10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2010

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

For the transition period from                  to                 

Commission file number 1-10777

Ambac Financial Group, Inc.

(DEBTOR-IN-POSSESSION as of November 8, 2010)

(Exact name of Registrant as specified in its charter)

 

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

One State Street Plaza

New York, New York

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

(212) 668-0340

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class   Name of each exchange on which registered
Common Stock, $0.01 per share   None(a)
5.875% Debentures, Due March 24, 2103   None(a)
5.95% Debentures, Due February 28, 2103   None(a)
9.50% Equity Units, Due February 15, 2021   None(a)

Securities registered pursuant to Section 12(g) of the Act: None

(a) On December 17, 2010, the New York Stock Exchange filed Forms 25 to delist and deregister the Company’s securities, which deregistration under Section 12(b) shall be effective on March 17, 2011.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes  ¨    No  x

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

Large Accelerated Filer  ¨

   Accelerated filer  x    Non-accelerated filer  ¨    Smaller reporting company  ¨
   (do not check if a smaller reporting company)

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

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes  ¨    No  ¨

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2010 was $192,435,130.04 (based upon the closing price of the Registrant’s shares on the New York Stock Exchange on that date, which was $0.67). For purposes of this information, the outstanding shares of Common Stock which were owned by all directors and executive officers of the Registrant were deemed to be shares of Common Stock held by affiliates.

As of March 1, 2011, 302,428,811 shares of Common Stock, par value $0.01 per share, (net of 5,587,953 treasury shares) were outstanding.

Documents Incorporated By Reference

Information required by Part III, Items 10, 11, 12, 13 and 14 of this Annual Report on Form 10-K will be either incorporated by reference from Ambac Financial Group, Inc.’s Proxy Statement or included in an amendment to this Annual Report on Form 10-K.


Table of Contents

TABLE OF CONTENTS

 

          Page  
  

Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995

     1   
PART I      

Item 1.

  

Business

  
  

Introduction

     3   
  

Business Segments

     3   
  

Investments and Investment Policy

     25   
  

Employees

     27   
  

Corporate Governance

     27   

Item 1A.

  

Risk Factors

     27   

Item 1B.

  

Unresolved Staff Comments

     40   

Item 2.

  

Properties

     40   

Item 3.

  

Legal Proceedings

     40   

Item 4.

  

Reserved

     40   
PART II      

Item 5.

  

Market for Registrant’s Common Equity and Related Stockholder Matters

     41   

Item 6.

  

Selected Financial Data

     43   

Item 7.

  

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

     45   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     92   

Item 8.

  

Financial Statements and Supplementary Data

     98   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     213   

Item 9A.

  

Controls and Procedures

     213   

Item 9B.

  

Other Information

     214   
PART III      

Item 10.

  

Directors and Executive Officers of the Registrant

     215   

Item 11.

  

Executive Compensation

     215   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management

     215   

Item 13.

  

Certain Relationships and Related Transactions

     215   

Item 14.

  

Principal Accountant Fees and Services

     215   
PART IV      

Item 15.

  

Exhibits, Financial Statement Schedules, and Reports on Form 8-K

     215   
FINANCIAL STATEMENT SCHEDULES      221   
SIGNATURES      229   


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CAUTIONARY STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

In this Annual Report, we have included statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “estimate,” “project,” “plan,” “believe,” “anticipate,” “intend,” “planned,” “potential” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” “could,” and “may”, or the negative of those expressions or verbs, identify forward-looking statements. We caution readers that these statements are not guarantees of future performance. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, which, may by their nature be inherently uncertain and some of which may be outside our control. These statements may relate to plans and objectives with respect to the future, among other things which may change. We are alerting you to the possibility that our actual results may differ, possibly materially, from the expected objectives or anticipated results that may be suggested, expressed or implied by these forward-looking statements. Important factors that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements include, among others, those discussed under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K.

Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on Ambac Financial Group, Inc. (“Ambac” or the “Company”) management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) a plan of reorganization under Chapter 11 will not be confirmed; (2) if Ambac is not successful in filing a plan of reorganization under Chapter 11, it is likely it would have to liquidate pursuant to Chapter 7; (3) the impact of the bankruptcy proceeding on the holders of Ambac securities; (4) the unlikely ability of Ambac Assurance Corporation (“Ambac Assurance”) to pay dividends to Ambac in the near term; (5) litigation between Ambac and Ambac Assurance regarding the allocation of net operating losses (“NOLs”) and other claims could reduce the overall value of the Company; (6) adverse events arising from the Segregated Account Rehabilitation Proceedings, including the injunctions issued by the Wisconsin rehabilitation court to enjoin certain adverse actions related to the Segregated Account being successfully challenged as not enforceable; (7) litigation arising from the Segregated Account Rehabilitation Proceedings; (8) decisions made by the rehabilitator for the benefit of policyholders may result in material adverse consequences for Ambac’s securityholders; (9) potential of a full rehabilitation proceeding against Ambac Assurance, with resulting adverse impacts; (10) inadequacy of reserves established for losses and loss expenses, including our inability to realize the remediation recoveries included in our reserves; (11) market risks impacting assets in our investment portfolio or the value of our assets posted as collateral in respect of investment agreements and interest rate swap and currency swap transactions; (12) risks relating to determination of amount of impairments taken on investments; (13) credit and liquidity risks due to unscheduled and unanticipated withdrawals on investment agreements; (14) market spreads and pricing on insured collateralized loan obligations (“CLOs”) and other derivative products insured or issued by Ambac; (15) Ambac’s financial position and the Segregated Account Rehabilitation Proceedings may prompt departures of key employees and may impact our ability to attract qualified executives and employees; (16) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on our business, operations, financial position, profitability or cash flows; (17) credit risk throughout our business, including credit risk related to residential mortgage-backed securities, CLOs, public finance obligations and large single exposures to reinsurers; (18) the risk that reinsurers may dispute amounts owed us under our reinsurance agreements; (19) default by one or more of Ambac Assurance’s portfolio investments, insured issuers, counterparties or reinsurers; (20) the risk that our risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (21) factors that may influence the amount of installment premiums paid to Ambac, including the imposition of the payment moratorium with respect to claims payments as a result of Segregated Account Rehabilitation Proceedings; (22) changes in prevailing interest rates; (23) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting, required under the relevant derivative accounting guidance, to the

 

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portion of our credit enhancement business which is executed in credit derivative form; (24) changes in accounting principles or practices that may impact Ambac’s reported financial results; (25) legislative and regulatory developments; (26) operational risks, including with respect to internal processes, risk models, systems and employees; (27) changes in tax laws, tax disputes and other tax-related risks; (28) other factors described in the Risk Factors section in Part I, Item 1A of Ambac’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and also disclosed from time to time by Ambac in its subsequent reports on Form 10-Q and Form 8-K, which are available on the Ambac website at www.ambac.com and at the SEC’s website, www.sec.gov; and (29) other risks and uncertainties that have not been identified at this time.

 

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Part I

 

Item 1. Business.

INTRODUCTION

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. On November 8, 2010, Ambac filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). Ambac will continue to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. Ambac Assurance is Ambac’s principal operating subsidiary. Ambac Assurance is a financial guarantee insurer whose financial strength was formerly rated triple-A by each of the major rating agencies and which provided financial guarantees and financial services to clients in both the public and private sectors around the world.

The deterioration of Ambac Assurance’s financial condition resulting from losses in its insured portfolio and the resulting downgrades of Ambac Assurance’s financial strength ratings have prevented it from being able to write new business. An inability to write new business will negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends, and as a result Ambac’s liquidity, has been significantly restricted by the deterioration of Ambac Assurance’s financial condition, by the rehabilitation of the Segregated Account (as hereinafter defined and described in more detail below) and by the terms of the Settlement Agreement (as hereinafter defined). Refer to “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of Ambac’s bankruptcy, the creation and rehabilitation of the Segregated Account and the Settlement Agreement with the counterparties of CDO of ABS transactions.

Ambac’s principal business strategy is to reorganize its capital structure and financial obligations through the bankruptcy process and to increase the residual value of its financial guarantee business by mitigating losses on poorly performing transactions (via the pursuit of recoveries in respect of paid claims, commutations of policies and repurchases of surplus notes issued in respect of claims) and maximizing the return on its investment portfolio. Ambac does not currently anticipate generating any new business. The execution of such strategy with respect to Segregated Account Policies will be subject to the authority of the rehabilitator of the Segregated Account to control the management of the Segregated Account. In exercising such authority, the rehabilitator will act for the benefit of policyholders, and will not take into account the interests of Ambac. Similarly, by operation of the contracts executed in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the rehabilitator retains rights to oversee and approve certain actions taken in respect of Ambac Assurance. This oversight by the rehabilitator could impair Ambac’s ability to execute the foregoing strategy.

BUSINESS SEGMENTS

Ambac has two reportable business segments: Financial Guarantee and Financial Services. Each of these businesses is conducted by Ambac Assurance and/or its subsidiaries and is therefore subject to control of, or oversight by the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”). Ambac is no longer originating or competing for new business and is currently managing the runoff of these portfolios.

Ambac provided financial guarantee insurance for public and structured finance obligations solely through the insurance operations of Ambac Assurance and its wholly owned subsidiary, Ambac Assurance UK, Ltd (“Ambac UK”). Ambac also has another wholly-owned subsidiary, Everspan, it had intended to reactivate for purposes of writing financial guarantee business; however, this effort was postponed indefinitely due to our inability to raise third party capital. While Ambac Assurance historically had AAA financial strength ratings, its

 

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ratings have been downgraded multiple times, beginning in 2008. Ambac Assurance currently has a Caa2 financial strength from Moody’s and has requested and received a withdrawal of its ratings from S&P. As described above, our activities in these sectors has been limited to loss mitigation and the recovery of residual value in Ambac Assurance as a result of the deterioration of Ambac Assurance’s financial condition. As such, the following descriptions of the Financial Guarantee and Financial Services segments relate to the existing portfolios in those segments.

Through its financial services subsidiaries, Ambac provided financial and investment products, including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to the clients of its financial guarantee business. Ambac Assurance insured all of the obligations of its financial services subsidiaries. As of December 31, 2009, all total return swaps were terminated and settled. The interest rate swap and investment agreement businesses are in active runoff, which is being effectuated by means of transaction terminations, settlements, restructurings and hedges, assignments and scheduled amortization of contracts.

Financial information concerning our business segments for each of 2010, 2009 and 2008 is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the Notes thereto, included elsewhere in this Form 10-K. Our Internet address is www.ambac.com. We make available free of charge, on or through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission. Our Investor Relations Department can be contacted at Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004, Attn: Investor Relations, telephone: 212-208-3222.

Financial Guarantee Segment

The financial guarantee segment includes financial guarantee insurance and other credit enhancement products, such as credit derivatives. Generally, financial guarantee insurance provides an unconditional and irrevocable guarantee which protects the holder of a debt obligation against non-payment when due. Pursuant to such guarantees, Ambac Assurance and its subsidiaries make payments if the obligor responsible for making payments fails to do so when scheduled. In some cases, the insured obligations permitted counterparties to assert mark-to-market termination claims; however, the assertion of any such mark-to-market claims has been enjoined by the rehabilitation court. See “2010 Overview” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 for further information.

In addition to the guarantees described above, Ambac Assurance has underwritten transactions which expose the company to risks which may not be limited to credit risk, such as market risk, natural disaster risk, mortality or other property and casualty type risk characteristics.

Ambac Assurance derives financial guarantee revenues from: (i) premiums earned from insurance contracts; (ii) net investment income; (iii) revenue from credit derivative transactions; (iv) net realized gains and losses from sales of investment securities; and (v) amendment and consent fees. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 and Note 18 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information. Prior to the discontinuance of the issuance of new financial guarantees, premiums for financial guarantees were received either upfront (typical of public finance obligations) or on an installment basis from the cash flows generated by the underlying assets (typical of structured finance obligations). Despite writing no material new business, Ambac continues to collect premiums on its existing portfolio of guarantees that pay premiums on an installment basis.

 

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Risk Management

The Risk Management group is primarily responsible for the development, implementation and oversight of loss mitigation strategies, surveillance and remediation of the financial guarantee portfolio (including through the pursuit of recoveries in respect of paid claims, commutations of policies and repurchases of surplus notes issued in respect of claims). These activities are integral to Ambac’s principal business strategy going forward to increase the residual value of its financial guarantee business by mitigating losses on poorly performing transactions and maximizing the return on its investment portfolio. As a consequence of the Segregated Account Rehabilitation Proceedings, the rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation and loss mitigation. The rehabilitator operates the Segregated Account through a management services contract executed between Ambac Assurance and the Segregated Account pursuant to which the Risk Management group provides all surveillance, remediation and loss mitigation services to the Segregated Account.

Furthermore, by virtue of the contracts executed between Ambac Assurance and the Segregated Account, the rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities which remain in Ambac Assurance. As such, the following discussion of Ambac’s risk management practices is qualified by reference to the rehabilitator’s exercise of its discretion to alter or eliminate any of these risk management practices.

Starting in 2008, Ambac’s risk management function has evolved significantly in order to adapt to the economic crisis and its impact on the insured portfolio (the insured portfolio in this discussion refers to both Segregated Account policies and Ambac Assurance policies). The economic crisis required us to heighten our surveillance efforts on all exposures, focusing on the identification of credits and asset types across the portfolio that were likely to experience increased stress or potential for losses. Staffing in all surveillance areas has been enhanced commensurate with this intensified emphasis on the oversight of vulnerable credits. Ambac has reorganized its risk management function, with the primary focus on reducing firm-wide risk and made structural and process-related changes resulting in an organizational structure designed around major areas of focus: (1) Portfolio Risk Management and Analysis (“PRMG”); and (2) Credit Risk Management (“CRM”). The senior managers within the risk management groups report directly to the Chief Executive Officer (“CEO”) and regularly inform and update the Audit Committees of the Boards of Directors of Ambac and Ambac Assurance with respect to risk-related topics in the insured portfolio.

Portfolio Risk Management and Analysis

In portfolio risk management, the focus is on surveillance, remediation, loss mitigation and risk reduction. Risk Management personnel perform periodic surveillance reviews of exposures according to a schedule based on the risk profile of the guaranteed obligations or as necessitated by specific credit events or other macro-economic variables. The monitoring activities are designed to detect deterioration in credit quality or changes in the economic, regulatory or political environment which could adversely impact the portfolio. Active surveillance enables PRMG to track single credit migration and industry credit trends. In some cases, PRMG will engage internal or external workout experts or attorneys and other consultants with appropriate expertise in the targeted loss mitigation to assist management in examining the underlying contracts or collateral, providing industry specific advice and/or executing strategies.

Analysts review, on a regular and ad hoc basis, credits in the book of business. Risk-adjusted surveillance strategies have been developed for each bond type with review periods and scope of review based upon each bond type’s inherent risk profile. The risk profile is assessed regularly in response to our own experience and judgments or external factors such as the current market crisis. The focus of the surveillance review is to assess performance, identify credit trends and recommend appropriate credit classifications, ratings and changes to a transaction or bond type’s review period. If a problem is detected, the group focuses on loss mitigation by recommending appropriate action and working with the issuer, trustee, bond counsel, servicer and other interested parties in an attempt to remediate the problem and minimize Ambac Assurance’s exposure to potential

 

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loss. Those credits that are either in default or have developed problems that eventually may lead to a default, claim or loss are tracked closely by the appropriate surveillance team and discussed at regularly scheduled meetings with CRM (see discussion following on “Credit Risk Management”).

In structured transactions, including structured public finance transactions, Ambac often is the control party as a result of insuring the transaction’s senior class or tranche. The control party may direct specified parties, usually the trustee, to take or not take certain actions following contractual defaults or trigger events. Control rights and the scope of direction and remedies vary considerably among our insured transactions. Because Ambac Assurance is party to and/or has certain rights in documents supporting transactions in the insured portfolio, Ambac Assurance frequently receives requests for amendments, waivers and consents (“AWCs”). As discussed below under “Credit Risk Management”, members of Ambac Assurance’s Risk Management personnel review, analyze and process all requests for AWCs. As a part of the Segregated Account Rehabilitation Proceedings, the rehabilitation court enjoined parties to preserve Ambac’s pre-rehabilitation control rights that could otherwise have lapsed or been compromised.

Surveillance for collateral dependent transactions, including, but not limited to, residential mortgage-backed securities (“RMBS”), asset-backed securities (“ABS”), and student loan transactions, focuses on review of the underlying asset cash flows and, if applicable, the performance of servicers or collateral managers. Ambac Assurance generally receives periodic reporting of transaction performance from issuers or trustees. Analysts review these reports to monitor performance and, if necessary, seek legal or accounting advice to assure that reporting and application of cash flows comply with transaction requirements.

Proactive credit remediation can help to reduce exposure and/or reduce risk in the insured portfolio by securing rights and remedies, both of which help to mitigate losses in the event of default. The emphasis on reducing risk is centered on reducing enterprise-wide exposure on a prioritized basis.

Cross-functional teams have been established within PRMG to promote the active mitigation and/or targeted remediation of the insured portfolio. Examples of such teams include teams of professionals focused on 1) RMBS servicing surveillance and transfer, 2) the review and enforcement of contractual representations and warranties in RMBS policies and 3) the analysis, restructuring and commutation of Segregated Account policies. The establishment and purview of cross-functional teams is targeted to address our highest risk exposures. Members of such teams work with both internal and external experts in the pursuit of risk reduction on all fronts.

The RMBS servicing surveillance team focuses on servicer oversight and remediation, with an immediate focus on active remediation of servicing in the mortgage-backed sector. Analysts monitor the performance of transaction servicers through a combination of (i) regular servicer reviews; (ii) compliance certificates received from servicer management; (iii) independent rating agency information; and (iv) a review of servicer financial information. Servicer reviews typically include a review of the collection, default management and quality control processes. In addition, Ambac Assurance may require a back-up servicer or require “term-to-term” servicing which provides for limited, renewable servicing terms in order to provide greater flexibility regarding the servicing arrangements of a particular transaction.

In some transactions Ambac Assurance has the right to direct a transfer of servicing to an alternative servicer, subject to certain conditions. The decision to exercise this right is made based on various factors, including an assessment of the performance of the existing servicer as outlined above, and an assessment of whether a transfer of servicing may improve the performance of the collateral. Ambac Assurance assesses potential transferee servicers through on-site servicer reviews and reviews of servicer financial information. Accordingly, Ambac Assurance has developed relationships with preferred servicers in the residential mortgage backed-sector. Preferred servicers are selected via a formalized servicer review process that determines, among other key factors, the servicer’s ability and willingness to actively manage intense and proven loss mitigation activities on RMBS. On selected distressed or high risk RMBS, Ambac Assurance may decide to exercise its rights to direct the transfer of servicing to a preferred servicer. The transfer of servicing is done with the

 

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objectives of (i) minimizing deal losses and distress levels by deploying targeted and enhanced loss mitigation programs; (ii) increasing visibility to Ambac Assurance of all servicing activities that impact overall deal performance; and (iii) better aligning the servicer’s financial interest to the performance of the underlying deal through the utilization of performance based incentives. Ambac Assurance believes that the improved loss mitigation activities, alignment of interests and close monitoring of the preferred servicers constitute credible means of minimizing risks and losses related to selected Ambac Assurance insured RMBS.

A team of professionals has also been established to focus on recoveries from sponsors where Ambac Assurance believes that a material breach of representations and warranties has occurred with respect to certain RMBS policies. The team monitors monthly performance of the RMBS insured portfolio and uses criteria to determine which transactions to pursue with regard to such recoveries. The team engages experienced consultants to perform the re-underwriting of loan files and consult with internal and external legal counsel with regard to loan putbacks as well as settlement and litigation strategies (see Management’s Discussion and Analysis of Financial Condition and Results of Operations – Representation and Warranty Breaches by RMBS Transaction Sponsors for further discussion on this topic).

The cross-functional restructuring team focuses on the analysis and prioritization of policies in the Segregated Account to target and execute risk reduction and commutation strategies. Analysis provided by this team may include assistance and guidance in model development and modeling, market, credit and data analysis and document review.

Credit Risk Management

CRM manages the decision process for all material matters that affect credit exposures within the insured portfolio. The scope of credit matters under the purview of CRM includes amendments, waivers and consents, remediation plans, credit review scheduling, adverse credit classification and below investment grade rating designations, adversely classified credit reviews, sector reviews, and overall portfolio review scheduling. The decision process may involve a review of structural, legal, political and credit issues and also includes determining the proper level of approval, which varies based on the nature and materiality of the matter.

Adversely Classified Credit Review

Credits that are either in default or have developed problems that eventually may lead to a default, claim or loss are tracked closely by the appropriate surveillance team and discussed at meetings with CRM. Adversely classified credit meetings include members of CRM and appropriate senior management, surveillance and legal analysts, as necessary. A summary of the adversely classified credits and trends is also provided to Ambac’s and Ambac Assurance’s Boards of Directors on a quarterly basis. As part of the review, relevant information, along with the plan for corrective actions and a reassessment of the credit’s rating and credit classification is considered. Internal and/or external counsel generally reviews the documents underlying any problem credit and, if applicable, an analysis is prepared outlining Ambac Assurance’s rights and potential remedies, the duties of all parties involved and recommendations for corrective actions. Ambac Assurance also meets with relevant parties to the transaction as necessary. The review schedule for adversely classified credits is tailored to the remediation plan to track and prompt timely action and proper internal and external resourcing.

Amendment, Waiver and Consent Review / Approval

The decision to approve or reject AWCs on an issue is based upon certain credit factors, such as the issuer’s ability to repay the bonds and the bond’s security features and structure. Members of Ambac Assurance’s Risk Management group review, analyze and process all requests for AWCs. All AWCs are initially screened for materiality in the surveillance groups. Material AWCs are within the purview of CRM, as discussed above. Non-material AWCs require the approval of at least a surveillance analyst and a portfolio risk manager. For material AWCs, CRM has established minimum requirements that may be modified to require more or varied signatures depending upon the matter’s complexity, size or other characteristics.

 

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Ambac Assurance assigns internal ratings to individual exposures as part of the AWC process and at surveillance reviews. These internal ratings, which represent Ambac Assurance’s independent judgments, are based upon underlying credit parameters consistent with the exposure type.

Financial Guarantees in Force

The following table provides a breakdown of guaranteed net par outstanding by market sector at December 31, 2010 and December 31, 2009. Guaranteed net par outstanding includes the exposures of policies that insure VIEs consolidated in accordance with ASU 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprise Involved with Variable Interest Entities:

 

($ in billions)

   December 31,
2010
     December 31,
2009
 

Public Finance

   $ 199.4       $ 223.2   

Structured Finance

     73.8         114.7   

International Finance

     45.7         52.5   
                 

Total net par outstanding

   $ 318.9       $ 390.4   
                 

Included in the above net par exposures at December 31, 2010 are $18,766 of exposures underwritten under credit derivative execution, primarily CDO exposures. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of CDO exposures. Please also refer to “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K for a description of the Settlement Agreement with respect to CDO of ABS and certain other CDO-related obligations.

Financial guarantee products were sold in three principal markets: the U.S. public finance market, the U.S. structured finance and asset-backed market and the international finance market.

U. S. Public Finance Insured Portfolio

Ambac’s portfolio of U.S. Public Finance exposures is $199 billion, representing 63% of Ambac’s net par outstanding as of December 31, 2010. U.S. Public Finance consists of U.S. municipal issuances, including general obligations, lease and tax-backed obligations, health care, housing, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as toll road and bridge financings, public transportation financings, stadium financings, military housing and student housing. Public finance obligations are generally supported by either the taxing authority of the issuer or the issuer’s or underlying obligor’s ability to collect fees or assessments for certain projects or public services. See Note 15 to the Consolidated Financial Statements, located in Part II, Item 8 of this Form 10-K for exposures by bond type as of December 31, 2010.

 

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The table below shows our ten largest Public Finance exposures, by repayment source, as a percentage of total Financial Guarantee net par outstanding at December 31, 2010:

 

($ in millions)

   Ambac
Ratings(1)
     Net Par
Outstanding
     % of Total
Net Par
Outstanding
 

California State—GO

     A       $ 3,094         1.0

New Jersey Transportation Trust Fund Authority—Transportation System

     A+         2,062         0.6

Washington State—GO

     AA         1,873         0.6

NYS Thruway Authority, Highway & Bridge Revenue

     AA-         1,694         0.5

Bay Area Toll Authority, CA Toll Bridge Revenue

     AA-         1,670         0.5

MTA, NY, Transportation Revenue (Farebox)

     A         1,447         0.5

New Jersey Turnpike Authority Revenue

     A         1,266         0.4

Massachusetts School Building Authority, MA, Sales Tax Revenue—GO

     AA         1,248         0.4

Massachusetts Commonwealth—GO

     AA         1,228         0.4

Los Angeles Unified School District, CA—GO

     AA-         1,126         0.4
                    

Total

      $ 16,708         5.3
                    

 

(1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac credit ratings are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.

U.S. Structured Finance and Asset-Backed Insured Portfolio

Ambac’s portfolio of U.S. Structured Finance exposures is $74 billion, representing 23% of Ambac’s net par outstanding as of December 31, 2010. Insured exposures include securitizations of mortgage loans, home equity loans, auto loans, student loans, leases, operating assets, CDOs and other asset-backed financings, in each case where the majority of the underlying collateral risks is situated in the United States. Additionally, Ambac’s Structured Finance insured portfolio encompasses both secured and unsecured debt issued by investor-owned utilities. Included within the operating asset sector are securitizations of aircraft, rental cars, shipping container and rail car fleets, franchise fees, pharmaceutical royalties, and intellectual property. See Note 15 to the Consolidated Financial Statements, located in Part II, Item 8 in this Form 10-K for exposures by bond type as of December 31, 2010.

Structured finance exposures generally entail three forms of risks: (i) asset risk, which relates to the amount and quality of the underlying assets; (ii) structural risk, which relates to the extent to which the transaction’s legal structure and credit support provide protection from loss; and (iii) servicer risk, which is the risk that poor performance at the servicer or manager level contributes to a decline in cash flow available to the transaction. Ambac Assurance seeks to mitigate and manage these risks through its Risk Management practices.

Structured securities are usually designed to help protect the investors and, therefore, the guarantor from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to a trustee for the benefit of the issuer. One potential issue is whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or stayed from remitting to investors cash collections held by it or received by it after the servicer or

 

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the originator becomes subject to bankruptcy or insolvency proceedings. Another potential issue is whether the originator sold ineligible assets to the securitization transaction that subsequently deteriorated, and, if so, whether the originator has the willingness or financial wherewithal to meet its contractual obligations to repurchase those assets out of the transaction. Structural features of a transaction, such as control rights that are typically held by the senior note holders, or guarantor in insured transactions, will impact the extent to which underlying asset performance affects the performance of the securities.

The following table presents the top five servicers by net par outstanding, for global structured finance exposures:

 

Servicer

   Bond Type    Net Par
Outstanding
 
($ in millions)            

Countrywide Home Loans.

   Mortgage-backed    $ 8,624   

PHEAA

   Student Loans    $ 4,169   

GMAC Mortgage, LLC

   Mortgage-backed    $ 3,679   

Wells Fargo Bank.

   Mortgage-backed    $ 3,149   

Specialized Loan Servicing, LLC

   Mortgage-backed    $ 2,628   

Structured Finance includes the credit enhancement of CDOs and CLOs. These transactions involve the securitization of a portfolio of corporate bonds, corporate loan obligations and/or asset-backed securities. In June 2010, all CDO of ABS transactions, which included substantial exposure to residential mortgages, were settled. Please refer to “U. S. Residential Mortgage-Backed Securities Exposures” below for further discussion. Please also refer to “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K for a description of the Settlement Agreement with respect to CDO of ABS and certain other CDO-related obligations.

The table below shows our ten largest Structured Finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2010:

 

     Ambac
Rating(1)
     Net Par
Outstanding
     % of Total
Net Par
Outstanding
 
($ in millions)                     

Private Commercial Asset-Backed Transaction

     BBB+       $ 2,159         0.7

CDO of ABS < 25% MBS

     A+         2,031         0.6

Wachovia Asset Securitization Issuance II, LLC 2007-HE2

     BIG         1,663         0.5

Iowa Student Loan Liquidity Corporation Revenue Bonds

     BIG         1,497         0.5

Vermont Student Assistance Corporation Revenue Bonds

     BIG         1,377         0.4

Private Commercial Asset-Backed Transaction

     AA         1,266         0.4

Wachovia Asset Securitization Issuance II, LLC 2007-HE1

     BIG         1,105         0.3

The National College Student Loan Trust 2007-4

     BIG         1,052         0.3

The National College Student Loan Trust 2007-3

     BIG         1,031         0.3

Ballantyne Re Plc

     BIG         900         0.3
                    

Total

      $ 14,081         4.3
                    

 

(1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac credit ratings are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees. “BIG” denotes credits deemed below investment grade (e.g. below BBB-).

 

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International Finance Insured Portfolio

Ambac’s portfolio of International Finance insured exposures is $46 billion, representing 14% of Ambac’s net par outstanding as of December 31, 2010. Ambac’s existing International Finance insured exposures include a wide array of obligations in the international markets, including infrastructure financings, asset-securitizations, CDOs, utility obligations, and whole business securitizations (e.g. securitizations of substantially all of the operating assets of a corporation). In emerging markets, Ambac had focused on future cash flow transactions from top tier issuers (structured transactions secured by U.S. Dollar and Euro cash flows generated from exports or payment remittances) and, to a more limited extent, on domestic securitizations. See Note 15 to the Consolidated Financial Statements, located in Part II, Item 8 in this Form 10-K for exposures by bond type as of December 31, 2010.

When underwriting transactions in the international markets, Ambac considered the specific risks related to the particular country and region that could impact the credit of the issuer. These risks include the legal and political environment, capital market dynamics, foreign exchange issues, and the degree of governmental support. Ambac continues to address these risks through its ongoing credit risk management.

Ambac UK, which is regulated in the United Kingdom, had been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the United Kingdom and the European Union with $27 billion of par outstanding at December 31, 2010. Geographically, Ambac UK’s exposures are principally in the United Kingdom, continental Europe, Australia and Japan. In 2009, Ambac UK’s license to issue new business was curtailed by the United Kingdom Financial Services Authority, Ambac UK’s regulator (the “FSA”). Following the AUK Commutation Agreement as discussed in the “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, there is no portfolio risk transfer from Ambac UK to Ambac Assurance, nor does Ambac Assurance have any capital support obligation of Ambac UK. The portfolio of insured exposures underwritten by Ambac UK is now financially supported entirely by Ambac UK on a standalone basis.

The table below shows our largest International Finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2010:

 

($ in millions)

   Ambac
Rating(1)
     Net Par
Outstanding
     % of Total
Net Par
Outstanding
 

Mitchells & Butlers Finance plc-UK Pub Securitisation

     A+       $ 2,084         0.7

Telereal Securitisation plc

     A+         1,761         0.6

Romulus Finance s.r.l

     BIG         1,505         0.5

Punch Taverns Finance plc-UK Pub Securitisation

     BBB+         1,303         0.4

Channel Link Enterprises

     BBB-         1,154         0.4

Aspire Defense Finance plc

     BBB-         1,141         0.4

Regione Campania

     A-         1,084         0.3

Powercor Australia

     A-         1,045         0.3

Ostregion Investmentgesellschaft NR 1 SA

     BBB-         994         0.3

Dampier to Bunbury Natural Gas Pipeline

     BBB         916         0.3
                    

Total

      $ 12,987         4.2
                    

 

(1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac credit ratings are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees. “BIG” denotes credits deemed below investment grade (e.g. below BBB-)

 

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Additional Insured Portfolio Statistics:

Ambac Assurance underwrote and priced financial guarantees based on the assumption that the guarantees would remain in force until the expected maturity of the underlying bonds. Ambac Assurance estimates that the average life of its guarantees on par in force at December 31, 2010 is approximately 13 years. The 13 year average life is determined by applying a weighted average calculation, using the remaining years to expected maturity of each guaranteed bond, and weighting them on the basis of the remaining net par guaranteed. No assumptions are made for future refundings of guaranteed issues.

U.S. Residential Mortgage-backed securities exposure

RMBS portfolio exposures included in financial guarantee insurance portfolio

Ambac has exposure to the U.S. mortgage market through direct financial guarantees of RMBS. Ambac insures tranches issued in RMBS, including transactions that contain risks to first and second-liens. The following tables provide current gross par outstanding by vintage and type, and underlying credit rating of Ambac’s affected U.S. RMBS book of business:

 

     Total Gross Par Outstanding
At December 31, 2010 ($ in millions)
 

Year of Issue

   Second Lien     Sub-prime     Mid-prime(1)  

1998-2001

   $ 123.7      $ 714.5      $ 7.5   

2002

     58.7        653.1        76.1   

2003

     39.7        1,002.9        564.9   

2004

     1,399.4        517.2        873.8   

2005

     1,413.9        1,182.0        2,863.3   

2006

     3,586.1        862.9        2,276.4   

2007

     4,049.8        559.8        3,359.9   
                        

Total

   $ 10,671.3      $ 5,492.4      $ 10,021.9   
                        

% of Total MBS Portfolio

     35.7     18.4     33.6

 

     Gross claim liability, before Subrogation Recoveries
At December 31, 2010 ($ in millions)
 

Year of Issue

   Second Lien        Sub-prime        Mid-prime(1)  

1998-2001

   $ 3.0         $ 6.7         $ —     

2002

     0.1           9.4           —     

2003

     2.5           —             —     

2004

     326.2           1.9           0.7   

2005

     406.2           85.3           556.2   

2006

     1,634.0           220.2           697.6   

2007

     675.0           119.6           697.8   
                              

Total

   $ 3,047.0         $ 443.1         $ 1,952.3   
                              

 

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     Gross Subrogation Recoveries
At December 31, 2010 ($ in millions)
 

Year of Issue

   Second Lien     Sub-prime     Mid-prime(1)  

1998-2001

   $ —        $ —        $ —     

2002

     —          —          —     

2003

     —          —          —     

2004

     (90.7     —          —     

2005

     (180.3     —          (23.2

2006

     (710.6     —          (140.1

2007

     (926.5     (221.0     (124.6
                        

Total

   $ (1,908.1   $ (221.0   $ (287.9
                        

 

     Percent of Related RMBS Transactions’
Gross Par At December 31, 2010
 

Internal Ambac Credit Rating(2)

   Second Lien     Sub-prime     Mid-prime(1)  

AAA

     0     5     2

AA

     <0.1     4     5

A

     2     9     6

BBB(3)

     2     2     1

Below investment grade(3)

     96     80     86

 

(1) Mid-prime includes Alt-A transactions and affordability product transactions, which includes interest only or option adjustable rate features.
(2) Ambac ratings set forth above reflect the internal Ambac ratings as of December 31, 2010, and may be changed at any time based on our internal credit review. Ambac undertakes no obligation to update such ratings. This does not constitute investment advice. Ambac or one of its affiliates has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.
(3) Ambac’s BBB internal rating reflects bonds which are of medium grade credit quality with adequate capacity to pay interest and repay principal. Certain protective elements and margins may weaken under adverse economic condition and changing circumstances. These bonds are more likely than higher rated bonds to exhibit unreliable protection levels over all cycles. Ambac’s below investment grade internal ratings reflect bonds which are of speculative grade credit quality with the adequacy of future margin levels for payment of interest and repayment of principal potentially adversely affected by major ongoing uncertainties or exposure to adverse conditions. Ambac’s below investment grade category includes transactions on which we are currently paying claims.

RMBS exposure in collateralized debt obligations

Ambac’s outstanding CDO exposures are comprised of the following asset type and credit ratings as of December 31, 2010 and December 31, 2009:

 

Business Mix by Net Par

   December 31, 2010     December 31, 2009  
   Net Par      Percentage     Net Par      Percentage  
($ in billions)                           

High yield corporate (CLO)

   $ 14.7         80   $ 21.2         48

CDO of ABS > 25% MBS(2)

     —           —          16.7         38   

CDO of ABS < 25% MBS

     0.5         3        2.6         6   

Market value CDOs

     1.5         8        1.6         4   

Other

     1.5         9        2.0         4   
                                  

Total

   $ 18.2         100   $ 44.1         100
                                  

 

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Ambac Ratings by Net Par(1)

   December 31, 2010     December 31, 2009  
   Net Par      Percentage     Net Par      Percentage  
($ in billions)                           

AAA

   $ 2.1         12   $ 4.2         9

AA

     9.9         54        17.0         39   

A….

     5.7         31        3.8         9   

BBB

     0.2         1        1.8         4   

Below investment grade(2)

     0.3         2        17.3         39   
                                  

Total

   $ 18.2         100   $ 44.1         100
                                  

 

(1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac. Ambac ratings set forth above reflect the internal Ambac ratings as of December 31, 2010, and may be changed at any time based on our internal credit review. This does not constitute investment advice. Ambac or one of its affiliates has guaranteed the obligations included above and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees
(2) As a result of the Settlement Agreement with certain Counterparties Ambac commuted all of the remaining CDO of ABS exposures that were BIG. Refer to Note 1 to the Consolidated Financial Statements for further discussion of the Settlement Agreement.

Auction Rate Securities and Variable Rate Demand Obligations:

Fixed income securities issued in the US bond market include fixed and variable rate bonds. Included within the variable rate bond category are Auction Rate Securities (“ARS”) and Variable Rate Demand Obligations (“VRDO”). The following table sets forth Ambac Assurance’s financial guarantee net par exposure outstanding, by bond type, relating to such variable rate securities at December 31, 2010 and December 31, 2009:

Total ARS and VRDO Net Par

 

     December 31,  2010
Total
     December 31,  2009
Total
 
($ in millions)              

Lease and Tax-backed

   $ 2,246       $ 2,539   

General Obligation

     978         1,237   

Utility

     534         1,130   

Transportation

     2,179         2,327   

Healthcare

     1,603         2,385   

Student Loans

     7,331         10,167   

Investor-owned utilities

     3,906         4,921   

Other

     1,796         1,928   
                 

Total

   $ 20,573       $ 26,634   
                 

ARS are sold through a Dutch auction, which is a competitive bidding process used to determine rates on each auction date. Bids are submitted to the auction agent. The winning bid rate is the rate at which the auction “clears”, meaning the lowest possible interest rate that results in the cumulative total of securities demanded at such rate (“buyers”) equaling the amount auctioned (“sellers”). VRDO are long-term bonds that bear a floating interest rate and that provide investors the option to tender or put securities back to the issuer at any time with appropriate notice. Additionally, there are certain mandatory events that require all bondholders to tender their VRDO to the issuer. Upon tender, bondholders are paid a purchase price, equal to the par amount of the tendered VRDO plus accrued interest, typically paid from the proceeds of a remarketing of the tendered VRDO by a remarketing agent. The interest rate resets daily or weekly, depending upon the security. The reset rate is based on comparable securities with similar maturities and credit ratings, as well as on supply and demand.

 

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VRDO are typically supported by a liquidity facility in the form of a standby bond purchase agreement (“Standby Bond Purchase Agreement”), usually provided by a commercial bank (“Liquidity Provider”). If the remarketing agent is unable to remarket all tendered VRDO, the Liquidity Provider is required to purchase such VRDO at the purchase price, subject to limited conditions precedent, thus providing liquidity to investors. While held by the Liquidity Provider, the VRDO bear interest at a rate determined under the Standby Bond Purchase Agreement, often based on the Prime Rate or LIBOR plus a spread (the “Bank Rate”). During such time, the remarketing agent remains obligated to continue to try to remarket the VRDO held by the Liquidity Provider. Many Standby Bond Purchase Agreements provide that, after the Liquidity Provider has held the VRDO for a specified time period, the issuer or other obligor is required to cause such VRDO to be redeemed prior to maturity, either: in periodic installments over a predetermined number of years, typically from three to five (the “Term-Out”); or with available funds as defined in the transaction documents; or in a single lump sum at the end of three to five years. Other Standby Bond Purchase Agreements do not contain a Term-Out. For VRDO insured by Ambac Assurance, Ambac Assurance has typically endorsed its insurance policy to cover interest at the Bank Rate. For VRDOs insured by Ambac Assurance that contain a Term-Out, Ambac has often endorsed its insurance policy to cover the required redemptions in accordance with the Term-Out schedule (though not any acceleration of the VRDO maturity ahead of the Term-Out schedule).

For student loan VRDO transactions, Ambac Assurance is required to purchase any outstanding VRDO from the Liquidity Providers at the end of the Term-Out period for the par amount of the bonds. All student loan VRDO transactions insured by Ambac Assurance have been purchased by the Liquidity Providers and, as such, Ambac Assurance has obligations to purchase, at par, outstanding VRDOs at par coming due in 2013, 2015 and 2018 in the amounts of $493.0 million, $68.3 million, and $175.1 million, respectively. Ambac Assurance’s purchase obligation in 2013, 2015 and 2018 will depend on many factors, including the successful execution of loss mitigation strategies, changes in interest rates, performance of the underlying collateral, the deterioration of the asset base and/or any amortization of the VRDO.

Issuers have been working toward reducing their debt service costs for ARS and VRDO transactions; the most prevalent ways are (i) converting the bonds to fixed rate (to maturity or for a shorter period of time); (ii) refunding the obligations and issuing bonds or other debt structures; (iii) purchasing direct-pay letters of credit from other financial institutions; or (iv) amending their liquidity facilities to address investor liquidity concerns.

For Ambac Assurance insured ARS and VRDO transactions that have been unable to refinance, the higher debt service costs have resulted in decreased debt service ratios and/or the erosion of first loss and/or other credit enhancements that are subordinate to Ambac Assurance’s risk position (such as excess spread). Through December 31, 2010, Ambac Assurance paid gross claims in the amount of $61 million on these transactions. This included approximately $13 million for certain student loan ARS transactions that were restructured in 2010, which resulted in the elimination of certain ARS policies. Ambac has established gross loss reserves of approximately $688 million for ARS and VRDO transactions, which is net of expected recoveries. Ambac continues to actively review the credit implications of this additional issuer stress and its impact to our internal credit ratings and loss reserves as necessary.

 

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Issue Size

Ambac Assurance’s financial guarantee exposure in the U.S. public finance market reflects the historical emphasis on issues guaranteed with an original par amount of less than $50 million. U.S. Structured Finance and International Finance transactions generally involved larger transaction sizes. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2010 with respect to the original size of each guaranteed issue:

 

Original Par Amount

   Number of
Issues
     % of Total
Number of Issues
    Par Amount
as of December 31, 2010
 
        Amount
Outstanding
     % of Total  

Less than $10 million

     6,714         54   $ 24,540         8

$10-less than 50 million

     3,809         30        59,783         19   

$50-250 million

     1,521         12        102,196         32   

Greater than $250 million

     533         4        132,335         41   
                                  

Total

     12,577         100   $ 318,854         100
                                  

Geographic Area

The following table sets forth the geographic distribution of Ambac Assurance’s insured exposure as of December 31, 2010:

 

Geographic Area

   Net Par
Amount
Outstanding
     % of Total Net
Par Amount
Outstanding
 
($ in millions)              

Domestic:

     

California

   $ 39,210         12.3

New York

     20,944         6.6   

Florida

     15,910         5.0   

Texas

     14,776         4.6   

New Jersey

     10,415         3.3   

Illinois

     9,351         2.9   

Massachusetts

     6,576         2.1   

Pennsylvania

     6,036         1.9   

Colorado

     5,786         1.8   

Washington

     5,710         1.8   

Mortgage and asset-backed

     37,493         11.8   

Other states

     100,941         31.6   
                 

Total Domestic

     273,148         85.7   
                 

International:

     

United Kingdom

     22,215         7.0   

Australia

     6,292         2.0   

Italy

     3,674         1.1   

Austria

     999         0.3   

Turkey

     848         0.3   

Internationally diversified

     7,793         2.4   

Other international

     3,885         1.2   
                 

Total International

     45,706         14.3   
                 

Grand Total

   $ 318,854         100
                 

 

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Mortgage and asset-backed obligations includes guarantees with multiple locations of risk within the United States and is primarily comprised of residential mortgage and asset-backed securitizations. Internationally diversified is primarily made up of CDOs which include significant components of U.S. exposure.

Exposure Currency:

The table below shows the distribution by currency of Ambac Assurance’s guaranteed portfolio as of December 31, 2010:

 

Currency

   Net Par Amount
Outstanding in Base
Currency
     Net Par Amount
Outstanding in
U.S. Dollars
 
($ in millions)              

U.S. Dollars

     279,016       $ 279,016   

British Pounds

     13,782         21,497   

Euros

     8,278         11,068   

Australian Dollars

     5,752         5,877   

Other

     3,763         1,396   
           

Total

      $ 318,854   
           

Ratings Distribution

The following tables provide a rating distribution of guaranteed total net par outstanding based upon internal Ambac Assurance credit ratings at December 31, 2010 and December 31, 2009 and a distribution by bond type of Ambac Assurance’s below investment grade exposures at December 31, 2010 and December 31, 2009. Below investment grade is defined as those exposures with a credit rating below BBB-:

Percentage of Guaranteed Portfolio(1)

 

     December 31,
2010
    December 31,
2009
 

AAA

     1     2

AA

     23        24   

A

     43        41   

BBB

     19        18   

BIG

     14        15   
                

Total

     100     100
                

 

  (1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac credit ratings are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.

 

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Summary of Below Investment Grade Exposure

 

Bond Type

   December 31,
2010
     December 31,
2009
 
($ in millions)              

Public Finance:

     

Transportation

   $ 1,175       $ 1,113   

Health care

     259         307   

General obligation

     234         280   

Tax-backed

     531         317   

Other

     1,345         939   
                 

Total Public Finance

     3,544         2,956   
                 

Structured Finance:

     

CDO of ABS > 25% RMBS

     —           16,718   

Mortgage-backed and home equity – first lien

     12,836         13,477   

Mortgage-backed and home equity – second lien

     10,121         12,050   

Auto Rentals

     1,270         2,849   

Student loans

     11,044         3,910   

Enhanced equipment trust certificates

     430         473   

Mortgage-backed and home equity – other

     369         584   

Other CDOs

     100         523   

Other

     1,662         2,106   
                 

Total Structured Finance

     37,832         52,690   
                 

International Finance:

     

Airports

     1,505         1,498   

Other

     922         1,210   
                 

Total International Finance

     2,427         2,708   
                 

Total

   $ 43,803       $ 58,354   
                 

The decrease in CDO of ABS greater than 25% RMBS resulted from execution of the Settlement Agreement in June 2010. Refer to “2010 Overview” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 for a description of the Settlement Agreement with respect to CDO of ABS and certain other CDO-related obligations. The decrease in mortgage-backed and home equity (first and second-liens) below investment grade exposures is primarily the result of principal pay-downs. The increase in student loan below investment grade exposures was due to deterioration in private student loan collateral performance and the failed debt structures for the ARS & VRDO exposures which exposes these transactions to interest rate risk. The decrease on other structured finance obligations is primarily related to the commutation of a film-securitization transaction. The increase in Public Finance is primarily related to deterioration of certain military housing and tax backed transactions.

Commitments to Issue Future Guarantees

In connection with its financial guarantee business, Ambac has outstanding commitments to provide guarantees (consisting of both insurance and credit derivatives) of $5.9 billion at December 31, 2010. 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 80% of the total commitment amount represents commitments that contain one or more of the following provisions: (i) the commitment may be terminated at Ambac’s election upon a material adverse change, (ii) in order for the funding levels to be

 

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increased, certain eligibility requirements must be met, or, (iii) for commitments to provide protection, the commitment may not be exercised upon an event of default or after the reinvestment period. Moreover, as a consequence of the Segregated Account Rehabilitation Proceedings and the terms of the Settlement Agreement, it is unclear whether such new policies could be issued. Accordingly, the $5.9 billion of commitments outstanding at December 31, 2010 do not necessarily reflect actual future obligations. Additionally, due to Ambac Assurance’s current financial position, most commitments are unlikely to be exercised.

Ceded Reinsurance

Ambac Assurance has reinsurance in place pursuant to treaty and facultative reinsurance agreements. For exposures reinsured, Ambac Assurance withholds a ceding commission to defray its underwriting and operating expenses. The following table shows the distribution, by bond type, Ambac Assurance’s ceded guaranteed portfolio at December 31, 2010:

 

Bond Type

   Ceded Par
Amount
Outstanding
     % of Gross
Par Ceded
 
($ in millions)              

Public Finance:

     

Lease and tax-backed revenue.

   $ 6,001         8

General obligation

     4,704         9   

Utility revenue

     2,791         10   

Transportation revenue

     2,817         12   

Higher education

     1,628         10   

Housing revenue

     1,127         10   

Health care revenue

     854         8   

Other

     154         4   
           

Total Public Finance

     20,076         9   
           

Structured Finance:

     

Mortgage-backed and home equity

     337         1   

Other CDOs

     18         —     

Student loan

     1,818         14   

Investor-owned utilities

     903         8   

Asset-backed and conduits

     1,005         9   

Other

     351         11   
           

Total Structured Finance

     4,432         6   
           

Total Domestic

     24,508         8   
           

International Finance:

     

Investor-owned and public utilities

     1,082         9   

Asset-backed and conduits

     321         3   

Sovereign/sub-sovereign

     31         —     

Other CDOs

     64         1   

Transportation

     252         4   

Mortgage-backed and home equity

     15         1   

Other

     —           —     
           

Total International Finance

     1,765         4   
           

Grand Total

   $ 26,273         8
           

As a primary financial guarantor, Ambac Assurance is required to honor its obligations to its policyholders whether or not its reinsurers perform their obligations under the various reinsurance agreements. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance is entitled to receive collateral from its reinsurance counterparties in certain reinsurance contracts and has certain cancellation rights that can be

 

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exercised by Ambac Assurance in the event of rating agency downgrades of a reinsurer. At the inception of each reinsurance contract, Ambac Assurance required collateral from certain reinsurers primarily to (i) receive statutory credit for the reinsurance to 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. When a reinsurer is downgraded by one or more rating agencies, less capital credit is given to Ambac Assurance under rating agency models. Ambac Assurance held letters of credit and collateral amounting to approximately $312.9 million from its reinsurers at December 31, 2010. Refer to Item 7A – Risk Management for further discussion on insured par ceded, credit ratings of our reinsurance counterparties and unsecured reinsurance balances.

Assumed Reinsurance:

The majority of Ambac Assurance’s assumed reinsurance contracts were cancelled in 2009. At December 31, 2010, the remaining assumed par outstanding was $439.5 million. On March 24, 2010, all assumed reinsurance agreements with third parties were allocated to the Segregated Account, which will not allow for further cancellations without the approval of the Rehabilitator.

Rating Agencies

Ambac Assurance’s financial strength ratings have been downgraded several times since 2008; it now has a Caa2 financial strength rating with a developing outlook from Moody’s. Moody’s rating refers to Ambac Assurance general account obligations and excludes obligations allocated to the segregated account.

In 2010 Ambac Assurance requested that S&P withdraw its ratings. Ambac Assurance’s request was predicated by a review of the value of such rating relative to the cost. Ambac continues to evaluate the relative merits of maintaining a Moody’s rating and may decide to similarly request a withdrawal of such rating.

Insurance Regulatory Matters

Ambac Assurance and Everspan are domiciled in the State of Wisconsin and, as such, are subject to the insurance laws and regulations of the State of Wisconsin (the “Wisconsin Insurance Laws”) and are regulated by the OCI. In addition, Ambac Assurance and Everspan are subject to the insurance laws and regulations of the other jurisdictions in which they are licensed. Ambac Assurance is licensed in all other 49 states, the District of Columbia, the Commonwealth of Puerto Rico, the territory of Guam and the U.S. Virgin Islands and Everspan is licensed in all states other than Virginia, the District of Columbia and the Commonwealth of Puerto Rico. Under Wisconsin insurance law, the Segregated Account is a separate insurer for purposes of the Segregated Account Rehabilitation Proceedings. As such, the Segregated Account is not separately licensed or regulated, but it is under the control of, and is overseen by, the Rehabilitator.

Insurance laws and regulations applicable to financial guarantee insurers vary by jurisdiction. The laws and regulations generally require financial guarantors to maintain minimum standards of business conduct and solvency; to meet certain financial tests; and to file policy forms, premium rate schedules and certain reports with regulatory authorities, including information concerning capital structure, ownership and financial condition. Regulated insurance companies are also required to file quarterly and annual statutory financial statements with the National Association of Insurance Commissioners (“NAIC”), and in each jurisdiction in which they are licensed. The level of supervisory authority that may be exercised by non-domiciliary insurance regulators varies by jurisdiction. Generally, however, non-domiciliary regulators are authorized to revoke insurance licenses and to impose license restrictions in the event that laws or regulations are breached by a regulated insurance company or in the event that continued or unrestricted licensure of the regulated insurance company constitutes a “hazardous condition” in the opinion of the regulator. Ambac Assurance’s authority to write new business in Alabama, Louisiana, North Dakota, Tennessee and Ohio has been suspended.

 

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Wisconsin Insurance Laws require regulated insurance companies to maintain minimum standards of business conduct, minimum surplus to policyholders and solvency. As the principal, or domiciliary, regulator of Ambac Assurance and Everspan, OCI has primary regulatory authority, including with respect to the initiation and administration of rehabilitation or liquidation proceedings with respect to Ambac Assurance and Everspan. Additionally, the accounts and operations of Ambac Assurance and Everspan are subject to a comprehensive examination by the OCI every three to five years. As described in “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, the rehabilitator of the Segregated Account has imposed certain constraints upon Ambac Assurance through the covenants made for the benefit of the Segregated Account and has assumed the authority to control the management of the Segregated Account.

During the course of 2009, Ambac UK’s license to do new business was curtailed by the FSA, and the insurance license was limited to undertaking only run-off related activity. As such, Ambac UK is authorized to run-off its credit, suretyship and financial guarantee insurance portfolio in the United Kingdom, and to do the same through a branch in Milan, Italy, and a number of other European Union (“EU”) countries. EU legislation has allowed Ambac UK to conduct business in EU states other than the United Kingdom through a “passporting” arrangement, which eliminates the necessity of additional licensing or authorization in those other EU jurisdictions.

Ambac UK remains subject to regulation by the FSA in the conduct of its business. The FSA is the single statutory regulator responsible for regulating the financial services industry in the United Kingdom, with the purpose of maintaining confidence in the U.K. financial system, providing public understanding of the system, securing the proper degree of protection for consumers and helping to reduce financial crime. In addition, the regulatory regime in the United Kingdom must comply with certain EU legislation binding on all EU member states. Notwithstanding the aforementioned, the regulatory structure of the United Kingdom is currently undergoing restructuring, whereby regulatory responsibility will be divided between The Bank of England and a reconstituted FSA. The precise impact on Ambac UK is as yet unclear however no material impact is anticipated with respect to Ambac UK being closely supervised as a run-off entity.

The FSA has exercised significant oversight of Ambac UK since 2008, when Ambac Financial Group, and Ambac Assurance (Ambac UK’s only reinsurer and principal financial support provider prior to the AUK Commutation Agreement) began experiencing financial stress. As more fully discussed in “2010 Overview” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K, Ambac Assurance entered into the AUK Commutation Agreement with Ambac UK and the Special Deputy Commissioner of OCI, on September 28, 2010, pursuant to which the AUK Reinsurance Agreement was commuted and the Net Worth Maintenance Agreement between Ambac UK and Ambac Assurance was terminated in exchange for, among other things, certain mutual releases, including, without limitation, any right of Ambac Assurance or the Segregated Account to reinsurance premiums from Ambac UK. Ambac Assurance paid a nominal termination amount of one U.S. dollar to Ambac UK in connection with the commutation.

The FSA requires that non-life insurance companies such as Ambac UK maintain a margin of solvency at all times in respect of the liabilities of the insurance company, the calculation of which depends on the type and amount of insurance business a company writes. In addition, the FSA had established a capital monitoring level for Ambac UK related to its insured portfolio. Breach of the monitoring level required that Ambac UK inform the FSA and enter into discussions as to the reasons for the breach, and ultimately with a view to a remedy that could include additional capital being required. The monitoring level is normally an interim arrangement, while the FSA reflects on alternative methodologies for a permanent basis for calculating regulatory capital in respect of Ambac UK and other financial guarantors regulated by the FSA. In addition, an insurer is required to perform and submit to the FSA a solvency margin calculation return in respect of its ultimate parent. All of these solvency requirements may be amended in order to implement the European Union’s proposed “Solvency II” directive on risk-based capital, but that is not expected to be implemented until 2012 at the earliest. The impact of such proposals on Ambac UK remains unclear.

 

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Notwithstanding the foregoing, following the Ambac UK Commutation Agreement, Ambac UK is deficient in terms of compliance with applicable regulatory capital requirements. The FSA is aware of the same, and dialogue between Ambac UK management and the FSA remains ongoing with respect to options for addressing the shortcoming, although such options remain few.

Under Wisconsin law applicable to insurance holding companies, any acquisition of control of Ambac, and any other direct or indirect control of Ambac Assurance and Everspan, requires the prior approval of the OCI. “Control” is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person. Any purchaser of 10% or more of the outstanding voting stock of a corporation is presumed to have acquired control of that corporation and its subsidiaries unless the OCI, upon application, determines otherwise. For purposes of this test, Ambac believes that a holder of common stock having the right to cast 10% of the votes which may be cast by the holders of all shares of common stock of Ambac would be deemed to have control of Ambac Assurance and Everspan within the meaning of the Wisconsin Insurance Laws. The United Kingdom has similar requirements applicable in respect of Ambac, as the ultimate holding company of Ambac UK.

At various times, investors have sought and obtained OCI’s approval to acquire greater than 10% of Ambac’s outstanding stock. As a condition to obtaining approval without undergoing a comprehensive “change of control” review process, those investors disclaimed any present intention to exercise control over Ambac, Ambac Assurance or Everspan or to control or attempt to control the management or operations of Ambac, Ambac Assurance or Everspan.

Dividend Restrictions, Including Contractual Restrictions

Pursuant to the Wisconsin Insurance Laws, Ambac Assurance and Everspan may declare dividends, subject to restrictions in their respective articles of incorporation, provided that, after giving effect to the distribution, such dividends would not violate certain statutory equity, solvency, income and asset tests. Shareholder distributions by Ambac Assurance and Everspan (other than stock dividends) must be reported to the OCI. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without notifying the OCI 30 days in advance of payment. Extraordinary dividends must be reported prior to payment and are subject to disapproval by the OCI. An extraordinary dividend is defined as a dividend or distribution, the fair market value of which, together with all dividends from the preceding 12 months, exceeds the lesser of: (a) 10% of policyholders’ surplus as of the preceding December 31 or (b) the greater of: (i) statutory net income for the calendar year preceding the date of the dividend or distribution, minus realized capital gains for that calendar year; or (ii) the aggregate of statutory net income for the three calendar years preceding the date of the dividend or distribution, minus realized capital gains for those calendar years and minus dividends paid or credited and distributions made within the first two of the preceding three calendar years. Additionally, in connection with the termination of reinsurance contracts, OCI requires adjustments to the dividend calculations for any surplus or net income gains recognized. Due to losses experienced by Ambac Assurance in 2009 and 2010, Ambac Assurance was unable to pay common dividends to Ambac in 2009 and 2010 and will be unable to pay common dividends in 2011, without the prior consent of the OCI.

During 2008, Ambac Assurance paid to Ambac cash dividends on its common stock totaling $218.5 million, respectively. See Note 17 to the Consolidated Financial Statements located in Part II, Item 8 for further information on dividends. During 2010 and 2009, Ambac Assurance paid cash dividends on its preferred shares of $0.8 million and $12.5 million, respectively.

Ambac Assurance’s ability to pay dividends is further restricted by certain covenants made for the benefit of the Segregated Account and by the Settlement Agreement. See “2010 Overview” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8 for further information.

 

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UK law prohibits Ambac UK from declaring a dividend to its shareholders unless it has “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the UK insurance regulatory laws impose no statutory restrictions on a general insurer’s ability to declare a dividend, the FSA’s capital requirements may in practice act as a restriction on the payment of dividends. Further, the FSA has amended Ambac UK’s license such that the FSA must specifically approve (“non-objection”) to any transfer of value and/or assets from Ambac UK to Ambac Assurance or any other Ambac group company, other than in respect of certain disclosed contracts between the two parties (such as in respect of a management services agreement between Ambac Assurance and Ambac UK). Ambac UK is not expected to pay any dividends to Ambac Assurance for the foreseeable future.

Pursuant to the Settlement Agreement, as discussed in the “2010 Overview” in Note 1 to the Consolidated Financial Statements located in Part II, Item 8, Ambac Assurance may not make any Restricted Payment (which includes dividends from Ambac Assurance to Ambac) in excess of $5 million in the aggregate, other than Restricted Payments from Ambac Assurance to Ambac in an amount (i) up to $52 million per annum solely to pay interest on indebtedness of Ambac outstanding as of March 15, 2010, or any indebtedness issued as a result of a restructuring or refinancing thereof and (ii) up to $7.5 million per annum solely to pay operating expenses of Ambac. Concurrent with making any such Restricted Payment, a pro rata amount of the Surplus Notes issued by Ambac Assurance to the bank group would also need to be redeemed at par.

Under the terms of Ambac Assurance’s Auction Market Preferred Shares (“AMPS”), dividends may not be paid on the common stock of Ambac Assurance unless all accrued and unpaid dividends on the AMPS for the then current dividend period have been paid, provided, that dividends on the common stock may be made at all times for the purpose of, and only in such amounts as are necessary for, enabling Ambac (i) to service its indebtedness for borrowed money as such payments become due or (ii) to pay its operating expenses. If dividends are paid on the common stock as provided in the prior sentence, dividends on the AMPS become cumulative until the date that all accumulated and unpaid dividends have been paid on the AMPS.

New York Financial Guarantee Insurance Law and Financial Guarantee Insurance Regulation in Other States

New York’s comprehensive financial guarantee insurance law defines the scope of permitted financial guarantee insurance and governs the conduct of business of all financial guarantors licensed to do business in New York, including Ambac Assurance. The New York financial guarantee insurance law also establishes single risk and aggregate limits with respect to insured obligations insured by financial guarantee insurers. Such single risk limits are specific to the type of insured obligation (for example, municipal or asset-backed). Under the aggregate limits, policyholders’ surplus and contingency reserves must at least equal a percentage of aggregate net liability that is equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. Wisconsin laws and regulations applicable to financial guarantors, as well as the laws of several other states, are less comprehensive than New York law and relate primarily to single and aggregate risk limits.

As a result of decreased statutory capital resulting from the significant losses experienced by Ambac Assurance, Ambac Assurance is not in compliance with the single and aggregate risk limits. Through run-off of the portfolio, Ambac Assurance will seek to reduce its exposure to no more than the permitted amounts, but may not be able to due so. Everspan is in compliance with all of such limits.

Financial Services Segment

Ambac’s Financial Services segment historically provided financial and investment products, including investment agreements, derivative products (interest rate, currency and total return swaps) and funding conduits, principally to clients of the financial guarantee business. In 2008, Ambac discontinued writing new investment agreements and derivative products. Its existing investment agreement and derivative product portfolios are in

 

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active runoff, which in addition to natural attrition, may include transaction terminations, settlements, restructuring and hedging, and transfers. As of December 31, 2009 all total return swaps were terminated and settled.

The principal factors that may affect results as the Financial Services portfolios runoff include: (1) availability of counterparties for hedging transactions; (2) investment returns; (3) the transaction value of future contract terminations, settlements or transfers which may differ from carrying value of the those assets; (4) changes in the value of securities posted as collateral; (5) the ability to obtain additional liquidity support from Ambac Assurance if needed; (6) changes in the fair value of the derivatives portfolio resulting from interest rate index fluctuations and (7) the restrictions imposed upon Ambac Assurance by the contracts executed with the Segregated Account, the restrictions imposed upon Ambac Assurance by the Settlement Agreement, and, to the extent that Segregated Account Policies are implicated, the authority of the rehabilitator of the Segregated Account to control the management of the Segregated Account.

Investment Agreements

Ambac provided investment agreements, including repurchase agreements, primarily to issuers of asset-backed and structured finance debt and, to a lesser extent, to municipal issuers through its wholly-owned subsidiary, Ambac Capital Funding. Investment agreements used in structured financings provide a guaranteed investment return customized to meet expected and potential cash flow requirements. Investment agreements are used by bond issuers to invest bond proceeds until such proceeds can be used for their intended purpose, such as financing construction. The investment agreement provides for the guaranteed return of principal invested, as well as the payment of interest thereon at a guaranteed rate.

Liquidity risk exists in the portfolio due to contract provisions which require collateral posting or allow early termination of contracts. During 2010, reductions to the balance of outstanding investment agreements resulting from required or negotiated early terminations totaled $0.3 billion. As of December 31, 2010, 98% of investment agreement principal and accrued interest outstanding was collateralized. Funding for early terminations was supported in part through loans between Ambac Capital Funding and Ambac Assurance. At December 31, 2010, Ambac Capital Funding was indebted to Ambac Assurance in the amount of $553 million in cash loans.

See “Liquidity and Capital Resources” of the Management Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 and Note 8 to the Consolidated Financial Statements located in Part II, Item 8 for further information on investment agreements.

Derivative Products

The primary activities in the derivative products business were intermediation of interest rate and currency swap transactions (through Ambac Financial Services (“AFS”)) and taking total return swap positions on certain fixed income obligations (through Ambac Capital Services). Certain municipal interest rate swaps are not hedged for the basis difference between issue specific and general tax-exempt index rates. The derivative portfolio also includes an unhedged Sterling-denominated exposure to consumer price inflation in the United Kingdom. In addition, the derivative products business also uses exchange traded U.S. Treasury futures contracts to hedge interest rate exposures. Therefore, changes in the relationship between taxable and tax-exempt index and municipal issue specific rates, as well as between taxable index and Treasury interest rates may result in gains or losses on interest rate swaps. Additionally, beginning in 2009, the derivative products portfolio retained positive mark-to-market sensitivity to interest rate increases to mitigate floating rate obligations in the Financial Guarantee segment, including in the credit derivative portfolio.

Interest rate and currency swaps used for hedging purposes are generally subject to master agreements. These agreements generally require a counterparty in a net mark-to-market liability position to post increasing amounts of collateral if that counterparty’s credit rating declines and/or the net mark-to-market liability

 

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increases. Some contracts also contain additional termination provisions linked to downgrades of Ambac Assurance, as guarantor of the swaps. As a result of ratings downgrades to Ambac Assurance in 2008 and 2009, AFS lost its collateral posting thresholds and experienced termination events across all its professional counterparties. Such termination events have resulted in losses to AFS due to the higher cost of replacing hedge positions, and may result in additional losses in future periods. Beginning in 2008, AFS borrowed from Ambac Assurance, to help support the incremental collateral posting requirements and termination payments resulting from the Ambac Assurance downgrades. At December 31, 2010, AFS was indebted to Ambac Assurance in the amounts of $385 million in cash loans and $175 million in borrowed securities.

AFS manages a variety of risks inherent in its businesses, including credit, market, liquidity, operational and legal. These risks are identified, measured, and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. See “Quantitative and Qualitative Disclosures About Market Risk” located in Part II, Item 7A for further information.

Funding Conduits

Ambac previously transferred financial assets to two special purpose entities. The business purpose of these entities was to provide certain financial guarantee clients with funding for their debt obligations. The activities of the special purpose entities are contractually limited to purchasing assets from a subsidiary of Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and related administrative services. As of December 31, 2010, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the special purpose entities. Ambac does not consolidate these special purpose entities under the relevant accounting guidance for consolidation of variable interest entities. See Notes 2 and 10 to the Consolidated Financial Statements located in Part II, Item 8 for further information.

INVESTMENTS AND INVESTMENT POLICY

As of December 31, 2010, the consolidated investments of Ambac had an aggregate fair value of approximately $6.9 billion and an aggregate amortized cost of approximately $6.5 billion. The majority of these investments are primarily managed internally by officers of Ambac, who are experienced investment managers. A portion of the portfolio is managed by external investment managers. All investments are made in accordance with the general objectives and guidelines for investments approved by Ambac’s Board of Directors. These guidelines encompass credit quality, risk concentration and duration, and are periodically reviewed and revised as appropriate.

As of December 31, 2010, the Financial Guarantee investment portfolio had an aggregate fair value of approximately $5.7 billion and an aggregate amortized cost of approximately $5.4 billion. Ambac Assurance’s investment objectives are to achieve the highest book-yield on a diversified portfolio of fixed income investments while employing active asset/liability management practices to satisfy all operating and strategic liquidity needs. Ambac Assurance is subject to internal investment guidelines and is subject to limits on types and quality of investments imposed by the insurance laws and regulations of the States of Wisconsin and New York. In compliance with these laws, Ambac Assurance’s Board of Directors approves any changes or exceptions to the Investment Policy.

As described in “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, Ambac Assurance’s investment policies are subject to certain covenants made for the benefit of the Segregated Account and for the benefit of the Counterparties to the Settlement Agreement. Further, Ambac Assurance’s investment policies are subject to oversight by the rehabilitator pursuant to contracts entered into between Ambac Assurance and the Segregated Account and, therefore, such policies may change. Any such changes could adversely impact the performance of the investment portfolio.

 

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Beginning in 2008, Ambac Assurance purchased Ambac Assurance insured securities in the open market given their relative risk/reward characteristics and to mitigate the effect of potential future claim payments on operating results. Ambac Assurance financial guarantee policies related to these securities have been allocated to the Segregated Account as described in “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K. As a result of the claims moratorium on such policies, payments on these investments were adversely impacted.

As of December 31, 2010, the Financial Services investment portfolio had an aggregate fair value of approximately $1.1 billion and an aggregate amortized cost of approximately $1.1 billion. The investment objectives are to invest primarily in high-grade securities that produce sufficient cash flow to satisfy all investment agreement liabilities and intercompany obligations. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

The following tables provide certain information concerning the investments of Ambac:

 

     Summary of Investments as of December 31,  
     2010     2009     2008  

Investment Category

   Carrying
Value
     Weighted
Average
Yield(1)
    Carrying
Value
     Weighted
Average
Yield(1)
    Carrying
Value
     Weighted
Average
Yield(1)
 
($ in thousands)                                        

Long-term investments:

               

Taxable bonds

   $ 4,385,550         6.09   $ 4,874,636         6.69   $ 4,826,768         4.53

Tax-exempt bonds

     1,758,864         4.13     2,865,300         4.70     3,997,761         4.60
                                 

Total long-term investments

     6,144,414         5.51     7,739,936         5.98     8,824,529         4.56

Short-term investments(2)

     708,797         0.16     962,007         0.10     1,454,229         1.10

Other

     100         —          1,278         —          14,059         —     
                                 

Total

   $ 6,853,311         4.93   $ 8,703,221         5.34   $ 10,292,817         4.16
                                 

 

(1) Yields are stated on a pre-tax basis, based on average amortized cost.
(2) Includes taxable and tax-exempt investments.

 

     Investments by Security Type as of December 31,  
     2010     2009     2008  

Investment Category

   Carrying
Value
     Weighted
Average
Yield(1)
    Carrying
Value
     Weighted
Average
Yield(1)
    Carrying
Value
     Weighted
Average
Yield(1)
 
($ in thousands)                                        

Municipal obligations(2)

   $ 2,204,106         4.55   $ 3,205,480         4.89   $ 4,260,543         4.71

Corporate securities

     917,908         4.31     841,218         4.12     381,564         4.67

Foreign obligations

     118,455         3.80     167,651         4.12     150,369         4.59

U.S. government obligations

     272,275         1.89     356,466         2.56     313,520         2.56

U.S. agency obligations

     88,294         4.35     90,929         4.45     591,241         4.96

Residential mortgage-backed securities.

     1,506,809         10.83     1,765,665         12.94     1,986,174         4.76

Asset-backed securities

     1,036,567         3.40     1,312,527         2.75     1,141,118         3.85
                                 

Total long-term investments

     6,144,414         5.51     7,739,936         5.98     8,824,529         4.56

Short-term investments(2)

     708,797         0.16     962,007         0.10     1,454,229         1.10

Other

     100         —          1,278         —          14,059         —     
                                 

Total

   $ 6,853,311         4.93   $ 8,703,221         5.34   $ 10,292,817         4.16
                                 

 

(1) Yields are stated on a pre-tax basis, based on average amortized cost.
(2) Includes taxable and tax-exempt investments.

 

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Ambac has RMBS exposure in the Ambac Assurance and Financial Services investment portfolios. Please refer to the tables in Part II, Item 7 “Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Liquidity and Capital Resources—Balance Sheet” section below for a discussion of (i) the fair value of mortgage and asset-backed securities by classification, (ii) the fair value of residential mortgage-backed securities by vintage and type, and (iii) the ratings distribution of the fixed income investment portfolio by segment.

EMPLOYEES

As of December 31, 2010, Ambac and its subsidiaries had 243 employees. Ambac considers its employee relations to be satisfactory.

CORPORATE GOVERNANCE

The Sarbanes-Oxley Act of 2002 requires chief executive officers and chief financial officers to make certain certifications with respect to this report and to Ambac’s disclosure controls and procedures and internal control over financial reporting.

Ambac’s Disclosure Committee has the responsibility for ensuring that there is an adequate and effective process for establishing, maintaining and evaluating disclosure controls and procedures for Ambac in connection with its external disclosures. Ambac has a Code of Business Conduct which promotes management’s control philosophy and expresses the values which govern employee behavior and help maintain Ambac’s commitment to the highest standards of conduct. This code can be found on Ambac’s website at www.ambac.com on the “Investor Relations” page followed by “Corporate Governance.” Ambac will disclose on its website any amendment to, or waiver from, a provision of its Code of Business Conduct that applies to its CEO, Chief Financial Officer (“CFO”) or Chief Accounting Officer (“CAO”). Ambac’s corporate governance guidelines and the charters for the audit committee, governance committee and compensation committee are also available on our website under the “Corporate Governance” page.

 

Item 1A. Risk Factors

References in the risk factors to “Ambac” are to Ambac Financial Group, Inc. References to “we,” “our,” “us” and “Company”) are to Ambac, Ambac Assurance Corporation, Everspan Financial Guarantee Corp., and Ambac Credit Products LLC as the context requires.

A long period of operations under Chapter 11 protection may harm our business.

As with any judicial proceeding, there are risks of unavoidable delay with a Chapter 11 proceeding and there are risks of objections from certain stakeholders, including objections from the holders of unsecured notes that vote to reject a plan of reorganization. Any material delay in the confirmation of a plan, or the threat of rejection of the plan by the Bankruptcy Court, would not only add substantial expense and uncertainty to the process, but also would adversely affect our operations during this period.

So long as the Chapter 11 proceeding continues, our senior management will be required to spend a significant amount of time and effort working on the reorganization, distracting focus from our business operations. A prolonged period of operating under Chapter 11 protection may also make it more difficult to attract and retain management and other key personnel necessary to effect a successful reorganization. See “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for additional information.

Furthermore, so long as the Chapter 11 proceedings continue, we will be required to incur substantial costs for professional fees and other expenses associated with the administration of the Chapter 11 proceedings. A

 

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prolonged continuation of the Chapter 11 proceedings may also require us to seek financing. If we require financing during the Chapter 11 proceedings and we are unable to obtain the financing on favorable terms or at all, our chances of successfully reorganizing our businesses may be seriously jeopardized, and as a result, our assets and securities could become further devalued or worthless.

Under the Bankruptcy Code, all debtors must obtain Bankruptcy Court approval to, among other things:

 

   

sell assets or engage in other actions outside the ordinary course of business;

 

   

consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and

 

   

obtain financing.

In addition, if a trustee is appointed to operate us while in Chapter 11 bankruptcy, the trustee would assume control of our assets.

While management believes that Ambac will have sufficient liquidity to satisfy its needs until it emerges from the bankruptcy proceeding, no guarantee can be given that it will be able to pay all expenses. If its liquidity runs out prior to emergence from bankruptcy, a liquidation of Ambac pursuant to Chapter 7 of the Bankruptcy Code will occur. In the event of a Chapter 7 liquidation, the Company is likely to be unable to utilize a substantial portion of its NOLs. However, the Company’s NOLs could be used to offset income of Ambac Assurance realized prior to a completion of a liquidation.

There is significant uncertainty as to how Ambac’s securityholders will be treated under any plan of reorganization.

To date, Ambac has been unable to agree to terms with the Creditors Committee in order to restructure its outstanding debt through a prepackaged bankruptcy proceeding. However, Ambac has agreed to a non-binding term sheet that continues to serve as a basis for negotiations with the Creditors Committee and that may allow Ambac to emerge from bankruptcy in a timely manner. Because a plan of reorganization (a “Reorganization Plan”) has not yet been agreed to, there is significant uncertainty as to how holders of Ambac’s securities will be treated under the Reorganization Plan. It is likely, however, that Ambac’s debtholders and creditors will receive all equity in the company.

If Ambac’s exclusivity period lapses, any party in interest would be able to file a plan of reorganization for Ambac.

Upon commencing the Bankruptcy Filing, Ambac had the exclusive right for 120 days after the Petition Date to file a plan of reorganization and, if we do so, 60 additional days to obtain necessary acceptances of the plan. Ambac filed and received Bankruptcy Court approval to extend its exclusive rights to file a plan of reorganization and obtain necessary acceptances of the plan by 120 days to and including July 6, 2011 and September 6, 2011, respectively. Further extensions are subject to approval by the Bankruptcy Court. If Ambac’s exclusivity period lapses, any party in interest would be able to file a plan of reorganization for Ambac. In that context, we cannot predict whether Ambac’s security holders will be treated better or worse and whether the consolidated value of the Company will be maximized.

A Reorganization Plan will not be confirmed by the Bankruptcy Court unless it concludes that the Reorganization Plan satisfies all requirements of Section 1129 of the Bankruptcy Code, including but not limited to the requirements that the Reorganization Plan is feasible, “does not discriminate unfairly” and is “fair and equitable” with respect to certain classes in the Chapter 11 Filing.

In order to confirm a plan of reorganization, a debtor must satisfy all of the requirements set forth in Section 1129(a) of the Bankruptcy Code, including but not limited to the requirement that the plan of reorganization is feasible. Such feasibility requirement obligates a debtor to show that confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor in interest to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.

 

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In addition, in the event any impaired class of claims or equity interests does not accept a plan of reorganization, a bankruptcy court may nevertheless confirm such plan at the proponent’s request under Section 1129(b) of the Bankruptcy Code if at least one impaired class has accepted the plan (with such acceptance being determined without including the vote of any “insider” in such class), and, as to each impaired class that has not accepted the plan, the bankruptcy court determines that the plan “does not discriminate unfairly” and is “fair and equitable” with respect to the dissenting impaired classes. Because certain classes in the Bankruptcy Filing will likely be deemed to reject any Reorganization Plan, these additional requirements of Section 1129(b) must be satisfied with respect to such classes in the Bankruptcy Filing. If these classes assert that the Reorganization Plan does not meet the aforementioned requirements of Sections 1129(a) and (b) of the Bankruptcy Code, there is no assurance that the Bankruptcy Court will confirm the Reorganization Plan.

If the bankruptcy court does not approve the Reorganization Plan for any reason, or does not approve the plan in a timely manner, there is increased risk that a liquidation of Ambac pursuant to Chapter 7 of the Bankruptcy Code will occur.

Disputes, including litigation, between Ambac and Ambac Assurance regarding the allocation of certain tax attributes, including NOLs, could reduce the overall value of the Company.

If the negotiations among Ambac, Ambac Assurance, OCI and the Creditors’ Committee do not produce an agreement among the parties with respect to the allocation of potential sources of value (principally, NOLs and other claims with respect to certain payments made by Ambac to Ambac Assurance pursuant to the tax sharing agreement) and expenses, Ambac’s creditors could take actions which would adversely affect Ambac Assurance and/or the Segregated Account. For example, the creditors could seek to impose a constructive trust with respect to cash payments received by Ambac Assurance and/or seek to re-organize Ambac’s ownership interest in Ambac Assurance in order to achieve a de-consolidation of Ambac and Ambac Assurance for tax purposes, with the result that Ambac would become entitled to the use of all NOLs in existence on the date of such de-consolidation. Such disputes and/or litigation between Ambac and Ambac Assurance could prolong the Chapter 11 proceeding, with resultant increases in the expenses of the Chapter 11 proceeding, and could ultimately impair Ambac’s ability to successfully reorganize. Additionally, such disputes and/or litigation could prompt OCI to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively, or in response to any such action; initiation of a rehabilitation proceeding with respect to Ambac Assurance could decrease the residual value, if any, of Ambac Assurance.

Pursuit of litigation by the parties in interest could disrupt the confirmation of a Reorganization Plan and could have material adverse effects on our businesses and financial condition.

There can be no assurance that any of the parties in interest will not pursue litigation strategies to enforce any claims against us. For example, on January 13, 2011, the IRS filed a motion in the United States District Court for the Southern District of New York (“USDC SDNY”) to withdraw the adversary proceeding from the Bankruptcy Court to the USDC SDNY. Litigation is by its nature uncertain and there can be no assurance of the ultimate resolution of any such claims. Any litigation may be expensive, lengthy, and disruptive to our normal business operations and the Reorganization Plan confirmation process, and a resolution of any such strategies that is unfavorable to us could have a material adverse affect on the Reorganization Plan confirmation process or their respective businesses, results of operations, financial condition, liquidity or cash flow.

Historical financial information may not be comparable.

Following confirmation of a Reorganization Plan and the transactions contemplated thereby, our financial condition and results of operations from and after the effective date of the Reorganization Plan may not be comparable to the financial condition or results of operations reflected in our historical financial statements.

 

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The occurrence of certain events could result in the initiation of rehabilitation proceedings against Ambac Assurance, with resulting adverse consequences to holders of Ambac securities.

The IRS and certain policyholders whose policies were allocated to the Segregated Account have challenged the establishment of the Segregated Account. If such challenges are successful, OCI may determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance. Similarly, if negotiations among Ambac, the Creditors Committee, OCI and the rehabilitator of the Segregated Account do not produce an agreement among the parties, Ambac (or its creditors) could take actions which would adversely affect Ambac Assurance and/or the Segregated Account. As such, OCI may determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively or in response to any such action. Finally, the incurrence of large losses in respect of policies in the general account of Ambac Assurance and other unknown contingencies (including disputes between Ambac and Ambac Assurance and/or the Segregated Account) might occur which would prompt OCI to initiate rehabilitation proceedings with respect to Ambac Assurance.

If, as a result of the occurrence of any such event(s), the OCI decides to initiate rehabilitation proceedings with respect to Ambac Assurance, adverse consequences may result, including, without limitation, the assertion of damages by counterparties (including mark-to-market claims with respect to insured transactions executed in ISDA format) and the acceleration of losses based on early termination triggers and the loss of control rights in insured transactions, thereby reducing the residual value of Ambac Assurance. Additionally, the rehabilitator would assume control of all of Ambac Assurance’s assets and management of Ambac Assurance. In exercising control, the rehabilitator will act for the benefit of policyholders, and will not take into account the interests of securityholders of Ambac; such actions may result in material adverse consequences for Ambac’s securityholders. In addition, the initiation of delinquency proceedings against Ambac Assurance would further decrease the likelihood that OCI will permit Ambac Assurance to make future dividend payments to Ambac.

As a result of the Segregated Account Rehabilitation Proceedings, various adverse events in the insured portfolio may be triggered. If injunctions issued by the rehabilitation court enjoining such adverse effects are ineffective, substantial adverse events may occur.

The rehabilitation court issued an injunction effective until further order of the court enjoining certain actions by Segregated Account policyholders and other counterparties, including the assertion of damages or acceleration of losses (including mark-to-market claims with respect to insured transactions executed in ISDA format) based on early termination triggers and the loss of control rights in insured transactions. If the challenges to the injunction that have been filed are successful, losses in the Segregated Account would likely increase substantially.

Our inability to realize the remediation recoveries included in our loss reserves could adversely impact our liquidity and financial condition and lead to delinquency proceedings.

As of December 31, 2010, we have estimated subrogation recoveries of $2,391.3 million (net of reinsurance), which is included in our loss reserves. These recoveries are based principally on contractual claims arising from RMBS transactions which we have insured, and represent our estimate of the amount we will ultimately recover. However, our ability to recover these amounts is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take the actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. The amount of these subrogation recoveries is significant and if we were unable to recover any amounts our stockholders’ deficit as of December 31, 2010 would increase from $1,354.2 million to $3,745.5 million.

 

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Actions of the rehabilitator could adversely affect Ambac, including impacting our ability to realize our remediation recoveries.

As a consequence of the Segregated Account Rehabilitation Proceedings, the rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation, loss mitigation and efforts to recover losses in the Segregated Account, including recovery efforts in respect of breaches of representations and warranties by sponsors of Ambac-insured RMBS. Similarly, by virtue of the contracts executed between Ambac Assurance and the Segregated Account in connection with the establishment, and subsequent rehabilitation, of the Segregated Account, the rehabilitator retains the discretion to oversee and approve certain actions taken by Ambac Assurance in respect of assets and liabilities which remain in Ambac Assurance. As a result, any efforts to remediate losses, and any actions taken by Ambac Assurance, are subject to the approval of the rehabilitator. In exercising such authority, the rehabilitator will act for the benefit of policyholders, and will not take into account the interests of securityholders of Ambac. Decisions made by the rehabilitator for the benefit of policyholders may result in material adverse consequences for Ambac’s securityholders. In addition, we are not able to predict the impact such oversight will have on the remediation of losses, and, in particular, on our efforts to recover losses attributable to breaches of representations and warranties by sponsors of Ambac-insured RMBS and our ability to commute outstanding policies and repurchase surplus notes, nor whether the rehabilitator will pursue such remediation as vigorously as we have done in the past. In addition, as a result of the Segregated Account Rehabilitation Proceedings, certain key personnel have chosen to leave Ambac, and additional people may decide to leave. The loss of such personnel could adversely impact Ambac’s remediation efforts.

Loss reserves may not be adequate to cover potential losses; changes in loss reserves may result in further volatility of net income and earnings.

Loss reserves established with respect to our non-derivative financial guarantee insurance business are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default, the severity of loss upon default and estimated remediation recoveries for, among other things, breaches by the issuer of representations and warranties. Loss reserves are established when management has observed credit deterioration, in most cases, when the underlying credit is considered below investment grade. Furthermore, the objective of establishing loss reserve estimates is not to reflect the worst possible outcome. As such, there can be no assurance that the actual losses in our financial guarantee insurance portfolio will not exceed our loss reserves. A further description of our accounting for loss and loss expenses can be found in Note 2 of the Notes to our Audited Consolidated Financial Statements included in Item 8 of this Form 10-K.

Additionally, inherent in our estimates of loss severities and remediation recoveries is the assumption that we will retain control rights in respect of our insured portfolio. However, we are subject to the loss of control rights in many insured transactions, in the event that we are the subject of delinquency proceedings and/or other regulatory actions which could result from our deteriorated financial position. In the event that we lose control rights, our ability to mitigate loss severities and realize remediation recoveries will be compromised, and actual ultimate losses in our insured portfolio could exceed our loss reserves. The rehabilitation court issued an injunction effective until further order of the court enjoining certain actions by holders of policies in the Segregated Account and other counterparties, including the loss of control rights. If this injunction were successfully challenged, Ambac Assurance could lose its control rights with respect to policies in the Segregated Account.

We also rely on internally and externally developed complex financial models to project performance of our insured obligations. Flaws in these financial models and/or faulty assumptions used by these financial models could lead to increased losses and loss reserving. In addition, for 2011, we expect to implement a new RMBS loss reserve model which could produce increased projected losses and loss reserves estimates for our RMBS portfolios. Uncertainty with respect to the ultimate performance of certain of our insured exposures may result in substantial changes in loss reserves and/or actual losses. Correspondingly, such changes to loss reserves would affect our reported earnings. If we do not have sufficient liquidity to meet the increase in actual losses, our insurance operating subsidiaries may become subject to delinquency proceedings.

 

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Some of the state and local governments and finance authorities that issue public finance obligations we insure are experiencing unprecedented budget shortfalls that could result in increased credit losses or impairments on those obligations

We have historically experienced low levels of defaults in our U.S. public finance insured portfolio, including during the financial crisis that began in mid-2007. However, recently many state and local governments that issue some of the obligations we insure have reported unprecedented budget shortfalls that will require them to significantly raise taxes and/or cut spending in order to satisfy their obligations. While there has been some support provided by the U.S. federal government designed to provide aid to state and local governments, certain state and local governments remain under extreme financial stress. If the issuers of the obligations in our U.S. public finance portfolio are unable to raise taxes, cut spending, or receive federal assistance, we may experience losses or impairments on those obligations, which could adversely affect our business, financial condition and results of operations.

We are exposed to operational risks with respect to the distribution of surplus notes in connection with the payment of claim liabilities of the Segregated Account.

Under the Plan of Rehabilitation, the Segregated Account will partially satisfy its claim liabilities through the issuance of surplus notes. In certain circumstances, Ambac Assurance, as management services provider, may be handling the distribution of the surplus notes issued by the Segregated Account. In connection with this process, Ambac Assurance has operational risks that the surplus notes may not be issued, settled or accounted for properly.

Market risks could adversely impact our assets posted as collateral in respect of investment agreements and interest rate swap and currency swap transactions.

As a result of the downgrades of Ambac Assurance’s financial strength rating, we are required to post collateral with respect to certain investment agreements, interest rate swap and currency swap transactions. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Ratings and Collateral” of this Form 10-K. We will be required to post additional collateral if the market value of the assets used to collateralize our obligations declines or if there are changes in the collateral posting obligations under these agreements and transactions.

These collateral-posting obligations could have a material adverse effect on our liquidity. At present, these collateral-posting requirements are being partially satisfied by Ambac Assurance and by loans from Ambac Assurance to the Financial Services businesses. As required by Wisconsin law, these transactions were approved by the OCI. To the extent that collateral-posting requirements increase as a result of changes in market conditions, as described above, it is likely that Ambac Assurance would need to provide increased lending capacity to the Financial Services businesses in order to satisfy these collateral-posting obligations. Any such increases to lending capacity would be subject to the prior consent of the OCI; there can be no assurance that we would obtain such consent. We believe that the OCI would consider several factors in determining whether to grant such consent, including its view of Ambac Assurance’s financial condition at the time of such loan or contribution.

If the Financial Services businesses fail to post collateral as required, counterparties may be entitled to terminate the transactions. Upon such terminations, we could liquidate securities with unrealized mark-to-market losses which could have a material adverse effect on our liquidity. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Ratings and Collateral” of this Form 10-K. The termination of such transactions, if unpaid by our Financial Services businesses, would trigger Ambac Assurance’s obligations to make payments under the financial guarantee insurance policies it previously issued. To the extent that the OCI determines that the payment by Ambac Assurance under such policies could place Ambac Assurance in a hazardous condition, the OCI could seize Ambac Assurance and place it into rehabilitation.

 

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Risks which impact assets in our investment portfolio could adversely affect our business.

Our investment portfolio may be adversely affected by events and developments in the capital markets, including interest rate movements; credit rating downgrades and foreign exchange movements. Please refer to the table in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Balance Sheet” of this Form 10-K, representing the fair value, including the value of the financial guarantee, and weighted-average underlying rating, excluding the financial guarantee, of the insured securities at December 31, 2010.

During the course of 2010, management identified and periodically revised certain investment securities in the investment portfolio to potentially sell in connection with plans to reposition the investment portfolio and/or to meet potential liquidity needs. We recorded an impairment charge through income on the portion of those securities which were in an unrealized loss position. Additionally, management determined that certain investments had suffered credit impairments. Credit impaired securities included certain securities that are guaranteed by Ambac under policies that are subject to the Segregated Account Rehabilitation Plan. We recorded an impairment charge through income in the amount of the estimated credit impairment on such securities. The impairments in value in the remaining investment portfolio are not deemed other-than-temporary, as such the remaining unrealized losses have been recognized in other comprehensive income. Please see Note 3 “Investments” in the Notes to Consolidated Financial Statements for additional information.

To the extent we liquidate large blocks of investment assets in order to pay claims under financial guarantee insurance policies, to make payments under investment agreements and/or to collateralize our obligations under investment agreements and interest rate swaps, such investment assets could be sold at prices less than fair value as of December 31, 2010. Refer to Note 3 “Investments” in the Notes to Consolidated Financial Statements for more information regarding the fair value of investment assets.

Prior to the rating agency actions on Ambac Assurance, Ambac Assurance managed its investment portfolio in accordance with rating agency standards for a AAA-rated insurance company. As a result of the significant declines in Ambac Assurance’s financial strength ratings, it is no longer necessary to comply with the strict investment portfolio guidelines for a AAA-rated company. Therefore, Ambac Assurance has decided to maintain a portion of its investment portfolio in lower-rated securities in order to increase the investment return on its portfolio. The investment in lower-rated securities and “alternative assets” could expose Ambac to increased losses on its investment portfolio in excess of those described above and/or decrease the liquidity of the insured portfolio. However, Ambac Assurance’s investment policies are subject to certain covenants made for the benefit of the Segregated Account and the Settlement Agreement for the benefit of the Counterparties. Any such changes could adversely impact the performance of the investment portfolio.

The determination of the amount of impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.

The determination of the amount of impairments on our investments vary by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in impairments in operations as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. In addition, in 2011, we expect to implement a new RMBS cash flow analysis model, which could produce increased projected impairments with regard to our investment portfolio.

 

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We are subject to credit and liquidity risk due to unscheduled and unanticipated withdrawals on Investment Agreements.

Ambac’s Investment Agreement business has issued investment agreements to investors that may allow for early withdrawal (i.e. deviate from a defined or expected withdrawal schedule). The provisions that allow for early withdrawal vary by transaction but include events such as credit events, early call provisions, loss events, construction project development variance and changes in tax code. To the extent we experience an increase in unanticipated withdrawals, the Investment Agreement business may be required to liquidate certain asset holdings. This early liquidation of asset holdings may result in a realized loss.

We are subject to dispute risk in connection with our reinsurance agreements.

In addition to having credit exposure to our reinsurance counterparties, we are exposed to the risk that reinsurance counterparties may dispute their obligations to make payments required by applicable reinsurance agreements, including scheduled payments and payments due in connection with the termination of reinsurance agreements. Such disputes could result in our being unable to collect all amounts due from reinsurers and/or collecting such amounts after potentially lengthy dispute resolution processes.

Our inability to attract and retain qualified executives and employees or the loss of any of these personnel could negatively impact our business.

Our ability to mitigate losses in Ambac Assurance’s insured portfolio and in the Segregated Account and to effectively implement a reorganization under Chapter 11 depend on the retention and recruitment of qualified executives and other professionals. We rely substantially upon the services of our current executive team. In addition to these officers, we require key staff with risk mitigation, structured finance, insurance, credit, investment, accounting and administrative skills. As a result of Ambac’s filing for chapter 11 bankruptcy protection and the implementation of rehabilitation proceedings against the Segregated Account, there is an increased risk that executive officers and other key staff will leave the company and replacements may not be incented to join the company. The loss of the services of members of our senior management team, or our inability to hire and retain other talented personnel, could delay or prevent us from fully implementing our remediation strategies, which could further negatively impact our business.

We are subject to the risk of litigation and regulatory inquiries or investigations, and the outcome of proceedings we are or may become involved in could have a material adverse effect on our business, operations, financial position, profitability or cash flows.

Ambac, 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. Ambac also has been named in lawsuits relating to transactions entered into by its financial guarantee subsidiary, Ambac Assurance, and its financial services businesses. In addition, Ambac has received various regulatory inquiries and requests for information. Please see Note 13 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for information on these various proceedings.

It is not possible to predict whether additional suits will be filed or whether additional inquiries or requests for information will be made, and it is also not possible to predict the outcome of litigation, inquiries or requests for information. It is possible that there could be unfavorable outcomes in these or other proceedings. Management is unable to make a meaningful estimate of the amount or range of loss that could result from unfavorable outcomes or of the expenses that will be incurred in defending these lawsuits. Under some circumstances, adverse results in any such proceedings and/or the incurrence of significant litigation expenses could be material to our business, operations, financial position, profitability or cash flows.

 

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We are subject to credit risk and other risks related to RMBS.

We have insured RMBS transactions (including transactions comprised of second lien mortgage products, home equity line of credit (“HELOCs”) and closed end second mortgage loans, and Alt-A or mid-prime loans) and are thus exposed to credit risk associated with those asset classes. Performance of these transactions can be adversely affected by general economic conditions, including a recession, rising unemployment rates, declining house prices, increasing foreclosure rates and unavailability of consumer credit; mortgage product attributes, such as interest rate adjustments and balloon payment obligations; borrower and/or originator fraud; mortgage servicer underperformance and financial difficulty experienced by such servicers.

While further deterioration in the performance of consumer assets, including mortgage-related assets, credit cards, student loans and auto loans and leases, may occur, the extent and duration of any future deterioration of the credit markets is unknown, as is the impact, if any, on potential claim payments and ultimate losses of the securities within Ambac Assurance’s portfolio. In addition, there can be no assurance that any of the governmental or private sector initiatives designed to address such credit deterioration in the markets will be successful, and there is no way to know the effect that any such initiatives could have on the credit performance over time of the actual securities that Ambac Assurance insures.

In addition, there can be no assurance that we would be successful, or that we would not be delayed, in enforcing the subordination provisions, credit enhancements or other contractual provisions of the RMBS that Ambac Assurance insures in the event of litigation or the bankruptcy of other transaction parties. Many of the subordination provisions, credit enhancements and other contractual provisions of the RMBS that Ambac Assurance insures are untested in the market and, therefore, it is uncertain how such subordination provisions, credit enhancements and other contractual provisions will be interpreted in the event of an action for enforcement.

We are subject to credit risk throughout our businesses, including large single risks, correlated risks and reinsurance counterparty credit risk.

We are exposed to the risk that issuers of debt which we have insured (or with respect to which we have written credit derivatives), issuers of debt which we hold in our investment portfolio, reinsurers and other contract counterparties (including derivative counterparties) may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure, fraud or other reasons. These credit risks could cause increased losses and loss reserves, estimates of credit impairments and mark-to-market losses with respect to credit derivatives in our financial guarantee business; and we could experience losses and decreases in the value of our investment portfolio and, therefore, our financial strength. Such credit risks may be in the form of large single risk exposures to particular issuers, reinsurers or counterparties; losses caused by catastrophic events (including terrorist acts and natural disasters); losses caused by increases in municipal defaults; or losses in respect of different, but correlated, credit exposures. For additional information on our reinsurers, see Item 7A, “Risk Management—Credit Risk” and “Quantitative and Qualitative Disclosures About Market Risk—Credit Risk” in this Form 10-K.

Our risk management policies and practices may not adequately identify significant risks.

As described in Part I, Item 1, “Business—Risk Management” of this Form 10-K, we have established risk management policies and practices which seek to mitigate our exposure to credit risk in our insured portfolio. Ongoing surveillance of credit risks in our insured portfolio is an important component of our risk management. These policies and practices in the past have not insulated us from risks that were unforeseen and which had unanticipated loss severity, and such policies and practices may not do so in the future. There can be no assurance that these policies and practices will be adequate to avoid future losses. If we are not able to identify significant risks prior to their occurrence, we may not be able to timely remediate such risks, thereby increasing the amount of losses to which we are exposed.

 

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Revenues and cash flow would be adversely impacted due to a decline in realization of installment premiums and transaction-related recoveries.

Due to the installment nature of a significant percentage of its premium income, Ambac Assurance has an embedded future revenue stream. The amount of installment premiums actually realized by Ambac Assurance could be reduced in the future due to factors such as early termination of insurance contracts, accelerated prepayments of underlying obligations or insufficiency of cash flows (by the premium paying entity). Additionally, the imposition of a payment moratorium with respect to policies in the Segregated Account may result in the loss of installment premium income or future recoveries from such insured transactions. Such reductions would result in lower revenues.

Changes in prevailing interest rate levels could adversely impact our business results and prospects.

Increases in prevailing interest rate levels can adversely affect the value of our investment portfolio and, therefore, our financial strength. In the event that investments must be sold in order to pay claims or to meet Financial Services liquidity needs due to contract terminations or collateral posting requirements, such investments would likely be sold at discounted prices. Additionally, increasing interest rates would have an adverse impact on our insured portfolio. For example, increasing interest rates could result in higher claim payments in respect of defaulted obligations which bear interest at floating rates of interest. Higher interest rates can also lead to increased credit stress on consumer asset-backed transactions in our insured portfolio (as the securitized assets supporting a portion of these exposures are floating rate consumer obligations); slower prepayment speeds and resulting “extension risk” relative to such consumer asset-backed transactions in our insured portfolio and in our investment portfolio; decreased volume of capital markets activity and, correspondingly, decreased volume of insured transactions.

Decreasing interest rates could result in early terminations of financial guarantee insurance policies in respect of which we are paid on an installment basis and do not receive a termination premium, thus reducing premium earned in respect of these transactions. Decreases in prevailing interest rates may also limit growth of or reduce investment income and may adversely impact the result of our interest rate swap portfolio.

Our net income and earnings have become more volatile due to the application of fair value accounting, required under the relevant derivative accounting guidance, to the portion of our credit enhancement business which is executed in credit derivative form.

The derivative accounting guidance requires that credit derivative transactions be recorded at fair value. Since quoted market prices for the contracts that we execute are not available, we estimate fair value by using models. Changes in estimated fair values relative to our credit derivative book have caused decreases in the value of such credit derivative transactions; those changes in value are reported in our financial statements and have therefore affected our reported earnings. Similarly, further decreases or increases in estimated fair values in the future can affect our reported earnings. Changes in estimated fair values can be caused by general market conditions, uncertainty regarding the quality of high yield corporate loans, student loans or other underlying collateral, perception of credit risk generally and events affecting particular credit derivative transactions (e.g. impairment or improvement of specific reference entities or reference obligations) and perception of the credit risk posed by Ambac Assurance as insurer of the CDS.

We are subject to extensive regulation in the conduct of our financial guarantee insurance business; application of and/or amendments to, these insurance laws and regulations could have a material adverse impact on our business results, the Company and Ambac Assurance.

Our principal subsidiary, Ambac Assurance, is subject to the insurance laws and regulations of each jurisdiction in which it is licensed. Ambac UK, the subsidiary through which we write financial guarantee insurance in the United Kingdom and in the European Union, is regulated by the Financial Services Authority. Failure to comply with applicable insurance laws and regulations (including, without limitation, minimum surplus

 

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requirements, aggregate risk limits and single risk limits) could expose us to fines, the loss of insurance licenses in certain jurisdictions, the imposition of orders by regulators with respect to the conduct of business by Ambac Assurance and/or the inability of Ambac Assurance to dividend monies to us, all of which could have an adverse impact on our business results and prospects.

Recently, there have been legislative and regulatory initiatives with respect to the regulation of financial guarantee insurance companies. Any changes to such laws and regulations could subject Ambac Assurance to increased reserving and capital requirements or more stringent regulation generally, which could materially adversely affect our financial condition, results of operations and future business. See Part I, Item 1 “Business—Insurance Regulatory Matters” in this Form 10-K for further information.

We are subject to a variety of operational risks which could have a material adverse impact on our business results.

We depend on internal processes, risk models, various systems and our employees in the conduct of our business. Any failure of such processes, models and systems and/or employee misconduct or fraud could have an adverse impact on our business results. We are also subject to external operational risks, including fraud, settlement risk and the failure of risk models or other analytical tools provided by third parties. Any such external fraud or failure could have an adverse impact on our business results.

There are limitations on the voting rights attached to our shares of common stock.

Our subsidiary, Ambac Assurance, is a Wisconsin corporation and is subject to the insurance and regulatory laws of the State of Wisconsin. Under Wisconsin insurance holding company laws, there is a presumption that a holder of 10% or more of Ambac’s voting stock controls Ambac Assurance and any such acquisition of control requires the prior approval of the OCI of the State of Wisconsin. In addition, as a result of Ambac being the holding company of Ambac (UK), the prior consent of the UK’s Financial Services Authority (“FSA”) is required for any individual, group or institution who proposes to take a step that would result in becoming a controller, or increasing control, over Ambac (UK). Among other things, any shareholder must receive the prior consent of the FSA prior to holding 10 percent or more of Ambac’s shares.

Section 4.5 of our amended and restated certificate of incorporation provides that no stockholder may cast votes with respect to 10% or more of our voting stock, regardless of the actual number of shares of voting stock beneficially held by the stockholder. In addition, any voting stock held by a stockholder in excess of 10% will not count in the calculation of or toward a quorum at any meeting of stockholders. In order to avoid these restrictions, a stockholder who acquires or owns 10% or more of our voting stock must have such acquisition or ownership previously approved by the OCI of the State of Wisconsin or file a disclaimer of “control” approved by such office.

The foregoing provisions of the Wisconsin insurance holding company laws, UK insurance laws and legal restrictions contained in our amended and restated certificate of incorporation will have the effect of rendering more difficult or discouraging unsolicited takeover bids from third parties or the removal of incumbent management.

Characterization of losses on our CDS portfolio as capital losses for U.S. federal tax purposes could result in a material assessment for federal income taxes.

Ambac Assurance’s CDS portfolio experienced significant losses. The majority of these CDS contracts are on a “pay as you go” basis, and we believe that they are properly characterized as notional principal contracts for U.S. federal income tax purposes. Generally, losses on notional principal contracts are ordinary losses. However, the federal income tax treatment of credit default swaps is an unsettled area of the tax law. As such, it is possible that the Internal Revenue Service may decide that the “pay as you go” CDS contracts should be characterized as capital assets or that certain payments made with respect to the CDS contracts should be characterized as capital

 

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losses. As of December 31, 2010, Ambac and Ambac Assurance had NOL amounting to approximately $7.0 billion for U.S. federal income tax purposes. Recently, the Internal Revenue Service opened an examination into certain issues related to Ambac’s tax accounting methods with respect to such CDS contracts and Ambac’s related characterization of such losses as ordinary losses. Although, as discussed above, Ambac believes these contracts are properly characterized as notional principal contracts, if the Internal Revenue Service today were to successfully assert, as a result of its examination, that these contracts should be characterized as capital assets or as generating capital losses, Ambac and Ambac Assurance would be subject to both a substantial reduction in its net operating loss carryforwards and would suffer a material assessment for federal income taxes. Such assessments and reductions in net operating loss carryforwards would have a material adverse impact on our financial condition. Such assessments related to the tentative refunds may be made by the Internal Revenue Service at any time and, without prior notice to Ambac, pursuant to Internal Revenue Code section 6213(b). The Internal Revenue Service may then file a lien that attaches to Ambac’s property interests, including the property interests of any member of the consolidated tax group, and commence collection efforts. Ambac filed and served a complaint against the IRS for a declaratory judgment relating to the tax refunds. If these events occur, Ambac Assurance’s Segregated Account rehabilitation plan may be materially impacted and Ambac’s ability to effectively reorganize may be seriously jeopardized.

The Surplus Notes issued pursuant to the final terms of the Settlement Agreement may be characterized as equity of Ambac Assurance and as a result Ambac Assurance may no longer be a member of the U.S. federal income tax consolidated group of which the Company is the common parent.

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

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

Deductions with respect to interest accruing on the Surplus Notes may be eliminated or deferred until payment.

To the extent the Surplus Notes are characterized as equity for U.S. federal income tax purposes, accrued interest will not be deductible. In addition, even if the Surplus Notes are characterized as debt for U.S. federal income tax purposes, the deduction of interest accruing on the Surplus Notes may be deferred until paid or eliminated in part depending upon (i) the terms of any deferral and payment provisions provided in the Surplus Notes, (ii) whether the Surplus Notes have “significant original issue discount” and (iii) the yield to maturity of the Surplus Notes. To the extent deductions with respect to interest is eliminated or deferred, the U.S. federal income tax of Ambac Assurance, the members of the Ambac Consolidated Tax Group or the members of the Ambac Assurance Consolidated Tax Group, as the case maybe, could be materially increased reducing the amount of cash available to pay third party obligations or dividends.

 

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The Ambac Assurance NOL (and certain other tax attributes or tax benefits of the Ambac Consolidated Tax Group) may be subject to limitation as a result of the bankruptcy reorganization.

Under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), if a “loss corporation” (generally, a corporation with NOLs and/or built-in losses) undergoes an “ownership change,” the amount of such corporation’s pre-ownership change NOLs that may be utilized to offset future taxable income generally is subject to an annual limitation (the “Annual Section 382 Limitation”). In general, the amount of the Annual Section 382 Limitation is equal to the product of (1) the fair market value of the stock of the corporation (or, in the case of a consolidated group, generally the stock of the common parent) immediately before the ownership change (with certain adjustments) and (2) the “long-term tax-exempt rate” in effect for the month in which the ownership change occurs (for example, 3.86 percent for an ownership change that occurs during November 2010). In general, an “ownership change” occurs if shareholders owning 5 percent or more of the corporation’s stock increase their ownership by greater than 50 percentage points over a three-year testing period.

It is likely that Ambac would undergo an “ownership change” for purposes of section 382 of the Code as a result of implementation of a bankruptcy plan of reorganization. Ambac hopes to qualify under a special exception contained in section 382(l)(5) of the Code (the “L5 Exception”) in order to avoid an ownership change as a result of the implementation of the bankruptcy plan of reorganization.

In connection with the Bankruptcy Filing, the Bankruptcy Court issued an order (the “Trading Order”) restricting certain transfers of equity interests in and claims against Ambac. The purpose of the Trading Order is to increase the likelihood that Ambac may qualify for the L5 Exception and thereby preserve Ambac’s NOLs. The Trading Order implements notice and hearing procedures for transfers by a person or entity that beneficially owns more than 13,500,000 shares of Ambac stock. Transfers of stock in violation of this Trading Order will be void ab initio. In addition, the Trading Order generally requires persons or entities that beneficially own claims against Ambac totaling more than $55,000,000 to agree to “sell down” a portion of its claims against Ambac prior to a bankruptcy reorganization, such that the claimholder would receive less than 5 percent of reorganized Ambac’s stock in a bankruptcy plan of reorganization that may qualify for the L5 Exception. Any claimholder who does not comply with the Trading Order would only receive stock in reorganized Ambac equal to less than 5 percent of reorganized Ambac’s outstanding stock.

If Ambac does not qualify for the L5 Exception, the bankruptcy plan of reorganization will adversely impact the preservation of, and likely substantially impair, the Ambac Assurance NOL, and some or all of Ambac’s taxable income after the reorganization may be subject to tax.

The amended tax sharing agreement may reduce the cash available to the Company limiting the Company’s ability to service its obligations to third parties.

Pursuant to the Settlement Agreement the existing tax sharing agreement among the members of the Company Consolidated Tax Group was terminated as to Ambac Assurance and its subsidiaries, including Everspan (the “AAC Subgroup”), and was replaced by an agreement that recognizes the consolidated NOL of the group as an asset of the AAC Subgroup and that requires the Company to compensate Ambac Assurance on a current basis for use of any portion of that asset, except that the Company shall not be required to compensate Ambac Assurance for the Company’s use of net operating losses in connection with cancellation of debt income associated with restructurings of its bonds outstanding as of March 15, 2010. The amended tax sharing agreement may materially reduce the cash available to the Company limiting the Company’s ability to service its obligations to third parties or pay dividends.

The U.S. federal income tax consequences resulting from the creation of the Segregated Account are uncertain and Ambac Assurance may realize gain or loss in connection with the creation of the Segregated Account.

The U.S. federal income tax consequences resulting from the creation of the Segregated Account are uncertain. For example, to the extent the Segregated Account were treated as a separate taxable entity, depending

 

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upon the terms of the Segregated Account Rehabilitation Plan, gain or loss could be realized by Ambac or the new taxable entity (i.e., the Segregated Account) materially increasing the U.S. federal income tax liability of the relevant party and materially reduce cash available to be pay third party obligations or dividends.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties.

The executive office of Ambac is located at One State Street Plaza, New York, New York 10004, which consists of approximately 145,000 square feet of office space, under an agreement that expires in September 2019. This office houses operations for all reportable business segments.

On March 1, 2011, Ambac entered into an agreement with the landlord to terminate the lease agreement for the office space at One State Street Plaza (“Termination Agreement”) and entered into a new lease with reduced space at a reduced rate. The effective date of the Termination Agreement and the new lease is subject to the following: (i) the approval of the Termination Agreement by the Rehabilitator, the Rehabilitator Court and the Board of Directors of Ambac and Ambac Assurance, the OCI and the Bankruptcy Court and (ii) the approval of the new lease by the OCI and Board of Directors of Ambac Assurance. The initial term of the new lease will end on December 31, 2015.

Ambac’s financial guarantee business segment also maintains offices in the United Kingdom (London), which consist of approximately 3,500 square feet of office space, under an agreement that expires in October 2020, with an earlier term option at Ambac’s discretion; and in Italy (Milan). Ambac ceased operations in its offices in California (Irvine), Connecticut (Greenwich) and Australia (Sydney) in 2010.

Ambac maintains a disaster recovery site in upstate New York as part of its Disaster Recovery Plan. This remote hot-site facility is complete with user work stations, phone system, data center, internet connectivity and a power generator, capable of serving the needs of the disaster recovery team to support all business segment operations. The plan, facility and systems are revised and upgraded where necessary, and user tested annually to confirm their readiness.

 

Item 3. Legal Proceedings.

Please refer to Note 13 “Commitments and Contingencies” of the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K for a discussion on Legal Proceedings against Ambac and its subsidiaries.

 

Item 4. Reserved.

 

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Part II

 

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.

As of February 28, 2011, there were 86 stockholders of record of Ambac’s Common Stock, which trades under the symbol “ABKFQ”.

The table below sets forth the high and low sales prices per share of Ambac’s Common Stock and the amount of cash dividends declared per common share.

 

     High      Low      Dividends  

2010:

        

Fourth Quarter

   $ 1.15       $ 0.02       $ 0.00   

Third Quarter

   $ 1.05       $ 0.40       $ 0.00   

Second Quarter

   $ 3.39       $ 0.54       $ 0.00   

First Quarter

   $ 0.88       $ 0.51       $ 0.00   

2009:

        

Fourth Quarter

   $ 1.56       $ .70       $ 0.00   

Third Quarter

   $ 1.88       $ .75       $ 0.00   

Second Quarter

   $ 1.75       $ .82       $ 0.00   

First Quarter

   $ 1.52       $ .35       $ 0.00   

The Board of Directors of Ambac has authorized the establishment of a stock repurchase program that permits the repurchase of up to 24,000,000 shares of Ambac’s Common Stock. Ambac does not expect to utilize its remaining repurchase capacity. Accordingly, Ambac has not repurchased shares of its Common Stock in the open market since 2007, including the period from January 1, 2011 through February 28, 2011. The following table summarizes Ambac’s repurchase program during the fourth quarter of 2010 and shares available at December 31, 2010:

 

     Total Shares
Purchased
     Average Price
Paid Per Share
     Total Number of
Shares Purchased

as Part of Publicly
Announced Plan
     Maximum
Number of Shares
That May Yet Be
Purchased Under
the Plan
 

October 2010

     —         $ —           —           3,050,326   

November 2010

     —         $ —           —           3,050,326   

December 2010

     —         $ —           —           3,050,326   
                                   

Fourth Quarter 2010

     —         $ —           —           3,050,326   
                                   

Information concerning payments and restrictions on the payment of dividends is set forth in Item 1 above under the caption “Insurance Regulatory Matters—Dividend Restrictions, Including Contractual Restrictions” and in Note 17 to the Consolidated Financial Statements located in Part II, Item 8 in this Form 10-K.

The graph below compares the five-year total return to stockholders (stock price appreciation plus reinvested dividends) for Ambac common stock with the comparable return of two indexes: the Standard & Poor’s 500 Stock Index and the Investor’s Business Daily Insurance-Property/Casualty/Title Index.

Cumulative total stockholder return assumes an initial investment of $100 on December 31, 2005. Total return includes reinvestment of dividends. Stock price performances shown in the graph are not necessarily indicative of future price performances.

 

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Comparison of Ambac Five-Year Cumulative Total Return to

Various Indicies

LOGO

 

 

     2005      2006      2007      2008      2009      2010  

Ambac

   $ 100       $ 116.5       $ 34.2       $ 1.8       $ 1.1       $ 0.2   

S&P Standard Index

   $ 100       $ 115.8       $ 122.2       $ 77.0       $ 97.3       $ 112.0   

Insurance-Property/Casualty/Title Index

   $ 100       $ 112.5       $ 100.9       $ 78.4       $ 84.9       $ 99.2   

 

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Item 6. Selected Financial Data.

The following financial information for the five years ended December 31, 2010, has been derived from Ambac’s Consolidated Financial Statements. This information should be read in conjunction with the Consolidated Financial Statements and related notes located in Part II, Item 8.

 

     Years Ended December 31,  

($ in millions, except per share amounts)

   2010     2009     2008     2007     2006  

Statement of Operations Highlights:

          

Gross premiums written

   ($ 476.1   ($ 548.8   $ 536.9      $ 1,031.4      $ 996.7   

Net premiums written

     (365.7     61.2        483.7        753.9        893.2   

Net premiums earned

     546.0        797.4        1,022.8        841.5        811.6   

Financial guarantee net investment income

     324.0        482.7        480.1        460.3        423.9   

Financial guarantee total other-than-temporary impairments recognized in earnings

     (56.7     (1,570.7     (70.9     —          —     

Financial guarantee net realized investment gains

     76.4        131.7        79.9        9.9        7.1   

Net change in fair value of credit derivatives

     60.2        3,812.9        (4,031.1     (5,928.0     68.8   

(Loss) income on variable interest entities

     (616.7     7.5        0.1        (7.8     —     

Interest income from investment and payment agreements

     34.1        70.7        255.9        445.3        391.7   

Financial services—other revenue

     (106.6     (207.2     (134.2     4.1        13.2   

Financial services net other-than-temporary impairments recognized in earnings

     (3.1     (283.9     (451.9     (40.1    

 

—  

—  

  

  

Financial services net realized investment gains

     72.9        184.5        215.6        11.0        59.3   

Total revenue

     434.1        3,900.4        (2,767.3     (4,227.5     1,832.1   

Losses and loss expenses

     719.4        2,815.3        2,227.6        256.1        20.0   

Financial guarantee underwriting and operating expenses

     198.4        175.7        215.8        139.3        133.7   

Financial guarantee interest expense

     62.2        —          —          —          —     

Interest expense from investment and payment agreements

     16.8        34.1        235.0        420.0        359.9   

Financial services—other expenses

     13.7        12.6        12.7        12.2        12.4   

Corporate interest expense

     102.3        119.6        114.2        85.7        75.3   

Reorganization items

     32.0        —          —          —          —     

Pre-tax (loss) income from continuing operations

     (735.0     724.9        (5,618.3     (5,154.7     1,210.3   

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

     (735.2     (14.6     (5,609.2     (3,248.2     875.9   

Net (loss) income per share:

          

Basic

     (2.56     (0.05     (22.31     (31.56     8.22   

Diluted

     (2.56     (0.05     (22.31     (31.56     8.15   

Cash dividends declared per common share

     0.00        0.00        0.10        0.780        0.660   

 

(1) n.m. = not meaningful. Return on equity is not meaningful due to a net loss and negative equity.

 

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     Years Ended December 31,  

($ in millions, except per share amounts)

   2010     2009     2008     2007      2006  

Balance Sheet Highlights:

           

Total investments, at fair value(1)

   $ 8,757.7      $ 9,229.2      $ 10,292.8      $ 18,395.7       $ 17,433.6   

Deferred ceded premium

     264.9        500.8        292.8        489.0         315.5   

Loans(1)

     15,761.8        2,716.4        798.8        867.7         625.4   

Total assets(1)

     29,047.1        18,886.4        17,259.7        23,713.8         20,267.8   

Unearned premiums

     4,007.9        5,687.1        2,382.2        3,123.9         3,037.5   

Losses and loss expense reserve

     5,288.7        4,771.7        2,275.9        484.3         220.1   

Obligations under investment agreements, investment repurchase agreements and payment agreements

     805.6        1,291.0        3,357.8        8,706.4         8,356.9   

Liabilities subject to compromise

     1,695.2        —          —          —           —     

Long-term debt(1)(2)

     16,309.3        4,640.2        1,868.7        1,669.9         991.8   

Total stockholders’ (deficit) equity

     (2,008.5     (2,287.8     (3,782.3     2,279.9         6,189.6   

 

(1) Includes assets and debt of variable interest entities consolidated under the provisions of relevant consolidation accounting guidance. See Note 10 of the Consolidated Financial Statements for amounts associated with variable interest entities as of December 31, 2010 and 2009.
(2) Debentures issued by Ambac are included in the line item “Liabilities subject to compromise” for 2010.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW

Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose affiliates provided financial guarantees and financial services to clients in both the public and private sectors around the world. On November 8, 2010 Ambac filed for a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”). The Company will continue to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court. Ambac’s activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services.

Ambac provided financial guarantee insurance for public and structured finance obligations through Ambac Assurance and Ambac Assurance UK, Ltd (“Ambac UK”). While Ambac Assurance historically had AAA financial strength ratings, its ratings have been downgraded multiple times, beginning in 2008. As a result, Ambac Assurance currently has a Caa2 financial strength from Moody’s. As a result of these downgrades and the events and circumstances described in the “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, our business activities have been limited to loss mitigation and the recovery of residual value in Ambac Assurance.

Through its financial services subsidiaries, Ambac provided financial and investment products, including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to the clients of its financial guarantee business. Ambac Assurance insured all of the obligations of its subsidiaries which wrote financial services business. As of December 31, 2009, all total return swaps had terminated and settled. The interest rate swap and investment agreement businesses are in active runoff, which may result in transaction terminations, settlements, restructurings, assignments and scheduled amortization of contracts. In the process of running off these businesses, we may execute hedging transactions to mitigate risks in the respective books of business to the extent that we are able to do so; however, the Segregated Account Rehabilitation Proceedings (as hereinafter defined) and the financial condition of Ambac Assurance will make execution of any such hedging transactions more difficult. To the extent we are unable to hedge such risks, adverse financial impacts may result. Beginning in 2009, the financial services interest rate derivative portfolio has also been used to hedge exposure to rising interest rates within the financial guarantee segment. As a result, declines in current or projected future interest rates could result in losses to the financial services segment.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

 

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Critical accounting policies are considered critical because they place significant importance on management to make difficult, complex or subjective estimates regarding matters that are inherently uncertain. Financial results could be materially different if alternative methodologies were used or if management modified its assumptions or estimates. Management has identified the accounting for loss and loss expenses of non-derivative financial guarantees, the valuation of financial instruments, including the determination of whether an impairment is other-than-temporary and the valuation allowance on deferred tax assets, as critical accounting policies. This discussion should be read in conjunction with the Consolidated Financial Statements and notes thereon included elsewhere in this report. We have discussed with the Audit Committee management’s assessment of such critical accounting policies, the reasons why they are considered critical, and how current and anticipated future events impact those determinations. The Company’s critical accounting policies and estimates are as follows:

Financial Guarantee Insurance Losses and Loss Expenses:

The loss and loss expense reserves for financial guarantee insurance discussed herein relates only to Ambac’s non-derivative insurance business for insurance policies issued to beneficiaries, including VIEs, for which we do not consolidate the VIE. Losses and loss expenses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining the level of reserves is subject to certain estimates and judgments.

ASC Topic 944, Financial Services—Insurance clarifies how existing guidance applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of claim liabilities (i.e., loss reserves). Ambac adopted the loss reserve provisions of ASC Topic 944 on January 1, 2009. ASC Topic 944 is required to be applied to inforce financial guarantee insurance contracts issued upon adoption as well as new financial guarantee contracts issued in the future.

Under ASC Topic 944, a loss reserve is recorded on the balance sheet for the excess of: (a) the present value of expected net cash outflows to be paid under an insurance contract, (i.e., the expected loss), over (b) the unearned premium reserve (“UPR”) for that contract. To the extent (a) is less than (b), no loss reserve is recorded. Changes to the loss reserve estimate in subsequent periods are recorded as a loss and loss expense on the income statement. Expected losses are based upon estimates of the ultimate aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date. The evaluation process for determining expected losses is subject to certain estimates and judgments based on our assumptions regarding the probability of default and expected severity of performing credits as well as our active surveillance of the insured book of business and observation of deterioration in the obligor’s credit standing.

Ambac’s loss reserves are based on management’s on-going review of the non-derivative financial guarantee credit portfolio. Active surveillance of the insured portfolio enables Ambac’s surveillance group to track credit migration of insured obligations from period to period and update internal credit ratings for each transaction. Non-adversely classified credits are assigned a Class I or Survey List (“SL”) risk classification, while adversely classified credits are assigned a risk classification of Class IA through Class V. The criteria for an exposure to be assigned an adversely classified credit includes the deterioration of an issuer’s financial condition, underperformance of the underlying collateral (for collateral dependent transactions such as mortgage-backed securitizations), poor performance by the servicer of the underlying collateral and other adverse economic events or trends. The servicer of the underlying collateral of an insured securitization transaction is a consideration in assessing credit quality because the servicer’s performance can directly impact the performance of the related issue. For example, a servicer of a mortgage-backed securitization that does not remain current in its collection and loss mitigation efforts could cause an increase in delinquencies and potential defaults of the underlying obligations. Similarly, loss severities increase when a servicer does not effectively handle loss mitigation activities such as (i) the advancing of delinquent principal and interest and default-related expenses which are deemed to be recoverable by the servicer, (ii) pursuit of loan charge-offs which maximize cash flows from the mortgage loan pool, and (iii) foreclosure and real estate owned disposition strategies and timelines.

 

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

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

The discount factor applied to both of the above described approaches is based on a risk-free discount rate corresponding to the remaining expected weighted-average life of the exposure and the exposure currency. For example, U.S. dollar exposures are discounted using U.S. Treasury rates while exposures denominated in foreign currency are discounted using the appropriate risk-free rate for the respective currency. The discount factor is updated for the current risk-free rate each reporting period.

Ambac establishes loss expense reserves based on our estimate of expected net cash outflows for loss expenses, such as legal and consulting costs.

As the probability of default for an individual credit increases and/or the severity of loss given a default increases, our loss reserve for that insured obligation will also increase. Political, economic, credit or other unforeseen events could have an adverse impact on default probabilities and loss severities. Loss reserves for public finance or other non-collateral dependent transactions whose underlying financial obligations have already defaulted (that is a 100% probability of default) are only sensitive to severity assumptions. Loss reserves for collateral dependent transactions (such as mortgage-backed security transactions) for which only a portion of the underlying collateral has already defaulted will be sensitive to both severity assumptions as well as probability of default of the underlying collateral.

Loss reserve volatility will be a direct result of the credit performance of our insured portfolio, including the number, size, bond types and quality of credits included in our loss reserves. The number and severity of credits included in our loss reserves depend to a large extent on transaction specific attributes, but will generally increase during periods of economic stress and decline during periods of economic stability. Reinsurance recoveries do not have a significant effect on loss reserve volatility because Ambac has little exposure ceded to reinsurers and

 

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has received collateral from such reinsurers. The current stressed credit environment has had an adverse impact on the financial strength of the reinsurers used by Ambac. Please refer to Item 7A “Quantitative and Qualitative Disclosures About Market Risk – Credit Risk” for further information and discussion.

Ambac has exposure to various bond types issued in the debt capital markets. Our experience has shown that, for the majority of bond types, we have not experienced significant claims and, therefore, the estimate of loss severity has remained constant. We have observed that, with respect to three bond types, it is reasonably possible that a material change in actual loss severities and defaults could occur over time. In the future, including as a result of the current credit market crisis, our experience may differ with respect to the types of guaranteed bonds affected or the magnitude of the effect. The three bond types are residential mortgage-backed securities (“RMBS”), collateralized debt obligations (“CDOs”) and student loan securities. These three bond types represent 86% of our ever-to-date claim payments with RMBS comprising 84% of our ever-to-date claims payments.

The table below indicates the number of credits and gross par outstanding for loss reserves on credits which have defaulted and all other credits for which loss reserves have been established at December 31, 2010:

 

($ in millions)

   Number of
credits
     Gross par
outstanding
     Gross Loss
Reserves(2)
 

RMBS

     147       $ 20,282       $ 3,066   

Student Loans

     98         10,825         865   

All other credits

     63         5,034         527   

Loss adjustment expenses

     —           —           95   
                          

Totals

     308       $ 36,141       $ 4,553 (1) 
                          

 

(1) Loss reserves of $4,553 are included in the balance sheet in the following line items: Loss and loss expense reserve—$5,288; Subrogation recoverable—$714; and Other assets—$21.
(2) Ceded Par Outstanding and ceded loss reserves are $1,880 and $129, respectively. Cede loss reserves are included in Reinsurance Recoverable on paid and unpaid losses.

RMBS:

Ambac insures RMBS transactions that contain first-lien mortgages. Ambac classifies its insured first-lien RMBS exposure principally into two broad credit risk classes: Alt-A (including mid-prime, interest only, and negative amortization) and sub-prime. Alt-A loans were typically made to borrowers who had stronger credit profiles, while sub-prime loans were typically made to borrowers with weaker credit profiles. Compared with Alt-A loans, sub-prime loans typically had higher loan-to-value ratios, reflecting the greater difficulty that sub-prime borrowers have in making down payments and the propensity of these borrowers to extract equity during refinancing. The Alt-A category includes loans backed by borrowers who typically did not meet standard agency guidelines for documentation requirement, property type or loan-to-value ratio. These are typically higher-balance loans made to individuals who might have past credit problems that are not severe enough to warrant “sub-prime” classification, or borrowers who chose not to obtain a prime mortgage due to documentation requirements.

Ambac has also insured RMBS transactions that contain predominantly second-lien mortgage loans such as closed-end seconds and home equity lines of credit. A second-lien mortgage loan is a type of loan in which the borrower uses the equity in their home as collateral and the second-lien loan is subordinate to the first-lien loan outstanding on the home. The borrower is obligated to make monthly payments on both their first and second-lien loans. If the borrower defaults on the payments due under these loans and the property is subsequently liquidated, the liquidation proceeds are first utilized to pay off the first-lien loan (as well as costs due the servicer) and any remaining funds are applied to pay off the second-lien loan. As a result of this subordinate position to the first-lien loan, second-lien loans carry a significantly higher severity in the event of a loss, typically at or above 100% in the current housing market.

 

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RMBS transaction-specific behavior is analyzed on a risk-priority basis. We employ a screening tool to assess the sufficiency of credit enhancement remaining in a transaction, as well as other adverse credit data that may result in deterioration. Transactions which are experiencing escalating delinquencies and increasing loss severities and/or which are experiencing declining levels of subordination or overcollateralization relative to collateral losses are identified as underperforming. For underperforming transactions, historical collateral performance is examined and future collateral performance and cash flows are projected and evaluated. These underperforming transactions are then included in an adversely classified credit list and assigned a credit classification consistent with the degree of underperformance.

The table below distinguishes between credits for which we have not established a subrogation recovery and those for which we have, providing in both cases the number of credits, gross par outstanding, gross loss reserves before subrogation, subrogation, and gross reserves net of subrogation for all RMBS exposures for which Ambac established reserves at December 31, 2010:

 

($ in millions)

   Number of
credits
     Gross
par
outstanding
     Gross claim
liability
before
subrogation
recoveries
     Subrogation
recoveries
    Gross claim
liability after
subrogation
recoveries
 

Second-lien

     33       $ 5,751       $ 842         NA      $ 842   

Mid-prime

     63         6,153         1,718         NA        1,718   

Sub-prime

     15         1,048         42         NA        42   

Other

     9         316         226         NA        226   
                                           

Total Credits Without Subrogation

     120         13,268         2,828         NA        2,828   
                                           

Second-lien

     19         4,319         2,127       ($ 1,908     219   

Mid-prime

     4         771         165         (221     (56

Sub-prime

     4         1,924         363         (288     75   
                                           

Total Credits With Subrogation

     27         7,014         2,655         (2,417     238   
                                           

Total

     147       $ 20,282       $ 5,483       $ (2,417   $ 3,066   
                                           

Second-Lien:

In evaluating our portfolio of insured second-lien transactions we use a roll-rate methodology which observes trends in delinquencies, defaults, loss severities and prepayments and extrapolates ultimate performance from this data on an individual transaction basis (and their component pools where they exist). As more information (performance and other) accumulates for each underperforming transaction we are able to update assumptions in this model to reflect these changes. By employing the roll-rate methodology, we examined the historical rate at which delinquent loans in each transaction rolled into later delinquency categories (i.e. 30-59 days, 60-89 days, 90+ days). This historical rate is adjusted each period to reflect current performance. We determined a pool specific current-to-30-to-59 day delinquency curve and applied a statistical regression technique to historical roll rates. We carried forward the non-performing mortgages through the delinquency pipeline through the 60-89 and 90+ delinquency categories all the way through to charge-off. We use this data to project a default curve for the life of the transaction. Listed below are specific inputs we used for 2010 loss estimates:

Prepayment Rates:

Voluntary prepayments have declined far below expected levels, driven by negative House Price Appreciation (“HPA”), an impaired mortgage market, and borrowers’ inability to prepay balances. In our opinion, these factors will not improve in the foreseeable future and thus we generally project recent trends into the future. This translates into projected prepayment rates in the 2% to 5% range.

 

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Loss Severity:

We project loss severities to between 100% and 105% as we expect complete write-offs in this asset class exacerbated by carrying costs. We have noted, with regard to several second-lien transactions, that the current unwillingness of mortgage insurers to pay claims under their contracts on bonds insured by Ambac has caused increased claim payments.

First-Lien:

Ambac utilizes a third-party multi-scenario stochastic (Monte Carlo) cash flow model to estimate first-lien product loss reserves. The model projects multiple scenarios at the individual mortgage loan level using various inputs, including:

 

  (i) Home price projections at the Core Based Statistical Area (CBSA) level. Home price projections were obtained from an independent third party;

 

  (ii) An interest rate tool to generate term interest rate scenarios;

 

  (iii) An unemployment module to project unemployment rates at the state level;

 

  (iv) A discrete loan-level credit module to estimate the probability of monthly loan level credit performance through time across eight possible status states (current, 30 day delinquent, 60 day delinquent, 90 + day delinquent, foreclosure, REO, prepay, and default); and

 

  (v) A severity module which pairs with the credit module and, on the basis of loan level information, generates a Loss Given Default severity time line.

The pool of mortgage loans backing each securitization are selected from a proprietary loan-level database and the loss and prepayment scenarios across all loans are used to generate aggregated future cash inflows. The cash flow model embeds all the priority of payments and cash-diversion structures documented in the contracts which define the liability payment obligations of the security being analyzed. We take the average of 300 claim cash-flow scenarios and discount it, as appropriate, to estimate the gross claim liability.

Government programs:

In May of 2009, the Federal Government initiated the Home Affordable Modification Plan (HAMP) which allows servicers to modify loans. After determining a borrower’s eligibility, a servicer can take a series of steps to reduce the monthly mortgage payment. HAMP is applicable to the Ambac-wrapped transactions serviced by the servicers that have signed servicer participation agreements to modify loans under HAMP. Based on the current activity of the trial plan HAMP offers and the latest indications from government published sources at December 31, 2010, we assume in the first-lien model that 0.5% of HAMP-eligible loans will be modified monthly for 24 months for Ambac portfolios serviced by HAMP participating servicers. At December 31, 2009, Ambac’s first-lien model assumed that 4% of HAMP-eligible loans will be modified monthly for 12 months (for a total of 48% of HAMP-eligible loans ultimately modified) for Ambac portfolios serviced by HAMP participating servicers.

Servicer Intervention:

The first-lien model also reflects the steps Ambac is taking to address shortcomings in servicing performance including transferring servicers where the legal right exists to do so. Ambac expects to initiate, with the cooperation of the Rehabilitator of the Segregated Account of Ambac Assurance, additional programs with servicers that will provide for loan modifications (principal forgiveness), improved liquidation timelines, short sales, and selected rate reductions. Ambac believes these are the principal factors that will result in reduced losses over time. We are projecting that only exposures that have already transferred servicing or entered into special servicing agreements will benefit from the effects of servicer intervention strategies.

 

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Representation and Warranty Breaches by RMBS Transaction Sponsors:

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

Subsequent to the forensic exercise of examining loan files to ascertain whether the loans conformed to the representations and warranties, we submit nonconforming loans to the sponsor for repurchase. To effect a repurchase, depending on the transaction, the sponsor is obligated to repurchase the loan at (a) for loans which have not been liquidated or charged off, either (i) the current unpaid principal balance of the loan, (ii) the current unpaid principal balance plus accrued unpaid interest, or (iii) the current unpaid principal balance plus accrued interest plus unreimbursed servicer advances/expenses and/or trustee expenses resulting from the breach of representations and warranties that trigger the repurchase, and (b) for a loan that has already been liquidated or charged-off, the amount of the realized loss (which in certain cases excludes accrued unpaid interest). Notwithstanding the material breaches of representations and warranties, up until the establishment of the Segregated Account and the associated Segregated Account Rehabilitation Proceedings, Ambac had continued to pay claims submitted under the financial guarantee insurance policies related to these securitizations and will pay claims in accordance with the Rehabilitation Plan after the plan becomes effective. In cases where loans are repurchased by a sponsor, the effect is typically to offset current period losses and then to increase the over-collateralization of the securitization, depending on the extent of loan repurchases and the structure of the securitization. Specifically, the repurchase price is paid by the sponsor to the securitization trust which holds the loan. The cash becomes an asset of the trust, replacing the loan that was repurchased by the sponsor. On a monthly basis the cash received related to loan repurchases by the sponsor is aggregated with cash collections from the underlying mortgages and applied in accordance with the trust indenture payment waterfall. This payment waterfall typically includes principal and interest payments to the note holders, various expenses of the trust and reimbursements to Ambac, as financial guarantor, for claim payments made in previous months. Notwithstanding the reimbursement of previous monthly claim payments, to the extent there continues to be insufficient cash in the waterfall in the current month to make scheduled principal and interest payments to the note holders, Ambac is required to make additional claim payments to cover this shortfall.

Ambac’s estimate of subrogation recoveries includes two components: (1) estimated dollar amounts of loans with material breaches of representations and warranties based on an extrapolation of the breach rate identified in a random sample of loans taken from the entire population of loans in a securitization (“random sample approach”); and (2) dollar amount of actual loans with identified material breaches of representations and warranties discovered from samples of impaired loans in a securitization (“adverse sample approach”). We do not include estimates of damages in our estimate of subrogation recoveries under either approach. The amount the sponsors believe to be their liability for these breaches is not known; however, certain large financial institutions who have served as sponsors for certain transactions that Ambac has insured have disclosed that reserves have been established related to claims by financial guarantors and others for breaches of representations and warranties.

 

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The random sample approach to estimate subrogation recoveries was based on obtaining a statistically valid random sample for all the original loans in the pool. First, a “breach rate” was computed by dividing (i) the loans identified in sample as having breached representations and warranties by (ii) the total sample size. Second, an extrapolation to the entire loan pool was performed by multiplying the breach rate by the sum of (a) the current unpaid loan pool balance (“CULPB”) plus (b) realized losses resulting from loan liquidations or charge-offs to date, to compute an estimated repurchase obligation. The CULPB includes principal only on non-charged-off and non-liquidated loans, and the realized losses include principal, interest and unreimbursed servicer advances and/or trustee expenses on charged-off and liquidated loans. As a result, the CULPB and realized loss components, which are used in extrapolating the estimated repurchase obligation, do not precisely correspond to each sponsor’s contractual repurchase obligation as defined in the transaction documents. Nonetheless, the CULPB and realized loss components are provided through trustee reports we receive in the normal course of our surveillance of these transactions and is the best information we have available to estimate the sponsor’s repurchase obligation under the random sample approach. Third, a realization factor (which incorporates Ambac’s views about the uncertainties surrounding the litigation process and/or settlement negotiation) was then applied to the estimated repurchase obligation to compute the undiscounted subrogation recovery. The realization factor was developed from a range of realization factors using Ambac’s own assumptions about the likelihood of outcomes based on all the information available to it including (i) discussions with external legal counsel and their views on ultimate settlement, (ii) recent experience with loan put back negotiations where the existence of a material breach was debated and negotiated at the loan level, and (iii) the pervasiveness of the breach rates. Finally, a discount factor was applied (using the assumptions discussed in the paragraph subsequent to the next table below) to the undiscounted subrogation recovery to compute the estimated subrogation recovery.

Due to the nature of the sampling methodology used, the subrogation recovery estimate Ambac has recorded based on the above-described random sample approach includes all breached loans which Ambac believes the sponsor is contractually required to repurchase, including extrapolation to a loan pool which includes loans which have not defaulted, and, in fact, may not default in the future (i.e. performing loans). In theory, a loan that continues to perform in accordance with its terms through repayment should have little or no effect on Ambac’s anticipated claim payments, regardless of whether or not the sponsor repurchases the loan. In other words, since there will be sufficient cash flows to service the notes in either situation (i.e. whether cash is received from a sponsor loan repurchase or whether cash is received from the underlying performing loan), there should be no claim payment under Ambac’s insurance policy in respect of such loans. Nonetheless, Ambac may have recorded a subrogation recovery for certain performing loans because it believes the breaches of representations and warranties are so pervasive that a court would deem it impractical to have the sponsor re-underwrite every loan in a given transaction and repurchase only individual loans that have breached. Rather, Ambac believes there is precedent for the utilization of a statistical sampling and extrapolation methodology across a population to prove liability and damages where it would be impractical to make a determination on an individual loan basis (a recent court ruling in a similar suit unrelated to Ambac but in the same jurisdiction in which Ambac has filed its litigation to date, supports the view that a sampling methodology is permissible.) Ambac believes a court would likely award damages based on a reasonable methodology, such as our random sample approach, which damages would be either remitted directly to Ambac, placed in the securitization trust, or otherwise held under an arrangement for the benefit of the securitization trust; however, Ambac believes that under such an approach individual loans would not be repurchased from the trust. In either case, Ambac believes those damages would compensate Ambac for past and future claim payments. Consequently, since the sponsor is contractually obligated to repurchase those loans which breach representations and warranties regardless of whether they are current or defaulted, Ambac believes the appropriate measure in estimating subrogation recoveries is to apply the breach rate to both performing and defaulted loans.

The adverse sample approach to estimate subrogation recoveries was based on a sample taken from those loans in the pool that were impaired, meaning loans greater than 90 days past due, charged-off, in foreclosure, REO or bankruptcy. The estimated subrogation recovery under this approach represents 100% of the original principal balance of those specific loans identified as having not met the underwriting criteria or otherwise breaching representations and warranties (i.e. the adverse loans), multiplied by a discount factor using the same

 

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assumptions used for the discount factor in the random sample approach. For transactions subject to the adverse sample approach, given Ambac’s limitations in developing a statistically valid random sample and its belief that the subrogation estimate under this approach is inherently conservative (for reasons discussed below), Ambac did not attempt to develop probability-weighted alternative cash flow scenarios as it believes such results would not be meaningful. The three primary differences between this adverse sample approach and the random sample approach, discussed in the previous paragraphs, are as follows:

 

  (i) There is no extrapolation to the CULPB and realized losses under the adverse sample approach. At December 31, 2010, the adverse sample approach continues to be used for 15 transactions that are with the same sponsor, who has limited our access to the underlying loan files and, therefore, a statistically valid random sample from the entire loan pool cannot be selected. This is in contrast to the transactions subject to the random sample approach where Ambac’s access to individual loan files has not been limited and the Company, therefore, has been able to develop a statistically valid representative sample.

 

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

 

  (iii) Unlike the random sample approach, for the adverse sample approach Ambac did not apply a realization factor to the estimated repurchase obligation for the adverse loans related to uncertainties surrounding settlement negotiation or litigation processes given that the adverse loans selected represent only approximately 40% of the value of the impaired population of loans, only approximately 5% of the value of the original loans in the pool, and the breach rate in the sample was pervasive. In other words, because the adverse loans selected represent only a fraction of the population of impaired loans and a very small proportion of the original loans in the pools, Ambac believes there is an ample population of additional impaired loans where breaches of representations and warranties exist that could potentially replace any adverse loans it already identified that might be successfully challenged in negotiations or litigation.

 

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Ambac has updated its estimated subrogation recoveries from $2,046.8 million ($2,026.3 million, net of reinsurance) at December 31, 2009 to $2,417.1 million ($2,391.3 million, net of reinsurance) at December 31, 2010. The balance of subrogation recoveries and the related claim liabilities at December 31, 2010 and December 31, 2009 are as follows:

 

     December 31, 2010  

Method

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

Adverse samples

     15 (2)    $ 1,644.5       $ (719.4   $ 925.1   

Random samples

     12 (3)      1,010.7         (1,697.7     (687.0
                                 

Totals

     27      $ 2,655.2       $ (2,417.1   $ 238.1   
                                 
     December 31, 2009  

Method

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

Adverse samples

     10      $ 759.4       $ (460.6   $ 298.8   

Random samples

     9        937.3         (1,586.2     (648.9
                                 

Totals

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

 

(1) The amount of recorded subrogation recoveries related to each securitization is limited to ever-to-date paid losses plus the present value of projected future paid losses for each policy. To the extent significant losses have been paid but not yet recovered, the recorded amount of subrogation recoveries may exceed the projected future paid losses for a given policy. The net cash inflow for these policies is recorded as a “Subrogation recoverable” asset. For those transactions where the subrogation recovery is less than projected future paid losses, the net cash outflow for these policies is recorded as a “Loss and loss expense reserve” liability. Of the $2,417.1 million of subrogation recoveries recorded at December 31, 2010, $1,702.4 million was included in “Subrogation recoverable” and $714.7 million was included in “Loss and loss expense reserves.”

 

(2) Of these 15 transactions, 10 contractually require the sponsor to repurchase loans at the unpaid principal balance and 5 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest. However, for reasons discussed above in the description of the adverse sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor’s contractual repurchase obligation.

 

(3) Of these 12 transactions, 3 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest and 9 contractually require the sponsor to repurchase loans at unpaid principal plus accrued interest plus servicer advances/expense and/or trustee expenses. However, for reasons discussed above in the description of the random sample approach, our estimated subrogation recovery for these transactions may not include all the components of the sponsor’s contractual repurchase obligation.

While the obligation by sponsors to repurchase loans with material breaches is clear, generally the sponsors have not yet honored those obligations. Ambac’s approach to resolving these disputes has included negotiating with individual sponsors at the transaction level and in some cases at the individual loan level and has resulted in the repurchase of some loans. Ambac has utilized the results of the above described loan file examinations to make demands for loan repurchases from sponsors or their successors and, in certain instances, as a part of the basis for litigation filings. Ambac has initiated and will continue to initiate lawsuits seeking compliance with the

 

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repurchase obligations in the securitization documents. Ambac estimates that it will take approximately three years from the initiation of litigation with the sponsor to ultimate resolution. Based on this estimate as a basis for projecting the future subrogation cash flows, Ambac assumes, on average, approximately three and a half years to collect recoveries, discounted at a risk-free rate of 2.39% and 1.88% at December 31, 2010 and 2009, respectively. Estimated recoveries will continue to be revised and supplemented as the scrutiny of the mortgage loan pools progresses.

We have performed the above-mentioned, detailed examinations on a variety of second-lien and first-lien transactions that have experienced exceptionally poor performance. However, the loan file examinations and related estimated recoveries we have reviewed and recorded to date have been limited to only those transactions whose sponsors (or their successors) are subsidiaries of large financial institutions, all of which carry an investment grade rating from at least one nationally recognized rating agency. A total of seven sponsors represent the 27 transactions which have been reviewed as of December 31, 2010. While our contractual recourse is generally to the sponsor/subsidiary, rather than to the financial institutional parent, each of these financial institutions has significant financial resources and an ongoing interest in mortgage finance, and we therefore believe that the financial institution/parent would not seek to disclaim financial responsibility for these obligations if the sponsor/subsidiary is unable to honor its contractual obligations or pay a judgment that we may obtain in litigation. Additionally, in the case of successor institutions, we are not aware of any provisions that explicitly preclude or limit the successors’ obligations to honor the obligations of the original sponsor. In fact, we have witnessed to date, certain successor financial institutions make significant payments to certain claimants to settle breaches of representations and warranties perpetrated by sponsors that have been acquired by such financial institutions. As a result, we did not make any significant adjustments to our estimated subrogation recoveries with respect to the credit risk of these sponsors or their successors. We believe that focusing our loan remediation efforts on large financial institutions first will provide the greatest economic benefit to Ambac. Ambac retains the right to review other RMBS transactions for representations and warranties breaches. Since a significant number of other second-lien and first-lien transactions are also experiencing poor performance, management is considering expanding the scope of this effort.

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

 

($ in millions)

   Random sample     # of
deals
     Adverse
Sample
    # of
deals
 

Rollforward:

         

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

   $ 1,586.2        9       $ 460.6        10   
                                 

Changes recognized in 2010:

         

Additional transactions reviewed

     124.6        3         218.2        5   

Additional adverse sample loans reviewed

     —          n/a         60.7        n/a   

Loans repurchased by the sponsor

     (6.0     n/a         (32.2     n/a   
                                 

Subtotal of changes recognized in current period

     118.6        3         246.7        5   
                                 

Changes from re-estimation of opening balance:

         

Change in pre-recovery loss reserves

     (7.1     n/a         12.1        n/a   

Discounted RMBS subrogation (gross of reinsurance) at 12/31/10

   $ 1,697.7        12       $ 719.4        15   
                                 

As a consequence of the Segregated Account Rehabilitation Proceedings, the rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including surveillance, remediation and loss mitigation. As noted in “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, all RMBS policies were allocated to the Segregated Account and as such, the foregoing discussion of Ambac’s risk management practices is qualified by reference to the rehabilitator’s exercise of its discretion to alter or eliminate the above risk management practices relating to representation and warranty breaches by RMBS transaction sponsors.

 

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Our ability to recover the RMBS subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties (and/or their respective parents and affiliates), timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. Our current estimate considers that we will receive subrogation recoveries of $900.2 million and $1,619.6 million in 2012 and 2013, respectively (gross of discounting, reinsurance and credit risk valuation in the amount of $97.6 million, $25.8 million and $5.1 million, respectively). The amount of these subrogation recoveries is significant and if we are unable to recover any amounts our future available liquidity to pay claims would be reduced and our stockholders’ deficit as of December 31, 2010 would increase from $1,354.2 million to $3,745.5 million.

Reasonably Possible Additional Losses:

RMBS:

It is possible that our loss estimate assumptions for the RMBS insurance policies discussed above could be materially under-estimated as a result of continued deterioration in housing prices, poor servicing, the effects of a weakened economy marked by growing unemployment, and wage pressures and/or continued illiquidity of the mortgage market. Additionally, our actual subrogation recoveries could be lower than our current estimates if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings, or (iii) no longer have the financial means to fully satisfy their obligations under the transaction documents or (iv) an election to accept a lower settlement.

We have attempted to identify the reasonably possible losses using more stressful assumptions in our existing methodologies and models. Different methodologies, assumptions and models could produce different base and reasonably possible outcomes and actual results may differ materially from all of these various modeled results. Using more stressful assumptions in our existing methodologies, the reasonably possible increase in loss reserves for second lien credits for which we have an estimate of expected loss at December 31, 2010 could be approximately $800 million. The reasonably possible scenario for second-lien mortgage collateral generally assumes that the voluntary constant prepayment rate decreases by 1 to 5 percent (depending on transaction performance), and the current-to-30 day roll assumption over a twelve month period increases by 0.25 percent to 1 percent (depending on transaction performance). In addition, the loss severities for second-lien products may be greater because of increased carrying costs and servicing advances that are not recovered and we frequently increased them in a range between 1 to 3 percent. Using more stressful assumptions in our existing methodologies, the reasonably possible increase in loss reserves for first-lien credits for which we have an estimate of expected loss at December 31, 2010 could be approximately $650 million. The reasonably possible scenario for first-lien mortgage credits assumes that aggravated losses occur as a result of deterioration of macroeconomic factors and a reduced impact from government programs and servicer intervention.

Student Loans:

It is possible that our loss estimate assumptions for student loan credits could be materially under-estimated as a result of various uncertainties including but not limited to, the interest rate environment, an increase in default rates and loss severities on the collateral due to economic factors, as well as a failure of issuers to refinance insured bonds which have a failed debt structure, such as auction rate securities and variable rate debt obligations. Refer to Auction Rate Securities and Variable Rate Demand Obligations in Part 1, Item 1 of this Form 10-K for further information on our exposures to such failed debt structures. Our student loan portfolio consists of credits collateralized by (i) federally guaranteed loans under the Federal Family Education Loan Program (“FFELP”) and (ii) private student loans. Whereas FFELP loans are guaranteed for a minimum of 97% of defaulted principal and interest, private loans have no government guarantee and therefore are subject to credit risk as with other types of unsecured credit. Recent default data has shown a significant deterioration in the performance of private student loans underlying our transactions. Additionally, due to the failure of the auction rate and variable rate markets, the interest rates on these securities increased significantly to punitive levels

 

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pursuant to the terms of the documents. Such increases have caused the collateralization ratio in these transactions to deteriorate on an accelerated basis due to negative excess spread and/or the use of principal receipts to pay current interest. Although some issuers have been successful in refinancing some of their failed debt obligations, refinancing alternatives are limited, and refinancing options for private loans are severely impaired. Effective July 1, 2010, lenders are unable to originate guaranteed loans, due to the termination of the FFELP program. The resulting reduction in new revenues may adversely affect a number of issuers, whose ability to continue as administrator of the relevant transaction trusts may become at risk. For student loan credits for which we have an estimate of expected loss at December 31, 2010, the reasonably possible increase in loss reserves from the December 31, 2010 balance could be approximately $2,417 million. The reasonably possible scenario considers the highest stress scenario that was utilized in the development of our probability weighted expected loss at December 31, 2010.

Ambac’s management believes that the reserves for losses and loss expenses and unearned premium reserves are adequate to cover the ultimate net cost of claims, but reserves for losses and loss expenses are based on estimates and there can be no assurance that the ultimate liability for losses will not exceed such estimates.

Valuation of Financial Instruments:

Ambac’s financial instruments that are reported on the Consolidated Balance Sheets at fair value and subject to valuation estimates include investments in fixed income securities, VIE assets and liabilities, and derivatives comprising credit default, interest rate and currency swap transactions. Surplus notes issued in connection with claim or commutation settlements are recorded at fair value at the date of issuance and subsequently reported at amortized cost within Long-term debt on the Consolidated Balance Sheet. Determination of fair value for newly issued surplus notes is a highly subjective process which relies upon the use of significant unobservable inputs and management judgment consistent with a Level 3 valuation.

The fair market values of financial instruments held are determined by using independent market quotes when available and valuation models when market quotes are not available. ASC Topic 820, Fair Value Measurements and Disclosures requires the categorization of these assets and liabilities according to a fair value valuation hierarchy. Approximately 82% of our assets and approximately 59% of our liabilities are carried at fair value and categorized in either Level 2 of the valuation hierarchy (meaning that their fair value was determined by reference to quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets and other observable inputs) or Level 3 (meaning that their fair value was determined by reference to significant inputs that are unobservable in the market and therefore require a greater degree of management judgment). The determination of fair value for financial instruments categorized in Level 2 or 3 involves significant judgment due to the complexity of factors contributing to the valuation. Third-party sources from which we obtain independent market quotes also use assumptions, judgments and estimates in determining financial instrument values and different third parties may use different methodologies or provide different prices for securities. In addition, the use of internal valuation models for certain highly structured instruments, such as credit default swaps, require assumptions about markets in which there has been a negligible amount of trading activity for over one year. As a result of these factors, the actual trade value of a financial instrument in the market, or exit value of a financial instrument position owned by Ambac, may be significantly different from its recorded fair value. Refer to Note 16 to the Consolidated Financial Statements in Item 8 of this Form 10-K for discussion related to the transfers in and/or out of Level 1, 2 and 3 fair value categories.

Investment in Fixed Income Securities:

Investments in fixed income securities are accounted for in accordance with ASC Topic 320, Investments—Debt and Equity Securities. ASC Topic 320 requires that all debt instruments and certain equity instruments be classified in Ambac’s Consolidated Balance Sheets according to their purpose and, depending on that classification, be carried at either cost or fair market value. The fair values of fixed income investments held in the investment portfolios of Ambac and its operating subsidiaries are based primarily on quoted market prices

 

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received from dealer quotes or alternative pricing sources with reasonable levels of price transparency. For those fixed income investments where quotes were not available, fair values are based on internal valuation models. Refer to Note 16 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the valuation methods, inputs and assumptions for fixed income securities. Ambac performs various review and validation procedures to quoted and modeled prices for fixed income securities, including price variance analyses, missing and static price reviews, overall valuation analyses by senior traders and finance managers and reviews associated with our ongoing impairment analysis. Unusual prices identified through these procedures will be evaluated further against separate broker quotes (if available) or internally modeled prices, and the pricing source values will be challenged as necessary. Price challenges generally result in the use of the pricing source’s quote as originally provided or as revised by the source following their internal diligence process. A price challenge may result in a determination by the pricing source that they cannot provide a reasonable value for a security, in which case Ambac would resort to using either other quotes or internal models. Valuation results, particularly those derived from valuation models and quotes on certain mortgage and asset-backed securities, could differ materially from amounts that would actually be realized in the market.

Ambac’s investments in fixed income securities (excluding VIE investments) classified as “available-for-sale” are carried at fair value, with the after-tax difference from amortized cost reflected in stockholders’ equity as a component of Accumulated Other Comprehensive Income (“AOCI”). One of the significant estimates related to available-for-sale securities is the evaluation of investments for other-than-temporary impairments. Effective April 1, 2009, Ambac adopted ASC Paragraph 320-10-65-1 of ASC Topic 320. ASC Paragraph 320-10-65-1 amends existing GAAP guidance for recognition of other-than-temporary impairments of debt securities. Beginning with the quarter ended June 30, 2009, if management assesses that it either (i) has the intent to sell its investment in a debt security or (ii) more likely than not will be required to sell the debt security before the anticipated recovery of its amortized cost basis less any current period credit loss, then an other-than-temporary impairment charge must be recognized in earnings, with the amortized cost of the security being written-down to fair value. If these conditions are not met, but it is determined that a credit loss exists, the impairment is separated into the amount related to the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income. To determine whether a credit loss has occurred, management considers certain factors, including the length of time and extent to which the fair value of the security has been less than its amortized cost and downgrades of the security’s credit rating. If such factors indicate that a potential credit loss exists, then management will compare the present value of estimated cash flows from the security to the amortized cost basis to assess whether the entire amortized cost basis will be recovered. When it is determined that all or a portion of the amortized cost basis will not be recovered, a credit impairment charge is recorded in earnings in the amount of the difference between the present value of cash flows and the amortized cost at the balance sheet date, with the amortized cost basis of the impaired security written-down to the present value of cash flows. Ambac uses the single most likely cash flow scenario in the assessment and measurement of credit impairments. Estimated cash flows are discounted at the effective interest rate implicit in the security at the date of acquisition or upon last impairment. For floating rate securities, estimated cash flows are projected using the relevant index rate forward curve and the discount rate is adjusted for changes in that curve since the date of acquisition or last impairment. Prior to April 1, 2009, if a decline in the fair value of an available-for-sale security was judged to be other-than-temporary a charge was recorded in net realized losses equal to the full amount of the difference between the fair value and amortized cost basis of the security. For fixed income securities, the Company accretes the new cost basis to par or to the estimated future cash flows over the expected remaining life of the security by adjusting the security’s yield.

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 effects of changes in interest rates or credit spreads and the expected recovery period. There is also significant judgment in determining whether Ambac intends to sell securities or will continue to have the ability to hold temporarily impaired securities until recovery. Future events could occur that were not reasonably foreseen at the time management rendered its

 

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judgment on the Company’s intent to retain such securities until recovery. Examples of such events include, but are not limited to, the deterioration in the issuer’s creditworthiness, a change in regulatory requirements or a major business combination or major disposition.

VIE Assets and Liabilities:

The assets and liabilities of VIEs consolidated under ASC Topic 810, Consolidation consist primarily of fixed income securities, loans receivable, derivative instruments and debt instruments and are generally carried at fair value with changes in fair value recognized in Financial Guarantee: (Loss) income on variable interest entity activities of the Consolidated Statements of Operations. These consolidated VIEs are securitization entities which have liabilities and/or assets guaranteed by Ambac. The fair values of VIE debt instruments are determined using the same methodologies used to value Ambac’s fixed income securities in its investment portfolio as described above.

VIE derivative asset and liability fair values are determined using valuation models. When specific derivative contractual terms are available and may be valued primarily by reference to interest rates, exchange rates and yield curves that are observable and regularly quoted the derivatives are valued using vendor-developed models. Other derivatives within the VIEs that include significant unobservable valuation inputs are valued using internally developed models.

The fair value of VIE assets are obtained from market quotes when available. Typically the asset fair values are not readily available from market quotes and are estimated internally. The consolidated VIEs are securitization entities in which net cash flows from assets and derivatives (after adjusting for financial guarantor cash flows and other expenses) will be paid out to note holders or equity interests. Our valuation of VIE assets (fixed income securities or loans), therefore, are derived from the fair value of debt and derivatives, as described above, adjusted for the fair value of cash flows from Ambac’s financial guarantee. The fair value of financial guarantee cash flows include: (i) estimated future premiums discounted at a rate consistent with that implicit in the fair value of the VIE’s liabilities and (ii) internal estimates of future loss payments by Ambac discounted to consider Ambac’s own credit risk.

Derivatives:

Ambac’s operating subsidiaries’ exposure to derivative instruments is created through interest rate and currency swaps, US Treasury futures contracts and credit default swaps. These contracts are accounted for at fair value under ASC Topic 815, Derivatives and Hedging. Valuation models are used for the derivatives portfolios, using market data from a variety of third-party data sources. Several of the more significant types of market data that influence fair value include interest rates (taxable and tax-exempt), credit spreads, default probabilities, recovery rates, comparable securities with observable pricing, and the credit rating of the referenced entities. The valuation of certain interest rate and currency swaps as well as all credit derivative contracts also require the use of data inputs and assumptions that are determined by management and are not readily observable in the market. Refer to Note 16 to the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the models, model inputs and assumptions used to value derivative instruments. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of derivative instruments, actual value realized in a market transaction may differ significantly from the estimates reflected in our financial statements.

The fair values of credit derivatives are sensitive to changes in credit ratings on the underlying reference obligations, particularly when such changes reach below investment grade levels. Ratings changes are reflected in Ambac’s valuation model as changes to the “relative change ratio,” which represents the ratio of the estimated cost of credit protection relative to the cash market spread on the reference obligation. Such adjustments to the relative change ratio have primarily impacted the fair value of CDO of ABS transactions containing over 25% MBS exposure which suffered significant credit downgrades. All remaining CDO of ABS transactions were

 

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settled in 2010. See Note 1 to the Consolidated Financial Statements for more information on the commutation of all such transactions under the Settlement Agreement. Within the remaining CDS portfolio as of December 31, 2010, transactions comprising approximately 87% of par outstanding have experience some degree of credit rating downgrade since inception, including three structured finance transactions that are internally rated below investment grade. The relative change ratio on these transactions is 93.7% at December 31, 2010. The average rating for all other transactions that have been downgraded was AA- as of December 31, 2010 and, therefore, changes to the relative change ratio have not been significant.

Ambac’s credit derivative valuation model, like any financial model, has certain strengths and weaknesses. We believe our model’s primary strength is that it maximizes the use of market-driven inputs, and, most importantly, its use of market-based fair values of the underlying reference obligations and discount rate utilized. Ambac employs a three-level hierarchy for obtaining reference obligation fair values used in the model as follows: (i) broker quotes on the reference obligation, (ii) broker quotes on a subordinate obligation within the same capital structure as the reference obligation and (iii) proxy spreads from similarly structured deals or other market proxies. We believe using this type of approach is preferable to other models, which may emphasize modeled expected losses or which rely more heavily on the use of market indices that may not be reflective of the underlying reference obligation. Another strength is that our model is relatively easy to understand, which increases its transparency.

A potential weakness of our valuation model is our reliance on broker quotes obtained from dealers which originated the underlying transactions, who in certain cases may also be the counterparty to our CDS transaction. All of the transactions falling into this category are illiquid and it is usually difficult to obtain alternative quotes. Ambac employs various procedures to corroborate the reasonableness of quotes received; including comparing to other quotes received on similarly structured transactions, observed spreads on structured products with comparable underlying assets and, on a selective basis when possible, values derived through internal estimates of discounted future cash flows. Each quarter, the portfolio of CDS transactions is reviewed to ensure every reference obligation price has been updated. Period to period valuations are compared for each CDS and by underlying bond type. For each CDS, this analysis includes comparisons of key valuation inputs to the prior period and against other CDS within the bond type. No adjustments were made to the broker quotes we received when determining fair value of CDS contracts as of December 31, 2010. Another potential weakness of our valuation model is the lack of new CDS transactions executed by financial guarantors, which makes it difficult to validate the percentage of the reference obligation spread which would be captured as a CDS fee at the valuation date, (i.e. the relative change ratio, a key component of our valuation calculation). Changes to the relative change ratio based on internal ratings assigned are another potential weakness as internal ratings could differ from actual ratings provided by rating agencies. However, we believe our internal ratings are updated at least as frequently as the external ratings. Nonetheless, we believe the approach we have developed, described above, to increase the relative change ratio as the underlying reference obligation experiences credit deterioration is consistent with a market-based approach to valuation. Ultimately, our approach exhibits the same weakness as other modeling approaches, as it is unclear if we could execute at these values.

Valuation of Deferred Tax Assets:

Our provision for taxes is based on our income, statutory tax rates and tax planning opportunities available to us in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions. We review our tax positions quarterly and adjust the balances as new information becomes available. Deferred tax assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carry forwards. More specifically, deferred tax assets represent a future tax benefit (or receivable) that results from losses recorded under U.S. GAAP in a current period which are only deductible for tax purposes in future periods and net operating loss carry forwards. In accordance with ASC Topic 740, Income Taxes, we evaluate our deferred income taxes quarterly to determine if valuation allowances are required. ASC Topic 740 requires that companies

 

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assess whether valuation allowances should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. All available evidence, both positive and negative, needs to be identified and considered in making the determination with significant weight given to evidence that can be objectively verified. The level of deferred tax asset recognition is influenced by management’s assessment of future expected taxable income, which depends on the existence of sufficient taxable income of the appropriate character (ordinary vs. capital) within the carry back or carry forward periods available under the tax law. In the event that we determine that we would not be able to realize all or a portion of our deferred tax assets, we would record a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable in the period in which that determination is made.

Federal Income Tax Legislation

During the fourth quarter of 2009, Congress enacted The Worker, Homeownership, and Business Assistance Act of 2009, which, among other measures, allows businesses to carryback net operating losses from 2008 and 2009 to profits from the past five years. Under prior law, the losses were limited to a two year carryback. As a result of this enacted legislation, Ambac realized a $443.9 million tax refund, which was received in February 2010.

RESULTS OF OPERATIONS

On November 8, 2010 (the “Petition Date”), Ambac (“Debtor”) filed a voluntary petition for relief under Chapter 11 (“Bankruptcy Filing”) of the Bankruptcy Code in the Bankruptcy Court. Ambac will continue to operate in the ordinary course of business as “debtor-in-possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and the orders of the Bankruptcy Court.

We follow the accounting prescribed by Financial Accounting Standards Board Accounting Standards Codification Topic 852, “Reorganizations” (“ASC Topic 852”). Entities operating in bankruptcy and expecting to reorganize under Chapter 11 of the Bankruptcy Code are subject to the additional accounting and financial reporting guidance in ASC Topic 852. While ASC Topic 852 provides specific guidance for certain matters, other portions of US GAAP continue to apply so long as the guidance does not conflict with ASC Topic 852. This accounting literature provides guidance for periods subsequent to a Chapter 11 filing, among other things, the presentation of liabilities that are and are not subject to compromise by the Bankruptcy Court proceedings, as well as the treatment of interest expense and presentation of costs associated with the proceedings. Accordingly, the financial results in the prior periods or filed in future filings may not be comparable to 2010.

The financial results beginning in 2007 and continuing into 2010 have been impacted directly and indirectly by exposure to residential mortgages and other financial market disruption-related losses. Ambac has experienced significant losses within its financial guarantee business (both insurance policies and credit derivatives transactions) which, beginning 2008, led to rating downgrades of Ambac Assurance by the independent rating agencies. Also, as a result of these downgrades, most of Ambac’s financial services counterparties exercised their contractual rights to either terminate contracts and/or obtain additional collateral from Ambac. Terminations of many interest rate, currency and total return swaps have also resulted in losses to Ambac. Financial guarantee losses and commutations along with financial services terminations and collateral requirements have resulted in partial liquidation of the investment portfolio, adversely impacting investment income. In certain circumstances, Ambac was able to negotiate terminations of investment agreement contracts at a discount to its liability, recognizing realized gains. The investment portfolio has suffered other-than-temporary impairment losses, especially among residential mortgage backed securities. Actions taken by our insurance regulator in early 2010 resulted in the temporary cessation of claim payments since March 24, 2010. While the claims moratorium has increased cash available for investment, it also resulted in additional investment impairment losses on Ambac-guaranteed securities within the investment portfolio. Also, in June 2010 Ambac commuted all of its CDS contracts related to CDO of ABS exposures, removing from credit derivative portfolio the contracts that have contributed the substantial majority of mark-to-market volatility in the Company’s results over the past few years.

 

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Ambac’s diluted loss was ($753.2) million or ($2.56) per share, ($14.6) million or ($0.05) per share, and ($5,609.2) million or ($22.31) per share, for 2010, 2009 and 2008, respectively.

The 2010 financial results compared to 2009 were primarily negatively impacted by (i) lower net gains in the change in the fair value of credit derivatives; (ii) net losses related to variable interest entity activities; (iii) lower Financial Guarantee other income; (iv) lower net premiums earned, (v) lower net investment income, and (vi) reorganization items related to our Chapter 11 bankruptcy filing, partially offset by (i) a lower provision for loss and loss expenses; (ii) lower other-than-temporary impairment charges in the investment portfolio; (iii) lower derivative products losses; and (iv) a lower provision for income taxes.

The 2009 financial results compared to 2008 were positively affected by (i) changes in the fair value of credit derivatives ($3.8 billion gain in 2009 as compared to a $4.0 billion loss in 2008); (ii) lower underwriting and operating expenses; (iii) higher realized gains; and (iv) lower interest expense on investment and payment agreements, partially offset by (i) higher loss and loss expenses; (ii) higher other- than-temporary impairments charges in the investment portfolio; (iii) lower net premiums earned; (iv) higher derivative products losses; and (v) a higher provision for income taxes.

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for 2010, 2009 and 2008 and its financial condition as of December 31, 2010 and 2009. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services.

Financial Guarantee

Effective January 1, 2009, Ambac adopted new accounting guidance which amended the accounting for financial guarantee insurance contracts. The new guidance clarified the accounting for financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. As a result, a cumulative effect adjustment of $381.7 million was recorded to reduce the opening balance of retained earnings at January 1, 2009. Accordingly, the Financial Guarantee segment results for net premiums earned, loss and loss expenses and underwriting and operating expenses are not comparable from 2008 to 2009.

Effective January 1, 2010, Ambac adopted new accounting guidance for the consolidations of Variable Interest Entities (VIEs), which requires an enterprise to perform an analysis to determine whether the enterprise’s variable interests give it a controlling financial interest in a VIE. As a result, a cumulative effect adjustment of $705.0 million was recorded as a net increase to total equity at January 1, 2010. Accordingly, amounts reported in 2010 are not comparable to amounts that were reported in 2009 for the significant majority of the Financial Guarantee Segment, including net premiums earned, losses incurred and underwriting and operating expenses. Refer to Note 10 of the Consolidated Financial Statements in Item 8 of this Form 10-K for further discussion of the cumulative effect of adopting the standard.

Commutations, Terminations and Settlements of Financial Guarantee Contracts. Ambac’s loss mitigation strategy on poorly performing transactions, includes commutations of which a significant number have been executed since 2008. As discussed in “2010 Overview” located in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, Ambac Assurance entered into a Settlement Agreement with respect to its CDO of ABS and certain other CDO-related obligations on June 7, 2010. Pursuant to the Settlement Agreement, in exchange for the termination of all credit default swaps written by ACP with respect to certain CDO of ABS obligations, and the related financial guarantee insurance policies written by Ambac Assurance with respect to ACP’s obligations thereunder, Ambac Assurance paid to ACP’s counterparties in the aggregate (i) $2,600 million in cash and (ii) $2,000 million in principal amount of newly issued surplus notes of Ambac Assurance. The par amount of the commuted CDO of ABS obligations was $16,543 million. In addition to the CDO of ABS obligations, Ambac Assurance has also commuted for $97 million of cash certain additional obligations, including certain non-CDO of ABS obligations to ACP’s counterparties with par or notional

 

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amounting to $1,407 million. Ambac Assurance commuted another CDO of ABS transaction in an amount equal to its remaining par value of $90 million. Also in 2010, Ambac Assurance settled all its remaining hedge contracts on exposures commuted as part of the Settlement Agreement and received $205 million. In addition to these commutations, during 2010 Ambac Assurance commuted certain additional obligations with a par of $4,516 million, receiving net settlement fees of approximately $7 million. These settlements are recognized within Net realized losses on credit derivatives on the Consolidated Statement of Operations.

In July 2010, the Segregated Account of Ambac Assurance Corporation commuted an insurance policy with a cash payment of $65 million and the issuance of Segregated Account Surplus Notes with a par value of $50 million.

During 2009, Ambac (i) commuted eight collateralized debt obligation of asset-backed securities (“CDO of ABS”) exposures with multiple counterparties and (ii) reduced a significant portion of exposure under a CDO of ABS transaction. These transactions resulted in the reduction of exposure by $8,620 million and combined cash payments by Ambac of approximately $1,381 million, which is reflected in changes in the fair value of credit derivatives – realized losses and gains and other settlements. During 2008, Ambac commuted five CDO of ABS exposures resulting in the reduction of exposure by $4,912 million and combined cash payments of $1,850 million.

Reinsurance Terminations. Pursuant to the Amended and Restated 1997 Reinsurance Agreement between Ambac UK and Ambac Assurance (the “AUK Reinsurance Agreement”), Ambac Assurance reinsured substantially all of the liabilities under policies issued by Ambac UK. On March 24, 2010, Ambac Assurance’s liabilities under the AUK Reinsurance Agreement were allocated to the Segregated Account. On September 28, 2010, Ambac Assurance entered into a Commutation and Release Agreement (the “AUK Commutation Agreement”) with Ambac UK and the Special Deputy Commissioner of OCI, pursuant to which the AUK Reinsurance Agreement was commuted and other capital support arrangements between Ambac Assurance and AUK were terminated. In connection with this termination, Ambac recorded other income of $157.8 million in the Consolidated Statement of Operations in 2010. This gain resulted primarily from the recognition of foreign currency gains that, prior to the termination, were not reflected in certain of Ambac Assurance’s non-monetary assets or liabilities such as unearned premium reserves or deferred acquisition costs, since these non-monetary assets and liabilities were required to be recorded based on their historical foreign exchange rates.

During 2009, Ambac terminated all reinsurance contracts with RAM Reinsurance Limited, Swiss Reinsurance Company, Assured Guaranty Municipal Corporation (formerly known as Financial Security Assurance Inc.), Financial Guaranty Insurance Company and all but one reinsurance contract with each of Radian Asset Assurance Inc. and MBIA Insurance Corporation. The terminations reflect a net recapture of approximately $22.3 billion of par. The economic result was net settlement payments to Ambac of $546 million. In connection with the terminations, Ambac recorded net gains of approximately $321.4 million in the Consolidated Statement of Operations during the year ended December 31, 2009 ($296.2 million recorded in other income).

Net Premiums Earned. Net premiums earned during 2010 were $546.0, a decrease of 32% from $797.4 million in 2009. Net premiums earned include accelerated premiums, which result from refunding, calls and other accelerations. Certain obligations insured by Ambac have been legally defeased whereby government securities are purchased by the issuer with the proceeds of a new bond issuance, or less frequently with other funds of the issuer, and held in escrow (a pre-refunding). The principal and interest received from the escrowed securities are then used to retire the Ambac-insured obligations at a future date either to their maturity date or a specified call date. Ambac has evaluated the provisions in certain financial guarantee insurance policies issued on legally defeased obligations and determined those policies have not been legally extinguished and, therefore, premium revenue recognition has not been accelerated. Normal net premiums earned excludes accelerated premiums. Normal net premiums earned for the year ended December 31, 2010 has been negatively impacted by the runoff of the insured portfolio, either via transaction terminations / refunding or scheduled maturities partially

 

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offset by an increase in net earnings due to reinsurance cancellations that were executed during 2009. As a result of the adoption of the new consolidations standard and the resulting consolidation of VIEs, $43.9 million of net premiums earned were not recognized in the year ended December 31, 2010; rather, the total income statement results of such VIEs were recorded in Financial Guarantee: (Loss) income on variable interest entity activities. Normal net premiums earned and accelerated premiums are reconciled to total net premiums earned in the table below.

The following table provides a breakdown of net premiums earned by market sector:

 

($ in millions)

   2010      2009      2008  

Public Finance

   $ 178.4       $ 195.9       $ 203.8   

Structured Finance

     164.8         220.5         261.0   

International Finance

     97.6         171.1         176.2   
                          

Total normal premiums earned

     440.8         587.5         641.0   

Accelerated earnings

     105.2         209.9         381.8   
                          

Total net premiums earned

   $ 546.0       $ 797.4       $ 1,022.8   
                          

The following table provides a breakdown of accelerated earnings by market sector:

 

($ in millions)

   2010      2009      2008  

Public Finance

   $ 61.6       $ 124.8       $ 343.5   

Structured Finance

     4.6         27.7         31.3   

International Finance

     39.0         57.4         3.1   

Reinsurance cancellations

     —           —           3.9   
                          

Total accelerated earnings

   $ 105.2       $ 209.9       $ 381.8   
                          

Normal net premiums earned for 2009 was negatively impacted by (i) limited new business written since November 2007, and none in 2009; (ii) the high level of public finance refunding activity during 2008 and 2009; and (iii) several structured finance transaction terminations, partially offset by an increase in net earnings due to the reinsurance cancellations that were executed during 2008 and 2009.

Net Investment Income. Net investment income in 2010 was $324.0 million, a 32.9% decrease from $482.7 million in 2009. The decline in net investment income resulted from the lower invested asset base in 2010 and a lower average yield of the portfolio compared to 2009. Please see “Liquidity and Capital Resources – Investment Portfolio” for more information.

The lower invested asset base in 2010 was driven by reductions in the portfolio to pay commutations on CDO of ABS transactions pursuant to the Settlement Agreement and RMBS claim payments, partially offset by cash flow from the collection of financial guarantee premiums, tax refunds, fees and coupon receipts on invested assets. Cash flow into the portfolio during most of 2010 also benefited from the claims moratorium on policies within the Segregated Account which was in effect from March 24, 2010. The average yield of the portfolio in 2010 declined compared to 2009 primarily as a result of changes in the portfolio mix. Higher yielding tax exempt municipals and certain RMBS and ABS securities were sold to fund the Settlement Agreement, reducing the average yield of these asset classes within the portfolio. The build up of liquidity for the Settlement Agreement, which settled on June 7, 2010, also caused a higher percentage of the investment portfolio to be held in short-term securities in 2010, earning low yields due to the prevailing interest rate environment during the year. The negative impact of these items was partially offset by increased investments in higher yielding corporate bonds, taxable municipal securities and Ambac-wrapped securities in 2010 compared to 2009.

 

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Net investment income in 2009 was up 0.5% over year-end 2008. The comparatively lower invested asset base in 2009 was offset by a higher average yield on the portfolio. The lower invested asset base was driven by reductions in the portfolio to pay commutations on CDO of ABS transactions, RMBS claim payments and to provide loans to the financial services businesses, partially offset by $1.3 billion in funds received via the capital raise in March 2008, $800 million from the issuance of Ambac Assurance preferred stock in December 2008 and January 2009, and cash flow from the collection of financial guarantee premiums, tax refunds, fees and coupon receipts on invested assets. Compared to 2008, the average portfolio mix in 2009 shifted away from tax-exempt municipals toward taxable securities, primarily floating rate RMBS securities purchased from the investment agreement business, Ambac insured securities purchased in the open market and corporate bonds. The average yield in 2009 was higher primarily as a result of accretion of bond discounts on Ambac insured securities and RMBS securities previously written-down to fair value in connection with earlier period other-than-temporary impairments. Floating rate taxable and short-term securities in the portfolio were adversely impacted in 2009 by the lower interest rate environment compared to 2008.

Other-Than-Temporary Impairment Losses. Ambac adopted new accounting guidance related to other-than-temporary impairment losses effective April 1, 2009. Under the new guidance, beginning April 1, 2009, other-than-temporary impairment losses recorded in the statement of operations exclude non-credit related impairment amounts on securities that are credit impaired to the extent management does not intend to sell and it is not more likely than not that the company will be required to sell before recovery of the amortized cost basis less any current period credit impairment. Such non-credit related impairment amounts are recorded in accumulated other comprehensive income on the balance sheet. Alternatively, the non-credit related impairment would be recorded in other-than-temporary impairment losses in the statement of operations if management intends to sell the securities or it is more likely than not the company will be required to sell before recovery of amortized cost less any current period credit impairment. Prior to the adoption of the new other-than-temporary impairment guidance, the full impairment amount of a security (i.e., the difference between the amortized cost of a security and its fair value) found to be other-than-temporarily impaired would be written-down to fair value through earnings, including securities that were credit impaired even if management had the intent and ability to hold them to maturity.

Charges for other-than-temporary impairment losses were $56.7 million, $1,570.7 million and $70.9 million for 2010, 2009 and 2008, respectively. Other-than-temporary impairments for 2010 reflect charges to write-down structured finance securities to fair value as a result of management’s intent to sell securities to meet liquidity needs as well as credit losses on securities guaranteed by Ambac Assurance. As further described in Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K, on March 24, 2010, the OCI commenced the Segregated Account Rehabilitation Proceedings in order to permit the OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account. As a result of actions taken by the OCI, financial guarantee payments on securities guaranteed by Ambac Assurance which have been placed in the Segregated Account are no longer under the control of Ambac management. Accordingly, estimated future cash flows on such securities have been adversely impacted, resulting in credit losses of $42.7 million and $98.7 million for the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, management has not asserted its intent to sell any securities from its portfolio. Future changes in our estimated liquidity needs could result in a determination that Ambac no longer has the ability to hold such securities, which could result in additional other-than-temporary impairment charges. Other-than-temporary impairments for 2009 primarily reflect charges to write-down the amortized cost basis of residential mortgage-backed securities that management believed had experienced some credit impairment and/or intended to sell.

Net Realized Investment Gains. The following table provides a breakdown of net realized gains for the years ended December 31, 2010, 2009 and 2008:

 

(Dollars in Millions)

   2010      2009      2008  

Net gains on securities sold or called

   $ 74.3       $ 128.5       $ 87.2   

Foreign exchange gains

     2.1         3.2         (7.3
                          

Total net realized gains

   $ 76.4       $ 131.7       $ 79.9   
                          

 

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Change in Fair Value of Credit Derivatives. The net change in fair value of credit derivatives was $60.2 million, $3,812.9 million, and ($4,031.1) million in 2010, 2009 and 2008, respectively. The net gain in 2010 is primarily the result of: (i) an increase in the valuation adjustment to reflect Ambac’s own credit risk (see Note 16 of the Consolidated Financial Statements in Item 8 of this Form 10-K for a description of the methodology used to determine this credit valuation adjustment) and (ii) gains from increases in reference obligation pricing and exposure amortization in asset classes other than CDO of ABS, partially offset by: (i) the recognition of losses related to transactions included in the Settlement Agreement and (ii) the impact of internal credit downgrades to below investment grade (“BIG”) on certain structured finance transactions within the portfolio. Our fair value methodology for credit derivatives reflects larger mark-to-market losses when a transaction is downgraded, with the greatest impact occurring upon a downgrade to BIG.

The net gain on change in fair value of credit derivatives during 2009 is primarily the result of: (i) the effect of significant widening of Ambac Assurance credit default swap spreads, which caused a $6,759.1 million benefit during the year, (ii) amortization of exposure in the portfolio and (iii) increases in reference obligation pricing in asset classes other than CDO of ABS, partially offset by rating downgrades and declines in reference obligation values related to CDO of ABS transactions. The net loss on change in fair value of credit derivatives of $4,031.1 million during 2008 is primarily the result of (i) declining market values on underlying reference obligations and (ii) internal ratings downgrades on CDO of ABS transactions, partially offset by the effect of incorporating Ambac Assurance credit default swap spreads into the measurement of fair value of credit derivative liabilities. The 2008 loss is net of a $10,793.9 million benefit from incorporating the risk of Ambac’s own non-performance into the fair value of credit derivatives throughout the year. This reflects the adoption of new accounting guidance that was effective January 1, 2008 as well as additional Ambac credit spread widening during 2008. Prior to January 1, 2008, the fair value of credit derivatives did not incorporate a measure of Ambac’s own credit risk. See Note 16 to the Consolidated Financial Statements in Item 8 of this Form 10-K for a further description of Ambac’s methodology for determining the fair value of credit derivatives.

Realized gains (losses) and other settlements on credit derivative contracts were ($2,757.6) million, ($1,379.7) million and ($1,794.4) million for the years ended December 31, 2010, 2009 and 2008, respectively. These amounts represent premiums received and accrued on written contracts, premiums paid and accrued on purchased contracts and net losses and settlements paid and payable where a formal notification of shortfall has occurred. Net realized gains for the year ended December 31, 2010 included $33.1 million of net fees earned. Loss and settlement payments, net of recoveries from hedge counterparties, included in net realized losses for the year ended December 31, 2010 were $2,789.0 million related to the Settlement Agreement and commutation of associated contracts with hedge counterparties. Net realized losses in 2009 and 2008 included loss and settlement payments of $1,428.4 million and $1,857.2 million, respectively, related primarily to the commutation of various CDO of ABS transactions.

Unrealized gains (losses) on credit derivative contracts were $2,817.8 million, $5,192.7 million and ($2,236.7) million for 2010, 2009 and 2008, respectively. The net unrealized gains (losses) in fair value of credit derivatives reflect the same factors as the overall change in fair value of credit derivatives as noted above, adjusted for the reclassification to realized losses in connection with loss and settlement payments. Excluding the impact of amounts reclassified to realized losses, unrealized gains (losses) on credit derivative contracts were $28.8 million, $3,764.3 million and ($4,093.9) million in 2010, 2009 and 2008, respectively.

Other Income. Other income in 2010 was $106.0 million, as compared to $410.9 million in 2009 and $8.5 million in 2008. Included within other income are non-investment related foreign exchange gains and losses, deal structuring fees, commitment fees and reinsurance settlement gains (losses). Other income for the year ended December 31, 2010 primarily resulted from the consolidated effect of terminating the reinsurance agreement between Ambac UK and Ambac Assurance for a gain of $157.8 million. Additionally, other income for the year ended December 31, 2010 included the impact of the movement in the British Pound and Euro to US Dollar exchange rate upon premium receivables, resulting in a loss of approximately $48.7 million. Other income for 2009 primarily resulted from the termination of reinsurance contracts, resulting in net gains of $296.2 million and

 

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the impact of the movement in the British Pound to US Dollar exchange rate upon premium receivables, resulting in a gain of $81.9 million.

(Loss) income on variable interest entity activities. (Loss) income on variable interest entity activities includes changes in fair value of consolidated VIEs’ assets and liabilities and gains (losses) upon consolidation or deconsolidation of variable interest entities. Ambac adopted the new consolidation standard (ASU 2009-17) effective January 1, 2010, with the adoption gain of $705.0 million recorded as an adjustment to beginning retained earnings. Under ASU 2009-17, Ambac consolidated significantly more VIEs beginning January 1, 2010 than were consolidated during 2009, and accordingly amounts reported in 2010 are not comparable to amounts that were reported for 2009 or 2008. Further, as a result of the Rehabilitation of the Segregated Account of Ambac Assurance, effective March 24, 2010 Ambac no longer had the unilateral power to direct the activities that most significantly impact the economic performance of most of the newly consolidated VIEs. Accordingly, Ambac deconsolidated 49 VIEs, mostly RMBS transactions, on March 24, 2010. Additionally, the financial guarantee policies on certain student loan securitization transactions were allocated to the Segregated Account in October 2010 causing Ambac to deconsolidate the related VIEs. The net loss related to these deconsolidated VIEs for 2010 was $630.3 million. The loss upon deconsolidation primarily arises from re-establishment of the carrying value of insurance loss reserves and other insurance accounts which had a greater aggregate net liability balance at the time of deconsolidation than the aggregate net liabilities of the VIEs which were carried at fair value. Refer to Note 10 of the Consolidated Financial Statements in Item 8 of this Form 10-K for further information on the accounting for VIEs. The remaining loss on variable interest entities during 2010 reflects fair value changes caused primarily by reductions in the estimated future cash flows on assets of certain amortizing transactions and increases in the net liability position of the student loan transactions that were later deconsolidated, partially offset by the accretion of discounted net assets of most VIEs into income. Income on variable interest entities in 2009 primarily relates to changes in the fair value of assets caused by the accretion of discounted net assets into income.

Losses and Loss Expenses. Losses and loss expenses are based upon estimates of the aggregate losses inherent in the non-derivative financial guarantee portfolio as of the reporting date, net of subrogation recoverable and reinsurance. Loss and loss expenses were $719.4 million, $2,815.3 million, and $2,227.6 million in 2010, 2009 and 2008, respectively. As a result of the adoption of the new accounting guidance related to financial guarantee contracts in 2009, losses and loss expenses are not comparable from 2008 to 2009.

Loss and loss expenses in 2010 were primarily driven by deterioration in student loan transactions. Recent default data has shown a significant deterioration in the performance of private student loans underlying our transactions. Due to the failure of the auction rate and variable rate markets, the interest rates on these securities increased significantly to punitive levels pursuant to the terms of the documents. Additionally, RMBS transactions experienced continued deterioration in the performance of the underlying home loans, most notably in the second lien product (closed end second liens and home equity lines of credit).

Losses and loss expenses in 2009 were heavily concentrated in the RMBS insurance portfolio. Continued deterioration in the performance of the underlying RMBS home loans was observed, most prominently in the first lien product (negative amortization and interest-only loans) and second lien product (closed end second liens and home equity lines of credit). The non-RMBS losses and loss expenses were highly concentrated in a handful of asset-backed securitizations, several student loan deals, and one municipal transportation transaction. The increased loss provision in 2009 was primarily the result of increases related to the residential mortgage-backed security sector.

 

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The following table summarizes the changes in the total net loss reserves for 2010 and 2009:

 

($ in millions)

   Year Ended
December 31, 2010
    Year Ended
December 31, 2009
 

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

   $ 3,777.3     

Impact of adopting ASU 2009-17(1)

     (503.8  
                

Beginning balance of net loss reserves

     3,273.5      $ 2,469.2 (4) 

Provision for losses and loss expenses

     719.4        2,766.6   

Losses paid

     (368.1     (1,734.3

Recoveries of losses paid from reinsurers

     14.6        203.6   

Other recoveries, net of reinsurance

     107.9        72.2   

Other adjustments (including foreign exchange)

     0.5        —     

Deconsolidation of certain VIEs(2)

     676.7        —     
                

Ending balance of net loss reserves(3)

   $ 4,424.5      $ 3,777.3   
                

 

  (1) Refer to Note 2 and Note 10 to the Consolidated Financial Statements for discussion of the new accounting standard.
  (2) Relates to VIEs where Ambac no longer has the unilateral power to direct the activities of the VIEs and, accordingly, Ambac deconsolidated the affected VIEs. Included here are VIEs that have insurance policies that were allocated to the Segregated Account.
  (3) Includes $1,411.4 of claims presented and not paid as a result of the claim moratorium imposed on the Segregated Account of Ambac Assurance by OCI.
(4)   

Net loss reserves, December 31, 2008

   $ 2,129.8   
  

Impact of adoption of ASC Topic 944

     339.4   
           
  

Net loss reserve, January 1, 2009

   $ 2,469.2   

The losses and loss expense reserves as of December 31, 2010 and December 31, 2009 are net of estimated recoveries under representation and warranty breaches for certain RMBS transactions in the amount of $2,391.3 million and $2,026.3 million, respectively. Please refer to the “Critical Accounting Estimates” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to the Loss Reserves section located in Note 2 of the Consolidated Financial Statements in Item 8 of this Form 10-K for further background information on the change in estimated recoveries.

The following tables provide details of net claims presented, net of recoveries received for the years ended December 31, 2010, 2009 and 2008:

 

($ in millions)

   2010(1)      2009      2008  

Net claims presented (recovered):

        

Public Finance

   $ 36.2       $ 29.7       $ 3.4   

Structured Finance

     1,597.0         1,276.0         567.6   

International Finance

     23.7         152.8         —     
                          

Total

   $ 1,656.9       $ 1,458.5       $ 571.0   
                          

 

(1) Includes $1,411.4 of claims presented and not paid as a result of the Segregated Account payment moratorium ($9.6 and $1,401.8) for Public Finance and Structured Finance, respectively.

At December 31, 2010, the expected future claims to be presented (gross of reinsurance and net of expected recoveries) for credits that have already defaulted totaled $863.9 million for Ambac Assurance and $1,423.4 million for policies allocated to the Segregated Account. As a result of the Segregated Account Rehabilitation Plan, only 25% of Segregated Account claims presented are expected to be paid in cash with the remainder

 

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settled via Segregated Account Surplus Notes. Related future claims expected to be presented are $1,548.0 million, ($242.2) million, ($1,225.5) million, $260.8 million and $167.6 million in 2011, 2012, 2013, 2014 and 2015 respectively. These amounts are net of the previously mentioned representation and warranty breach recoveries totaling $2,514.5 million (with $899.6 million and $1,614.9 million expected to be received in 2012 and 2013, respectively).

Please refer to the “Critical Accounting Estimates—Financial Guarantee Insurance Losses and Loss Expenses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and to the Loss Reserves section located in Note 2 of the Consolidated Financial Statements located in Item 8 of this Form 10-K for further background information on loss reserves.

Underwriting and Operating Expenses. Underwriting and operating expenses of $198.4 million in 2010 increased by 13% from $175.7 million in 2009. Underwriting and operating expenses consist of the gross underwriting and operating expenses plus the amortization of previously deferred expenses. The increase in underwriting and operating expenses was primarily due to higher consulting costs and legal fees, partially offset by lower compensation expenses. The increase in consulting and legal costs was primarily the result of the establishment and continued operations of the Segregated Account and the negotiation and closing of the Settlement Agreement. As a consequence of the Segregated Account Rehabilitation Proceedings, the rehabilitator retains operational control and decision-making authority with respect to all matters related to the Segregated Account, including the hiring of advisors. During 2010, expenses incurred in connection with legal and consulting services provided for the benefit of OCI amounted to $20.8 million. Accordingly, future expenses may include a significant amount of advisory costs for the benefit of OCI that are outside the control of Ambac’s management.

Underwriting and operating expenses in 2009 decreased 19% from $215.8 million in 2008 primarily due to lower compensation expenses, consulting costs and premium taxes, partially offset by higher legal fees. Premium taxes in 2009 were impacted by the adoption of the new accounting guidance related to financial guarantee contracts and were lower due to reductions in estimated future installment premiums. Compensation expenses in 2010, 2009 and 2008 were $67.6 million, $94.5 million and $114.0 million, respectively.

Interest Expense. Interest of $62.2 million for the year ended December 31, 2010 relates to surplus notes issued by Ambac Assurance and the Segregated Account of Ambac Assurance in connection with the June 7, 2010 Settlement Agreement with certain Counterparties and the settlement of a Segregated Account insurance policy, respectively. Interest expense on the surplus notes includes accrual of the annual 5.1% coupon plus accretion of the original issue discount to par using the effective yield method.

Financial Services

Through its Financial Services subsidiaries, Ambac historically provided financial and investment products including investment agreements, funding conduits and derivative products. The primary activities in the derivative products business were intermediation of interest rate and currency swap transactions and taking total return swap positions on certain fixed income obligations. Since 2008, all Financial Services portfolios have been in runoff. As of December 31, 2009 all total return swap positions had been terminated. While the derivative products business generally seeks to remain neutral to interest rate and currency fluctuations, the portfolio could experience gains or losses related to certain aspects of portfolio positioning. Beginning in 2009, the derivative products portfolio has been positioned to benefit from rising interest rates in order to mitigate exposure to floating rate obligations in the Financial Guarantee segment.

 

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Revenues. The following table provides a breakdown of Financial Services revenues for 2010, 2009 and 2008:

 

($ in millions)

   2010     2009     2008     % Change  
         2010
vs.
2009
    2009
vs.
2008
 

Investment income

   $ 34.1      $ 70.7      $ 255.9        (52 %)      (72 %) 

Derivative products

     (106.6     (207.2     (134.2     49     (54 %) 

Other-than-temporary impairment losses

     (3.1     (283.9     (451.9     99     37

Net realized investment gains

     72.9        184.5        215.6        (60 %)      (14 %) 

Net change in fair value of total return swaps

     —          18.6        (129.6     (100 %)      114

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

     (14.3     11.3        (15.8     (227 %)      172
                            

Total Financial Services revenue

   $ (17.0   $ (206.0   $ (260.0     92     21
                            

Investment Income. The decrease in investment income for the year ended December 31, 2010 compared to 2009 and 2008 was driven primarily by a decreasing portfolio of investments in the investment agreement business, as securities are sold to fund repayment of investment agreements. Ambac’s investment agreement obligations were reduced from $2.8 billion at December 31, 2008 to $1.2 billion at December 31, 2009 and $0.8 billion at December 31, 2010.

Derivative Products. Losses in derivative product revenues for the year ended December 31, 2010 were lower than for 2009 as a result of lower termination charges and positive valuation adjustments related to Ambac’s own credit risk in 2010, partially offset by higher mark-to-market losses caused by lower interest rates during the period. Termination charges generally reflect the counterparties’ cost to replace Ambac on their swaps. These fees are realized upon the swap counterparties’ exercise of termination rights allowed by Ambac Assurance’s rating downgrades or upon negotiated settlements. Termination charges included in derivative product revenues for the years ended December 31, 2010 and 2009 also include fair value adjustments to reflect estimated swap termination or replacement costs in the current market for swaps that remain in the portfolio. The net gain (loss) included in derivative product revenues related to termination charges totaled $23.4 million and ($204.2) million for the years ended December 31, 2010 and 2009, respectively. Many derivative counterparties retain the right to terminate contracts. The value of future terminations cannot be determined with certainty until such terminations occur. Accordingly, further termination losses may occur in the future. The benefit of lower termination losses in 2010 compared to 2009 was partially offset by losses during 2010 arising from declines in interest rates during the year. Beginning in the third quarter of 2009, the derivative products portfolio was positioned to benefit from rising interest rates in order to mitigate interest rate exposure in the financial guarantee portfolio. Losses attributed to this macro hedge were ($120.5) million in 2010 compared to net gains of $16.3 million in 2009.

The increased losses in derivative product revenues for 2009 compared to 2008 resulted primarily from higher termination charges, partially offset by 2009 gains on the macro hedge. The net loss included in derivative product revenues for termination charges totaled ($204.2) million and ($35.0) million for the years ended December 31, 2009 and 2008, respectively. The 2009 results include a charge related to one municipal swap counterparty that exercised its termination rights but paid Ambac less than carrying value. Ambac is seeking legal remedies against this former counterparty; however, no recovery amount has been included in results. Additionally, 2009 results included the impact of applying fair value adjustments to reflect estimated swap replacement costs in the current market for swaps that remain in the portfolio. These fair value adjustments were based on actual experience from recently increased termination activity, and incorporated other information obtained from termination and settlement negotiations with certain counterparties. Derivative product revenues in 2008 were driven primarily from turmoil in the short-term municipal bond market. In certain interest rate swaps where a municipality is the counterparty, Ambac’s swap subsidiary was required to pay the actual issue-

 

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specific variable rate paid by the municipality on its floating-rate debt (primarily Ambac guaranteed debt), in exchange for receiving a fixed rate. These municipal interest rate swaps (the “cost of funds swaps”) were hedged against general interest rate fluctuations but were not hedged between taxable index rates (such as LIBOR) and issue-specific rates (this is generally known as “basis risk”). Beginning in the first quarter 2008, the decline in demand for variable-rate municipal debt drove issue-specific rate resets to very high levels which persisted throughout 2008, thereby increasing Ambac’s payment obligations under the interest rate swaps.

Other-Than-Temporary Impairment Losses. Charges for other-than-temporary impairment losses in the financial services investment portfolios were $3.1 million, $283.9 million and $451.9 million for 2010, 2009 and 2008, respectively. Other-than-temporary charges in 2010 related to securities that management intended to sell. Losses in 2009 and 2008 resulted from a combination of credit and price deterioration on Alt-A residential mortgage backed securities held in the investment agreement investment portfolio and the need to fund terminations of investment agreement contracts following downgrades of Ambac Assurance. Other-than-temporary impairments in 2009 reflected management’s intent to dispose of Alt-A residential mortgage backed investment securities that are rated below investment grade. Other-than-temporary impairment charges in 2008 included $269.2 million of write-downs to fair value due to expected credit losses on the securities and $182.7 million as a result of management’s intent to sell securities.

Net Realized Investment Gains. The following table summarizes the main components of net realized investment gains for 2010, 2009 and 2008:

 

($ in millions)

   2010     2009      2008  

Net (losses) gains on securities sold or called

   $ (1.7   $ 35.0       $ 27.7   

Net gain on terminations of investment agreements

     74.6        149.5         173.7   

Other net realized gains

     —          —           14.2   
                         

Total realized investment gains

   $ 72.9      $ 184.5       $ 215.6   
                         

The net realized gains on investment agreements in 2010, 2009 and 2008 primarily resulted from the termination of certain investment agreement contracts at a discount from their carrying value. Other net realized gains include foreign exchange gains on investment agreements and cash recoveries on a previously defaulted investment security.

Net change in fair value of total return swaps. During 2009, Ambac terminated all remaining total return swaps. The net change in fair value of total return swaps resulted in gains in 2009 reflecting general credit spread tightening on the reference obligation bonds underlying the total return swaps. Prices on these underlying bonds declined substantially during 2008, resulting in mark-to-market losses in this portfolio.

Expenses. Financial Services expenses were $30.6 million, $46.7 million and $247.7 million for 2010, 2009 and 2008, respectively. Included in the above is interest expense related to investment and payment agreements of $16.8 million, $34.1 million and $235.0 million for 2010, 2009 and 2008, respectively. The decreases are primarily related to a smaller volume of investment agreements. Additionally, expenses for 2010 and 2009 include the positive impact from the liquidity support from Ambac Assurance for repayment of investment agreement liabilities. The result of this support is a reduction in both financial services interest expense and financial guarantee investment income of approximately $6.0 million and $16.1 million in consolidation for 2010 and 2009, respectively.

Corporate and Other Items

On July 16, 2010, Ambac completed the sale of its advisory services subsidiary, RangeMark Financial Services, Inc. (“RangeMark”) to the management of RangeMark, resulting in a realized loss of $0.5 million plus $4.0 million of goodwill impairment charges included in 2010 Corporate and Other Expense. Ambac will

 

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continue to contract with RangeMark for certain valuation services for a period of time. In October 2010, Ambac (Bermuda) Ltd. (“ABL”) requested and received permission from the Bermuda Monetary Authority to cancel ABL’s registration as a class 3 Bermuda Insurer. After approval of this application by the Bermuda Monetary Authority, $36.5 million was returned to Ambac.

Other Income. Other income was $1.7 million, $34.1 million and $3.3 million for 2010, 2009 and 2008, respectively. Included with other income for 2010 are (i) investment income from corporate investments, and (ii) RangeMark investment advisory, consulting and research services fees (prior to the sale in July 2010). Included within other income for 2009 are (i) investment income from corporate investments; (ii) distributions from a VIE consolidated under the relevant consolidation accounting guidance ($32.1 million earned in 2009), and (iii) RangeMark investment advisory, consulting and research services fees. Other income for 2008 includes only investment income from corporate investments.

Net Realized Investment Gains. Net realized investment gains were $10.2 million, $33 thousand and $0 for 2010, 2009 and 2008, respectively. Included in the year ended December 31, 2010 are gains of $10.7 million from the extinguishment of $20.3 million of Ambac’s 9.375% debentures and the $0.5 million loss from the sale of RangeMark. These Ambac debentures were acquired when Ambac entered into a series of debt for equity exchanges with certain holders of Ambac’s common stock. Ambac recognized a gain on the extinguishment of these debentures, which was the difference between the fair value of the new shares issued less than the net carrying value of the debentures.

Interest Expense. Interest expense was $102.3 million, $119.6 million and $114.2 million in 2010, 2009 and 2008, respectively. The decreased interest expense in 2010 is primarily due to Ambac’s Chapter 11 bankruptcy filing. Interest was no longer accrued after November 8, 2010. If Ambac had continued to accrue interest on its debt obligations, contractual interest expense would have been $113.6 million for 2010, compared to $114.2 million in 2009. This lower amount is primarily due to the debt for equity exchange noted above, partially offset by higher compounded interest related to the Directly Issued Subordinated Capital Securities Due 2087 (the “DISCs”). The increase in 2009 compared to 2008 is primarily attributable to the public offering of $250 million of Equity Units on March 12, 2008.

Corporate and Other Expenses. Corporate and Other expenses include the operating expenses of Ambac, and, for 2010 and 2009 only, RangeMark Financial Services. Corporate and Other expenses were $42.3 million, $18.2 million and $45.8 million in 2010, 2009 and 2008, respectively. The increases in 2010 are due to higher legal expenses, litigation provision, and higher RangeMark operating expenses ($8.6 million in 2010 vs. $4.7 million in 2009). The decrease in 2009 expenses compared with 2008 is primarily due to lower legal expenses, consulting expenses and lower contingent capital costs, as Ambac Assurance exercised its rights under the contingent capital facility in December 2008, partially offset by RangeMark operating expenses. Ambac’s contingent capital facility expense for 2010, 2009 and 2008 were $0, $0.3 million and $18.3 million, respectively.

Reorganization Items. Reorganization items are primarily expenses directly attributed to our Chapter 11 reorganization process. See Note 2 to the Consolidated Financial Statements in Item 8 of this Form 10-K for a summary of these costs. Reorganization items reported in 2010 included professional advisory fees and debt valuation adjustments on pre-petition liabilities. The debt valuation adjustments were one-time charges.

Provision for Income Taxes. Income taxes for 2010 were at an effective rate of 0.00%, compared to 102.0% and 0.2% for 2009 and 2008, respectively. The increase in the effective tax rates for 2009 relates predominantly to the set up of a full deferred tax valuation allowance against ordinary losses, partially offset by federal income tax refunds. See Critical Accounting Estimates—Valuation Allowance on Deferred Tax Assets for further information.

 

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Ambac Assurance Statutory Basis Financial Results

Ambac Assurance’s statutory financial statements are prepared on the basis of accounting practices prescribed or permitted by the OCI (“SAP”). OCI recognizes only statutory accounting practices prescribed or permitted by the State of Wisconsin for determining and reporting the financial condition and results of operations of an insurance company for determining its solvency under Wisconsin Insurance Law. The National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures manual (“NAIC SAP”) has been adopted as a component of prescribed practices by the State of Wisconsin.

On March 24, 2010, Ambac Assurance acquiesced to the request of OCI to establish a Segregated Account. Under Wisconsin insurance law, the Segregated Account is a separate insurer from Ambac Assurance and accordingly is subject to all of the filing and statutory reporting requirements of Wisconsin domiciled insurers. The purpose of the Segregated Account is to segregate certain segments of Ambac Assurance’s liabilities. The total assets, total liabilities, and total surplus of the Segregated Account are reported as discrete components of Ambac Assurance’s assets, liabilities, and surplus reported in Ambac Assurance’s statutory basis financial statements. Accordingly, Ambac Assurance’s statutory financial statements include the results of Ambac Assurance’s general account, the Segregated Account as well as Ambac Assurance’s equity investment in its subsidiaries.

At December 31, 2010, Ambac Assurance reported statutory capital and surplus of $1,026.9 million and contingency reserves of $512.6 million, respectively, as compared to $801.9 million and $352.2 million, respectively, at December 31, 2009. Ambac Assurance reported a statutory net loss of $1,471.9 million for the year ended December 31, 2010. The primary drivers of the statutory net loss were (i) statutory loss and loss expenses related primarily to Ambac Assurance’s RMBS financial guarantee portfolio for both initial defaults and continued deterioration in previously defaulted credits; (ii) impairment losses related to Ambac Assurance’s CDO of ABS transactions which were commuted during the second quarter of 2010; and (iii) impairment losses within Ambac Assurance’s investment portfolio driven by reduced pricing on certain previously impaired RMBS securities. These negative drivers were partially offset by (i) revenues (primarily premiums earned and investment income) generated during the period and (ii) the net income impact relating to the commutation of the AUK Reinsurance Agreement.

Statutory surplus is sensitive to: (i) further credit deterioration on the defaulted credits in the insured portfolio, (ii) deterioration in CDS exposures that give rise to further impairments, (iii) first time payment defaults of insured obligations, which increases statutory loss reserves, (iv) commutations of insurance policies or credit derivative contracts at amounts that differ from the amount of liabilities recorded, (v) reinsurance contract terminations at amounts that differ from net assets recorded, (vi) reductions in the fair value of previously impaired investments or additional downgrades of the ratings on investment securities to below investment grade by the independent rating agencies, (vii) settlements of representation and warranty breach claims at amounts that differ from amounts recorded, including failures to collect such amounts, (viii) issuance of Segregated Account Surplus Notes in settlement of presented and unpaid claims of the Segregated Account, (ix) intercompany loan impairments could change based on changes to interest rates and/or early terminations of investment agreements at amounts that differ from the amount of liabilities recorded, and (x) defaults by reinsurers.

The significant differences from U.S. GAAP are that under SAP:

 

   

Loss reserves are only established for losses on guaranteed obligations that have defaulted in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default, less estimated recoveries under subrogation rights (currently discounted at 5.10% as prescribed by OCI). Under U.S. GAAP, in addition to the establishment of loss reserves for defaulted obligations, loss reserves are established (net of U.S GAAP basis unearned premium reserves) for obligations that have experienced credit deterioration, but have not yet defaulted using a risk-free discount rate, currently at 3.02%.

 

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Mandatory contingency reserves are required based upon the type of obligation insured, whereas U.S. GAAP does not require such a reserve. Releases of the contingency reserves are generally subject to OCI approval and relate to a determination that the held reserves are deemed excessive.

 

   

Investment grade fixed income investments are stated at amortized cost and below investment grade fixed income investments are reported at the lower of amortized cost or fair value. Under U.S. GAAP, all bonds are reported at fair value.

 

   

Wholly owned subsidiaries are not consolidated; rather, the equity basis of accounting is utilized and the carrying values of these investments are subject to an admissibility test and permitted accounting practices. When Ambac Assurance’s share of the subsidiaries’ losses exceeds the related carrying amounts of the wholly owned subsidiary, Ambac Assurance discontinues applying the equity method and the investment is reduced to zero. For those subsidiaries that have insufficient claims paying resources and its obligations are guaranteed by Ambac Assurance, Ambac Assurance records an estimated impairment for probable losses which are in excess of the subsidiaries’ claims paying resources. Such impairments were recorded for our credit derivative subsidiary for periods prior to the Settlement Agreement. Under U.S. GAAP, credit derivatives are recorded at fair value, which is impacted by market valuations of the exposures and includes the effect of Ambac Assurance’s own credit in the measurement. This mark-to-market valuation often differs significantly from the statutory measure of impairment discussed above.

 

   

Variable interest entities are not required to be assessed for consolidation. Under U.S. GAAP, a reporting entity that has both the following characteristics is required to consolidate the VIE: a) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and b) the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. With regard to issuance of a financial guarantee insurance policy, Ambac generally has the obligation to absorb losses of VIEs that could potentially be significant to the VIE as the result of its guarantee of insured obligations issued by VIEs.

 

   

As a result of a prescribed practice by OCI, surplus notes issued in conjunction with commutations or the settlement of claims are included in Surplus at an amount equal to par regardless of the amounts received in consideration for issuance of the notes. Under U.S. GAAP, surplus notes are included in long-term debt obligations recorded at their estimated fair value and accrete up to face value via the effective interest method. The OCI has extended the preceding prescribed practice related to surplus notes to the evaluation of other-than-temporary impairments for Ambac Assurance guaranteed securities held in the investment portfolio. Under the NAIC SAP, the present value of cash flows expected to be collected will be equal the sum of the present value of (i) cash receipts and (ii) the fair value of surplus notes received from Ambac Assurance, as required under the Rehabilitation Plan. The Wisconsin Insurance Commissioner has directed Ambac Assurance to utilize par value rather than fair value of these surplus notes in this computation. Under U.S. GAAP, the present value of cash flows expected to be collected is equal to the sum of the present value of cash flows expected to be collected, plus the fair value of the surplus notes to be received from Ambac.

 

   

Upfront premiums written are earned on a basis proportionate to the remaining scheduled debt service to the original total principal and interest insured. Installment premiums are reflected in income pro rata over the period covered by the premium payment. Under U.S. GAAP, premium revenues for both upfront and installment premiums are earned over the life of the financial guarantee contract in proportion to the insured principal amount outstanding at each reporting date.

 

   

Costs related to the acquisition of new business are expensed as incurred, whereas under U.S. GAAP, the related costs are expensed over the periods in which the related premiums are earned; and

 

   

Deferred tax assets are reduced by a statutory valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized; any remaining net deferred tax asset is then subject

 

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to an admissibility test; whereas US GAAP only requires a valuation allowance if it is more likely than not that the deferred tax asset will not be realized.

LIQUIDITY AND CAPITAL RESOURCES

Ambac Financial Group, Inc. Liquidity. The matters described herein, to the extent that they relate to future events or expectations, may be significantly affected by Ambac’s Chapter 11 Bankruptcy filing. We believe the consummation of a successful restructuring under Chapter 11 of the Bankruptcy Code is critical to our continued viability and long term liquidity. As with any judicial proceeding, there are risks of unavoidable delay with a Chapter 11 proceeding and there are risks of objections from certain stakeholders, including objections from the holders of unsecured debt that vote to reject a plan of reorganization. Any material delay in the confirmation of a plan, or the threat of rejection of the plan by the Bankruptcy Court, would add expense as Ambac will be required to incur substantial costs for professional fees and other expenses associated with the administration of the Chapter 11 proceedings. A prolonged continuation of the Chapter 11 proceedings may also require us to seek financing. If we require financing during the Chapter 11 proceedings and we are unable to obtain the financing on favorable terms or at all, our chances of successfully reorganizing our businesses may be seriously jeopardized, and as a result, our assets and securities could become further devalued or worthless. While management believes that Ambac will have sufficient liquidity to satisfy its needs until it emerges from the bankruptcy proceeding, no guarantee can be given that it will be able to pay all such expenses. If its liquidity runs out prior to emergence from bankruptcy, a liquidation of Ambac pursuant to Chapter 7 of the Bankruptcy Code will occur.

Ambac’s liquidity and solvency is largely dependent upon: (i) Ambac Assurance’s ability to pay dividends; (ii) cash on hand; (iii) the level of costs associated with the reorganization; and (iv) the value of Ambac Assurance. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future. Ambac’s principal uses of liquidity during 2010 were for the payment of interest on its senior debt (until its Bankruptcy filing on November 8, 2010) and operating expenses. In addition, contingencies could cause additional liquidity strain. Ambac did not pay any dividends on its common stock in 2010. Beginning August 15, 2009, Ambac elected to defer interest payments on its $400 million of Directly Issued Subordinated Capital Securities Due 2087 (the “DISCS”). By deferring interest payments on the DISCS, Ambac reduced its 2010 cash debt service requirements by $24.6 million to $88.7 million. Total operating expenses, which include legal and other professional fees, trust and stock transfer/listing fees, and compensation costs, etc., equaled $33.1 million for 2010. Contingencies (e.g., an unfavorable outcome in the outstanding class action lawsuits) could cause material liquidity strains on Ambac.

The following table includes aggregated information about contractual obligations for Ambac and its subsidiaries. These obligations include payments due under specified contractual obligations, aggregated by type of contractual obligation, including claim payments, principal and interest payments under Ambac Assurance and Ambac Assurance Segregated Account’s surplus note obligations, investment agreement obligations, payment agreement obligations and payments due under operating leases. The table and commentary below reflect scheduled payments and maturities based on the original payment terms specified in the underlying agreements and contracts and exclude Liabilities subject to compromise which will be disbursed in accordance with our plan of reorganization.

 

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     Contractual Obligations by Year  

($ in millions)

   2011      2012      2013      2014      2015      Thereafter  

Surplus note obligations(1)

   $ 104.3       $ 104.6       $ 104.6       $ 104.6       $ 104.6       $ 2,572.8   

Investment agreement obligations(2)

     412.8         79.4         26.3         167.6         2.7         211.8   

Operating lease obligations(3)

     9.3         9.4         9.7         10.1         10.4         40.1   

Purchase obligations(4)

     3.5         1.5         493.1         —           68.3         175.1   

Post retirement benefits(5)

     0.3         0.3         0.4         0.4         0.4         2.9   

Loss and loss expense reserves(6)(9)

     2,464.8         1,104.5         623.0         459.7         295.0         4,762.0   

Impairment on credit default swaps(7)(9)

     —           7.3         —           —           —           43.7   

Other(8)

     —           —           —           —           —           23.0   
                                                     

Total

   $ 2,995.0       $ 1,307.0       $ 1,257.1       $ 742.4       $ 481.4       $ 7,831.4   
                                                     

 

(1) Includes principal of and interest on surplus notes, issued as of December 31, 2010, when due. All payments of principal and interest on Surplus Notes are subject to the prior approval of the OCI. If the OCI does not approve the payment of interest on the surplus notes, such interest will accrue and compound annually until paid.
(2) Includes principal of and interest on obligations using current rates for floating rate obligations. Certain investment agreements have contractual provisions that allow our counterparty the flexibility to withdraw funds prior to legal maturity date. Amounts included in the table are based on the earliest optional draw date.
(3) Amount represents future lease payments on lease agreements existing as of December 31, 2010. On March 1, 2011, Ambac entered into an agreement with the landlord to terminate the 1992 Lease for the office space at One State Street Plaza originally scheduled to expired in 2019 (“Settlement Agreement”) and entered into a new lease. The effective date of the Settlement Agreement and the new lease is subject to, among other things, the following: (i) the approval of the Settlement Agreement by the Rehabilitator, the Rehabilitation Court and the Boards of Directors of Ambac and Ambac Assurance, the OCI and the Bankruptcy Court and (ii) the approval of the new lease by the OCI and the Board of Directors of Ambac Assurance. The initial term of the new lease will end on December 31, 2015. If the Settlement Agreement and new lease were executed as of December 31, 2010 and effective as of March 1, 2011, the future lease payments in the table above would have been reduced by $3.8 million, $4.5 million, $4.8 million, $5.1 million, $5.4 million and $39.3 million for the years ended 2011, 2012, 2013, 2014, 2015 and thereafter, respectively. Refer to the Subsequent Event section located in Note 1 to the Consolidated Financial Statements for more information.
(4) Purchase obligations include the purchase of insured student loan obligations by Ambac Assurance, primarily variable rate demand obligations from liquidity providers as required by the terms of our insurance agreements. Amounts reflected in this table are the current outstanding par although actual ultimate payment amounts may differ primarily as a result of the successful execution of loss mitigation strategies, changes in interest rates, performance of the underlying collateral, the deterioration of the asset base and/or any amortization of the VRDO. Please refer to Financial Guarantees in Force located in Part 1 Item 1 in this Form 10-K. Additionally, Purchase obligations represent future expenditures for contractually scheduled fixed terms and amounts due for various technology related maintenance agreements, rating agency fees and other outside services.
(5) Amount represents future benefit payments on the postretirement benefit plans for the next 10 years (unfunded).
(6)

The timing of expected claim payments is based on deal specific cash flow payments, excluding expected recoveries and those student loan obligations as noted in Purchase obligations. These deal specific cash flow payments are based on the expected cash flows of the underlying transactions (e.g. for RMBS credits we model estimated future claim payments). The timing of expected claim payments for credits with reserves that were established using our statistical loss reserve method is determined based on the weighted average expected life of the exposure. Refer to the Loss Reserves section located in Note 2 of this Form 10-K for further discussion of our statistical loss reserve method. The timing of these payments may vary

 

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significantly from the amounts shown above, especially for credits that are based on our statistical loss reserve method. Claims on Segregated Account Policies remain subject to a payment moratorium until the Segregated Account Rehabilitation Plan becomes effective. Insurance claims presented during the moratorium of $1.4 billion for policies allocated to the Segregated Account have not yet been paid. Since the Rehabilitator has not established an effective date for the Rehabilitation Plan, we have not included such unpaid amounts in the table above, Under the Segregated Account Rehabilitation Plan, holders of permitted policy claims will receive 25% of their permitted claims in cash and 75% in Segregated Account Surplus Notes.

(7) Impairment amounts on CDS contracts represent Ambac’s expected loss payments on such contracts.
(8) Includes $23.0 million of unrecognized tax benefits that is not possible to make a reliable estimate about the period in which the payment may occur.
(9) Refer to 2010 Overview section in Note 1 to the Consolidated Financial Statements for discussion of insurance policies and credit default swaps transferred to the Segregated Account on March 24, 2010 and the settlement with respect to certain CDO-related obligations.

Ambac Assurance Liquidity. Ambac Assurance’s liquidity on a long-term basis is dependent on receipt of installment premiums on existing financial guarantees, principal and interest cash flows from investments, and the amount of required loss and commutation payments on both insurance and credit derivative contracts. The principal sources of Ambac Assurance’s liquidity are gross installment premiums on insurance and credit default swap contracts, investment coupon receipts, scheduled investment maturities, sales of investment securities, repayment of affiliate loans, claim recoveries from reinsurers and RMBS subrogation recoveries. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, loss and commutation payments on both insurance and credit derivative contracts, reinsurance premiums, surplus notes interest payments and additional loans to affiliates. As a result of the Segregated Account Rehabilitation Plan, claim payments on policies allocated to the Segregated Account will not be paid until the Segregated Account Rehabilitation Plan is declared effective.

Our ability to recover the RMBS subrogation recoveries is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties (and/or their respective parents and affiliates), timing of receipt of any such recoveries, regulatory intervention which could impede our ability to take actions required to realize such recoveries and uncertainty inherent in the assumptions used in estimating such recoveries. Our current estimate considers that we will receive subrogation recoveries of $900.2 million and $1,619.6 million in 2012 and 2013, respectively. The amount of these subrogation recoveries is significant and if we’re unable to recover any amounts our future available liquidity to pay claims would be reduced.

A subsidiary of Ambac Assurance provides a $360 million liquidity facility to a reinsurance company which acts as reinsurer with respect to a portfolio of life insurance policies. The liquidity facility, which is guaranteed by Ambac Assurance, provides temporary funding in the event that the reinsurance company’s capital is insufficient to make payments under the reinsurance agreement. The reinsurance is required to repay all amounts drawn under the liquidity facility. At December 31, 2010 and 2009, $8.8 million and $8.9 million were drawn on this liquidity facility, respectively. Therefore, at December 31, 2010 and December 31, 2009, the undrawn balance of the liquidity facility was $351.2 million and $351.1 million, respectively.

Ambac and its affiliates participate in leveraged lease transactions with municipalities, utilities and quasi-governmental agencies (collectively “lessees”), either directly or through various affiliated companies. Assets underlying these leveraged lease transactions involve equipment and facilities used by the lessees to provide basic public services such as mass transit and utilities. Ambac and its affiliates may provided one or more of the following financial products in these transactions: (i) credit default swaps, (ii) guarantees of the lessees’ termination payment obligations, (iii) loans, and (iv) investment agreements and payment agreements, both of which serve as collateral to economically defease portions of the lessees’ payment obligations in respect of termination payments.

 

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These transactions expose Ambac to the following risks:

 

   

Collateral posting requirements due to Ambac Assurance rating downgrade triggering events under certain agreements.

 

   

As a consequence of Ambac Assurance’s ratings downgrades, in some of the transactions the lessees are currently obligated to replace Ambac Assurance as credit enhancer, subject to waivers granted by the lessors. Failure of the waivers to be renewed followed by a failure to replace Ambac could result in a lease event of default and the requirement for a lessee to make a termination payment upon a demand by the lessor. Portions of any termination payments may be funded from the liquidation of the related defeasance collateral (i.e. payment agreements, investment agreements and/or other securities). To the extent a lessee fails to make a required termination payment, Ambac may be required to make a surety bond payment, or a swap settlement, under its guarantee policy or credit default swap, as applicable. The payment required under the Ambac credit enhancement will be based on the difference between the termination amount and the value derived from the defeasance collateral. Following a payment, Ambac would then be entitled to settle a credit default swap with the lessee or exercise its reimbursement rights against the lessee. In such circumstances Ambac, through subrogation or ownership in the leased assets, would have the right, along with other remedies, to liquidate the leased assets.

At December 31, 2010, Ambac Assurance’s aggregate financial enhancement exposure related to leveraged lease transactions that contain Ambac Assurance rating downgrade triggering events at December 31, 2010 was $572 million. Ambac Assurance’s exposure to these termination or swap settlement payments, net of defeasance collateral, was $432 million.

As a result of Ambac Assurance’s credit rating downgrades, seven lessees in these transactions may be required to replace Ambac Assurance as financial enhancement provider if waivers granted by the lessors are not renewed. There are four additional lessees that could be required to replace Ambac Assurance as financial enhancement provider in certain circumstances. In one case, Ambac Assurance’s replacement could be required upon the withdrawal of the guarantee provided by the lessee’s municipal owner. In another case, Ambac Assurance’s replacement could be required upon the rating downgrade of the second guarantor below a threshold level. In the other two cases, Ambac Assurance’s replacement could be required if the lessee withdrew additional collateral it has pledged to the lessor.

Ambac Assurance’s aggregate financial guarantee exposure to termination payments related to leveraged lease transactions that contain Ambac Assurance rating downgrade triggering events at December 31, 2009 was $889 million. Ambac Assurance’s financial guarantee exposure to these termination payments, net of defeasance collateral was $749 million, at December 31, 2009.

Ambac Assurance elected to defer dividend payments on its Auction Market Preferred Securities for dividend payment dates subsequent to January 15, 2010.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payments on investment and payment agreement obligations; payments on intercompany loans; payments under derivative contracts (primarily interest rate swaps, currency swaps and US Treasury futures); collateral posting; and operating expenses. Management believes that its Financial Services’ short and long-term liquidity needs can be funded from net investment income; the maturity of invested assets; sales of invested assets; intercompany loans from Ambac Assurance; and receipts from derivative contracts.

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of certain contingent withdrawal investment agreements, including those issued to entities that provide credit protection with respect to collateralized debt obligations. These entities issue credit linked-notes, invest a portion of the proceeds in the contingent withdrawal investment agreements and typically

 

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sell credit protection by issuing a credit default swap referencing specified asset-backed or corporate securities. Upon a credit event of one of the underlying reference obligations, the issuer may need to draw on the investment agreement to pay under the terms of the credit default swap. Accordingly, these investment agreements may be drawn prior to our original expectations, resulting in an unanticipated withdrawal. As of December 31, 2010, $0.6 billion of contingent withdrawal investment agreements issued to CDOs remained outstanding, of which $0.02 billion were related to CDOs with primarily RMBS underlying collateral. To manage the liquidity risk of unscheduled withdrawals, Ambac utilizes several tools, including regular surveillance of the related transactions. This surveillance process is customized for each investment agreement transaction and includes a review of past activity, recently issued trustee reports, reference name performance characteristics and third party tools to analyze early withdrawal risk.

Credit Ratings and Collateral. The significant rating downgrades of Ambac Assurance by Moody’s and S&P resulted in the triggering of required cure provisions in nearly all of the investment agreements issued. Most investment agreements contain multiple possible remedies, including collateral posting; a termination of the investment agreement contract, both of which demand significant liquidity; or the designation of a replacement guarantor. In most cases Ambac had the option to select the remedy and, therefore, could either post collateral or otherwise enhance its credit, prior to an actual draw on the investment agreement. In many cases, Ambac chose to terminate investment agreements, particularly when it was able to do so at levels that resulted in meaningful discounts to book value. In addition, Ambac has posted collateral of $845.6 million in connection with its outstanding investment agreements, including accrued interest, at December 31, 2010.

Ambac Financial Services (“AFS”) provided interest rate and currency swaps for states, municipalities, asset-backed issuers and other entities in connection with their financings. AFS hedges most of the related interest rate and currency risks of these instruments with standardized derivative contracts, which include collateral support agreements. Under these agreements, AFS is required to post collateral to a swap dealer to cover unrealized losses. In addition, AFS is often required to post collateral in excess of the amounts needed to cover unrealized losses, often referred to as an independent amount. Additionally, AFS hedges part of its interest rate risk with financial futures contracts which require it to post margin with its futures clearing merchant. All AFS derivative contracts possessing rating-based downgrade triggers that could result in collateral posting or a termination have been triggered. If additional terminations were to occur, it would generally result in a return of collateral to AFS in the form of cash, U.S. Treasury or U.S. government agency obligations with market values approximately equal to or in excess of market values of the swaps. In most cases, AFS will look to re-establish the hedge positions that are terminated early. This may result in additional collateral posting obligations or the use of futures contracts or other derivative instruments which could require AFS to post margin amounts. The amount of additional collateral required or margin posted on futures contracts will depend on several variables including the degree to which counterparties exercise their termination rights and the ability to replace these contracts with existing counterparties under existing documents and credit support arrangements. All contracts that require collateral posting are currently collateralized. Collateral and margin posted by AFS totaled a net amount of $117.4 million, including independent amounts, under these contracts at December 31, 2010.

Ambac Credit Products enters into credit derivative contracts. Ambac Credit Products was not required to post collateral under any of its contracts, except under a 2009 negotiated amendment of one credit derivative contract. This contract was commuted and settled in 2010.

While meaningful progress has been made in unwinding the Financial Services businesses, multiple sources of risk continue to exist. These include further deterioration in investment security market values, additional unexpected draws on outstanding investment agreements, the inability to unwind derivative hedge positions needed to settle investment agreement terminations, the settlement of potential swap terminations, and the inability to replace or establish new hedge positions.

Capital and Capital Support. In December 2008, Ambac Assurance exercised a series of perpetual put options on its own preferred stock (“the preferred stock”). The counterparty to these put options were trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to

 

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Ambac Assurance by allowing it to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. Ambac Assurance received $800 million in return for the issuance of the preferred stock. The auction for these securities occurs every 28 days. Due to the dislocation in the auction rate markets and Ambac Assurance’s downgrade below triple-A by Moody’s, the dividend rate on the auction market preferred has continuously been reset at the maximum rate of one-month LIBOR plus 200 bps. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Ambac Assurance’s Board of Directors has not declared cash dividend on the preferred stock for periods subsequent to July 31, 2009, except for the period December 23, 2009 through January 15, 2010. For the year ended December 31, 2008, Ambac Assurance incurred aggregate fees related to these perpetual put options of $18.3 million. The fees are included as Corporate expenses on the Consolidated Statements of Operations.

Balance Sheet. In 2010, total assets increased by approximately $10.2 billion, driven primarily by: (i) the impact of consolidating additional variable interest entities as a result of new accounting guidance effective January 1, 2010 ($14.7 billion); (ii) installment premium receipts on insurance and credit derivative transactions; and (iii) coupon payments on investment securities, partially offset by: (i) commutation payments, including the Settlement Agreement ($2.8 billion), (ii) payments for investment agreement contract maturities and settlements, and (iii) claim payments prior to the establishment of the Segregated Account and commencement of Segregated Account Rehabilitation Proceedings in March 2010. As of December 31, 2010, stockholders’ deficit was $1.35 billion, as compared to $1.63 billion deficit at December 31, 2009. This change was primarily caused by the additional net assets of consolidated VIEs resulting from the adoption of new accounting guidance in 2010 and improvements in fair value of investment securities during the period, partially offset by net losses.

Investment Portfolio. Ambac Assurance’s investment objectives for the Financial Guarantee portfolio are to achieve the highest yield on a diversified portfolio of fixed income investments while protecting claims-paying resources and satisfying liquidity needs. The Financial Guarantee investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits. Beginning in 2008, Ambac Assurance has opportunistically purchased Ambac Assurance insured securities in the open market given their relative risk/reward characteristics and to mitigate the effect of potential future claim payments on operating results. Ambac Assurance financial guarantee policies related to these securities have been placed in the Segregated Account. As such, future payments on these securities are subject to the Segregated Account Rehabilitation Plan and the market for securities may be less liquid than other assets within Ambac Assurance’s investment portfolio.

The Financial Services investment portfolio consists primarily of assets funded with proceeds from the issuance of investm