (included in Other assets), Loans and Obligations under investment, repurchase and payment agreements are estimated based upon internal valuation models that discount expected cash flows using a discount rates consistent with the credit quality of the obligor after considering collateralization. The fair value of debentures classified as Long-term debt is based on quoted market prices.
The following tables present the changes in the Level 3 fair value category for the year ended December 31, 2008. Ambac classifies financial instruments in Level 3 of the fair value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Thus, the gains and losses presented below include changes in the fair value related to both observable and unobservable inputs.
Gains and losses (realized and unrealized) relating to Level 3 assets and liabilities included in earnings for year ended December 31, 2008 are reported as follows:
Ambac Assurance’s ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin. Wisconsin insurance law restricts the payment of dividends in any 12-month period without regulatory approval to the lesser of (a) 10% of policyholders’ surplus as of the preceding December 31, and (b) the greater of (i) statutory net income (loss) for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year or (ii) the aggregate of statutory net income (loss) for three calendar years preceding the date of the dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without notifying the Wisconsin Insurance Commissioner 30 days in advance of payment. Based upon these restrictions, at December 31, 2008, Ambac Assurance will not be able to pay dividends during 2009, without regulatory approval. Ambac Assurance paid cash dividends of $218,540, $190,200 and $136,000 on its common stock in 2008, 2007 and 2006, respectively. The 2007 dividend required regulatory approval since it exceeded the statutorily prescribed threshold.
Section 3.08 of the Wisconsin Administrative Code prohibits the Company from having total net liability in respect to any one issue of municipal bonds in excess of an amount representing 10% of its policyholders’ surplus. Total net liability, as defined by the Wisconsin Administrative Code, means the average annual amount due, net of reinsurance, for principal and interest on the insured amount of any one issue of municipal bonds.
Additionally, Section 3.08 of the Wisconsin Administrative Code prohibits the Company from having outstanding cumulative net liability, under inforce policies of municipal bond insurance in an amount which exceeds the sum of the Company’s: i.) capital and surplus, plus ii.) contingency reserves. Cumulative net liability, as defined by the Wisconsin Administrative Code, means one-third of one percent of the insured unpaid principal and insured unpaid interest covered by inforce policies of municipal bond insurance. As of December 31, 2008 and 2007, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.
The New York Financial Guarantee Insurance Law defines the scope of permitted financial guarantee insurance business and establishes single risk limits applicable to obligations insured by Ambac Assurance. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits compare the insured net par outstanding and average annual debt service, net of reinsurance and collateral, for a single risk to the insurer’s qualified statutory capital, which is defined as the sum of the insurer’s policyholders’ surplus and contingency reserves. As a result of (i) decreased statutory capital resulting from the significant losses experienced by Ambac Assurance during 2008 and (ii) terminations of reinsurance arrangements and related buy-backs of previously reinsured exposures, Ambac’s net insured exposure under certain individual policies exceeded the applicable single risk limits prescribed by New York State Insurance Law. As required by New York State Insurance Law, Ambac Assurance intends to submit a plan to the Superintendent of the NYSID detailing the steps that Ambac Assurance has taken and will seek to take to reduce its exposure to no more than the permitted amounts. Following the submission of such plan, after notice and hearing, the Superintendent could require Ambac Assurance to cease transacting any new financial guarantee business until its exposure to loss no longer exceeds said limits.
Ambac has two reportable segments, as follows: (1) Financial Guarantee, which provides 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, total return 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. As described in Note 1, Ambac has curtailed its activities on a going-forward basis in certain sectors of Financial Guarantee and will discontinue writing new Financial Services business (except where new transactions hedge or mitigate risks). 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.
Ambac Assurance guarantees the swap and investment agreement obligations of its Financial Services affiliates. Additionally, as described in Note 1, the OCI approved various loans from Ambac Assurance to the Financial Services businesses. Inter-segment revenues include the premiums and investment income earned under those agreements and dividends received from its Financial Services subsidiaries. Such premiums are determined as if they were premiums paid by third parties, that is, at current market prices.
The following tables summarize gross premiums written, net premiums earned and the net change in fair value of credit derivatives included in the Financial Guarantee segment, by location of risk for the years ended December 31, 2008, 2007 and 2006: