10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT

PURSUANT TO SECTION 13 OR 15(D) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended	Commission File Number
December 31, 2002	1-10777

Ambac Financial Group, Inc.

(Exact name of Registrant as specified in its charter)

Delaware	13-3621676
(State of incorporation)	(I.R.S. employer identification no.)
One State Street Plaza
New York, New York	10004
(Address of principal executive offices)	(Zip code)

(212) 668-0340

(Registrant’s telephone number, including area code)

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 and
Preferred Stock Purchase Rights	New York Stock Exchange, Inc.

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

None

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 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.  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)    Yes  x    No  ¨

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2002 was $7,021,552,722 (based upon the closing price of the Registrant’s shares of the New York Stock Exchange on that date, which was $67.20). 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 11, 2003, 106,069,280 shares of Common Stock, par value $0.01 per share, (net of (182,191 treasury shares) were outstanding.

Documents Incorporated By Reference

Portions of the Registrant’s Annual Report to Stockholders for the year ended December 31, 2002 are incorporated by reference into Parts II and IV hereof. Portions of the Registrant’s Proxy Statement dated March 28, 2003 in connection with the Annual Meeting of Stockholders scheduled to be held on May 6, 2003 are incorporated by reference into Part III hereof.

TABLE OF CONTENTS

		Page
PART I
Item 1.	Business	1
Item 2.	Properties	26
Item 3.	Legal Proceedings	26
Item 4.	Submission of Matters to a Vote of Security Holders	26
PART II
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	26
Item 6.	Selected Financial Data	26
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 8.	Financial Statements and Supplementary Data	27
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	27
PART III
Item 10.	Directors and Executive Officers of the Registrant	27
Item 11.	Executive Compensation	27
Item 12.	Security Ownership of Certain Beneficial Owners and Management	27
Item 13.	Certain Relationships and Related Transactions	28
Item 14.	Controls and Procedures	28
PART IV
Item 15.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	28
SIGNATURES		36
CERTIFICATIONS		37
FINANCIAL STATEMENT SCHEDULES		S-1

Part I

Item 1.     Business.

GENERAL

Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products and other financial services to clients in both the public and private sectors around the world. Ambac Financial Group was incorporated on April 29, 1991. Ambac Financial Group provides financial guarantees for public finance and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation. Through its financial services subsidiaries, Ambac Financial Group provides financial and investment products including investment agreements, interest rate and total return swaps, funding conduits, investment advisory and cash management services, principally to its clients which include municipalities and their authorities, school districts, health care organizations and asset-backed issuers. Information about Ambac Financial Group is available through our website at http://www.ambac.com. In addition, our press releases and filings with the Securities and Exchange Commission are available free of charge on the investor relations portion of our website.

Ambac Assurance, which serves the global capital markets, is primarily engaged in guaranteeing public finance and structured finance obligations and is the successor to the founding financial guarantee insurance company, which wrote the first bond insurance policy in 1971. Financial guarantee insurance policies written by Ambac Assurance generally guarantee payment when due of the principal of and interest on the guaranteed obligation. Ambac Assurance seeks to minimize the risk inherent in its financial guarantee portfolio by maintaining a diverse portfolio which spreads its risk across a number of criteria, including issue size, type of obligation, geographic area and obligor.

Ambac Assurance has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”), Fitch, Inc. (“Fitch”) and Rating and Investment Information, Inc. (“R&I”). These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement. See “Rating Agencies” below.

Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance, provides credit protection in the global markets in the form of structured credit derivatives. These structured credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation (generally a fixed income obligation). Upon a credit event, Ambac is required to either (i) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation or (ii), make a payment equivalent to the difference between the par value and market value of the underlying obligation. Substantially all of Ambac’s structured credit derivative contracts are partially hedged with various financial institutions or structured with first loss protection. Structured credit derivatives issued by Ambac Credit Products are insured by Ambac Assurance. See “Business Segments—Financial Guarantee” below and “Management’s Discussion and Analysis—Risk Management” in Ambac Financial Group’s 2002 Annual Report to Stockholders for more detail about structured credit derivatives.

Ambac Financial Group’s investment agreement business, conducted through its subsidiary, Ambac Capital Funding, Inc., provides investment agreements primarily to municipalities and their authorities, issuers of structured finance obligations and international

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issuers. Investment agreements issued by Ambac Capital Funding are insured by Ambac Assurance. Investment agreements are primarily used by issuers to invest bond proceeds until the proceeds can be used for their intended purpose. The investment agreement provides for the guaranteed return of principal invested, and for the payment of interest thereon at a guaranteed rate. See “Investment Agreements” below.

Ambac Financial Group provides interest rate swaps through its subsidiary Ambac Financial Services, L.P., primarily to states, municipalities and their authorities, issuers of asset-backed securities and other entities in connection with their financings. Ambac Financial Group also enters into total return swaps with professional counterparties through its subsidiary Ambac Capital Services LLC. Total return swaps are only used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria. See “Derivative Products” below.

Ambac Financial Group provides investment advisory, cash management and fund administration services through its subsidiary, Cadre Financial Services, Inc., and broker/dealer services through its subsidiary, Ambac Securities, Inc., primarily to school districts, hospitals and health care organizations, and municipalities.

As a holding company, Ambac Financial Group, Inc. is largely dependent on dividends from Ambac Assurance, its principal operating subsidiary, to pay dividends on its capital stock, to pay principal and interest on its indebtedness, to pay its operating expenses, to purchase its common stock in the open market and to make capital investments in its subsidiaries. Dividends from Ambac Assurance are subject to certain insurance regulatory restrictions. See “Insurance Regulatory Matters—Wisconsin Dividend Restrictions” below and “Management’s Discussion and Analysis—Liquidity and Capital Resources” in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Materials in this Form 10-K may contain information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements give Ambac Financial Group’s expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future operating or financial performance.

Any or all of our forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac Financial Group’s actual results may vary materially, and there are no guarantees about the performance of Ambac Financial Group’s securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) the policies and actions of the United States and other governments and (7) other risks and uncertainties that have not been identified at this time. Ambac Financial Group is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to consult any further disclosures we make on related subjects in Ambac Financial Group’s reports to the Securities and Exchange Commission (“SEC”).

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BUSINESS SEGMENTS

The following paragraphs describe the business operations of Ambac Financial Group, Inc. and its subsidiaries for its two reportable segments: Financial Guarantee and Financial Services.

Financial Guarantee

Generally, financial guarantee insurance written by Ambac Assurance guarantees to the holder of the underlying obligation timely payment of principal and interest by the issuer on such obligation in accordance with its original payment schedule.

Financial guarantee insurance is a form of credit enhancement that benefits both the issuer and the investor. Issuers benefit because their securities are sold with a higher credit rating than securities of the issuer sold without credit enhancement, resulting in interest cost savings and greater marketability. In addition, for complex financings and obligations of issuers that are not well known by investors, credit enhanced obligations receive greater market acceptance than obligations without credit enhancement. Investors benefit from greater marketability, secondary market price stability, active credit surveillance and protection from loss associated with issuer default.

Ambac Financial Group derives financial guarantee revenues from: (i) premiums earned over the life of the obligations guaranteed; (ii) net investment income; (iii) revenue from credit derivative transactions; (iv) net realized gains and losses from sales of investment securities; and (v) certain structuring and other fees. Financial guarantee revenues were $816.2 million, $672.0 million and $565.4 million in 2002, 2001 and 2000, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 17 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Financial guarantee products are 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. Total gross par guaranteed for the years ended December 31, 2002, 2001 and 2000 were $116.4 billion, $90.1 billion and $77.0 billion, respectively.

U. S. Public Finance Market

The U.S. public finance market includes taxable and tax-exempt bonds, notes and other evidences of indebtedness issued by states, political subdivisions (e.g., cities, counties and towns), water, sewer, electric and other utility districts, airports, higher educational institutions, hospitals, transportation and housing authorities and other similar authorities and agencies. 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. More recently, the public finance market has expanded to include structured, project finance and asset-backed bond issues for infrastructure projects, sports stadiums, and other municipal purposes. This portion of the market is growing and has become a focus for Ambac Financial Group in recent years. The following table sets forth the volume of new issues of long-term (longer than 12 months) public finance bonds and the volume of new issues of insured long-term public finance bonds over the past ten years in the United States.

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U.S. Public Finance Long-Term Market

	New Money		Refundings		Total Volume		Refundings as Percentage of Total Volume	Insured Volume		Insured Bonds as Percentage of Total Volume
	($ in Billions)
1993	$	142.1	$	150.1	$	292.2	51.4%	$	108.0	37.0%
1994		126.4		38.6		165.0	23.4		61.5	37.3
1995		126.1		33.9		160.0	21.1		68.5	42.8
1996		139.1		45.9		185.0	24.8		85.7	46.3
1997		160.3		60.2		220.5	27.3		107.5	48.8
1998		204.2		82.0		286.2	28.7		145.1	50.7
1999		189.1		38.3		227.4	16.8		105.3	46.3
2000		180.8		19.4		200.2	9.7		79.4	39.6
2001		222.8		62.9		285.7	22.0		132.2	46.3
2002		265.2		91.9		357.1	25.7		173.5	48.6

Source: Amounts, except for 2002, are based upon estimated data reported by The Bond Buyer’s 2002 Yearbook. The 2002 amounts are Ambac Assurance estimates, compiled from industry sources including Securities Data Company, Inc. and The Bond Buyer. Amounts represent gross par amounts issued or insured, respectively, during such year.

The foregoing table illustrates the changes in the total volume and insured volume of new issues of public finance bonds over the past ten years. Changes in volume of public finance bond issuance during this period are primarily attributable to changes in refunding activity related to the then-current interest rate environment, along with the issuers new money requirements. Insured volume, as a percentage of total volume, which had grown consistently from 1993 through 1998, declined during 1999 and 2000. The decline during 2000 is generally considered to have resulted from the combination of the relatively high credit quality of issues that came to market during the period and the firmness in premium pricing in the industry. During 2001 and 2002, this market has shown a resurgence, largely the result of the lower interest rate environment causing an increase in both the refinancing and new money components of the market. Also, the percentage of insured bonds increased, partially due to general credit concerns.

Ambac Assurance guaranteed gross par of $43.7 billion, $33.2 billion and $19.6 billion in 2002, 2001 and 2000, respectively, in the U.S. public finance market.

In the U.S. public finance market, an issuer typically pays an up-front premium to Ambac Assurance at the time the policy is issued. Premiums are usually quoted as a percentage of the total amount of principal and interest that is scheduled to become due during the life of the insured bonds.

Proposed new public finance bond issues are submitted to Ambac Assurance by issuers (or their investment bankers or financial advisors) to determine their suitability for financial guarantee. Public finance bond issues are sold on either a competitive or a negotiated basis. With respect to competitive issues, an issuer will publish a notice of sale soliciting bids for the purchase of a proposed issue of bonds. Potential bidders on the bonds then form syndicates. These syndicates then solicit a determination from some or all of the financial guarantors whether an issue is suitable for financial guarantee and at what premium rate and on what terms. The syndicate then determines whether to bid on the issue with a financial guarantee (and if so, with which financial guarantor) or without a financial guarantee. The issuer then generally selects the syndicate with the lowest bid. In a negotiated offering, the issuer has already selected an investment bank and that investment bank solicits premium quotes and terms from the financial guarantors.

Ambac Assurance also provides financial guarantees on public finance bonds outstanding in the secondary market that are typically purchased by an institution to facilitate

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the sale of bonds in its portfolio or inventory. The financial guarantee generally increases the sale price of bonds (typically by an amount greater than the cost of the policy) and affords a wider secondary market and therefore greater marketability to a given issue of previously issued bonds. As is the case with new issues, the premium is generally payable in full at the time of policy issuance. Ambac Assurance employs the same underwriting standards on secondary market issues that it does on new public finance issues.

As of December 31, 2002 and 2001, net outstanding par exposure related to public finance bond transactions was $206.5 billion and $185.0 billion, respectively. See “Financial Guarantees in Force—Types of Bonds” below, for a breakout of net outstanding par exposure by bond type.

U.S. Structured Finance and Asset-backed Market

Financial guarantees of securities in the U.S. structured finance and asset-backed market are typically issued in connection with transactions in which the securities being issued are secured by or payable from a specific pool of financial or tangible assets. This pool of assets has an identifiable cash flow or market value and is generally held by a special purpose issuing entity. Structured finance and asset-backed obligations insured by Ambac Assurance generally have the benefit of over-collateralization and/or other forms of credit enhancement to mitigate credit risks associated with the related assets. These forms of credit enhancement are designed to absorb the expected losses in these transactions.

Structured finance obligations include the securitization of a variety of asset types such as mortgages, home equity loans, leases and pooled debt obligations originated in the United States (“Structured Finance”). Currently, the largest component of Ambac’s Structured Finance business relates to the securitization of mortgages and home equity loans. Another target area in Structured Finance is the credit enhancement of pooled debt obligations known as collateralized debt obligations (“CDOs”) including cash flow CDOs and structured credit derivatives. These transactions involve the securitization of a portfolio of corporate bonds, loan obligations and asset-backed securities (the “Securitized Assets”). Ambac’s exposure to these Securitized Assets is mitigated through first loss protection. Typically, first loss protection is in the form of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), which allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations which have been guaranteed by Ambac.

Structured finance also encompasses credit enhancement for asset-backed commercial paper conduits (“conduits”). Conduits are used by issuers to efficiently fund assets in the short-term commercial paper market. Typically sponsored by financial institutions, the conduits typically purchase financial assets and asset-backed securities, and issue commercial paper to fund the purchase of the assets. The typical conduit structure provides Ambac with significant credit protection prior to a claim on Ambac’s insurance policy. A conduit requires program-wide credit enhancement as one of several elements needed to support the conduit’s credit rating for the structure, of which Ambac provides a senior portion.

Unlike the public finance market in which a substantial portion of the deals is bid competitively by the financial guarantors, the structured and asset-backed market is essentially a negotiated one. The financial guarantor will work directly with the investment bank or client to create an acceptable structure. Consequently, in addition to the types of deals listed above, structured finance will also include unique transactions and small market niches.

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The U.S. structured finance and asset-backed market in which Ambac Assurance provides financial guarantees is broad and varied, comprising public issues, private placements and asset-backed commercial paper. The increasing array of classes of assets securitized or guaranteed, and the recent rapid development of the market, makes estimating the size of the aggregate U.S. structured finance and asset-backed markets difficult. Two of the most developed sectors of this market are public asset-backed and mortgage-backed securities. According to Asset-Backed Alert, volume in U.S. public asset-backed and mortgage-backed securities combined totaled $626.4 billion and $474.7 billion in 2002 and 2001, respectively. Approximately 17% and 19% of those markets were insured in 2002 and 2001, respectively.

Premiums for structured finance and asset-backed policies are typically based on a percentage of principal insured. The timing of the collection of structured finance and asset-backed premiums can be collected in a single payment at policy inception date or collected periodically (e.g., monthly, quarterly or annually) from the cash flow generated by the underlying assets.

Ambac Assurance insured gross par of $47.5 billion, $37.4 billion and $33.9 billion in 2002, 2001 and 2000, respectively, in the U.S. Structured Finance and Asset-backed market.

As of December 31, 2002 and 2001, net outstanding par exposure related to U.S. structured finance and asset-backed transactions was $105.0 billion and $88.7 billion, respectively. See “Financial Guarantees in Force—Types of Bonds” below, for a breakout of net outstanding par exposure by bond type.

International Finance Market

Outside of the United States, structured and asset-backed issuers, utilities, sovereign and sub-sovereign issuers, and other issuers are increasingly using financial guarantee products, particularly in markets throughout Western Europe. A number of important trends in international finance markets have contributed to this expansion. In the United Kingdom, ongoing privatization efforts have shifted certain risks associated with the development or operation of infrastructure projects from the government to market participants, thus prompting investors in such projects to seek the security of financial guarantee products. In Europe, Australia, Japan and the Emerging Markets, there is growing interest in asset-backed securitization.

While the principles of securitization have been increasingly applied in overseas markets, development in particular countries has varied due to the sophistication of the local capital markets and the impact of legal and financial regulatory requirements. It is anticipated that securitization will continue to expand internationally, albeit at varying rates in each country. Ambac Assurance insures a wide array of obligations in the international finance markets including infrastructure finance, asset-backed and structured finance transactions, utilities, and other obligations in selected international finance markets.

Ambac Assurance’s strategy in the international finance markets is to strengthen its franchise in developed markets by focusing on high quality infrastructure, structured finance, securitization, and utility finance transactions, and in emerging markets by focusing on top tier future flow transactions (structured transactions secured by U.S Dollar cash flows generated from exports or payment remittances) and collateralized debt obligations.

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Ambac Assurance UK Limited, which is authorized to conduct certain classes of general financial guarantee business in the United Kingdom, has been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the United Kingdom and Europe. Ambac UK has entered into net worth maintenance and reinsurance agreements with Ambac Assurance, which support its triple-A ratings.

Ambac Assurance is party to an alliance in Japan with Sompo Japan Financial Guarantee Insurance Co., Ltd. (“Sompo Japan”), a monoline financial guarantor in Japan. Although the development of the Japanese securitization market has been slow, we believe that this alliance is competitively positioned for future growth.

While there is evidence that the volume of international structured finance transactions has increased significantly in the recent past, unlike the public finance and domestic asset-backed markets, there are few statistics that effectively track volume in the global markets. There are several reasons for this, including the varied nature of the deals coming to market, the early stages of development of certain asset classes and the fact that many international deals are privately placed.

Ambac Assurance guaranteed gross par of $25.2 billion, $19.5 billion and $23.5 billion in 2002, 2001 and 2000, respectively, in the international finance market. Premiums for international finance policies are based on a percentage of either principal or principal and interest insured. The timing of the collection of international finance premiums varies among individual transactions; some being collected in a single payment at policy inception date, and others being collected periodically (i.e., monthly, quarterly or annually).

As of December 31, 2002 and 2001, net outstanding par exposure related to international finance transactions was $67.7 billion and $44.3 billion, respectively. See “Financial Guarantees in Force—Types of Bonds” below, for a breakout of net outstanding par exposure by bond type.

Underwriting and Surveillance

Underwriting guidelines, policies and procedures have been developed by Ambac Assurance’s management with the intent that Ambac Assurance guarantee only those obligations which, in the opinion of Ambac Assurance underwriting officers, are of investment grade quality with a remote risk of loss. However, losses may occur from time to time and it is Ambac Assurance’s policy to provide for loss reserves that are adequate to cover potential losses. See “Losses and Reserves” below.

The underwriting process involves review of structural, legal, political and credit issues, including compliance with current Ambac Assurance underwriting standards. These standards are reviewed periodically by management. Additionally, the underwriting process often entails on-site due diligence covering the parties to the transaction, such as the issuer, originator, servicer or manager.

The decision to guarantee an issue is based upon such credit factors as the issuer’s ability to repay the bonds, the bond’s security features and the bond’s structure, rather than upon an actuarial prediction of the likelihood that the issuer will default on the underlying debt obligation.

Members of Ambac Assurance’s underwriting staff review all requests for guarantees. The underwriting process is designed to screen issues and begins with a credit analysis by the primary analyst assigned to the issue. The credit is then reviewed within the primary analyst’s

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underwriting group. At a minimum, the primary analyst’s recommendation to qualify or reject an issue must be approved by a concurring analyst and an underwriting officer. The number of additional approvals required for a particular credit depends in part on Ambac Assurance’s aggregate exposure to the credit. In some cases, the complexity of the credit or whether it is a new asset type are determining factors in the approval/review process. For large, complex or new types of credits, the underwriting decision must be approved by a credit committee comprised of senior underwriting officers and an attorney, in addition to the analysts and underwriting officer mentioned above.

Ambac Assurance assigns internal ratings to individual exposures as part of the underwriting process and at surveillance reviews. These internal ratings, which represent Ambac Assurance’s independent judgments, are based upon underlying credit parameters similar to those used by rating agencies.

Public Finance Underwriting:

In addition to general underwriting standards, each asset class, and bond type within asset class, has more specific underwriting criteria. For example, the critical risk factors for public finance credits will include the credit quality of the issuer, type of issue, the repayment source, the type of security pledged, the presence of restrictive covenants, and the bond’s maturity. Each bond issue is evaluated in accordance with, and the final premium rate is a function of, the particular factors as they relate to such issue.

Underwriting criteria that have been developed for each bond type reflect the differences in, for example, economic and social factors, debt management, project essentiality, financial management, legal and administrative factors, revenue sources and security features.

Structured Finance Underwriting:

Structured finance and asset-backed obligations generally entail three forms of risks: asset risk, which relates to the amount and quality of the underlying assets; structural risk, which relates to the extent to which the transaction’s legal structure provides protection from loss; and execution 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 addresses these risks through its credit underwriting guidelines, standards and procedures.

In general, the amount and quality of asset coverage required is determined by the historical performance of the underlying asset type or the transaction’s specific underlying assets. The future performance or value of the underlying pool of assets will generally determine whether the amount of over-collateralization or other credit enhancement ultimately is sufficient to protect investors, and therefore the guarantor, against adverse asset performance. The ability of the servicer or manager to properly service and/or manage the underlying assets often is a factor in determining future asset performance.

Structured and asset-backed securities are usually designed to 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 the special purpose issuing entity. Related issues that often arise concern whether the sale of the assets by the originator to the issuer of the asset-backed obligations would be respected in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or required to delay the remittance to investors of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings.

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Within the mortgage-backed and home equity loan market, Ambac Assurance seeks to work with higher quality, well-capitalized issuers. The issuers typically originate or purchase first lien mortgages, home equity loans or home equity lines of credit, which are in turn sold by the issuers in the form of asset-backed securities. In considering whether to guarantee these securities, Ambac Assurance analyzes the quality of the underlying assets, the structure of the securitization, the experience and financial strength of the servicer of the underlying assets and the credit quality of the issuer.

International Finance Underwriting:

In the international markets, Ambac Assurance seeks to guarantee transactions of the same high credit standards it applies in its U.S. business. However, an understanding of the unique risks related to the particular country and region that could impact the credit of the issuer is necessary. These risks include legal and political environments, capital market dynamics, foreign exchange issues, and the degree of governmental support. Ambac Assurance monitors these risks carefully and addresses them through its credit underwriting guidelines, (which include single party country limits), underwriting procedures and transaction documentation.

Geographically, the markets receiving Ambac Assurance’s primary international focus have been the United Kingdom, Australia, Japan, Germany and certain parts of Latin America. In addition, Ambac has guaranteed transactions in which the geographic risk is spread over multiple countries. The types of international obligations guaranteed have primarily been pooled debt obligations, asset-backed securities, special revenue and infrastructure obligations. Management believes that risk associated with its international book of business is similar in risk type to its domestic structured finance book of business and, in fact, international transactions may include components of domestic exposure.

Pricing:

Ambac Assurance determines premium rates on the basis of the type of transaction and its assessment of the risk it is assuming. Factors considered in pricing include term to maturity, structure of the issue, and credit and market factors including security features and other credit enhancement features. Additionally, the interest rate spread between insured and uninsured obligations with characteristics similar to those of the proposed bond issue is considered in the pricing process as well as the cost and the projected return to Ambac Assurance. The premium rate for a new issue also takes into account the benefits to be obtained by the issuer.

Surveillance and Remediation:

Surveillance analysts schedule and execute regular and ad hoc reviews of credits in the book of business. Risk-adjusted surveillance strategies have been developed for each transaction type. Review periods and scope of review vary by bond type based upon the risk inherent in the nature of the credits. The focus of the surveillance review is to determine credit trends and recommend appropriate classifications, ratings and review periods. Surveillance groups and other credit professionals review the financial guarantee portfolio for concentration of risk by (i) specific bond types; (ii) geographic location; and (iii) size of issue. The separate underwriting groups are also responsible for portfolio analysis which entails a broader examination of trends in specific asset classes and bond types.

Surveillance of the credit quality of underlying reference obligations in the Ambac Financial Group’s structured credit derivatives portfolio is performed on a regular basis. Credit spreads, which act as a measure of the market’s perception of an issuer’s credit quality, are monitored to identify potential problems. In addition, published credit ratings and current news reports are monitored regularly.

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Those issues that are either in default or have developed problems that eventually may lead to a claim or loss are tracked closely by the appropriate surveillance team. Relevant information, along with the schedule of corrective actions, is reviewed in the regular remedial credit meetings. Internal and/or outside counsel reviews the documents underlying any problem credit and 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. In many instances, Ambac Assurance, under the terms of the documents governing the underlying obligation, has the ability, among other things, to direct that audits be performed with respect to servicer and trustee contractual responsibilities.

The rating agencies also monitor the credits underlying Ambac Assurance’s financial guarantees in force and, in most cases, advise Ambac Assurance of the credit rating each transaction would receive if it were not insured.

Portfolio Risk Management Committee:

Ambac Financial Group has a Portfolio Risk Management Committee (“PRMC”) which has established various procedures and controls to monitor and manage credit risk. The Portfolio Risk Management Committee is comprised of senior risk management professionals and senior management of Ambac Financial Group. Its purview is enterprise-wide and its focus is on risk limits and measurement, concentration and correlation of risk, and the attribution of economic and regulatory capital in a portfolio context.

Financial Guarantees in Force

Ambac Assurance underwrites and prices financial guarantees on the assumption that the guarantee will remain in force until maturity of the underlying bonds. Ambac Assurance estimates that the average life of its guarantees on par in force at December 31, 2002 was 11 years. The 11 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 par guaranteed. No assumptions are made for future refundings of guaranteed issues.

Ambac Assurance seeks to maintain a diversified financial guarantee portfolio designed to spread its risk based on a variety of criteria, including issue size, type of bond, geographic area and issuer.

As of December 31, 2002, the total net par amount of guaranteed bonds outstanding was $379.2 billion.

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Types of Bonds

The table below shows the distribution by bond type of Ambac Assurance’s guaranteed portfolio as of December 31, 2002.

Guaranteed Portfolio by Bond Type

as of December 31, 2002

Bond Type	Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
	($ In Millions)
U.S. Public Finance:
Lease and tax-backed revenue	$	60,118	16%
General obligation		41,359	11
Utility revenue		33,289	9
Health care revenue		20,675	5
Transportation revenue		15,218	4
Higher education		14,138	4
Housing revenue		8,345	2
Student loans		7,629	2
Other		5,723	1
Total U.S. Public Finance		206,494	54
U.S. Structured Finance:
Mortgage-backed and home equity		49,262	13
Asset-backed and conduits		25,977	7
Investor-owned utilities		14,285	4
Pooled debt obligations (1)		9,178	2
Other		6,290	2
Total Structured Finance		104,992	28
Total Domestic.		311,486	82
International Finance:
Pooled debt obligations (1)		45,697	12
Asset-backed and conduits		9,232	2
Mortgage-backed and home equity		4,828	1
Investor-owned and public utilities		3,680	1
Sovereign/sub-sovereign		1,916	1
Other		2,372	1
Total International Finance		67,725	18
Grand Total	$	379,211	100%

(1) Pooled debt obligations include $43,701 of structured credit derivatives at December 31, 2002.

International Finance transactions includes components of domestic exposure.

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The table below shows the percentage, by bond type, of new business guaranteed by Ambac Assurance during each of the last three years.

New Business Guaranteed by Bond Type ⁽¹⁾

Bond Type	2002	2001	2000
U.S. Public Finance:
Lease and tax-backed revenue	12%	12%	11%
General obligation	6	6	4
Utility revenue	6	4	2
Transportation revenue	4	4	2
Higher education	3	3	1
Health care revenue	2	4	2
Housing revenue	2	1	1
Student loans	1	1	2
Other	1	1	1
Total U.S. Public Finance	37	36	26
U.S. Structured Finance:
Mortgage-backed and home equity	22	20	21
Asset-backed and conduits	10	11	14
Pooled debt obligations	3	4	2
Investor-owned utilities	3	3	2
Other	3	4	5
Total U.S. Structured Finance	41	42	44
Total Domestic	78	78	70
International Finance:
Pooled debt obligations	14	12	23
Asset-backed and conduits	4	4	4
Mortgage-backed and home equity	3	2	0
Investor-owned and public utilities	1	2	2
Sovereign/sub-sovereign	0	0	0
Other	0	2	1
Total International Finance	22	22	30
Grand Total	100 %	100 %	100 %

(1) Stated as a percentage of total gross par amounts guaranteed during such year.

Issue Size

Ambac Assurance seeks a broad coverage of the market by guaranteeing small and large issues alike. Ambac Assurance’s financial guarantee exposure as of December 31, 2002 reflects the historical emphasis on issues guaranteed with an original par amount of less than $25 million in the public finance market. However, U.S. structured finance and international finance transactions have an emphasis on larger deals. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2002, with respect to the original size of each guaranteed issue:

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Original Par Amount Per Issue

as of December 31, 2002

Original Par Amount	Number of Issues	% of Total Number of Issues	Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
			($ In Millions)
Less than $10 million	8,280	56%	$	27,257	7%
$10-25 million	2,892	20		36,367	10
$25-50 million	1,414	10		39,540	10
Greater than $50 million	2,049	14		276,047	73
	14,635	100%	$	379,211	100%

Geographic Area

Ambac Assurance is licensed to write business in the U.S. and abroad. As of December 31, 2002, the ten largest U.S. states, as measured by net par amount outstanding, accounted for approximately 37% of Ambac Assurance’s total net par amount outstanding. The following table sets forth the geographic distribution of Ambac Assurance’s insured exposure as of December 31, 2002.

Guaranteed Portfolio by Geographic Area as of December 31, 2002

Geographic Area	Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
	($ In Millions)
Domestic:
California	$	33,271	9%
New York		21,400	6
Florida		16,546	4
Pennsylvania		14,024	4
Texas		11,663	3
Illinois		9,972	3
New Jersey		9,568	2
Ohio		7,598	2
Massachusetts		7,569	2
Michigan		6,826	2
Mortgage and asset-backed		80,898	21
Other states		92,151	24
Total Domestic		311,486	82
International:
Germany		10,556	3
United Kingdom		9,289	2
Australia		2,486	1
Japan		2,393	1
France		1,001	—
Mexico		668	—
Internationally diversified		36,454	10
Other international		4,878	1
Total International		67,725	18
Grand Total	$	379,211	100%

Mortgage and asset-backed obligations include guarantees with multiple locations of risk within the United States. Internationally diversified includes pooled debt obligations which includes components of domestic exposure.

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Single Risk

Ambac Assurance has adopted underwriting and exposure management policies designed to limit the net guarantees in force for any one credit. In addition, Ambac Assurance uses reinsurance to limit net exposure to any one credit. As of December 31, 2002, Ambac Assurance’s net par amount outstanding for its 20 largest credits, totaling $17.7 billion, was approximately 4.7% of Ambac Assurance’s total net par amount outstanding with no one credit representing more than 1% of Ambac Assurance’s total net par amount outstanding. Ambac Assurance is also subject to certain regulatory limits and rating agency guidelines on exposure to a single credit. See “Insurance Regulatory Matters” and “Rating Agencies,” below.

Underlying Ratings

The following table sets forth Ambac Assurance’s financial guarantee portfolio by underlying rating prior to being guaranteed by Ambac Assurance, as of December 31, 2002:

Insured Portfolio by Underlying Rating ⁽¹⁾

as of December 31, 2002

Rating	Net Par Amount Outstanding		% of Total Net Par Amount Outstanding
	($ In millions)
AAA	$	38,877	10%
AA		78,524	21
A		171,874	45
BBB		85,561	23
Below investment grade		4,375	1
	$	379,211	100%

(1) Ratings represent Ambac Assurance internal ratings.

Losses and Reserves

Although there have been certain defaults in bond issues of substantial amounts, the incidence of default on public finance and structured finance bonds has historically been infrequent. The relatively low incidence of bond defaults is the result of many factors, including the high quality of issuers, the essentiality of the financed projects, funding, strong cash flow and legal structures. Ambac Assurance’s loss experience has been excellent historically, due to its adherence to strict underwriting standards within these already high quality markets. While this underwriting process has resulted in low loss rates historically, an increased level of defaults in the future may be caused by presently unforeseen economic and other factors.

Ambac Assurance’s policy is to provide for loss and loss adjustment expense reserves that are adequate to cover losses inherent in the portfolio, as well as losses that may arise from guaranteed obligations that have already defaulted. The active credit reserve is established based upon probable debt service defaults from incurred losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based upon management’s review of each credit. As of December 31, 2002, Ambac Assurance’s active credit reserve was $118.6 million. When a monetary default occurs with respect to a particular guaranteed obligation, a case basis credit reserve is established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and the estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. In estimating the losses on monetary defaults, Ambac

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Assurance makes its assessment based on the full term of the guaranteed obligation. All or part of the case basis credit reserve may be allocated from the available active credit reserve. Ambac Assurance’s net case basis credit reserves totaled $49.0 million at December 31, 2002.

The most recent three-year history of Ambac Assurance’s loss reserves, and losses and loss adjustment expenses incurred and paid, is detailed in the table below:

Reserve for Losses and Loss Adjustment Expenses

	Years Ended December 31,
	2002			2001			2000
	($ In Thousands)
Reserve for losses and loss adjustment expenses at January 1,	$	151,114		$	132,365		$	120,975
Less: reinsurance recoverable		1,021			1,011			—
Net reserve for losses and loss adjustment expenses at January 1,		150,093			131,354			120,975
Net provision for losses		26,700			20,000			15,000
Losses and loss adjustment expenses paid (net of salvage received)		(9,256	)		(1,261	)		(4,621	)
Net reserve for losses and loss adjustment expenses at December 31,		167,537			150,093			131,354
Plus: reinsurance recoverable		4,600			1,021			1,011
Reserve for losses and loss adjustment expenses at December 31,	$	172,137		$	151,114		$	132,365

Management of Ambac Assurance believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net costs of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 and Note 6 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Competition

The financial guarantee business is highly competitive. Ambac Assurance’s principal competitors in the market for financial guarantees are three other triple-A rated monoline insurance companies, Financial Guaranty Insurance Company, Financial Security Assurance Inc. and MBIA. In addition, banks, smaller and lower rated financial guarantee insurance companies, multiline insurers and reinsurers represent additional participants in the broader market. The principal competitive factors are: (i) premium rates; (ii) conditions precedent to the issuance of a policy related to the structure and security features of a proposed bond issue; (iii) the financial strength of the guarantor; and (iv) the quality of service provided to issuers, investors and other clients of the issuer. With respect to each of these competitive factors, Ambac Assurance believes it is on at least equal footing with each of its principal competitors.

Financial guarantee insurance also competes domestically and internationally with other forms of credit enhancement, including letters of credit and guarantees (for example, mortgage guarantees where pools of mortgages secure debt service payments) provided by banks and other financial institutions, some of which are governmental agencies. Letters of credit are most often issued for periods of less than 10 years, although there is no legal restriction on the issuance of letters of credit having longer terms. Thus, financial institutions and banks issuing letters of credit compete directly with Ambac Assurance to guarantee short-term notes and bonds with a maturity of less than 10 years.

In order to enter the financial guarantee market certain requirements must be met, most restrictive of which is that a significant minimum amount of capital is required of a financial guarantor in order to obtain financial strength ratings by the rating agencies. In addition, under

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the New York law, a monoline financial guaranty insurer must have at least $75 million of paid-in capital and surplus and maintain thereafter at least $65 million of policyholders’ surplus. A similar law in California imposes a $100 million minimum capital and surplus requirement, with a maintenance requirement thereafter of $75 million.

Reinsurance

State insurance laws and regulations (as well as the rating agencies) impose minimum capital requirements and single risk limits on financial guarantee insurance companies, limiting the aggregate amount of insurance which may be written and the maximum size of any single risk exposure which may be assumed. Such companies can use reinsurance to diversify risk, increase underwriting capacity, reduce additional capital needs, stabilize shareholder returns and strengthen financial ratios. See “Insurance Regulatory Matters,” below.

Ambac Assurance has facultative and treaty reinsurance agreements with reinsurers that allow Ambac Assurance to reduce its large risks, to manage its portfolio of insurance by bond type and geographic distribution, and to provide additional capacity for frequent bond issuers. In April 2001, Ambac Assurance entered into a new surplus share treaty in order to secure reinsurance on large domestic and international transactions. Additionally, Ambac Assurance utilizes facultative reinsurance when needed. A ceding commission is withheld by Ambac Assurance to defray its underwriting expenses.

As of December 31, 2002, Ambac Assurance had retained approximately 88% of its gross financial guarantees in force of $632.2 billion and had ceded approximately 12% to its reinsurers. The largest reinsurer accounts for 3% of gross financial guarantees in force. See Note 12 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2002 Annual Report to Stockholders.

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 with Ambac Assurance. To minimize its exposure to significant losses from reinsurer insolvencies, Ambac Assurance evaluates the financial condition of its reinsurers, prepares annual written reviews of such reinsurers and monitors for concentrations of credit risk. Ambac Assurance’s current primary reinsurers are Ace Guaranty Corporation, American Re-Insurance Company, AXA Re Finance, Radian Reinsurance Inc., Sompo Japan Financial Guarantee Insurance Co., Ltd., Ram Reinsurance Company, Ltd. and MBIA Insurance Corporation. See financial strength ratings located under the Ceded Premiums Written section of the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Rating Agencies

Moody’s, S&P, Fitch and Ratings & Investment periodically review the business and financial condition of Ambac Assurance and other companies providing financial guarantees. These rating agencies’ reviews focus on the guarantor’s underwriting policies and procedures and the quality of the obligations guaranteed. The rating agencies have access to all insured obligations and frequently perform assessments of the credits guaranteed by Ambac Assurance to confirm that Ambac Assurance continues to meet the capital allocation criteria considered necessary by the particular rating agency to maintain Ambac Assurance’s triple-A ratings. Ambac Assurance’s ratings have been periodically affirmed by each of the rating agencies and have never been revised downward or put on review for a possible downgrade. Moody’s and

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S&P’s ratings were last reaffirmed in 2002. Fitch’s rating was last reaffirmed in 2001, and Ratings and Investment’s rating was last reaffirmed in 2003. A rating by Moody’s, S&P, Fitch or Ratings & Investment, however, is not a “market rating” or a recommendation to buy, hold or sell any security. Ambac Assurance’s ability to attract new business or to compete with other triple-A rated financial guarantors, and its results of operations and financial condition, would be materially adversely affected by any reduction in its ratings.

Insurance Regulatory Matters

General Law

Ambac Assurance is licensed to transact financial guarantee and surety business as an insurance company in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico and the territory of Guam. Ambac Assurance is subject to the insurance laws and regulations of the State of Wisconsin (the “Wisconsin Insurance Laws”), its state of incorporation, and the insurance laws and regulations of other states in which it is licensed to transact business. These laws and regulations, as well as the level of supervisory authority that may be exercised by the various state insurance departments, vary by jurisdiction. They generally require financial guarantors to maintain minimum standards of business conduct and solvency, meet certain financial tests, file certain reports with regulatory authorities, including information concerning their capital structure, ownership and financial condition. They generally require prior approval of certain changes in control of domestic financial guarantors and their direct and indirect parents and the payment of certain dividends and distributions. In addition, these laws and regulations require approval of certain inter-corporate transfers of assets and certain transactions between financial guarantors and their direct and indirect parents and affiliates. They generally require that all such transactions have terms no less favorable than terms that would result from transactions between parties negotiating at arm’s length. Ambac Assurance is required to file quarterly and annual statutory financial statements in each jurisdiction in which it is licensed. It is subject to single and aggregate risk limits and other statutory restrictions concerning the types and quality of investments and the filing and use of policy forms and premium rates. Additionally, Ambac Assurance’s accounts and operations are subject to periodic examination by the Office of the Commissioner of Insurance of the State of Wisconsin (the “Wisconsin Commissioner”) and other state insurance regulatory authorities. See Note 9 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Ambac U.K., Ambac Assurance’s wholly owned subsidiary, is licensed to transact credit, suretyship and financial guarantee insurance in the United Kingdom and to offer insurance services into twelve other European countries. Ambac UK is subject to regulation by the Financial Services Authority (“FSA”) in the conduct of its insurance business. Under FSA regulations, Ambac UK is subject to certain requirements and limits, including risk assessments and the maintenance of a minimum margin of solvency. The FSA monitors each regulated insurance company through site visits and required annual financial filings. The FSA requires approval of related party transactions and requires that all such transactions have terms no less favorable than terms that would result from transactions between parties negotiating at arm’s length.

Ambac Financial Group believes that Ambac Assurance and Ambac U.K. are in material compliance with all applicable insurance laws and regulations.

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Insurance Holding Company Laws

Under the Wisconsin insurance holding company laws, any acquisition of control of Ambac Financial Group and thereby indirect control of Ambac Assurance requires the prior approval of the Wisconsin Commissioner. “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 Wisconsin Commissioner, upon application, determines otherwise. For purposes of this test, Ambac Financial Group 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 Financial Group would be deemed to have control of Ambac Assurance within the meaning of the Wisconsin Insurance Laws.

Pursuant to these laws, JP Morgan Chase obtained approval from the Wisconsin Insurance Commissioner to acquire greater than 10% of Ambac Financial Group’s outstanding stock. As of December 31, 2002, their percentage of ownership was approximately 10.3%. In their request for approval from the Wisconsin Commissioner, JP Morgan Chase disclaimed any present intention to exercise control over Ambac Financial Group or Ambac Assurance or to control or attempt to control the management or operations of Ambac Financial Group or Ambac Assurance.

The Wisconsin insurance holding company laws also require prior approval by the Wisconsin Commissioner of certain transactions between Ambac Assurance and companies affiliated with Ambac Assurance.

Wisconsin Dividend Restrictions

Pursuant to the Wisconsin Insurance Laws, Ambac Assurance may declare dividends, subject to any restriction in its articles of incorporation, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency, income and asset tests. Distributions to the shareholder (other than stock dividends) must be reported to the Wisconsin Commissioner. Extraordinary dividends must be reported prior to payment and are subject to disapproval by the Wisconsin Commissioner. 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.

During 2002, 2001 and 2000, Ambac Assurance paid to Ambac Financial Group, Inc. cash dividends on its common stock totaling $78.0 million, $68.0 million and $59.8 million, respectively. See Note 9 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Statutory Contingency Reserve

Ambac Assurance is required to establish a mandatory contingency reserve in accordance with the National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures manual (“NAIC SAP”) and the Wisconsin Administrative Code. Under

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NAIC SAP, financial guarantors are required to establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed depending on the category of obligation insured. However, under the Wisconsin Administrative Code, a municipal bond insurer is required to establish a contingency reserve consisting of 50% of earned premiums on policies of municipal bond insurance. The only exemption is when another jurisdiction in which the insurer is licensed requires a larger contingency reserve than required by the Wisconsin Administrative Code. Ambac Assurance calculates contributions using both methodologies and records the higher contribution amount. Contributions are required to be made in equal quarterly installments over a period of 20 years for municipal bonds and 15 years for all other obligations. Under NAIC SAP, contributions may be discontinued if the total reserve established for all categories exceeds the sum of the stated percentages contained therein multiplied by the unpaid principal balance. This reserve must be maintained for the periods specified above, except that the guarantor may be permitted to release reserves under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the guarantor’s outstanding guaranteed obligations, with notice to or approval by the insurance commissioner.

New York Financial Guarantee Insurance Law

New York’s comprehensive financial guarantee insurance law governs the conduct of business of all financial guarantors licensed to do business in New York, including Ambac Assurance. Financial guarantors are also required to maintain case basis credit loss and loss adjustment expense reserves and unearned premium reserves on a basis established by the regulations.

The New York financial guarantee insurance law establishes single risk limits with respect to obligations insured by financial guaranty insurers. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits generally compare the insured principal amount outstanding and/or average annual debt service on the insured obligations, net of reinsurance and collateral, for a single risk to the insurer’s qualified statutory capital, which is defined as the sum of the insurer’s policyholders’ surplus and contingency reserves. As of December 31, 2002 and 2001, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Aggregate risk limits are also established on the basis of aggregate net liability and policyholders’ surplus requirements. “Aggregate net liability” is defined as outstanding principal and interest of guaranteed obligations, net of reinsurance and collateral. Under these 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. The percentage varies from 0.33% for municipal bonds to 4.00% for certain non-investment grade obligations. As of December 31, 2002 and 2001, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Financial Guarantee Insurance Regulation in Other States

The Wisconsin insurance laws and regulations governing municipal bond guarantors are similar to those in New York. The Wisconsin regulations also include certain single and aggregate risk limitations. The average annual debt service for any single issue of municipal bonds may not exceed 10% of Ambac Assurance’s policyholders’ surplus. In addition, Ambac Assurance’s cumulative net liability, defined as one-third of one percent of the guaranteed

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unpaid principal and interest covered by current municipal bond insurance policies, may not exceed its qualified statutory capital, which is defined as the sum of its capital and surplus and contingency reserve.

California has financial guarantee insurance laws similar in structure to those of New York. None of the risk limits established in California’s legislation with respect to business transacted by Ambac Assurance are more stringent in any material respect than the corresponding provisions in the New York financial guarantee insurance statute.

In addition to the laws and regulations of New York, Wisconsin and California, Ambac Assurance is subject to laws and regulations of other states concerning the transaction of financial guarantees, none of which is more stringent in any material respect than the New York financial guarantee insurance statute.

Financial Services

Ambac Financial Group’s Financial Services segment provides financial and investment products including investment agreements; interest rate and total return swaps; funding conduits; investment advisory and cash management services, to municipalities and their authorities, school districts, health care organizations and asset-backed issuers.

Financial services revenues are primarily derived from: (i) gross investment income; (ii) net swap revenues; (iii) fund management and advisory revenues; and (iv) net realized gains and losses on sales of securities. Total revenues were $150.6 million, $284.6 million and $336.6 million in 2002, 2001 and 2000, respectively.

The principal competitive factors among providers of financial service products that Ambac Financial Group offers are: (1) pricing of contracts; (2) investment returns; (3) the financial strength of the financial guarantee provider; (4) the ability to provide services tailored to customers’ needs; and (5) the quality of service provided to customers. With respect to each of these competitive factors, Ambac Financial Group believes that it is on equal footing with its principal competitors.

Investment Agreements

The principal purpose of Ambac Capital Funding is providing investment agreements, including repurchase agreements, primarily to municipalities and their authorities and structured finance entities. Investment agreements are used by municipal bond issuers to invest bond proceeds until such proceeds can be used for their intended purpose, such as financing construction. Investment agreements used in structured financings provide a guaranteed investment return customized to meet expected cash flow requirements. The investment agreement provides for the guaranteed return of principal invested, as well as the payment of interest thereon at a guaranteed rate and is rated triple-A by virtue of Ambac Assurance’s financial guarantee policy, which guarantees its payment obligations.

Ambac Capital Funding manages its balance sheet to protect against a number of risks inherent in its business including liquidity, market (principally interest rate), credit, operational and legal risk. See “Management’s Discussion and Analysis—Risk Management” in Ambac Financial Group’s 2002 Annual Report to Stockholders. Ambac Capital Funding is managed with the goal of matching the payment schedule of the invested assets, including hedges, to the payment schedule of the investment agreement liabilities in order to minimize market and liquidity risk.

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A source of liquidity risk is the ability of some counterparties to withdraw moneys on dates other than those specified in the draw down schedule. Liquidity risk is somewhat mitigated by provisions in certain of the investment agreements that limit a counterparty’s ability to draw on the funds and by risk management procedures that require the regular re-evaluation and re-projection of draw down schedules. Investments are restricted to fixed income securities with a credit quality such that the overall minimum average portfolio credit quality is maintained at Aa/AA. Based upon management’s projections, Ambac Capital Funding maintains funds invested in cash and cash equivalents to meet short-term liquidity needs.

The following table sets forth the net payments due under Ambac Capital Funding’s settled investment agreements in each of the next five years ending December 31 and the period thereafter, based on expected call dates:

Investment Agreements Obligations

	Principal Amount (1)
	($ In Thousands)
2003	$1,575,150
2004	1,061,816
2005	415,068
2006	746,924
2007	638,338
All later years	1,790,583
	$6,227,879

(1) As of December 31, 2002, the interest rates on these agreements ranged from 1.25% to 8.14%.

Ambac Capital Funding may use interest rate swap contracts in the normal course of business for hedging purposes as part of its overall cash flow risk management. Some of its interest rate swap agreements have been entered into with its affiliate, Ambac Financial Services. Interest rate swap contracts are agreements where Ambac Capital Funding agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts or the difference between different interest rate indices calculated by reference to an agreed upon notional amount.

Derivative Products

Ambac Financial Services provides interest rate swaps and other derivative products primarily to states, municipalities and their authorities, issuers of asset-backed securities and other entities in connection with their financings. Ambac Financial Services generally hedges its transactions with clients to eliminate sensitivity to overall interest rates. On interest rate swaps for municipalities, Ambac Financial Services is subject to the risk of changes in the relationship between tax-exempt and taxable interest rates, referred to as “basis risk.” If actual or projected tax-exempt interest rates change in relation to taxable rates, Ambac Financial Services may experience a mark-to-market gain or loss. Most municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac Financial Group against certain forms of tax reform, thus mitigating its basis risk. The interest rate swaps provided by Ambac Financial Services are guaranteed by Ambac Assurance through policies that guarantee the obligations of Ambac Financial Services and its counterparties. Total return swaps, which are entered into by Ambac Capital Services, are only used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria.

Ambac Financial Services is a limited partnership. Ambac Assurance, the sole limited partner, owns a limited partnership interest representing 90% of the total partnership interests

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of Ambac Financial Services. Ambac Financial Services Holdings, Inc., a wholly-owned subsidiary of Ambac Financial Group, the sole general partner, owns a general partnership interest representing 10% of the total partnership interest in Ambac Financial Services. Ambac Capital Services is a wholly-owned subsidiary of Ambac Assurance.

Ambac Financial Services and Ambac Capital Services manage a variety of risks inherent in their 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 “Management’s Discussion and Analysis—Risk Management” in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Investment Advisory and Cash Management

Cadre Financial Services is registered as an investment adviser with the SEC. As a registered adviser, Cadre Financial Services is subject to regulation in certain aspects of its business, particularly with respect to investment advisory services provided to investment companies and clients. Cadre Financial Services provides investment advisory and administrative services to money market funds that are primarily offered to qualified participants, including school districts, health care service providers and municipalities.

Ambac Securities’ principal business is the distribution of money market funds to the education, health care and municipal sectors, as well as the brokering of short-term fixed income securities trades on behalf of its clients. It also serves as placement agent and dealer for securities issued by its affiliates in private placement transactions. Ambac Securities is registered as a broker-dealer with the SEC and with certain states that require such registration, and it is a member of the National Association of Securities Dealers, Inc. As a registered broker-dealer, Ambac Securities is subject to the net capital requirements of Rule 15c3-1 of the Securities Exchange Act of 1934, as amended, which is designed to measure the general financial condition and liquidity of a broker-dealer. In accordance with this rule, the ratio of aggregate indebtedness to net capital (“net capital ratio”) shall not exceed 15 to 1. At December 31, 2002, Ambac Securities had net capital of approximately $0.9 million, which was $0.8 million in excess of its required net capital of $100 thousand. The net capital ratio was 1.2 to 1.

At December 31, 2002, Cadre Financial Services and Ambac Securities provided services to approximately 2,800 clients with approximately $6.2 billion in assets.

Fees from the money market funds for which Cadre Financial Services and Ambac Securities perform services are based on percentages of the average daily net assets of such funds. Ambac Securities receives fees for brokering short-term fixed income securities trades by marking up the price of the securities purchased and sold on behalf of clients. These fees are recorded upon execution of the trades since, at that time, substantially all of Ambac Securities’ obligations have been fulfilled.

Investments and Investment Policy

As of December 31, 2002, the consolidated investments of Ambac Financial Group had an aggregate fair value of approximately $12.5 billion and an aggregate amortized cost of approximately $12.1 billion. These investments are managed internally by officers of Ambac Financial Group, who are experienced investment managers. All investments are effected in accordance with the general objectives and guidelines for investments established by each

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subsidiary’s Board of Directors. These guidelines encompass credit quality, risk concentration and holding period, and are periodically reviewed and revised as appropriate.

Pursuant to Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” Ambac Financial Group has designated all investments as “available-for-sale” and reports them at fair value. Unrealized gains and losses are excluded from earnings and reported as a component of “Accumulated Other Comprehensive Income (Loss)”, in stockholders’ equity, net of tax.

As of December 31, 2002, Ambac Assurance’s investment portfolio had an aggregate fair value of approximately $6.5 billion and an aggregate amortized cost of approximately $6.2 billion. Ambac Assurance’s investment policy is designed to achieve diversification of its portfolio and only permits investment in fixed income securities, consistent with its goal to achieve the highest after-tax, long-term return. This policy takes into consideration Ambac Assurance’s desire for both current income and long-term capital growth. Ambac Assurance 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 each specific investment transaction of Ambac Assurance. See “Insurance Regulatory Matters—General Law,” above.

As of December 31, 2002, the investment agreement business investment portfolio had an aggregate fair value of approximately $6.0 billion and an aggregate amortized cost of approximately $5.9 billion. Ambac Capital Funding’s investment policy is designed to achieve the highest after-tax return on equity, subject to minimum average quality ratings. For further discussion, see “Investment Agreements,” above.

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

Investments by Rating ⁽¹⁾

as of December 31, 2002

Rating	% of Investment Portfolio
AAA(2)	81 %
AA	9
A	6
BBB	2
Below investment grade	1
Not Rated	1
	100 %

(1) Ratings represent S&P classifications. If unavailable, Moody’s rating is used.

(2) Includes U.S. Treasury and agency obligations, which comprised approximately 29% of the total investment portfolio.

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Summary of Investments

As of December 31,

	2002			2001			2000
Investment Category	Carrying Value		Weighted Average Yield (1) (2)	Carrying Value		Weighted Average Yield (1) (2)	Carrying Value		Weighted Average Yield (1) (2)
	($ In Thousands)
Long-term investments:
Taxable bonds	$	7,424,907	5.33%	$	6,471,468	5.50%	$	4,945,457	6.62%
Tax-exempt bonds		4,716,288	5.19		3,399,217	5.47		3,119,044	5.77
Total long-term investments		12,141,195	5.28		9,870,685	5.49		8,064,501	6.29
Short-term investments (3):		395,761	1.28		415,002	2.25		253,519	6.30
Total	$	12,536,956	5.14%	$	10,285,687	5.35%	$	8,318,020	6.30%

(1) Yields presented include assets held in the Investment Agreement Business portfolio.

(2) Yields are stated on a pre-tax basis, based on average amortized cost.

(3) Includes taxable and tax-exempt investments.

Investments by Security Type

As of December 31,

	2002			2001			2000
Investment Category	Carrying Value		Weighted Average Yield (1) (2)	Carrying Value		Weighted Average Yield (1) (2)	Carrying Value		Weighted Average Yield (1) (2)
	($ In Thousands)
Municipal obligations (4)	$	4,887,902	5.24%	$	3,684,798	5.56%	$	3,414,964	5.85%
Corporate securities		1,569,314	5.46		1,330,589	6.66		980,746	7.47
Foreign government obligations		120,600	4.93		96,600	4.68		35,370	6.08
U.S. government obligations		108,193	4.27		78,254	5.65		72,709	6.08
Mortgage and asset-backed securities (includes U.S. government agency obligations) (3)		5,455,186	5.28		4,680,444	5.10		3,560,712	6.39
Total long-term investments		12,141,195	5.28		9,870,685	5.49		8,064,501	6.29
Short-term investments (4)		395,761	1.28		415,002	2.25		253,519	6.30
Total	$	12,536,956	5.14%	$	10,285,687	5.35%	$	8,318,020	6.30%

(1) Yields presented include assets held in the Investment Agreement Business portfolio.

(2) Yields are stated on a pre-tax basis, based on average amortized cost.

(3) The actual maturity dates of mortgage- and asset-backed securities are uncertain because the underlying mortgages may be paid prior to the stated maturity of such securities. This possibility of prepayment creates the risk that Ambac Financial Group will be unable to replace such investments with securities of comparable yield.

(4) Includes taxable and tax-exempt investments.

24

Distribution of Investments by Maturity

as of December 31, 2002

Maturity	Amortized Cost		Estimated Fair Value
	($ In Thousands)
Due in one year or less (1)	$	479,271	$	482,008
Due after one year through five years		796,429		824,868
Due after five years through ten years		895,574		960,295
Due after ten years		4,557,928		4,814,599
		6,729,202		7,081,770
Mortgage and asset-backed securities (2)		5,337,583		5,455,186
Total	$	12,066,785	$	12,536,956

(1) Includes securities with a fair value of $86.3 million, which are classified as long-term investments in the tables above but which mature within one year.

(2) The actual maturity dates of mortgage and asset-backed securities are uncertain because the underlying mortgages may be paid prior to the stated maturity of such securities. This possibility of prepayment creates the risk that Ambac Financial Group will be unable to replace such investments with securities of comparable yield.

For further discussion, see Note 2 and 3 of Notes to Consolidated Financial Statements in Ambac Financial Group’s 2002 Annual Report to Stockholders.

Recent Debt Issuance and Debt Retirement

On February 28, 2003, Ambac Financial Group issued $200 million of 5.95% Debentures due February 28, 2103. The Debentures were priced at par and are callable at par on or after February 28, 2008. The Debentures are rated Aa2 and AA by Moody’s and S&P, respectively. Interest is payable on March 31, June 30, September 30 and December 31. The proceeds from this issuance will be used for general corporate purposes, including additions of working capital to subsidiaries.

On March 24, 2003, Ambac Financial Group issued $175 million of 5.875% debentures due March 24, 2103. The Debentures were priced at par and are callable at par on or after March 24, 2008. The Debentures are rated Aa2 and AA by Moody’s and S&P, respectively. Interest is payable on March 31, June 30, September 30 and December 31. The primary purpose of this debt issuance was to refinance at a lower interest rate the 7.08% Debentures (discussed below).

On March 24, 2003, Ambac Financial Group exercised its option to call at par, the $200 million 7.08% Debentures due in 2098. Deferred debt issuance costs amounting to $6.5 million will be expensed when the call is settled early in the second quarter of 2003.

Employees

As of December 31, 2002, Ambac Financial Group and its subsidiaries had 391 employees. None of the employees are covered by collective bargaining agreements. Ambac Financial Group considers its employee relations to be satisfactory.

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Item 2.     Properties.

The principal executive offices of Ambac Financial Group are located at One State Street Plaza, New York, New York 10004. The telephone number is (212) 668-0340.

Ambac Assurance, Ambac Capital Funding, Ambac Financial Services and Ambac Capital Services maintains its principal executive offices 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 on September 30, 2019. Ambac Assurance maintains other locations at Otemachi Financial Center 17th Floor, 5-4, Otemachi 1-chome, Chiyoda-ku, Tokyo 100-0004, Japan and at ABN AMRO Tower, L31, 88 Phillip Street, Sydney 2000 NSW, Australia. Both locations consist of approximately 1,000 square feet of office space.

Ambac UK maintains its principal offices at Hasilwood House, 60 Bishopsgate, London EC2N4BE, England, which consists of 7,100 square feet of office space, under an agreement that expires in December 2006.

Cadre Financial Services and Ambac Securities maintains its principal executive office at 905 Marconi Avenue, Ronkonkoma, New York 11779. Cadre Financial Services owns the office building. It consists of approximately 15,000 square feet of office space and storage.

Item 3.     Legal Proceedings.

There are no material lawsuits pending, or to the knowledge of Ambac Financial Group threatened, to which Ambac Financial Group or any of its majority-owned subsidiaries is a party.

Item 4.     Submission of Matters to a Vote of Security-Holders.

There were no matters submitted to a vote of security holders during the fourth quarter of 2002.

Part II

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

Information relating to the principal market on which Ambac Financial Group’s Common Stock is tradable, the high and low sales prices per share for each full quarterly period within the two most recent fiscal years, and the frequency and amount of any cash dividends declared for the two most recent fiscal years is set forth on the inside back cover of Ambac Financial Group’s 2002 Annual Report to Stockholders and such information is incorporated herein by reference. Information concerning restrictions on the payment of dividends is set forth in Item 1 above under the caption “Insurance Regulatory Matters—Wisconsin Dividend Restrictions.” As of March 11, 2003, there were 78 stockholders of record of Ambac Financial Group’s Common Stock, which is listed on the New York Stock Exchange.

Item 6.     Selected Financial Data.

Selected financial data for Ambac Financial Group and its subsidiaries for each of the last ten fiscal years is set forth under the captions “10-Year Performance” and “Financial Highlights” on pages 4 and 5 and pages 6 and 7, respectively, of Ambac Financial Group’s 2002 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 42 through 65 of such Annual Report.

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations is set forth under the same caption on pages 25 through 40 of Ambac Financial Group’s 2002 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 42 through 65 of such Annual Report.

Item 7A.     Quantitative and Qualitative Disclosures About Market Risk.

Quantitative and Qualitative Disclosures About Market Risk is set forth under the caption Risk Management on pages 38 to 40 of Ambac Financial Group’s 2002 Annual Report to Stockholders. Such information is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 42 to 65 of such Annual Report.

Item 8.     Financial Statements and Supplementary Data.

The 2002 Consolidated Financial Statements, together with the Notes thereto and the Independent Auditors’ Report thereon, are set forth on pages 41 through 65 of Ambac Financial Group’s 2002 Annual Report to Stockholders. Such information is incorporated herein by reference.

Item 9.     Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

Part III

Item 10.     Directors and Executive Officers of the Registrant.

Information relating to Ambac Financial Group’s directors and executive officers is set forth on pages 8, 15, 16, 31 and 32 of Ambac Financial Group’s 2003 Proxy Statement and such information is incorporated herein by reference.

Item 11.     Executive Compensation.

Information relating to compensation of Ambac Financial Group’s directors and executive officers is set forth on pages 10 to 12 and on pages 17 to 24 of Ambac Financial Group’s 2003 Proxy Statement and such information is incorporated herein by reference.

Item 12.     Security Ownership of Certain Beneficial Owners and Management.

Information relating to security ownership of certain beneficial owners and management is set forth on pages 6 to 8 of Ambac Financial Group’s 2003 Proxy Statement and such information is incorporated herein by reference.

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Item 13.     Certain Relationships and Related Transactions.

None.

Part IV

Item 14.     Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures.    Ambac’s Chief Executive Officer and Chief Financial Officer completed an evaluation of the effectiveness of Ambac’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on this evaluation, Ambac’s Chief Executive Officer and Ambac’s Chief Financial Officer have concluded that, as of the Evaluation Date, Ambac’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Ambac (including its consolidated subsidiaries) required to be included in Ambac’s reports filed or submitted under the Exchange Act.

(b) Changes in Internal Controls.    Since the Evaluation Date, there have not been any significant changes in Ambac’s internal controls or in other factors that could significantly affect such controls. There were no significant deficiencies or material weaknesses identified in the evaluation and therefore, no corrective actions were taken.

Item 15.     Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

(a) Documents filed as a part of this report:

1. Financial Statements

The following consolidated financial statements included in the 2002 Annual Report to Stockholders are incorporated herein by reference under Part II, Item 8:

	Page Number In Annual Report
Independent Auditors’ Report	41
Consolidated Balance Sheets as of December 31, 2002 and 2001	42
Consolidated Statements of Operations for each of the years ended December 31, 2002, 2001 and 2000.	43
Consolidated Statements of Stockholders’ Equity for each of the years ended December 31, 2002, 2001 and 2000.	44
Consolidated Statements of Cash Flows for each of the years ended December 31, 2002, 2001 and 2000	45
Notes to Consolidated Financial Statements	46-65

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2. Financial Statement Schedules

The financial statement schedules filed herein, which are the only schedules required to be filed, are as follows:

Independent Auditors’ Report			(Page S-1)
Schedule I	—	Summary of Investments Other Than Investments in Related Parties	(Page S-2)
Schedule II	—	Condensed Financial Information of Registrant (Parent Company Only)	(Pages S-3 to S-7)
Schedule IV	—	Reinsurance	(Page S-8)

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3. Exhibits

The following items are annexed as exhibits:

Exhibit Number	Description
3.01	Conformed Amended and Restated Certificate of Incorporation of the Company filed with the Secretary of State of the State of Delaware on July 11, 1997. (Filed as Exhibit 4.05 to the Company’s Quarterly Report for the quarter ended September 30, 1997 and incorporated herein by reference.)
3.02	Conformed Copy of the Certificate of Amendment to the Amended and Restated Certificate of Incorporation of the Company filed with the Secretary of State of the State of Delaware on May 13, 1998. (Filed as Exhibit 4.04 to the Company’s Quarterly Report for the quarter ended June 30, 1998 and incorporated herein by reference.)
3.03	By-laws of the Company, as amended through January 28, 1998. (Filed as Exhibit 3.02 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
4.01	Definitive Engraved Stock Certificate representing shares of Common Stock. (Filed as Exhibit 4.01 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
4.02	Indenture, dated as of August 1, 1991, between the Company and The Chase Manhattan Bank (National Association), Trustee. (Filed as Exhibit 4.01 to the Company’s Registration Statement on Form S-3 (Reg. No. 33-59290) and incorporated herein by reference.)
4.03	Indenture dated as of April 1, 1998, between the Company and First Union National Bank, Trustee. (Filed as Exhibit 5.2 to the Company’s Current Report on Form 8-K dated April 1, 1998 and incorporated herein by reference.)
4.04	Rights Agreement, dated as of January 31, 1996, between Ambac Financial Group, Inc. and Citibank N.A., as Rights Agent, including all exhibits thereto. (Filed as Exhibit 1 to the Company’s Registration Statement on Form 8-A dated February 27, 1996 and incorporated herein by reference.)
4.05	Form of 9.38% Debenture due August 1, 2011. (Filed as Exhibit 4.02 to the Registration Statement on Form S-1 (Reg. No. 33-40385) and incorporated herein by reference.)
4.06	Form of 7.50% Debenture due May 1, 2023. (Filed as Exhibit 4.06 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1998 and incorporated herein by reference.)
4.07	Form of 7.08% Debenture due March 31, 2098. (Filed as Exhibit 5.3 to the Company’s Current Report on Form 8-K dated April 1, 1998 and incorporated herein by reference.)
4.08	Form of 7.00% Debenture due October 17, 2051. (Filed as Exhibit 1 to the Company’s Registration Statement on Form 8-A dated October 26, 2001 and incorporated herein by reference.)

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Exhibit Number	Description
4.09	Form of 5.95% Debenture due February 28, 2103 (Filed as Exhibit 2 to the Company’s Registration Statement on Form 8-A dated February 26, 2003 and incorporated herein by reference.)
4.10	Indenture dated as of August 24, 2001 between Ambac Financial Group and the Chase Manhattan Bank as trustee. (Filed as Exhibit 4.1 to the Company’s Amendment No. 2 to Registration Statement on Form S-3 (Reg. No. 333-57206) and incorporated herein by reference.)
10.01*	Second Amended and Restated Employment Agreement dated as of December 2, 1997, between the Company and Phillip B. Lassiter. (Filed as Exhibit 10.01 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.02*	Ambac Financial Group, Inc. 1991 Stock Incentive Plan, as amended as of December 2, 1997 (Filed as Exhibit 10.02 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference.)
10.03*	Ambac Financial Group, Inc. 1997 Equity Plan, amended as of December 12, 2000. (Filed as Exhibit 10.03 to Ambac Financial Group’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.04*	Ambac Financial Group, Inc. 1991 Non-Employee Directors Stock Plan (Filed as Exhibit 10.09 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference.)
10.05*	Ambac Financial Group, Inc. 1997 Non-Employee Directors Equity Plan. (as amended through December 12, 2000.) (Filed as Exhibit 10.05 to Ambac Financial Group’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.06*	Ambac Financial Group, Inc. 1997 Executive Incentive Plan, amended as of January 1, 2000. (Filed as Exhibit 10.23 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2000 and incorporated herein by reference.)
10.07*	Ambac Financial Group, Inc. Deferred Compensation Plan for Outside Directors, effective as of December 1, 1993 as amended through October 15, 2002.
10.08*	Ambac Financial Group, Inc. 1997 Equity Plan Senior Officer Deferred Compensation Sub-Plan of the 1997 Equity Plan effective as of October 26, 1999 (Filed as Exhibit 10.27 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1999 and incorporated herein by reference.)
10.09*	Form of Amended and Restated Management Retention Agreement dated as of December 2, 1997. (Filed as Exhibit 10.08 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)

* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.

31

Exhibit Number	Description
10.10*	The Ambac Financial Group, Inc. Non-Qualified Savings Incentive Plan (effective as of January 1, 1995). (Filed as Exhibit 10.16 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.)
10.11*	Amendment Number 1 to the Ambac Financial Group, Inc. Non-Qualified Savings Incentive Plan effective as of April 30, 1997. (Filed as Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.12*	Ambac Financial Group, Inc. Excess Benefits Pension Plan (Amended and Restated as of January 1, 1994) (As amended through October 25, 1995). (Filed as Exhibit 10.17 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.)
10.13*	Amendment Number 1 to the Ambac Financial Group, Inc. Excess Benefits Pension Plan effective as of April 30, 1997. (Filed as Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.14*	Supplemental Pension Agreement between the Company and Philip B. Lassiter dated April 30, 1997. (Filed as Exhibit 10.24 in the Company’s Quarterly Report Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.)
10.15*	Supplemental Pension Agreement between the Company and David L. Boyle dated April 30, 1997. (Filed as Exhibit 10.25 in the Company’s Quarterly Report Form 10-Q for the quarter ended June 30, 1997, and incorporated herein by reference.)
10.16*	Ambac Financial Group, Inc. Supplemental Pension Plan (Amended and Restated as of January 1, 1995) (As amended through October 25, 1995). (Filed as Exhibit 10.18 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1995, and incorporated herein by reference.)
10.17*	Amendment Number 1 to the Ambac Financial Group, Inc. Supplemental Pension Plan effective as of April 30, 1997. (Filed as Exhibit 10.18 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)
10.18	Lease Agreement, dated as of January 1, 1992 between South Ferry Building Company and Ambac Assurance Corporation. (Filed as Exhibit 10.36 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 and incorporated herein by reference.)
10.19	Amendment to Lease Agreement dated August 1, 1997 between South Ferry Building Company and Ambac Assurance Corporation. (Filed as Exhibit 10.20 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.)

* Management contract or compensatory plan, contract or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.

32

Exhibit Number	Description
10.20	Amendment to Lease Agreement dated December 23, 2002 between South Ferry Building Company and Ambac Assurance Corporation.
10.21	Tax Settlement Agreement, dated as of March 30, 1993, among Citicorp, Citibank, N.A., Citicorp Financial Guaranty Holdings, Inc., Ambac Financial Group, Inc., Ambac Assurance Corporation, American Municipal Bond Holding Company and Health Care Investment Analysts, Inc. (Filed as Exhibit 10.02 to the Company’s Registration Statement on Form S-3 (Registration No. 33-59290) and incorporated herein by reference.)
10.22	Conformed Copy of U.S. $300,000,000 Revolving Credit Agreement, dated as of August 1, 2002 (the “BNS Credit Agreement”) among the Company and Ambac Assurance Corporation as the Borrowers, the banks, financial institutions and other institutional lenders as are or may become parties hereto, as the Lenders, The Bank of New York as the Syndication Agent and the Bank of Nova Scotia, as the Administrative Agent. (Filed as Exhibit 10.31 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2002 and incorporated herein by reference.)
10.23	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust I, dated as of December 3, 2001. (Filed as Exhibit 10.27 to Ambac Financial Group’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.24	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust II, dated as of December 3, 2001. (Filed as Exhibit 10.28 to Ambac Financial Group’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.25	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust III, dated as of December 3, 2001. (Filed as Exhibit 10.29 to Ambac Financial Group’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.26	Put Option Agreement between Ambac Assurance Corporation and Dutch Harbor Finance Master Trust, on Behalf of its Series Dutch Harbor Finance Sub-Trust IV, dated as of December 3, 2001. (Filed as Exhibit 10.30 to Ambac Financial Group’s Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.)
10.27	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust I, dated May 23, 2002.
10.28	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust II, dated May 23, 2002.

33

Exhibit Number	Description
10.29	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust III, dated May 23, 2002.
10.30	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust IV, dated May 23, 2002.
12.01	Statement re computation of ratios.
13.01	Certain portions of the Annual Report to Stockholders for the fiscal year ended December 31, 2002 (Pages 4-7, pages 25-65 and the inside back cover).
21.01	List of Subsidiaries of Ambac Financial Group, Inc.
24.01	Power of Attorney from Phillip B. Lassiter.
24.02	Power of Attorney from Michael A. Callen.
24.03	Power of Attorney from Renso L. Caporali.
24.04	Power of Attorney from Jill M. Considine.
24.05	Power of Attorney from Richard Dulude.
24.06	Power of Attorney from Thomas J. Gandolfo.
24.07	Power of Attorney from Robert J. Genader.
24.08	Power of Attorney from W. Grant Gregory.
24.09	Power of Attorney from Laura S. Unger.
99.01	Ambac Assurance Corporation and Subsidiaries Consolidated Financial Statements (with independent auditors’ report thereon) as of December 31, 2002 and 2001.
99.02	Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.03	Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

34

(b)    Reports on Form 8-K:

On November 20, 2002, Ambac Financial Group Inc. filed a Current Report on Form 8-K with its November 18, 2002 press release containing information regarding a write-down relating to impairment on a note it owns in its financial services investment portfolio. On January 24, 2003, Ambac Financial Group, Inc. filed a Current Report on Form 8-K with its January 23, 2003 press release containing unaudited financial information and accompanying discussion for the three months ended December 31, 2002 and the year ended December 31, 2002. On February 28, 2003, Ambac Financial Group, Inc. filed a Current Report on Form 8-K with its February 25, 2003 press release announcing the issuance of $200 million of 5.95% Debentures due February 28, 2103. On March 4, 2003, Ambac Financial Group, Inc. filed a Current Report on Form 8-K disclosing copies of the Underwriting Agreement and Terms Agreement dated February 25, 2003 associated with the issuance of $200 million of 5.95% Debentures due February 28, 2103. On March 20, 2003, Ambac Financial Group, Inc. files a Current Report on Form 8-K with its press releases of March 18, 2003 and March 20, 2003 announcing a debenture offering and intention to call $200 million of long-term debentures and announcing the offering of $175 million in long-term debentures, respectively.

35

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	AMBAC FINANCIAL GROUP, INC. (Registrant)
Dated: March 28, 2003	By:	/S/    THOMAS J. GANDOLFO
	Name:	Thomas J. Gandolfo
	Title:	Senior Vice President and Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Signature	Title	Date
Phillip B. Lassiter* Phillip B. Lassiter	Chairman and Chief Executive Officer and Director (Principal Executive Officer)	March 28, 2003
/S/    THOMAS J. GANDOLFO Thomas J. Gandolfo	Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)	March 28, 2003
Michael A. Callen* Michael A. Callen	Director	March 28, 2003
Renso L. Caporali* Renso L. Caporali	Director	March 28, 2003
Jill M. Considine* Jill M. Considine	Director	March 28, 2003
Richard Dulude* Richard Dulude	Director	March 28, 2003
Robert J. Genader* Robert J. Genader	Director	March 28, 2003
W. Grant Gregory* W. Grant Gregory	Director	March 28, 2003
Laura S. Unger* Laura S. Unger	Director	March 28, 2003

* Thomas J. Gandolfo, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of each of the directors and officers of the Registrant after whose typed names asterisks appear pursuant to powers of attorney duly executed by such directors and officers and filed with the Securities and Exchange Commission as exhibits to this report.

By:	/S/    THOMAS J. GANDOLFO
	Thomas J. Gandolfo
	Attorney-in-fact

36

Ambac Financial Group, Inc.

Certifications

I, Phillip B. Lassiter, certify that:

1. I have reviewed this annual report on Form 10-K of Ambac Financial Group, Inc;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b. evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

c. presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weakness in internal controls; and

b. any fraud, whether or not material, that involves management or other employees who have significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

By:	/S/    PHILLIP B. LASSITER
	Phillip B. Lassiter
	Chairman and Chief Executive Officer

Date: March 28, 2003

37

Ambac Financial Group, Inc.

Certifications

I, Thomas J. Gandolfo, certify that:

1. I have reviewed this annual report on Form 10-K of Ambac Financial Group, Inc;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b. evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

c. presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weakness in internal controls; and

b. any fraud, whether or not material, that involves management or other employees who have significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

By:	/S/    THOMAS J. GANDOLFO
	Thomas J. Gandolfo
	Senior Vice President and Chief Financial Officer

Date: March 28, 2003

38

INDEPENDENT AUDITORS’ REPORT ON SCHEDULES AND CONSENT

The Board of Directors

Ambac Financial Group, Inc.:

The audits referred to in our report dated January 21, 2003, included the related financial statement schedules as of December 31, 2002 and 2001 and for each of the years in the three-year period ended December 31, 2002, included in this Form 10-K. These financial statement schedules are the responsibility of Ambac Financial Group Inc.’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

We consent to the use of our reports incorporated by reference in the registration statement (Nos. 333-43695 and 333-57206) on Form S-3, and the registration statements (Nos. 33-47970, 33-63134, 33-47971, 33-44913 and
333-52449) on Form S-8 of Ambac Financial Group, Inc.

/S/    KPMG LLP

KPMG LLP

New York, New York

March 28, 2003

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

SCHEDULE I—SUMMARY OF INVESTMENTS

Other Than Investments in Related Parties

December 31, 2002

(Dollar Amounts in Thousands)

Type of Investment	Amortized Cost		Estimated Fair Value		Amount at which shown in the balance sheet
U.S. government obligations	$	104,966	$	108,193	$	108,193
Municipal obligations		4,587,545		4,887,902		4,887,902
Mortgage—and asset-backed securities (includes U.S. government agency obligations)		5,337,583		5,455,186		5,455,186
Corporate obligations		1,532,859		1,569,314		1,569,314
Foreign government obligations		108,071		120,600		120,600
Short-term		395,761		395,761		395,761
Total	$	12,066,785	$	12,536,956	$	12,536,956

S-2

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II—CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Balance Sheets

December 31, 2002 and 2001

(Dollar Amounts in Thousands Except Share Data)

	2002			2001
ASSETS
Assets:
Cash	$	211		$	2,700
Investments in subsidiaries		4,185,367			3,560,598
Fixed income securities, at fair value     (amortized cost of $17,341 in 2002 and $31,887 in 2001)		17,597			30,830
Short-term investments, at cost (approximates fair value)		39,863			19,160
Other investments		650			769
Current income taxes receivable		6,332			27,813
Deferred income taxes receivable		20,684			13,843
Other assets		15,960			18,284
Total assets	$	4,286,664		$	3,673,997
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Debentures	$	616,715		$	619,315
Note payable to subsidiary		8,942			8,942
Accrued interest payable		6,275			6,155
Other liabilities		29,553			55,897
Total liabilities		661,485			690,309
Stockholders’ equity:
Preferred stock, par value $0.01 per share; authorized shares—4,000,000; issued and outstanding shares—none		—			—
Common Stock, par value $0.01 per share; authorized shares—200,000,000 at December 31, 2002 and 2001; issued shares—106,211,467 at December 31, 2002 and 106,020,537 at December 31, 2001		1,062			1,060
Additional paid-in capital		550,289			538,135
Accumulated other comprehensive income		265,427			62,476
Retained earnings		2,820,281			2,403,473
Common Stock held in treasury at cost, 220,876 shares at December 31, 2002 and 436,488 at December 31, 2001		(11,880	)		(21,456	)
Total stockholders’ equity		3,625,179			2,983,688
Total liabilities and stockholders’ equity	$	4,286,664		$	3,673,997

S-3

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II—CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Statements of Operations

Three Years Ended December 31,

(Dollar Amounts in Thousands)

	2002			2001			2000
Revenues:
Dividend income	$	81,500		$	69,000		$	63,800
Interest and other income		3,537			4,328			2,359
Net realized (losses) gains		1,482			(564	)		8
Total revenues		86,519			72,764			66,167
Expenses:
Interest expense		43,295			35,965			33,450
Operating expenses		7,170			5,947			6,669
Total expenses		50,465			41,912			40,119
Income before income taxes and equity in undistributed net income of subsidiaries		36,054			30,852			26,048
Federal income tax benefit		(15,906	)		(13,341	)		(18,088	)
Income before equity in undistributed net income of subsidiaries		51,960			44,193			44,136
Equity in undistributed net income of subsidiaries		380,634			388,713			322,036
Net income	$	432,594		$	432,906		$	366,172

S-4

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II—CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Statements of Stockholders’ Equity

Three Years Ended December 31,

(Dollar Amounts in Thousands)

	2002						2001						2000
Retained Earnings:
Balance at January 1	$	2,403,473					$	2,035,209					$	1,713,446
Net income		432,594		$	432,594			432,906		$	432,906			366,172		$	366,172
Dividends declared—common stock		(40,251	)					(35,937	)					(32,213	)
Exercise of stock options		24,465						(28,705	)					(12,196	)
Balance at December 31	$	2,820,281					$	2,403,473					$	2,035,209
Accumulated Other Comprehensive Income (Loss):
Balance at January 1	$	62,476					$	45,154					$	(187,540	)
Unrealized gains (losses) on securities, $339,039, $39,542, and $373,291, pre-tax, in 2002, 2001 and 2000, respectively) (1)					214,943						23,643						234,178
Cumulative effect of accounting change					—						(880	)					—
Loss on derivative hedges					(14,171	)					(4,371	)					—
Foreign currency gain					2,179						(1,070	)					(1,484	)
Other comprehensive income		202,951			202,951			17,322			17,322			232,694			232,694
Total comprehensive income				$	635,545					$	450,228					$	598,866
Balance at December 31	$	265,427					$	62,476					$	45,154
Preferred Stock:
Balance at January 1 and December 31	$	—					$	—					$	—
Common Stock:
Balance at January 1	$	1,060					$	1,060					$	707
Issuance of stock		2						—						—
Stock split effected as dividend		—						—						353
Balance at December 31	$	1,062					$	1,060					$	1,060
Additional Paid-in Capital:
Balance at January 1	$	538,135					$	533,558					$	525,012
Exercise of stock options		16,320						13,045						8,899
Issuance of stock		4,287						—						—
Capital issuance costs		(8,453	)					(8,468	)					—
Stock split effected as dividend		—						—						(353	)
Balance at December 31	$	550,289					$	538,135					$	533,558
Common Stock Held in Treasury at Cost:
Balance at January 1	$	(21,456	)				$	(18,867	)				$	(33,175	)
Cost of shares acquired		(41,101	)					(40,876	)					(23,618	)
Shares issued under equity plans		50,677						38,287						37,926
Balance at December 31	$	(11,880	)				$	(21,456	)				$	(18,867	)
Total Stockholders’ Equity at     December 31	$	3,625,179					$	2,983,688					$	2,596,114

(1) Disclosure of reclassification amount:	2002			2001		2000
Unrealized holding gains arising during period	$	154,065		$	25,817	$	230,985
Less: reclassification adjustment for net (losses) gains included in net income		(60,878	)		2,174		(3,193	)
Net unrealized gains on securities	$	214,943		$	23,643	$	234,178

S-5

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II—CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Condensed Statements of Cash Flows

Three Years Ended December 31,

(Dollar Amounts in Thousands)

	2002			2001			2000
Cash flows from operating activities:
Net income	$	432,594		$	432,906		$	366,172
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Equity in undistributed net income of Subsidiaries		(380,634	)		(388,713	)		(322,036	)
Net realized losses (gains)		(1,482	)		564			(8	)
(Increase) decrease in current income taxes receivable		21,481			(24,401	)		(1,499	)
Decrease (increase) in other assets		2,324			(8,675	)		8,041
Other, net		4,190			6,479			(6,853	)
Net cash provided by operating activities		78,473			18,160			43,817
Cash flows from investing activities:
Proceeds from sales of bonds		91,602			48,205			—
Proceeds from maturities of bonds		7,404			3,584			542
Purchases of bonds		(82,865	)		(248,251	)		(1,615	)
Change in short-term investments		(20,703	)		15,323			(22,160	)
Other, net		(14	)		8,795			(1,894	)
Net cash (used in) provided by investing activities		(4,576	)		(172,344	)		(25,127	)
Cash flows from financing activities:
Dividends paid		(40,251	)		(35,937	)		(32,213	)
Proceeds from issuance of debentures		—			193,700			—
Payment for buyback of debentures		—			(7,500	)		—
Proceeds from intercompany note		—			8,942			—
Issuance of common stock		4,289			—			—
Purchases of treasury stock		(41,101	)		(40,876	)		(23,618	)
Proceeds from sale of treasury stock		50,677			38,287			37,926
Contribution to subsidiaries		(50,000	)		(20	)		(500	)
Net cash provided by (used in) financing activities		(76,386	)		156,596			(18,405	)
Net cash flow		(2,489	)		2,412			285
Cash at January 1		2,700			288			3
Cash at December 31	$	211		$	2,700		$	288
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes	$	159,500		$	45,000		$	75,000
Interest expense on debt	$	47,145		$	36,704		$	33,848

Supplemental disclosure of non-cash financing activities:

Ambac Financial Group, Inc. contributed fixed income securities to Ambac Assurance Corporation

amounting to $176,193 in November 2001.

S-6

AMBAC FINANCIAL GROUP, INC.

SCHEDULE II—CONDENSED FINANCIAL INFORMATION

OF REGISTRANT (PARENT COMPANY ONLY)

Note to Condensed Financial Information

The condensed financial information of Ambac Financial Group, Inc. for the years ended December 31, 2002, 2001 and 2000, should be read in conjunction with the consolidated financial statements of Ambac Financial Group, Inc. and Subsidiaries and the notes thereto. Investments in subsidiaries are accounted for using the equity method of accounting.

S-7

AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES

SCHEDULE IV—REINSURANCE

(Dollar Amounts in Thousands)

Insurance Premiums Written	Gross Amount		Ceded to Other Companies		Assumed from Other Companies		Net Amount		Percentage of Amount Assumed to Net
Year ended December 31, 2000	$	440,111	$	80,789	$	42,971	$	402,293	10.68%
Year ended December 31, 2001	$	632,413	$	95,534	$	50,883	$	587,762	8.66%
Year ended December 31, 2002	$	871,070	$	113,542	$	32,962	$	790,490	4.17%

S-8

INDEX TO EXHIBITS

Exhibit Number	Description
10.07	Ambac Financial Group, Inc. Deferred Compensation Plan for Outside Directors, effective as of December 1, 1993 as amended through October 15, 2002.
10.20	Amendment to Lease Agreement dated December 23, 2002 between South Ferry Building Company and Ambac Assurance Corporation.
10.27	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust I, dated May 23, 2002.
10.28	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust II, dated May 23, 2002.
10.29	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust III, dated May 23, 2002.
10.30	Put Option Agreement between Ambac Assurance Corporation and Anchorage Finance Master Trust on Behalf of its Series Anchorage Finance Sub-Trust IV, dated May 23, 2002.
12.01	Statement re computation of ratios.
13.01	Certain portions of the Annual Report to Stockholders for the fiscal year ended December 31, 2002 (Pages 4-7, pages 25-65 and the inside back cover).
21.01	List of Subsidiaries of Ambac Financial Group, Inc.
24.01	Power of Attorney from Phillip B. Lassiter.
24.02	Power of Attorney from Michael A. Callen.
24.03	Power of Attorney from Renso L. Caporali.
24.04	Power of Attorney from Jill M. Considine.
24.05	Power of Attorney from Richard Dulude.
24.06	Power of Attorney from Thomas J. Gandolfo.
24.07	Power of Attorney from Robert J. Genader.
24.08	Power of Attorney from W. Grant Gregory.
24.09	Power of Attorney from Laura S. Unger.
99.01	Ambac Assurance Corporation and Subsidiaries Consolidated Financial Statements (with independent auditors’ report thereon) as of December 31, 2002 and 2001.
99.02	Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.03	Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

EX-10.07

EXHIBIT 10.07

AMBAC FINANCIAL GROUP, INC.

DEFERRED COMPENSATION PLAN

FOR OUTSIDE DIRECTORS

Effective as of December 1, 1993,

As Amended through October 15, 2002

AMBAC Financial Group

DEFERRED COMPENSATION PLAN FOR OUTSIDE DIRECTORS

Page 2 of 13

AMBAC FINANCIAL GROUP, INC.

DEFERRED COMPENSATION PLAN FOR

OUTSIDE DIRECTORS

1.     Definitions

“Account” and “Deferred Compensation Account” are used interchangeably and mean the bookkeeping record established for each Participant. A Deferred Compensation Account is established only for purposes of measuring a Deferred Benefit and not to segregate assets or to identify assets that may be used to pay a Deferred Benefit.

“Account Value” means the amount reflected on the books and records of the Company as the value of a Participant’s Deferred Compensation Account at any date of determination, as determined in accordance with this Plan.

“Annual Fees” means the cash portion of (i) any annual fee payable to an Outside Director for service on the Board, (ii) any other fee determined on an annual basis and payable for service on (as distinguished from attendance at meetings of), or for acting as chairperson of, any committee of the Board and (iii) any similar annual fee payable in respect of service on the board of directors of any Subsidiary or any committee of any such board of directors.

“Beneficiary” or “Beneficiaries” means a person or other entity designated by a Participant on a Beneficiary Designation Form to receive Deferred Benefit payments in the event of the Participant’s death.

“Beneficiary Designation Form” means a document, in form approved by the Committee, to be used by Participants to name their respective Beneficiaries.

“Board” means the Board of Directors of the Company.

“Cash Deferral Option” means a Performance Option under which the Deferred Amount credited to a Participant’s Deferred Compensation Account is carried as a cash balance to which interest equivalents are credited from time to time as provided in Section 6(c)(i).

“Committee” means the Compensation and Organization Committee of the Board or any successor committee thereto.

“Common Stock” means the Company’s common stock, par value $0.01 per share.

“Conversion Date” has the meaning assigned to such term in Section 6(e).

AMBAC Financial Group

DEFERRED COMPENSATION PLAN FOR OUTSIDE DIRECTORS

Page 3 of 13

“Deemed Capital Gain Tax Charge” has the meaning assigned to such term in Section 6(c).

“Deferral Election” means the election of a Participant, made in accordance with the terms and conditions of the Plan, to defer all or a portion of his/her Directors Fees for a Deferral Year.

“Deferral Election Form” means a document, in form approved by the Committee, pursuant to which a Participant makes a Deferral Election.

“Deferral Year” means the calendar year, starting with calendar year 1994. If an individual becomes eligible to participate in the Plan after the commencement of a Deferral Year, the Deferral Year for the individual shall be the remainder of such Deferral Year.

“Deferred Amount” means the amount of Directors Fees, deferred by a Participant pursuant to a Deferral Election.

“Deferred Benefit” means the amount that will be paid on a deferred basis under the Plan to a Participant who has made a Deferral Election. A Participant’s Deferred Benefit will equal the Account Value of his or her Deferred Compensation Account, calculated as provided herein.

“Director Fees” means the aggregate of a Participant’s Annual Fees and Meeting Fees.

“Election Date” means December 31 of the year preceding the beginning of the Deferral Year, provided, however, that if an individual becomes an Outside Director for the first time during a Deferral Year, that Outside Director’s Election Date for such Deferral Year is any day within thirty days of the date he/she becomes an Outside Director.

“Exchange Act” means the Securities Exchange Act of 1934, as amended.

“Fair Market Value” of a share of Common Stock means the average of the highest and the lowest quoted selling price of a share of Common Stock as reported on the composite tape for securities listed on the New York Stock Exchange, or such other national securities exchange as may be designated by the Committee, or in the event that the Common Stock is not listed for trading on a national securities exchange but is quoted on an automated quotation system, on such automated quotation system, in any such case on the valuation date (or if there were no sales on the valuation date, the average of the highest and the lowest quoted selling prices as reported on such composite tape or automated quotation system for the most recent day during which a sale occurred).

“Meeting Fees” means (i) any meeting fee payable in respect of attendance at or participation in meetings of the Board or any committee of the Board or any meeting of the

AMBAC Financial Group

DEFERRED COMPENSATION PLAN FOR OUTSIDE DIRECTORS

Page 4 of 13

stockholders of the Company and (ii) any similar meeting fee payable in respect of service on the board of directors of any Subsidiary or any committee of any such board of directors.

“Outside Director” means a duly-elected member of the Board who is not an employee of the Company or any Subsidiary.

“Participant” means an Outside Director who participates in the Plan pursuant to Section 4.

“Performance Option” means the performance options made available from time to time for selection by Participants to measure the return (positive or negative) to be attributed to Deferred Amounts.

“Phantom Stock Option” means a Performance Option under which a Deferred Amount is credited to a Participant’s Deferred Compensation Account as a number of Phantom Stock Units.

“Phantom Stock Unit” means a bookkeeping unit representing one share of Common Stock.

“Subsidiary” means any corporation 50 percent or more of the voting stock of which is owned directly or indirectly by the Company.

2.     Purpose

The purpose of the Plan is to provide the Company’s Outside Directors an opportunity to defer payment of all or part of their Directors Fees in accordance with the terms and conditions set forth herein.

3.     Administration

(a) Authority. The Committee will be responsible for administering the Plan. The Committee will have authority to adopt such rules as it may deem appropriate to carry out the purposes of the Plan, and shall have authority to interpret and construe the provisions of the Plan and any agreements under the Plan and to make determinations pursuant to any Plan provision. Each interpretation, determination or other action made or taken by the Committee pursuant to the Plan shall be final and binding on all persons. No member of the Committee shall be liable for any action or determination made in good faith, and the members of the Committee shall be entitled to indemnification and reimbursement in the manner provided in the Company’s Amended and Restated Certificate of Incorporation as it may be amended from time to time.

(b) Delegation. The Committee may designate a committee composed of one or more members of the Board to carry out its responsibilities under such conditions as it may set.

AMBAC Financial Group

DEFERRED COMPENSATION PLAN FOR OUTSIDE DIRECTORS

Page 5 of 13

4.     Eligibility

(a) Directors. Any Outside Director may participate in the Plan.

(b) Becoming a Participant. An Outside Director becomes a Participant for any Deferral Year by filing a Deferral Election Form according to Section 5 of the Plan.

5.     Deferral Elections

(a) General Provisions. A Participant may elect to defer all or a specified percentage (in multiples of 10 percent) of Directors Fees for a Deferral Year, in the manner provided in this Section 5. A Participant’s Deferred Benefit is at all times nonforfeitable.

(b) Deferral Election Forms. Before the Election Date applicable to a Deferral Year, each Outside Director will be provided with a Deferral Election Form and a Beneficiary Designation Form. In order for an Outside Director to participate in the Plan for a given Deferral Year, a Deferral Election Form, completed and signed by him/her, must be delivered to the Secretary of the Board on or prior to the applicable Election Date. An Outside Director electing to participate in the Plan for a given Deferral Year shall indicate on his/her Deferral Election Form:

(i) the percentage of Director Fees for the applicable Deferral Year to be deferred;

(ii) the allocation of the Deferred Amount among the several Performance Options then available to Participants, in accordance with the terms and conditions of Section 6(b); and

(iii) the Participant’s election either to have distribution of his/her Deferred Benefit commence following termination of service as an Outside Director or to have such distribution commence as of a date specified on such Form, provided, however, that any such election concerning the commencement of distribution of a Participant’s Deferred Benefit shall be subject to the terms and conditions of Section 6(e).

(c) Effect of No Deferral Election. An Outside Director who does not submit a completed and signed Deferral Election Form to the Secretary of the Board before the relevant Election Date is not a Participant for the Deferral Year and may not defer his/her Directors Fee for the Deferral Year.

(d) Revocation of Deferral Election.

(i) A Participant may revoke a Deferral Election applicable to a Deferral

AMBAC Financial Group

DEFERRED COMPENSATION PLAN FOR OUTSIDE DIRECTORS

Page 6 of 13

Year, but only pursuant to the procedure described in subsection (ii) below. Any purported revocation that does not comply with subsection (ii) below will not be given effect.

(ii) To be effective, a revocation must be in writing and signed by the Participant, must express the Participant’s intention to revoke his Deferral Election applicable to that Deferral Year, and must be delivered to the Secretary of the Board before the close of business on the Election Date applicable to such Deferral Year. For example, to revoke a Deferral Election relating to calendar year 2001, a written revocation of such Deferral Election must be delivered to the Secretary of the Board before the close of business on December 31, 2000.

6.     Deferred Compensation Accounts; Distributions

(a) Deferred Compensation Accounts.

(i) Establishment of Accounts. A Participant’s deferrals will be credited to a Deferred Compensation Account set up for that Participant. Each Deferred Compensation Account will be credited with Deferred Amounts, as provided in Section 6(b), and credited (or charged) with earnings (or loss) as provided in Section 6(c).

(ii) Crediting of Deferred Amounts.

Director Fees. As of the dividend payment date following the last business day of each calendar quarter, an Outside Director’s Deferred Compensation Account will be credited with (A) 25% of Annual Fees deferred for the Deferral Year in which such quarter occurs and (B) 100% of deferred Meeting Fees earned during such quarter.

(b) Allocations Among Performance Options. A Participant shall have the right to allocate the Deferred Amount for any Deferral Year, in minimum allocations of at least 10%, among one or more Performance Options made available from time to time under the Plan. The Performance Options generally available to Participants shall include:

(i) A Cash Deferral Option;

(ii) A Phantom Stock Option; and

(iii) Such other Performance Options as the Committee may make available to Participants from time to time. Deemed allocations among the available Performance Options shall be made exclusively for the purpose of determining the Account Value from time to time, and the Company will have no obligation to invest amounts corresponding to Deferred Amounts in investment vehicles corresponding to the Performance Options selected by the Participant. Participants may change the deemed allocation of their Account Value among the Performance Options then available under the Plan in accordance with procedures established by the

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Committee from time to time; provided, however, that, unless otherwise determined by the Committee, no such reallocation shall be made more frequently than quarterly; and providedfurther that no such reallocation may result in less than 10% of the Account Value being deemed allocated to any single Performance Option.

(c) Determination of Account Value.

The Company will from time to time calculate the Account Value based on the Participant’s Deferred Amounts and his/her then-effective elections with respect to deemed allocation of the Account among the available Performance Options. Such calculation will be based on the best information available to the Company as of the date of determination, which information may include estimates. In addition, the following shall apply:

(i) Amounts allocated to the Cash Deferral Option (including amounts resulting from the conversion of Phantom Stock Units as provided in Section 6(c)(ii)), will be credited with interest equivalents as of the first business day of each calendar quarter based upon the average daily balance credited to such Cash Option (which balance shall include any earnings on amounts so credited pursuant to this Section 6(c)(i)) during the preceding quarter. Interest equivalents will be calculated using the 90-day commercial paper composite rate published by the Federal Reserve Bank as of the last business day of such preceding calendar quarter, or such other rate as the Committee may designate from time to time by resolution.

(ii) The number of Phantom Stock Units credited to a Participant’s Deferred Compensation Account (including fractions of Phantom Stock Units) will be determined by dividing (A) the amount of Director Fees deferred by (B) the Fair Market Value of a share of Common Stock on the date of crediting.

(iii) If the Company pays any cash or other dividend or makes any other distribution in respect of the Common Stock, each Phantom Stock Unit credited to the Deferred Compensation Account of a Participant will be credited with an additional number of Phantom Stock Units (including fractions thereof) determined by dividing (A) the amount of cash, or the value (as determined by the Committee) of any securities or other property, paid or distributed in respect of one outstanding share of Common Stock by (B) the Fair Market Value of a share of Common Stock on the date of such payment or distribution. Such credit shall be made effective as of the date of the dividend or other distribution in respect of the Common Stock.

(iv) In determining the value attributable to that portion of a Participant’s Deferred Compensation Account allocated to Performance Options other than the Cash Deferral Option and the Phantom Share Option, the Company will track the rate of return (positive or negative) over the relevant measurement period of the investment fund, index or other vehicle by reference to which the Performance Option is defined.

(v) Upon any reallocation of all or any portion of a Participant’s Deferred Compensation Account from one Performance Option to any other Performance Option,

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the Company may charge such Account with an amount not to exceed 5% of the amount so reallocated. The amount of the charge shall be determined by the Company in its discretion and may vary depending on the Performance Options from which and into which the Account is being reallocated.

(vi) In addition, the returns attributable to a Deferred Compensation Account shall be subject to the following adjustments:

(A) Returns attributable to any Performance Option other than the Phantom Stock Option shall be reduced to reflect the amount that a corporate taxpayer in the highest tax bracket for federal corporate tax purposes would pay on the interests, dividends, distribution or similar items of income that it would receive if it had invested in the commercial paper, investment fund, index or other vehicle by reference to which the Performance Option is defined for the period of time, and in the same amounts, that the relevant Deferred Compensation Account was deemed allocated to such Performance Option.

(B) Upon any change in the deemed allocation of a Participant’s Deferred Compensation Account among the Performance Options then available, the Account shall be charged with the amount (if any) (the “Deemed Capital Gain Tax Charge”) of capital gains tax that a corporate taxpayer in the highest bracket for federal corporate tax purposes would pay upon the amount of gain it would recognize had it invested in the investment fund, index or other vehicle by reference to which the Performance Option is defined for the period of time, and in the same amounts, that the relevant Deferred Compensation Account was deemed allocated to such Performance Option. No credit shall be made to an Account for any loss that would be recognized by a corporate taxpayer that had invested in such Performance Option for such period and in such amount.

The amount of the adjustments described in this subparagrpah (vi) shall be determined by the Company in its discretion. The Company shall use its best efforts to apply adjustments on a consistent basis to all Participants who invest in any particular Performance Option.

(d) Manner of Payment of Deferred Benefit. All payments of Deferred Benefits under the Plan will be in cash. The Company shall pay a Participant’s Deferred Benefit either in a single lump sum or in a series of installments, as the Committee in its sole discretion shall determine, provided, however, that if the Committee elects to pay a Participant’s Deferred Benefit in a series of installments, such installments shall be paid no more frequently than quarterly and the Deferred Benefit must be distributed over a period not exceeding five years. The Committee may, but shall not be required to, consult with the Participant prior to determining the manner of payment of such Participant’s Deferred Benefit. If the Committee elects to pay a Participant’s Deferred Benefit in a series of installments, the relative size of such installments shall be determined by the Committee in its discretion, and such installments need not be in equal amounts or equal percentages of such Benefit. The unpaid portion of a Participant’s Deferred Benefit shall continue to be credited with earnings as provided in Section

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6(c) until paid.

(e) Commencement of Payment of Deferred Benefit. For purposes of this Agreement a “Conversion Date” means the earliest to occur of:

(i)(A) termination of service as an Outside Director (unless upon such termination of service the Participant becomes an employee of the Company or any Subsidiary, in which case the following clause (B) shall apply), and (B) termination of employment with the Company and its Subsidiaries (unless upon such termination of employment the Participant becomes an Outside Director, in which case the foregoing clause (A) shall apply);

(ii) the date specified in the Deferral Election Form executed by the Participant;

or

(iii) the Participant’s death.

Notwithstanding any other term or provision of this Plan, upon the occurrence of a Conversion Date, any portion of a Participant’s Deferred Compensation Account that is allocated either to the Phantom Unit Option or to any Performance Option other than the Cash Deferral Option will be converted into the Cash Deferral Option based upon (X) in the case of amounts allocated to the Phantom Unit Option, the Fair Market Value of the Common Stock as of the Conversion Date and (Y) in the case of any Performance Option other than the Phantom Stock Option, the net asset value or other relevant valuation measure of the investment fund, index or other vehicle by reference to which the Performance Option is defined, determined as of the Conversion Date or, if such net asset value or other valuation information is not available as of the Conversion Date, as of the latest date preceding the Conversion Date for which the same is generally available. The amount credited to the Cash Deferral Option as a result of such conversion shall, in the case of conversions from any Performance Option other than the Phantom Stock Option, be subject to the Deemed Capital Gain Tax Charge as described in Section 6(c) above. Following conversion, amounts so credited to the Cash Deferral Option will be credited with interest equivalents as provided in Section 6(c)(i). Except as provided in Section 6(f), a Participant’s Deferred Benefit shall be paid (if payable in a lump sum), or commence to be paid (if payable in a series of installments), to the Participant as soon as practicable (but in no event more than 60 days) after the Conversion Date.

(f) Death. In the event of a Participant’s death, the Participant’s entire Deferred Benefit (including any unpaid portion thereof corresponding to installments not yet paid at the time of death), to the extent not distributed earlier pursuant to Section 6(e), will be distributed in a lump sum to the Participant’s Beneficiary or Beneficiaries (or, in the absence of any Beneficiary, to the Participant’s estate) on a date, selected by the Committee, no more than six months after the Participant’s date of death.

(g) Statements. The Company will furnish each Participant with a statement setting forth the value of the Participant’s Deferred Compensation Account as of the end of each calendar year and all credits to and payments from the Deferred Compensation Account during

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such year. Such statement will be furnished no later than 60 days after the end of each calendar year.

7.     Designation of Beneficiary

(a) Beneficiary Designations. Each Participant may designate a Beneficiary to receive any Deferred Benefit due under the Plan upon the Participant’s death by executing a Beneficiary Designation Form. A Beneficiary designation is not binding on the Company until the Secretary of the Board receives the Beneficiary Designation Form. If no designation is made or no designated Beneficiary is alive (or in the case of an entity designated as a Beneficiary, in existence) at the time of the Participant’s death, payments due under the Plan will be made to the Participant’s estate.

(b) Change of Beneficiary Designation. A Participant may change an earlier Beneficiary designation by executing a later Beneficiary Designation Form. The execution of a Beneficiary Designation Form revokes and rescinds any prior Beneficiary Designation Form.

8.     Amendments

(a) General Power of Committee. Subject to Section 8(b), the Plan may be altered, amended, suspended, or terminated at any time by the Committee in its sole discretion.

(b) When Participants’ Consents Required. Except for a termination of the Plan caused by the Committee’s determination that the laws upon which the Plan is based have changed in a manner that negates the Plan’s objectives, the Committee may not alter, amend, suspend, or terminate the Plan without the consent of any Participant to the extent that such action would result in the distribution to such Participant of amounts then credited to his/her Deferred Compensation Account in any manner other than as provided in the Plan or could reasonably be expected to result in the immediate taxation to such Participant of Deferred Benefits.

9.     Employer’s Obligation

This Plan is unfunded. A Deferred Compensation Account represents at all times an unfunded and unsecured contractual obligation of the Company. Each Participant or Beneficiary will be an unsecured creditor of the Company. Amounts payable under the Plan will be satisfied solely out of the general assets of the Company subject to the claims of the Company’s creditors. No Participant, Beneficiary or any other person shall have any interest in any fund or in any specific asset of the Company by reason of any amount credited to him/her hereunder, nor shall any Participant, Beneficiary or any other person have any right to receive any distribution under the Plan except as, and to the extent, expressly provided in the Plan. The Company will not segregate any funds or assets for Deferred Benefits or issue any notes or security for the payment of any Deferred Benefits. Any reserve or other asset that the Company

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may establish or acquire to assure itself of the funds to provide benefits under the Plan shall not serve in any way as security to any Participant, Beneficiary or other person for the performance of the Company under the Plan.

10.     No Control by Participant

A Participant shall have no control over his Deferred Compensation Account except for (i) designating initial allocation among Performance Options and subsequently revising such allocation, in all cases to the extent permitted by the Plan, (ii) designating the date of initial distribution of benefits on his Deferral Election Form (which designation shall be subject to the terms and conditions of the Plan, including without limitation Section 6) and (iii) designating his or her Beneficiary on a Beneficiary Designation Form.

11.     Restrictions on Transfer

The Company shall pay all amounts payable under the Plan only to the Participant or Beneficiary designated under the Plan to receive such amounts. Neither a Participant nor his Beneficiary shall have any right to anticipate, alienate, sell, transfer, assign, pledge, encumber or change any benefits to which he may become entitled under the Plan, and any attempt to do so shall be void. A Deferred Benefit shall not be subject to attachment, execution by levy, garnishment, or other legal or equitable process for a Participant’s or Beneficiary’s debts or other obligations.

12.     Election and Revocation Notices

Notices of elections or revocations of elections under the Plan must be in writing. A notice of election or revocation of election will be deemed delivered to the Secretary of the Board on the date it is (i) delivered personally to the Secretary of the Board at One State Street Plaza, New York, New York 10004 (or at such other address as the Company may from time to time designate as the address for elections and revocations of elections under the Plan), (ii) mailed by registered mail or certified mail to the Secretary of the Board at such address or (iii) sent by facsimile transmission to the Secretary of the Board at 212-208-3558 (or such other facsimile transmission number as the Company may designate from time to time for elections and revocations of elections under the Plan), provided that an original signed election or revocation of election is received by the Secretary of the Board no later than 10 business days after such transmission.

13.     Waivers

The waiver of a breach of any provision in the Plan shall not operate as and may not be construed as a waiver of any later breach.

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14.     Governing Law

The Plan shall be construed in accordance with and governed by the laws of the State of New York.

15.     Effective Date

The Plan shall be effective as of December 1, 1993 and Deferral Elections may be made beginning with Eligible Compensation earned during the year beginning January 1, 1994.

16.     Construction

The headings in the Plan have been inserted for convenience of reference only and are to be ignored in any construction of the Plan’s provisions. If a provision of the Plan is not valid or enforceable, that fact shall in no way affect the validity or enforceability of any other Provision. Use of one gender includes the other, and the singular and plural include each other. The provisions of the Plan are binding on the Company, each Participating Subsidiary and their respective successors or assigns, and on the Participants, their Beneficiaries, heirs, and personal representatives.

17.     Tax Withholding

The Company shall have the right, in connection with any Deferral Election, (i) to require the Participant to remit to the Company an amount sufficient to satisfy any Federal, state or local tax withholding requirements, (ii) to withhold an amount necessary to satisfy such requirements from other cash compensation owed to the Participant or (iii) to reduce the amount of Director Fees deferred pursuant to the Plan in order to ensure that all such requirements are satisfied. The Company shall also have the right to deduct from all cash payments made pursuant to the Plan any Federal, state or local taxes required to be withheld with respect to such payments.

18.     No Right to Reelection or Continued Employment

Nothing in the Plan shall be deemed to create any obligation on the part of the Board to nominate any of its members for reelection by the Company’s stockholders, nor confer upon any Outside Director the right to remain a member of the Board for any period of time, or at any particular rate of compensation.

19.     No Stockholder Rights

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The crediting of Phantom Stock Units to a Participant’s Deferred Compensation Account shall not confer on the Participant any rights as a stockholder of the Company, nor shall such Units confer on any Participant any right to receive stock of the Company in settlement thereof.

20.     Adjustment of and Changes in Shares

In the event of any merger, consolidation, recapitalization, reclassification, stock dividend, special cash dividend or other change in corporate structure affecting the Common Stock, the Committee shall make such adjustments, if any, as it deems appropriate in the number of Phantom Stock Units credited to a Participant’s Deferred Compensation Account. The foregoing adjustments shall be decided by the Committee in its discretion.

21.     About the Plan

The Deferred Compensation Plan for Outside Directors and Senior Officers was established as of December 1, 1993 by Ambac Inc. In 1997 Ambac Inc. became Ambac Financial Group, Inc. The Plan was amended on October 28, 1998 in order to offer its participants more investment options.

The Plan was amended and restated, effective October 26, 1999 to provide that this Plan be available only to Outside Directors. Senior Officers no longer participate in this Plan as a new deferred plan has been adopted for them.

AMBAC FINANCIAL GROUP, INC.

DEFERRED COMPENSATION PLAN

FOR OUTSIDE DIRECTORS

Beneficiary Designation Form

To: Secretary, Board of Directors

Ambac Financial Group, Inc.

I designate                                                                                                   as my primary Beneficiary(ies) of any benefits that become payable under the Ambac Financial Group, Inc. Deferred Compensation Plan for Outside Directors (the “Plan”) as a result of my death.

If a designated Beneficiary survives me but dies (or if a trust, terminates) before all benefits have been paid to the Beneficiary, I direct the remainder of the payments to be made as the Beneficiary designates or, if the Beneficiary fails to properly execute a Beneficiary designation, to the Beneficiary’s estate, or, if a trust, to the trustee to be distributed in accordance with the terms of the trust.

This designation revokes and rescinds any prior Beneficiary designation made by me.

If a Beneficiary is not named, or if there is no Beneficiary otherwise in existence at the time of my death, I understand that payments will be made according to Section 7(a) of the Plan.

I understand that this Beneficiary designation applies until revoked by my written request.

I also understand that, in executing this Beneficiary designation, I agree to be bound by the terms and conditions of the Plan and agree that such terms and conditions are binding upon my Beneficiary(ies), distributee(s), and personal representative(s).

	Signature
Date	Name (Please Print)

EX-10.20

Exhibit 10.20

ONE STATE STREET, LLC

One State Stteet Plaza

New York, NY 10004

December 23, 2002

Ambac Financial Group, Inc.

One State Street Plaza

New York, NY 10004

Attention: Mr. Gregg Bienstock

Dear Sirs:

Reference is made to the Lease between South Ferry Building Company, as assigned to One State Street, LLC by assignment dated June 13, 2000, Landlord, and AMBAC Assurance Corporation (formerly known as AMBAC Indemnity Corporation), as assigned to Ambac Financial Group, Inc. by assignment of even date herewith. Tenant, dated January 1, 1992 (as amended on August 1, 1997, the (“1997 Amendment”) and as may be further amended from time to time, the “Lease”). Capitalized terms not defined in this Amendment (this “Amendment”) shall have their respective meanings as set forth in the Lease.

Landlord and Tenant hereby agree that the Lease be amended as follows:

1. Landlord hereby leases to Tenant, and Tenant hereby hires from Landlord and adds to the Premises under the Lease, the entire twentieth (20th) floor (the “20th Floor Space”) for the period commencing on the date hereof and ending on the Expiration Date (or sooner termination of the Lease), pursuant to the terms, covenants, conditions and provisions of the Lease, subject to the terms hereof. Landlord shall deliver possession of the entire 20th Floor (20th) floor on the date hereof free and clear of all tenants or other occupants and rights to occupancy.

2.    (a) In addition to all amounts currently due under 3.01 of the Lease, the Tenant shall, as of the date hereof, with respect to the 20th Floor Space, make an additional Operating Payment (the “20th Floor Operating Payment”) in accordance with the terms of Section 3.01 of the Lease provided that solely with respect to the 20th Floor Operating Payment:

(i) the Operating Payment multiplier under clause (ii) of the first sentence of the second paragraph of Section 3.01(c) ofthe Lease shall be 27,719;

(ii) the Base Wage Rate shall be the Wage Rate (as defined below) in effect on January 1, 2003;

(iii) “Wage Rate” shall be calculated as provided in the Lease except it shall be calculated without regard to fringe benefits. For avoidance of doubt,

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under such a calculation, the Wage Rate for 2002 is equal to $17.448 and for 2003 is equal to $17.998; and

(iv) the multiplication factor shall equal 125% (rather than the 75 as set forth in Section 3.01(c) of the Lease).

(b) In addition to all amounts currently due under Article 3 of the Lease, the Tenant shall, as of the date hereof, with respect to the 20th Floor Space, make an additional Tenant’s Tax Payment (the “20th Floor Tax Payment”) in accordance with the terms of Article 3 of the Lease provided that solely with respect to the 20th Floor Tax Payment:

(i) For purposes of calculating Tenant’s Tax Payments allocable to the 20th Floor Space, the Basic Tax shall be one half of the sum of (A) the Taxes for the real estate tax fiscal year commencing July 1, 2002 and ending June 30, 2003, as finally determined, and (B) the Taxes for the real estate tax fiscal year commencing July 1, 2003 and ending June 30, 2004, as finally determined, and

(ii) “Tenant’s Proportionate Share” under Section 3.02(c) of the Lease as applicable to the 20th Floor Space shall be 3.4058%.

3.    (a) Tenant has examined the 20th Floor Space and agrees to take the same “as is” and Landlord shall not be obligated to perform any work or incur any expense to prepare the 20th Floor Space for Tenant’s use and the provisions of Landlord’s Work in Article 38 of the Lease shall not apply to the 20th Floor Space, provided that Landlord shall prior to commencement of the Tenant’s initial buildout of the 20th Floor Space (i) remove the compartmentation walls in the 20th Floor Space within three (3) business days of Tenant’s written request, (ii) perform any necessary additional fireproofing work on the 20th Floor Space to the extent required by applicable law or requirements, (iii) remove the two pipes protruding from the drain lines and cap the related drain lines and (iv) perform any repairs required to bring the bathrooms to building standard.

(b) To the extent required by applicable law, Landlord shall, in conjunction with the Tenant’s initial buildout of its space, perform any work required to bring the core areas of the 20th floor of the Building in compliance with the American with Disabilities Act of 1990, as amended to date.

(c) Landlord shall deliver to Tenant an ACP-5 Certificate applicable to the area in which Tenant plans to perform construction in connection with its initial buildout of the 20th Floor Space. Landlord shall deliver to Tenant such ACP-5 Certificate promptly after Tenant delivers to Landlord construction plans for the 20th Floor Space which are sufficient to obtain such ACP-5 Certificate. Landlord, at its sole

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cost and expense shall remove any asbestos, required to deliver the ACP-5 Certificate described above.

(d) The provisions of Article 14 of the Lease which are applicable to Tenant’s use and consumption of electricity in the 15th, 16th and 17th floors of the Building shall apply to Tenant’s use and consumption of electricity in the 20th Floor Space; provided (i) the $2.80 per rentable square foot “interim rate” described in Section 14.01 of the Lease shall commence on the date that Tenant commences its buildout of the 20th Floor Space and (ii) Landlord shall install the meters described in Section 14.01 of the Lease with respect to the 20th Floor Space within six (6) months after commencement by Tenant of its buildout of the 20th Floor Space and in the event that Landlord fails to install such meters within such six (6) month period then the remedies available to Tenant under Section 37.03 of the Lease with respect to the installation of meters in the 18th floor of the Building shall be available to Tenant with respect to the installation of meters in the 20th Floor Space.

(e) In connection with Tenant’s initial buildout of the 20th Floor Space, Landlord shall provide Tenant with forty (40) hours of free overtime freight elevator service.

4. In addition to the rent for the existing space as set forth in Section 1.04(a) of the Lease, the fixed rents reserved under the Lease for the 20th Floor Space shall be and consist of the following fixed rent at the following rates during the following periods:

(a) Six Hundred Ninety Two Thousand Two Hundred Seventy Five ($692,975) dollars per annum during the period commencing on the 153rd day following the date hereof (the “20th Floor Rent Commencement Date”) and ending on the fifth (5th) anniversary of the 20th Floor Rent Commencement Date;

(b) One Million Eighty One Thousand Forty One ($1,081,041) dollars per annum during the period commencing on the day following the fifth (5th) anniversary of the 20th Floor Rent Commencement Date and ending on the tenth (10th) anniversary of the 20th Floor Rent Commencement Date; and

(c) One Million Four Hundred Sixty Nine Thousand One Hundred Seven ($1,469,107) dollars per annum during the period commencing on the day following the tenth (10th) anniversary of the 20th Floor Rent Commencement Date and ending on the Expiration Date.

5. The initial buildout of the 20th Floor Space (“Tenant’s Work”) shall be at the sole cost and expense of Tenant, provided that with respect to the Tenant’s Work, Landlord shall pay Tenant $1,385,950 (the “TI Payment”) in accordance with the terms hereof. Tenant’s Work shall be done in accordance with Article 11 and the other provisions of the Lease, including Landlord’s prior approval of plans and specifications if required pursuant to the

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Lease. Landlord shall pay Tenant pro rata portions of the TI Payment based on the percentage of Tenant’s Work completed as estimated by Tenant’s architect and submitted to Landlord in writing up a maximum of the lesser of the actual aggregate cost of Tenant’s Work or the total TI Payment, provided that any amount of the TI Payment remaining unpaid on the 20th Floor Rent Commencement Date shall be paid in full on such date for subsequent application by Tenant solely to the cost of Tenant’s Work.

6.    (a) Landlord hereby grants to Tenant a right of first refusal (the “Right of First Refusal”) with respect to each and every proposed letting of any space in the elevator bank serving the Premises on the date hereof (a “Letting”) upon the terms and conditions set forth herein.

(b) If at any time Landlord wishes to effect a Letting to any bona fide unaffiliated third party or entity (an “Outside Party”), Landlord shall deliver to Tenant a deal sheet setting forth the material terms (including, at a minimum, the material economic terms such as the anticipated delivery date, fixed rent, tax and operating escalation rates, base years, tenant improvement allowance and fixed rent increases) pursuant to which Landlord would be prepared to lease space to an Outside Party (the “Offer”) which shall be deemed to be an offer by Landlord to lease to Tenant the floor (or the portion thereof) or floors which is/are described in such Offer. Landlord need not have an actual offer from a potential tenant in order to present a deal sheet as aforesaid but must be prepared in good faith to offer such space to the market on such terms in contemplation of leasing such space to an Outside Party.

(c) The term of the Right of First Refusal shall commence as of the date hereof and shall remain in effect during the Term; provided, however, that notwithstanding the foregoing the Right of First Refusal shall terminate upon the occurrence of any of the following:

(i) if Tenant exercises the Right of First Refusal and the transaction is not consummated due solely to Tenant’s default, then on the date of such default; or

(ii) the occurrence and continuation of an Event of Default.

Subject to the foregoing provisions of this Section 6(c), the Right of First Refusal, if then subsisting, shall survive any Letting of any kind or nature to an Outside Party and each and every subsequent Letting shall be subject to the Right of First Refusal.

(d)    (i) Tenant may initiate the exercise of the Right of First Refusal by delivery to Landlord of a notice to that effect (“Notice of Acceptance”) on or before the fifteenth (15th) day following Tenant’s receipt of the Offer (the “Exercise Period”). If Tenant fails to deliver a Notice of Acceptance within the Exercise Period, Tenant shall be deemed to have elected not to exercise the Right of First Refusal at that time, and Landlord may let the

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applicable floor (or portion thereof) or floors which is the subject of the Offer to an Outside Party upon economic terms that are not lower than ten (10) per cent less than the economic terms set forth in the Offer, provided that the Letting is in fact closed no later than four (4) months (“Outside Date”) following the expiration of the Exercise Period. If a Letting meeting the requirements of the immediately preceding sentence of the applicable floor (or portion thereof) or floors which is referred to in the Offer is not closed on or before the Outside Date, then a Letting shall not be consummated with respect to such space without it being subjected again to the Right of First Refusal.

(ii) If Tenant timely delivers the Notice of Acceptance, Tenant will be deemed to have accepted the Offer and an amendment of this Lease, containing the terms and conditions of the Offer as modified in accordance with the provisions herein, shall be prepared promptly by Landlord. Tenant and Landlord shall immediately execute such amendment (“Right of First Refusal Amendment”) confirming the applicable terms and conditions contained in the Offer. Any terms and conditions not expressly addressed in the Offer shall be the same as then current terms of the Lease. The failure of the parties to execute the Right of First Refusal Amendment shall not affect the respective obligations of the parties under this Lease.

(e) The termination, cancellation or surrender of this Lease shall terminate any rights of Tenant pursuant to this provision.

7.      (a) Provided this Lease is in effect and Tenant is not in default hereunder beyond any applicable grace period on the date the option is exercised or on the Delivery Date (as hereinafter defined). Tenant shall have the option (the “Expansion Option”) to add the 21st Floor of the Building (the “Expansion Space”) to the Premises under this Lease as of the earlier of(i) the fourth (4th) anniversary of the date hereof (the “Fourth Anniversary”) if such space is available on such date or (ii) if the Expansion Space is subject to a lease to an Outside Party as of the Fourth Anniversary, the first day following the Fourth Anniversary, but prior to the seventh (7th) anniversary of the date hereof (the “Seventh Anniversary”), that the Expansion Space becomes available for occupancy. In the event the Expansion Space is not available on the Fourth Anniversary and does not become available on or before the Seventh Anniversary, then the Expansion Option shall expire and Tenant’s right to lease the Expansion Space shall terminate.

(b) In the event Landlord enters into a lease of the Expansion Space prior to the Fourth Anniversary with an Outside Party which by its terms shall remain in effect as of the Fourth Anniversary (the “Other Lease”), Landlord shall advise Tenant of the expiration date for such lease (the “21st Floor Expiration Date”). In the event the 21st Floor Expiration Date is prior to the Seventh Anniversary (the “Lease Scenario”), the Expansion Option shall be exercised, if at all, by Tenant giving notice to Landlord in writing at least twelve (12) full calendar months prior

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to the 21st Floor Expiration Date. If the Expansion Space is not subject to a lease as of the Fourth Anniversary (the “Vacant Scenario”), then the Expansion Option shall be exercised, if at all, by Tenant by giving notice to Landlord in writing at least twelve (12) months, but no more than thirteen (13) full calendar months, prior to the Fourth Anniversary, provided that following such exercise of the Expansion Option Landlord shall nevertheless retain the right to lease the Expansion Space to an Outside Party prior to the Fourth Anniversary (the period subsequent to such exercise by Tenant of the Expansion Option but prior to the Fourth Anniversary being referred to herein as the “Interim Period”). In the event of such a letting to an Outside Party during the Interim Period, (x) the exercise of the Expansion Option shall not be deemed effectively exercised and shall be of no effect and (y) in the event Tenant exercises the Right of First Refusal with respect to such Letting of the Expansion Space during the Interim Period in accordance with Section 6 of this Amendment, the terms of such lease of the Expansion Space to Tenant shall be determined by this Section 7 instead of Section 6 of this Amendment. Tenant’s failure duly to give notice of its intent to exercise its option as set forth above or below at the end of this paragraph shall be deemed a waiver of such right to lease the Expansion Space. Time shall be of the essence in respect of the giving of such notice. Upon the effective exercise by Tenant of the Expansion Option, Landlord shall deliver possession of the Expansion Space in accordance with Section 7(c) on one of the following dates (the “Delivery Date”) as determined by Landlord: (i) in the case of a Lease Scenario, no earlier than six (6) months prior to the 21st Floor Expiration Date and no later than the sixth (6th) month following the 21st Floor Expiration Date; or (ii) in the case of a Vacant Scenario, the Fourth Anniversary and no later than the sixth (6th) month following the Fourth Anniversary. Notwithstanding the prior provision of this Section (b), in the case of a Lease Scenario, if at any time during the period between the Fourth Anniversary and the Seventh Anniversary the Other Lease expires (including without limitation by reason of default under the Other Lease) then Landlord shall promptly notify Tenant and Tenant shall have twenty (20) days to exercise its Expansion Option, and for purposes hereof, if Tenant exercises its Expansion Option pursuant to this sentence, the Delivery Date shall be the date of Tenant’s notice of its intent to exercise the Expansion Option.

(c) If Tenant shall effectively exercise the Expansion Option, Tenant shall accept the Expansion Space vacant and free and clear of all tenants, other occupants or rights to occupancy but otherwise “as is” in the state and condition that it may be in on the Delivery Date and Landlord shall have no liability to Tenant by reason of such state and condition, provided that Landlord shall perform, to the extent necessary, demolition of the space, removal of asbestos and general repair work so as to deliver the Expansion Space in essentially the same condition as the 20th Floor. Landlord makes no representations as to the condition of the Expansion Space or as to any other thing or fact related thereto and Landlord shall have no obligation

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to decorate, repair, alter, improve or otherwise prepare the Expansion Space for Tenant’s occupancy.

(d) If Tenant shall effectively exercise the Expansion Option then, effective on and after the Delivery Date, this Lease shall be deemed amended as follows:

(i) The Expansion Space shall be added to and form a part of the Premises, and the term “Premises” as used in this Lease shall include the Expansion Space.

(ii) The Fixed Rent payable by Tenant for such Expansion Space shall be ninety five percent (95%) of the fair market Fixed Rent determined as of the commencement date of the term of the Expansion Space. In such event, on a date that is not less than six (6) months prior to the Delivery Date, Landlord shall submit to Tenant Landlord’s estimate (“Landlord’s Estimate”) of the fair market Fixed Rent for the Expansion Space. The determination of fair market shall take into account all relevant factors including without limitation rents in all comparable buildings and the fact that current base years shall be used. If Tenant shall not accept Landlord’s Estimate as the Fixed Rent to be paid for the Expansion Space, Landlord and Tenant shall attempt to agree upon the Fixed Rent to be paid for the Expansion Space, m the event that by the date that is three (3) months prior to the Delivery Date, Landlord and Tenant shall not have agreed upon the Fixed Rent to be paid by Tenant for the Expansion Space, such dispute shall be submitted to arbitration in accordance with the provisions of Article 39, and the arbitrators shall determine the fair market Fixed Rent for such Expansion Space for the balance of the Term upon the same terms as provided in the Lease (and in determining such fair market Fixed Rent the arbitrators shall consider the terms relating to payments of Additional Charges pursuant to Article 3 and shall not include in Fixed Rent any amount for the furnishing of electricity by Landlord to Tenant and instructions to that effect shall be given to the arbitrators), and that amount shall be the Fixed Rent payable by Tenant for such Expansion Space during the balance of the Initial Term, subject to the other provisions of this Lease. All computations of the fair market Fixed Rent for the Expansion Space pursuant to this Section shall be made without allocating any value to any leasehold improvements made in or to the Expansion Space. If on the Delivery Date the Fixed Rent to be paid by Tenant for the Expansion Space shall not have been determined (by arbitration or by agreement of Landlord and Tenant), Tenant shall, effective as of the Delivery Date, pay as Fixed Rent therefor the amount set forth in Landlord’s Estimate as the fair market Fixed Rent for such Expansion Space, subject to adjustment upon the determination of such Fixed Rent. Upon the determination of such Fixed Rent, Tenant shall promptly pay to Landlord any underpayment of Fixed Rent by Tenant

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since the Delivery Date and, in the event of any overpayment of such Fixed Rent by Tenant since the Delivery Date, Landlord, at its election, shall either pay to Tenant the amount of such overpayment or permit Tenant to receive a credit of the amount of such overpayment against the next installments of Fixed Rent falling due until such time as such overpayment has been fully credited to Tenant and, if the overpayment has not been fully credited prior to the Expiration Date, Landlord shall promptly after the Expiration Date, pay the uncredited portion of such overpayment to Tenant. Each arbitrator appointed pursuant to this Section shall have at least 10 years’ experience in the City of New York in real property management, brokerage or appraising.

(iii) With respect to the Expansion Space, the term “Tenant’s Proportionate Share”, as such term is defined in Article 3 of the Lease, and the “Operating Payment” multiplier under clause (ii) of the first sentence of the second paragraph of Section 3.01 (c) of the Lease, shall be equal to those set forth in Section 2 of this Amendment with respect to the 20th Floor Space and shall be paid in addition to such amounts.

(e) If Landlord is unable to give possession of the Expansion Space on the Delivery Date, because of the holding over or retention of possession of any tenant, undertenant or occupant or as a result of Force Majeure, any Legal Requirement, casualty or condemnation, Landlord shall have no liability to Tenant therefore and the validity of the Lease shall not be impaired under such circumstances, nor shall the same be construed in any way to extend the Term, but the rent payable hereunder for the Expansion Space shall be abated (provided Tenant is not responsible for the inability to obtain possession) until Landlord is able to deliver possession of the Expansion Space for Tenant’s occupancy. Landlord agrees to use reasonable efforts to remove such hold-over and to obtain possession of the Expansion Space.

(f)    (i) Within thirty (30) days after the Delivery Date, Landlord and Tenant shall join in executing and delivering an agreement supplementary hereto clearly identifying the Delivery Date, the Expansion Space added thereon and specifying the rental payable with respect to such Expansion Space and the items referred to in Section 7(d)(iii). The failure of the parties to execute such agreement shall not affect the respective obligations of the parties under this Lease.

(iii) In the event the Expansion Option is not exercised by Tenant in respect of any Expansion Space, Tenant agrees, within ten (10) days after demand therefor from Landlord, to confirm, in writing, that the same has not been so exercised.

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(g) The termination, cancellation or surrender of this Lease shall terminate any rights of Tenant pursuant to this Section.

8. As of the date hereof and thereafter throughout the term of the Lease, Landlord shall make available, in addition to the condenser water to be provided pursuant to the Lease, 20 tons of additional condenser water from the Building tower for Tenant’s use, and Tenant shall pay, as additional rent, at the same time together with the payments of the monthly rent under the Lease, the amounts set forth in this paragraph (hereinafter referred to as the “20th Floor Additional Condenser Water Charges”) for such 20 tons. Pursuant to Article 15 of the Lease, there shall be a one-time tap fee of $1,000 and the condenser water shall be supplied to Tenant via such tap on the 20th Floor Space. The 20th Floor Additional Condenser Water Charges are Three Hundred Seventy Dollars and Fifty Cents ($370.50) per ton of the maximum permitted use (whether or not Tenant shall use such maximum) per year, which rate shall be increased on each anniversary of January 1, 2003 to an amount equal to 105 of the Additional Condenser Water Charges payable during the immediately preceding year (without regard to any abatement or setoff which may have been in effect).

9.    (a) Tenant shall have the right, at no additional charge, to place an emergency back-up dry cooler air conditioning system (the “Back-up AC System”) for the Tenant’s computer room on the fourteenth floor of the Building in an area specified on the attached Exhibit A and to install the piping and duct work necessary to connect the Back-up AC System directly to the louvers. Landlord shall have the right in its sole discretion at its sole cost and expense to move or at Landlord’s expense to cause the Tenant to move and reinstall the equipment (with attendant ductwork, piping and electric) for the Back-up AC System up to 25 feet from the center point of the installation to another location in the Building, provided that such location shall be one in which the Back-up AC System can properly function throughout the term of this Lease. Except in the case of an emergency, Landlord agrees that such movement shall occur at a time when the Back-up AC System is not likely to be needed. Tenant represents that the Back-up AC System will be used for emergency back-up for the computer room in the event the primary systems servicing such space are not functional and for no other purpose.

(b) Tenant shall be solely responsible for the cost and expense of installation, operation, repair and maintenance of the Back-up AC System, including any necessary piping, ductwork and electricity. Tenant’s installation of the Back-up AC System shall be made in accordance with Article 11 of the Lease, provided that solely for purposes of such installation. Article 11 shall be read as if the space on the 14th Floor for the Back-up AC System was part of the Premises. The Back-up AC System shall be designed, constructed, installed, maintained and operated in compliance with all applicable all statutes, rules, and governmental regulation and good engineering practices. Tenant shall indemnify and hold Landlord

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harmless in accordance with Article 18 of the Lease as a result of any breach of the foregoing.

(c) Access to the 14th Floor and the Back-up AC System shall be: (i) only in the presence of a representative of the Landlord, which Landlord shall endeavor to make available upon reasonable notice (such as one to two hours, but Tenant shall endeavor to give longer notice), and (ii) only on business days and during business hours, except in the event of an emergency which requires access to the Back-up AC System, in which case Landlord shall use commercially reasonable efforts to provide immediate access, provided that Tenant shall pay Landlord’s charges for overtime personnel if such overtime or additional personnel were required as a result of Tenant’s access. An emergency shall include, without limitation, any malfunction of the Building’s cooling system.

10. Tenant represents that it has not dealt with any brokers in connection with this Amendment, and agrees to indemnify and hold harmless Landlord from and against any and all claims for brokerage commissions and all costs, expenses and liabilities (including, without limitation, reasonable attorneys fees) by any person, other than Grubb & Ellis, Inc. Landlord represents that it has not dealt with any brokers other than Grubb & Ellis in connection with this Amendment.

11. The provisions of Section’s 8 and 9 of the 1997 Amendment shall be applicable to the 20th Floor Additional Space and shall apply to comparable laws, rules and regulations adopted by applicable governmental authorities.

12. Landlord has advised Tenant that it requires approval of this Amendment by Landlord’s mortgagee (the “Mortgagee”) and an amendment to the existing Subordination and Non-Disturbance Agreement (“SNDA”) to reflect this Amendment. The parties agree that this Amendment is binding as of the date hereof, subject to receipt of written approval by the Mortgagee. Accordingly, Landlord shall promptly submit this Amendment to the Mortgagee and pay the Mortgagee any amounts required under its mortgage to obtain the SNDA. If the Mortgagee does not provide such consent or amendment for the SNDA within thirty days, either party can terminate this Amendment by written notice to the other party. The SNDA amendment shall be in a form reasonably satisfactory to Tenant.

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Please confirm your agreement to this letter by executing and returning a copy of this letter to the undersigned.

Sincerely,
ONE STATE STREET, LLC, Landlord
By:	South Ferry Building Company, Managing Member
By:	/S/    ABRAHAM WOLFSON
Name:	Abraham Wolfson
Title	General Partner

ACCEPTED AND AGREED TO: Ambac Financial Group, Inc., Tenant
By:	/S/    GREGG L. BIENSTOCK
Name:	Gregg L. Bienstock
Title:	Managing Director

EX-10.27

EXHIBIT 10.27

PUT OPTION AGREEMENT

between

AMBAC ASSURANCE CORPORATION

and

ANCHORAGE FINANCE MASTER TRUST,

ON BEHALF OF ITS SERIES

ANCHORAGE FINANCE SUB-TRUST I

Dated as of May 23, 2002

Preamble

This Put Option Agreement, dated as of May 23, 2002 (the “Agreement”), is by and between Ambac Assurance Corporation, a Wisconsin corporation (“Ambac Assurance”) and Anchorage Finance Master Trust (the “Master Trust”), a Delaware business trust, on behalf of its series, Anchorage Finance Sub-Trust I (the “Sub-Trust”).

Recitals

WHEREAS, Ambac Assurance is authorized to issue 4,000 shares of non-cumulative, perpetual preferred stock designated “Auction Market Preferred Shares,” which shares shall not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date (defined below) (the “Preferred Stock”); and

WHEREAS, Ambac Assurance and the Master Trust, on behalf of the Sub-Trust, desire to enter into a binding agreement pursuant to which Ambac Assurance will have the right to sell, at its option, the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, and the Master Trust, on behalf of the Sub-Trust, will have an obligation to purchase the Preferred Stock upon Ambac Assurance’s exercise of its option and upon the other terms and conditions agreed upon by the parties.

NOW THEREFORE, the parties hereto agree as follows:

1. Definitions; Interpretation

1.1    The words “herein,” “hereof” and “hereunder” and other words of similar import refer to this Agreement as a whole and not to any particular section, clause or other subdivision, and references to “Sections” refer to Sections of this Agreement except as otherwise expressly provided.

1.2    In this Agreement:

“ABC Securities” has the meaning set forth in the Declaration.

“Agreement” has the meaning set forth above in the Preamble.

“Ambac Assurance” has the meaning set forth above in the Preamble.

“Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

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“Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Broker-Dealer” has the meaning set forth in the Declaration.

“Business Day” has the meaning set forth in the Declaration.

“Closing Date” means the date of this Agreement.

“Declaration” means the Declaration of Trust governing the Master Trust, as the same may be amended or restated from time to time.

“Default” has the meaning set forth in the Declaration.

“Delayed Auction” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Distribution Rate” means, for each Delayed Auction Period, an amount equal to (a) the yield anticipated to be earned during such period on the Trust Property, minus (b) the anticipated expenses of the Sub-Trust for such Delayed Auction Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Delayed Put Option Premium is determined.

“Delayed Put Option Premium” has the meaning set forth in Section 5.1.

“Delayed Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Distribution Rate” means, for each Distribution Period, an amount equal to (a) the Projected Yield for such period, minus (b) the anticipated expenses of the Sub-Trust for such Distribution Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Put Option Premium is determined. The Distribution Rate for

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each Distribution Period will be calculated on the Auction Date occurring on the last Business Day prior to such Distribution Period.

“Distribution Payment Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Distribution Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Federal Funds Effective Rate” has the meaning set forth in the Declaration.

“Holder” has the meaning set forth in the Declaration.

“Overnight Rate of Return” means the rate earned on the earnings on the principal of the Trust Property from each Auction Date to the Distribution Payment Date occurring on the next Business Day, which shall be equal to the Federal Funds Effective Rate in effect as of the Business Day prior to the date of the determination of the Put Option Premium with respect to the Distribution Period for which such Put Option Premium is calculated.

“Preferred Stock” has the meaning set forth above in the Recitals.

“Projected Yield” means all amounts of interest (including accreted interest) and other payments due and payable (upon maturity or otherwise) on the principal amount of the Trust Property (excluding any repayment of principal) held by the Sub-Trust during the respective Distribution Period, plus the amount of interest anticipated to be earned based on the Overnight Rate of Return, as calculated on or prior to 11:00 a.m. on the Auction Date for each respective Distribution Period.

“Put Notice” means a written notice substantially in the form attached hereto as Annex A.

“Put Option Premium” has the meaning set forth in Section 5.

“Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Put Option Payment Date” has the meaning set forth in Section 3.2(a).

“Put Option Price” has the meaning set forth in Section 4.1.

“Sub-Trust” has the meaning set forth above in the Preamble.

“Tax Matters Partner” has the meaning set forth in the Declaration.

“Trust Property” has the meaning set forth in the Declaration.

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“Trustee” has the meaning set forth in the Declaration.

In this Agreement, any reference to a “company” shall be construed so as to include any corporation, trust, partnership, limited liability company or other legal entity, wheresoever incorporated or established.

1.3    In this Agreement, save where the contrary is indicated, any reference to:

(a)  this Agreement or any other agreement or document shall be construed as a reference to this Agreement or, as the case may be, such other agreement or document as the same may have been, or may from time to time be, amended, varied, novated or supplemented in accordance with its terms; and

(b)  a statute shall be construed as a reference to such statute as the same may have been, or may from time to time be, amended or re-enacted.

1.4    In this Agreement, any definition shall be equally applicable to both the singular and plural forms of the defined terms.

2. Put Option; Term

2.1    In consideration of the payment of the Put Option Premium and the Delayed Put Option Premium, if any, the Master Trust, on behalf of the Sub-Trust, hereby grants to Ambac Assurance the right to require the Master Trust, on behalf of the Sub-Trust, to purchase the Preferred Stock on the terms set forth in this Agreement.

2.2    This Agreement and the put option created hereby shall remain in effect until the earlier to occur of the following:

(a)  Ambac Assurance terminates this agreement by delivering a written notice to the Master Trust, on behalf of the Sub-Trust, stating that Ambac Assurance is terminating the Agreement on the next succeeding Auction Date that follows the notice by at least three (3) Business Days and indicating the Auction Date on which the termination shall become effective. Delivery of a termination notice by Ambac Assurance shall be irrevocable; and

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(b) Ambac Assurance fails to make payment of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured within five (5) Business Days.

2.3    This Agreement shall terminate upon Ambac Assurance’s exercise of its rights under Section 3 and the payment of the Put Option Price under Section 4, provided, however, that Section 7.5 shall survive such termination.

3. Exercise of Put Option

3.1    The Master Trust, on behalf of the Sub-Trust, agrees that it shall, upon exercise of the option as provided in Section 3.2, purchase the Preferred Stock from Ambac Assurance for a purchase price equal to the Put Option Price, which Put Option Price shall be payable on the Put Option Payment Date in accordance with Section 4.

3.2    (a)  Ambac Assurance may exercise the option at any time upon three (3) Business Days’ notice after the date hereof and prior to the termination of this Agreement by serving a Put Notice on the Master Trust, on behalf of the Sub-Trust, specifying a payment date (the “Put Option PaymentDate”), which shall be the next Distribution Payment Date on or after the third Business Day after service of the Put Notice on the Master Trust, on behalf of the Sub-Trust. Any notice of exercise provided pursuant to this Section 3.2(a) shall be irrevocable.

(b)  On the Put Option Payment Date, Ambac Assurance shall convey to the Master Trust, on behalf of the Sub-Trust, or its designee Preferred Stock with an aggregate liquidation preference equal to the aggregate face amount of the ABC Securities outstanding on the Put Option Payment Date. In addition, the number of shares of Preferred Stock delivered shall equal the number of ABC Securities outstanding on the Put Option Payment Date. The Preferred Stock shall be delivered free and clear of any defect in title, together with all transfer and registration documents (or all notices, instructions or other communications) as are necessary to convey title to the Preferred Stock to the Master Trust, on behalf of the Sub-Trust (or its nominee).

(c)  For avoidance of doubt, (1) any cash received by the Master Trust, on behalf of the Sub-Trust, as interest or other payments earned on the principal amount of the Trust Property (net of fees and expenses and excluding any repayment of principal) and not distributed to Holders as of the Put Option Payment Date shall be distributed to Holders and shall not be used to purchase shares of Preferred Stock; and (2) the amount of Preferred Stock purchased from Ambac Assurance shall be reduced by the amount, if any, by which the aggregate face

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amount of ABC Securities is reduced pursuant to principal or interest losses on Trust Property as a result of Defaults as required by the operation of Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A on or before the Put Option Payment Date.

4. Payments

4.1    Upon receipt of a Put Notice, the Master Trust will allow the then current assets of the Sub-Trust to mature, and will deliver the proceeds attributable to principal received upon maturity of the assets (after satisfying the Sub-Trust’s creditors, if any, and after any principal returned to holders of the ABC Securities pursuant to Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A) to Ambac Assurance on the Put Option Payment Date. The amount of such payment shall be referred to herein as the “Put Option Price.”

4.2    Payment by the Master Trust, on behalf of the Sub-Trust, of the Put Option Price shall be made on or prior to 3:00 p.m. on the Put Option Payment Date and to the account of Ambac Assurance specified in the Put Notice.

4.3    Payment of the Put Option Price by the Master Trust, on behalf of the Sub-Trust, shall be made as provided in Section 4.1 and Section 4.2 without setoff, claim, recoupment, deduction or counterclaim; provided, however, that if Ambac Assurance exercises its option under Section 3 hereof at any time that it has failed to pay all or a portion of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured on or before the Put Option Payment Date, the Master Trust, on behalf of the Sub-Trust, shall be entitled to set off against the Put Option Price such unpaid portion of the Put Option Premium or the Delayed Put Option Premium, as the case may be.

5. Put Option Premium

5.1    In consideration for the Master Trust’s agreement to purchase the Preferred Stock on behalf of the Sub-Trust in accordance with the terms of this Agreement, Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars, on each Distribution Payment Date, an amount equal to the product of (A) the Auction Rate on the ABC Securities for the respective Distribution Period less the Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the Sub-Trust outstanding at the time the Put Option Premium is calculated and (C) a fraction, the numerator of which will be the

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number of calendar days in the respective Distribution Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Put Option Premium.”

If there is a Default during any Distribution Period, then Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars on each Distribution Payment Date following receipt of the Delayed Put Option Premium Certificate an amount, as determined by the Trustee, equal to the product of (A) the Delayed Auction Rate on the ABC Securities for the Delayed Auction Period less the Delayed Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the respective Sub-Trust outstanding at the time the Delayed Put Option Premium is calculated and (C) a fraction, the numerator of which will be the number of calendar days in the respective Delayed Auction Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Delayed Put Option Premium.”

5.2    The amount of the Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Put Option Premium Certificate”), substantially in the form attached hereto as Annex B, to Ambac Assurance prior to 5:00 p.m. on each Auction Date. The amount of the Delayed Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Delayed Put Option Premium Certificate”) to Ambac Assurance prior to 5:00 p.m. on the Delayed Auction Date. The Put Option Premium Certificate, and any Delayed Put Option Premium Certificate, also shall set forth the eligible assets held by the Sub-Trust, the anticipated yield earned on each such asset, any anticipated fees to be paid or incurred by the Trustee on behalf of the Trust and the computation of the Put Option Premium, or the Delayed Put Option Premium, as the case may be, in each case for the respective Distribution Period and the Delayed Auction Period, respectively, and shall be in the form attached hereto as Annex B.

5.3    If the Put Option Premium, or the Delayed Put Option Premium, if any, is not paid on the date on which it is due, interest shall accrue thereon at a rate equal to the maximum rate then in effect, during the five (5) day cure period set forth in Section 2.2(b) hereof until such Put Option Premium, or Delayed Put Option Premium, is paid.

6. Obligations Absolute

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6.1    The Master Trust, on behalf of the Sub-Trust, acknowledges that, provided Ambac Assurance has complied with the terms of this Agreement, the obligations of the Master Trust, on behalf of the Sub-Trust, undertaken under this Agreement are absolute, irrevocable and unconditional irrespective of any circumstances whatsoever, including any defense otherwise available to the Master Trust, on behalf of the Sub-Trust, in equity or at law, including, without limitation, the defense of fraud, any defense based on the failure of Ambac Assurance to disclose any matter, whether or not material, to the Master Trust, on behalf of the Sub-Trust, or any other person, and any defense of breach of warranty or misrepresentation, and irrespective of any other circumstance which might otherwise constitute a legal or equitable discharge or defense of an insurer, surety or guarantor under any and all circumstances. The enforceability and effectiveness of this Agreement and the liability of the Master Trust, on behalf of the Sub-Trust, and the rights, remedies, powers and privileges of Ambac Assurance under this Agreement shall not be affected, limited, reduced, discharged or terminated, and the Master Trust, on behalf of the Sub-Trust, hereby expressly waives, to the fullest extent permitted by applicable law, any defense now or in the future arising by reason of:

(a) the illegality, invalidity or unenforceability of all or any part of the Declaration;

(b) any action taken by Ambac Assurance;

(c) any change in the direct or indirect ownership or control of Ambac Assurance or of any shares or ownership interests thereof;

(d) any other circumstance whatsoever that might otherwise constitute a legal or equitable discharge or defense of or for the Master Trust, on behalf of the Sub-Trust;

provided, however, that notwithstanding the provisions of this Section 6.1, the Master Trust, on behalf of the Sub-Trust, shall have no further obligations under this Agreement after the termination of this Agreement. In addition, the breach of any covenant made in this Agreement by the Master Trust, on behalf of the Sub-Trust, shall not terminate this Agreement or limit the rights of Ambac Assurance hereunder.

6.2    For the avoidance of doubt, no failure or delay by Ambac Assurance in exercising its rights hereunder shall operate as a waiver of its rights hereunder (except as specifically provided in this Agreement, including, without limitation, in respect of the notice periods and payment dates set forth in Section 3.2(a)) and, subject to the termination of this Agreement not having occurred, Ambac Assurance may continue to exercise its rights hereunder at any time.

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7. Covenants

7.1    Ambac Assurance hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the Preferred Stock whether by operation of merger, reorganization or otherwise, without the prior consent of the Master Trust, on behalf of the Sub-Trust, and it will not register the Preferred Stock with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date.

7.2    The Master Trust, on behalf of the Sub-Trust, hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the ABC Securities whether by operation of merger, reorganization or otherwise and it will not register the ABC Securities with the Securities and Exchange Commission under the Securities Act of 1933, as amended.

7.3    Ambac Assurance hereby covenants and agrees that any Preferred Stock delivered to the Master Trust, on behalf of the Sub-Trust, shall rank, at the time of delivery, (a) senior to the common stock of Ambac Assurance and (b) senior to or pari passu with the most senior preferred shares of Ambac then authorized by its Restated Articles of Amendment or then issued and outstanding; provided that this covenant may be amended with the consent of Ambac Assurance and at least a Majority in Face Amount (as defined in the Declaration) of the ABC Securities.

7.4    Ambac Assurance hereby covenants and agrees that if Ambac Assurance’s financial strength rating is ever lowered while this Agreement remains effective, Ambac Assurance shall provide written notice to the Trustee, on behalf of the Sub-Trust, of such lowered rating.

7.5    Ambac Assurance hereby covenants and agrees that it will not pay a dividend on its common stock pursuant to the first and second provisos of Section 4 of its Restated Articles of Incorporation unless it receives written assurance from Ambac Financial Group, Inc. that it will use such dividends for the purposes permitted by such provisos. Such written assurance shall provide that the holders of the Preferred Stock shall be third party beneficiaries of, and entitled to enforce, the provisions of such assurance as if they were parties

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thereto. The agreements and rights set forth in this Section 7.5 shall survive the exercise by Ambac Assurance of its rights under this Agreement, the issuance of the Preferred Stock and the liquidation of the Sub-Trust.

8. This Agreement to Govern

If there is any inconsistency between any provision of this Agreement and any other agreement, the provisions of this Agreement shall prevail to the extent of such inconsistency but not otherwise.

9. Representations and Warranties

9.1    The Master Trust represents and warrants to Ambac Assurance, on behalf of the Sub-Trust, that, as of the date hereof:

(a)  the Master Trust is duly organized and validly existing under the Delaware Business Trust Act and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)  the Sub-Trust has been duly formed by the Master Trust in accordance with its Declaration;

(c)  its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

(d)  it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(e)  it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

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(f)  its obligations under this Agreement are valid, binding and enforceable at law;

(g)  it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(h)  it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(i)  each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(j)  no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by the Master Trust, on behalf of the Sub-Trust, of the transactions contemplated by this Agreement; and

(k)  assuming compliance with the transfer restrictions with respect to the ABC Securities set forth in the Declaration, neither the Sub-Trust nor the Master Trust is required to register with the Securities and Exchange Commission as an investment company under the Investment Company Act of 1940, as amended.

9.2    Ambac Assurance represents and warrants to the Master Trust, on behalf of the Sub-Trust, that, as of the date hereof:

(a)  it is duly organized and validly existing as a corporation under the corporate law statutes of the State of Wisconsin and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)  its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

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(c)  it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(d)  it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

(e)  its obligations under this Agreement are valid, binding and enforceable at law;

(f)  it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(g)  it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(h)  each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(i)  no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by Ambac Assurance of the transactions contemplated by this Agreement and the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to the terms hereof need not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended; and

(j)  as of the Put Option Payment Date, the Preferred Stock will be duly authorized for issuance and sale to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement and, when issued and delivered by Ambac Assurance pursuant to this Agreement against payment of the Put Option Price, will be validly issued, fully paid and nonassessable; the Preferred Stock will conform in all respects to the terms of the Preferred Stock set forth in the Restated Articles of Incorporation of Ambac Assurance attached hereto as Annex C; and the Preferred Stock will not be subject to preemptive or other similar rights.

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10. Severability

10.1    Any provision of this Agreement which is or becomes illegal, invalid or unenforceable in any jurisdiction may be severed from the other provisions of this Agreement without invalidating the remaining provisions hereof, and any such illegality, invalidity or unenforceability shall not invalidate or render illegal or unenforceable such provision in any other jurisdiction.

11. Notices

11.1    Each communication to be made hereunder shall be deemed to have been given (i) five (5) days after deposit of such communication with a reputable national courier service addressed to such party at its address specified below (or at such other address as such party shall specify to the other party hereto in writing) or (ii) when transmitted by facsimile to such party at its facsimile number specified below (or at such other facsimile number as such party shall specify to the other party hereto in writing):

If to Ambac Assurance at:

Ambac Assurance Corporation

One State Street Plaza

New York, New York 10004

Attention:    Robert Starr, Treasurer

Facsimile:    (212) 208-3108

Copy to:    Kevin Doyle, General Counsel

If to the Master Trust or Sub-Trust at:

The Bank of New York (Delaware)

P.O. Box 6973

White Clay Center

Route 273

Newark, Delaware 19714

Attention:    Kristine Gullo

Facsimile:    (302) 283-8279

Copies to:

The Bank of New York

Corporate Trust Administration

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5 Penn Plaza

New York, NY 10001

Attention: Dealing and Trading Group

Facsimile: (212) 896-7295

12. Counterparts

This Agreement may be executed in any number of counterparts and by the different parties hereto on separate counterparts each of which when executed and delivered shall constitute an original, but all the counterparts shall together constitute but one and the same instrument.

13. Benefit of Agreement and Disclaimer

13.1    This Agreement shall enure to the benefit of each party hereto and its successors and assigns and transferees; provided that neither party hereto may transfer its rights and obligations hereunder, by operation of law or otherwise, without the prior written consent of the other party.

14. Amendment and Assignment

14.1    This Agreement may not be amended or modified in any respect, nor may any provision be waived, without the written agreement of both parties. No waiver by one party of any obligation of the other hereunder shall be considered a waiver of any other obligation of such party.

14.2    Neither the Master Trust, on behalf of the Sub-Trust, nor Ambac Assurance may assign its rights or obligations under this Agreement to any other person, except that Ambac Assurance may assign its rights and obligations under this Agreement to another person as a result of a merger of Ambac Assurance with another person or as a result of a sale of all or substantially all of the assets of Ambac Assurance to another person if the other person expressly assumes all of the rights and obligations of Ambac Assurance under this Agreement; and immediately following the merger or sale of substantially all of its assets, the rating of the substitute preferred stock or the unsecured debt obligations of the other person is at least as high as the credit rating of the Preferred Stock or the general unsecured debt obligations of Ambac Assurance, as the case may be (or if no such ratings exist, the financial strength rating of Ambac Assurance) immediately prior to the merger or sale.

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15. Governing Law

15.1    THIS AGREEMENT SHALL IN ALL RESPECTS BE GOVERNED BY, AND CONSTRUED IN ACCORDANCE WITH, THE LAWS OF THE STATE OF NEW YORK.

16. Jurisdiction

16.1    Each of the parties hereto irrevocably submits to the non-exclusive jurisdiction of the courts of the State of New York in respect of any action or proceeding arising out of or in connection with this Agreement (“Proceedings”). Each of the parties hereto irrevocably waives, to the fullest extent permitted by applicable law, any objection that it may now or hereafter have to the laying of the venue of any such Proceedings in the courts of the State of New York and any claim that any Proceeding brought in any such court has been brought in an inconvenient forum. Each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance agrees that it shall at all times have an authorized agent in the State of New York upon whom process may be served in connection with any Proceedings, and each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance hereby authorizes and appoints the Trustee to accept service of all legal process arising out of or connected with this Agreement in the State of New York and service on such person (or substitute) shall be deemed to be service on the Master Trust, on behalf of the Sub-Trust, or Ambac Assurance, as the case may be. Except upon such a substitution, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall not revoke any such authority or appointment and shall at all times maintain an agent for service of process in the State of New York. If for any reason such person shall cease to act as agent for the service of process, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall promptly appoint another such agent, and shall forthwith notify each other of such appointment. The submission to jurisdiction reflected in this paragraph shall not (and shall not be construed so as to) limit the right of any person to take Proceedings in any court of competent jurisdiction, nor shall the taking of Proceedings in any one or more jurisdictions preclude the taking of Proceedings in any other jurisdiction (whether concurrently or not) if and to the extent permitted by law.

17. Limitation of Liability

17.1    It is expressly understood that (a) this Agreement is executed and delivered by The Bank of New York (Delaware), not individually or personally but solely as Trustee, in the exercise of the powers and authority conferred and vested in it under the Declaration, (b) each of the representations, undertakings and agreements herein made on the part of the Master Trust, on behalf of the Sub-Trust, is made and intended not as personal representations,

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undertakings and agreements by The Bank of New York (Delaware), but is made and intended for the purpose of binding only the Master Trust, on behalf of the Sub-Trust, and (c) under no circumstances shall The Bank of New York (Delaware) be personally liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Master Trust, on behalf of the Sub-Trust, under this Agreement or the other related documents.

18. Replacement of Broker-Dealer

18.1    Ambac Assurance shall have the right to direct the Trustee to replace the Broker-Dealer at any time that Ambac Assurance believes, in the reasonable good faith exercise of its discretion, that the continued service of such Broker-Dealer could have an adverse impact on the rights and benefits conferred on Ambac Assurance pursuant to this Agreement.

18.2    In the event Ambac Assurance elects to exercise its right described in Section 18.1, Ambac Assurance shall propose to the Trustee a replacement Broker-Dealer. The Trustee shall enter into an agreement with such replacement Broker-Dealer, unless it has a reasonable basis for failing to do so, in which case the parties shall repeat such process until an acceptable Broker-Dealer is so selected.

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IN WITNESS WHEREOF the parties hereto have caused this Put Option Agreement to be duly executed as of the day and year first above written.

ANCHORAGE FINANCE MASTER TRUST, on behalf of its series, Anchorage Finance Sub-Trust I,
By:	The Bank of New York (Delaware), not in its individual capacity but solely as Trustee
By:
	Name: Title:

AMBAC ASSURANCE CORPORATION
By:
	Name: Title:

ANNEX A

Form of Put Notice

To: Anchorage Finance Sub-Trust I

c/o Bank of New York (Delaware)

P.O. Box 6973

502 White Clay Center

Route 273

Newark, Delaware 19714

with a copy to:

The Bank of New York

5 Penn Plaza

New York, New York 10001

Attention: Dealing and Trading Group

Date:

Ladies and Gentlemen:

We refer to the put option agreement dated May 23, 2002 (as heretofore amended, the “Put Option Agreement”) entered into between us and you. Terms defined in the Put Option Agreement (except where otherwise defined herein) shall have the same respective meanings herein.

This notice is the notice for the purposes of Section 3.2(a) of the Put Option Agreement. We hereby require you to pay the Put Option Price on the Put Option Payment Date, which shall be [                    ] to the following account:

[         ]

Yours faithfully,

for and on behalf of

Ambac Assurance Corporation

Put Option Premium Certificate

Ambac Assurance Corporation

Put Option on Auction Market Preferred Shares

1.	Distribution Period: [first day of Period]-[last day of Period]: [number of days in period–generally 28]
2.	Auction Rate determined for the Distribution Period on [insert date of Auction].                         0.000000%                     $ (0)
3.
	Issuer	Ratings	Purchase Price	Yield to Maturity	Interest
	One Corp	A1+/P1
	Two Corp	A1+/P1
	Three Corp	A1+/P1
	Four Corp	A1+/P1
	Five Corp	A1+/P1
	Six Corp	A1+/P1
	Seven Corp	A1+/P1
	Eight Corp	A1+/P1
	Nine Corp	A1/P1
	Ten Corp	A1/P1
4.			000,000,000	0.0%	$  0.0
5.	Applicable Federal Funds Effective Rate: 0.00%			0.0%	$  0.0
6.	Broker-Dealer Fee			0.0%	$(0.0)
7.	Trustee, Custodian and IPA Fees			0.0%	$(0.0)
8.	Asset Management Fee			0.0%	$(0.0)
9.	Tax Matters Partner Fee			0.0%	$(0.0)
10.	Servicing Agent Fee			0.0%	$(0.0)
11.	Other Fees and Expenses for the Distribution Period, if any			0.0%	$(0.0)
12.	Computation of Put Premium Due on [insert Distribution Payment Date] by 11:00 a.m. New York Time:			0.0%	$(0.0)
13.	The asset manager is in compliance with the investment policy.

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EX-10.28

EXHIBIT 10.28

PUT OPTION AGREEMENT

between

AMBAC ASSURANCE CORPORATION

and

ANCHORAGE FINANCE MASTER TRUST,

ON BEHALF OF ITS SERIES

ANCHORAGE FINANCE SUB-TRUST II

Dated as of May 23, 2002

Preamble

This Put Option Agreement, dated as of May 23, 2002 (the “Agreement”), is by and between Ambac Assurance Corporation, a Wisconsin corporation (“Ambac Assurance”) and Anchorage Finance Master Trust (the “Master Trust”), a Delaware business trust, on behalf of its series, Anchorage Finance Sub-Trust II (the “Sub-Trust”).

Recitals

WHEREAS, Ambac Assurance is authorized to issue 4,000 shares of non-cumulative, perpetual preferred stock designated “Auction Market Preferred Shares,” which shares shall not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date (defined below) (the “Preferred Stock”); and

WHEREAS, Ambac Assurance and the Master Trust, on behalf of the Sub-Trust, desire to enter into a binding agreement pursuant to which Ambac Assurance will have the right to sell, at its option, the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, and the Master Trust, on behalf of the Sub-Trust, will have an obligation to purchase the Preferred Stock upon Ambac Assurance’s exercise of its option and upon the other terms and conditions agreed upon by the parties.

NOW THEREFORE, the parties hereto agree as follows:

1. Definitions; Interpretation

1.1    The words “herein,” “hereof” and “hereunder” and other words of similar import refer to this Agreement as a whole and not to any particular section, clause or other subdivision, and references to “Sections” refer to Sections of this Agreement except as otherwise expressly provided.

1.2    In this Agreement:

“ABC Securities” has the meaning set forth in the Declaration.

“Agreement” has the meaning set forth above in the Preamble.

“Ambac Assurance” has the meaning set forth above in the Preamble.

“Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

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“Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Broker-Dealer” has the meaning set forth in the Declaration.

“Business Day” has the meaning set forth in the Declaration.

“Closing Date” means the date of this Agreement.

“Declaration” means the Declaration of Trust governing the Master Trust, as the same may be amended or restated from time to time.

“Default” has the meaning set forth in the Declaration.

“Delayed Auction” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Distribution Rate” means, for each Delayed Auction Period, an amount equal to (a) the yield anticipated to be earned during such period on the Trust Property, minus (b) the anticipated expenses of the Sub-Trust for such Delayed Auction Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Delayed Put Option Premium is determined.

“Delayed Put Option Premium” has the meaning set forth in Section 5.1.

“Delayed Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Distribution Rate” means, for each Distribution Period, an amount equal to (a) the Projected Yield for such period, minus (b) the anticipated expenses of the Sub-Trust for such Distribution Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Put Option Premium is determined. The Distribution Rate for

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each Distribution Period will be calculated on the Auction Date occurring on the last Business Day prior to such Distribution Period.

“Distribution Payment Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Distribution Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Federal Funds Effective Rate” has the meaning set forth in the Declaration.

“Holder” has the meaning set forth in the Declaration.

“Overnight Rate of Return” means the rate earned on the earnings on the principal of the Trust Property from each Auction Date to the Distribution Payment Date occurring on the next Business Day, which shall be equal to the Federal Funds Effective Rate in effect as of the Business Day prior to the date of the determination of the Put Option Premium with respect to the Distribution Period for which such Put Option Premium is calculated.

“Preferred Stock” has the meaning set forth above in the Recitals.

“Projected Yield” means all amounts of interest (including accreted interest) and other payments due and payable (upon maturity or otherwise) on the principal amount of the Trust Property (excluding any repayment of principal) held by the Sub-Trust during the respective Distribution Period, plus the amount of interest anticipated to be earned based on the Overnight Rate of Return, as calculated on or prior to 11:00 a.m. on the Auction Date for each respective Distribution Period.

“Put Notice” means a written notice substantially in the form attached hereto as Annex A.

“Put Option Premium” has the meaning set forth in Section 5.

“Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Put Option Payment Date” has the meaning set forth in Section 3.2(a).

“Put Option Price” has the meaning set forth in Section 4.1.

“Sub-Trust” has the meaning set forth above in the Preamble.

“Tax Matters Partner” has the meaning set forth in the Declaration.

“Trust Property” has the meaning set forth in the Declaration.

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“Trustee” has the meaning set forth in the Declaration.

In this Agreement, any reference to a “company” shall be construed so as to include any corporation, trust, partnership, limited liability company or other legal entity, wheresoever incorporated or established.

1.3    In this Agreement, save where the contrary is indicated, any reference to:

(a)  this Agreement or any other agreement or document shall be construed as a reference to this Agreement or, as the case may be, such other agreement or document as the same may have been, or may from time to time be, amended, varied, novated or supplemented in accordance with its terms; and

(b)  a statute shall be construed as a reference to such statute as the same may have been, or may from time to time be, amended or re-enacted.

1.4    In this Agreement, any definition shall be equally applicable to both the singular and plural forms of the defined terms.

2. Put Option; Term

2.1    In consideration of the payment of the Put Option Premium and the Delayed Put Option Premium, if any, the Master Trust, on behalf of the Sub-Trust, hereby grants to Ambac Assurance the right to require the Master Trust, on behalf of the Sub-Trust, to purchase the Preferred Stock on the terms set forth in this Agreement.

2.2    This Agreement and the put option created hereby shall remain in effect until the earlier to occur of the following:

(a)  Ambac Assurance terminates this agreement by delivering a written notice to the Master Trust, on behalf of the Sub-Trust, stating that Ambac Assurance is terminating the Agreement on the next succeeding Auction Date that follows the notice by at least three (3) Business Days and indicating the Auction Date on which the termination shall become effective. Delivery of a termination notice by Ambac Assurance shall be irrevocable; and

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(b)  Ambac Assurance fails to make payment of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured within five (5) Business Days.

2.3    This Agreement shall terminate upon Ambac Assurance’s exercise of its rights under Section 3 and the payment of the Put Option Price under Section 4, provided, however, that Section 7.5 shall survive such termination.

3. Exercise of Put Option

3.1    The Master Trust, on behalf of the Sub-Trust, agrees that it shall, upon exercise of the option as provided in Section 3.2, purchase the Preferred Stock from Ambac Assurance for a purchase price equal to the Put Option Price, which Put Option Price shall be payable on the Put Option Payment Date in accordance with Section 4.

3.2    (a)  Ambac Assurance may exercise the option at any time upon three (3) Business Days’ notice after the date hereof and prior to the termination of this Agreement by serving a Put Notice on the Master Trust, on behalf of the Sub-Trust, specifying a payment date (the “Put Option PaymentDate”), which shall be the next Distribution Payment Date on or after the third Business Day after service of the Put Notice on the Master Trust, on behalf of the Sub-Trust. Any notice of exercise provided pursuant to this Section 3.2(a) shall be irrevocable.

(b)  On the Put Option Payment Date, Ambac Assurance shall convey to the Master Trust, on behalf of the Sub-Trust, or its designee Preferred Stock with an aggregate liquidation preference equal to the aggregate face amount of the ABC Securities outstanding on the Put Option Payment Date. In addition, the number of shares of Preferred Stock delivered shall equal the number of ABC Securities outstanding on the Put Option Payment Date. The Preferred Stock shall be delivered free and clear of any defect in title, together with all transfer and registration documents (or all notices, instructions or other communications) as are necessary to convey title to the Preferred Stock to the Master Trust, on behalf of the Sub-Trust (or its nominee).

(c)  For avoidance of doubt, (1) any cash received by the Master Trust, on behalf of the Sub-Trust, as interest or other payments earned on the principal amount of the Trust Property (net of fees and expenses and excluding any repayment of principal) and not distributed to Holders as of the Put Option Payment Date shall be distributed to Holders and shall not be used to purchase shares of Preferred Stock; and (2) the amount of Preferred Stock purchased from Ambac Assurance shall be reduced by the amount, if any, by which the aggregate face

6

amount of ABC Securities is reduced pursuant to principal or interest losses on Trust Property as a result of Defaults as required by the operation of Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A on or before the Put Option Payment Date.

4. Payments

4.1    Upon receipt of a Put Notice, the Master Trust will allow the then current assets of the Sub-Trust to mature, and will deliver the proceeds attributable to principal received upon maturity of the assets (after satisfying the Sub-Trust’s creditors, if any, and after any principal returned to holders of the ABC Securities pursuant to Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A) to Ambac Assurance on the Put Option Payment Date. The amount of such payment shall be referred to herein as the “Put Option Price.”

4.2    Payment by the Master Trust, on behalf of the Sub-Trust, of the Put Option Price shall be made on or prior to 3:00 p.m. on the Put Option Payment Date and to the account of Ambac Assurance specified in the Put Notice.

4.3    Payment of the Put Option Price by the Master Trust, on behalf of the Sub-Trust, shall be made as provided in Section 4.1 and Section 4.2 without setoff, claim, recoupment, deduction or counterclaim; provided, however, that if Ambac Assurance exercises its option under Section 3 hereof at any time that it has failed to pay all or a portion of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured on or before the Put Option Payment Date, the Master Trust, on behalf of the Sub-Trust, shall be entitled to set off against the Put Option Price such unpaid portion of the Put Option Premium or the Delayed Put Option Premium, as the case may be.

5. Put Option Premium

5.1    In consideration for the Master Trust’s agreement to purchase the Preferred Stock on behalf of the Sub-Trust in accordance with the terms of this Agreement, Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars, on each Distribution Payment Date, an amount equal to the product of (A) the Auction Rate on the ABC Securities for the respective Distribution Period less the Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the Sub-Trust outstanding at the time the Put Option Premium is calculated and (C) a fraction, the numerator of which will be the

7

number of calendar days in the respective Distribution Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Put Option Premium.”

If there is a Default during any Distribution Period, then Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars on each Distribution Payment Date following receipt of the Delayed Put Option Premium Certificate an amount, as determined by the Trustee, equal to the product of (A) the Delayed Auction Rate on the ABC Securities for the Delayed Auction Period less the Delayed Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the respective Sub-Trust outstanding at the time the Delayed Put Option Premium is calculated and (C) a fraction, the numerator of which will be the number of calendar days in the respective Delayed Auction Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Delayed Put Option Premium.”

5.2    The amount of the Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Put Option Premium Certificate”), substantially in the form attached hereto as Annex B, to Ambac Assurance prior to 5:00 p.m. on each Auction Date. The amount of the Delayed Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Delayed Put Option Premium Certificate”) to Ambac Assurance prior to 5:00 p.m. on the Delayed Auction Date. The Put Option Premium Certificate, and any Delayed Put Option Premium Certificate, also shall set forth the eligible assets held by the Sub-Trust, the anticipated yield earned on each such asset, any anticipated fees to be paid or incurred by the Trustee on behalf of the Trust and the computation of the Put Option Premium, or the Delayed Put Option Premium, as the case may be, in each case for the respective Distribution Period and the Delayed Auction Period, respectively, and shall be in the form attached hereto as Annex B.

5.3    If the Put Option Premium, or the Delayed Put Option Premium, if any, is not paid on the date on which it is due, interest shall accrue thereon at a rate equal to the maximum rate then in effect, during the five (5) day cure period set forth in Section 2.2(b) hereof until such Put Option Premium, or Delayed Put Option Premium, is paid.

6. Obligations Absolute

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6.1    The Master Trust, on behalf of the Sub-Trust, acknowledges that, provided Ambac Assurance has complied with the terms of this Agreement, the obligations of the Master Trust, on behalf of the Sub-Trust, undertaken under this Agreement are absolute, irrevocable and unconditional irrespective of any circumstances whatsoever, including any defense otherwise available to the Master Trust, on behalf of the Sub-Trust, in equity or at law, including, without limitation, the defense of fraud, any defense based on the failure of Ambac Assurance to disclose any matter, whether or not material, to the Master Trust, on behalf of the Sub-Trust, or any other person, and any defense of breach of warranty or misrepresentation, and irrespective of any other circumstance which might otherwise constitute a legal or equitable discharge or defense of an insurer, surety or guarantor under any and all circumstances. The enforceability and effectiveness of this Agreement and the liability of the Master Trust, on behalf of the Sub-Trust, and the rights, remedies, powers and privileges of Ambac Assurance under this Agreement shall not be affected, limited, reduced, discharged or terminated, and the Master Trust, on behalf of the Sub-Trust, hereby expressly waives, to the fullest extent permitted by applicable law, any defense now or in the future arising by reason of:

(a)  the illegality, invalidity or unenforceability of all or any part of the Declaration;

(b)  any action taken by Ambac Assurance;

(c)  any change in the direct or indirect ownership or control of Ambac Assurance or of any shares or ownership interests thereof;

(d)  any other circumstance whatsoever that might otherwise constitute a legal or equitable discharge or defense of or for the Master Trust, on behalf of the Sub-Trust;

provided, however, that notwithstanding the provisions of this Section 6.1, the Master Trust, on behalf of the Sub-Trust, shall have no further obligations under this Agreement after the termination of this Agreement. In addition, the breach of any covenant made in this Agreement by the Master Trust, on behalf of the Sub-Trust, shall not terminate this Agreement or limit the rights of Ambac Assurance hereunder.

6.2    For the avoidance of doubt, no failure or delay by Ambac Assurance in exercising its rights hereunder shall operate as a waiver of its rights hereunder (except as specifically provided in this Agreement, including, without limitation, in respect of the notice periods and payment dates set forth in Section 3.2(a)) and, subject to the termination of this Agreement not having occurred, Ambac Assurance may continue to exercise its rights hereunder at any time.

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7. Covenants

7.1    Ambac Assurance hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the Preferred Stock whether by operation of merger, reorganization or otherwise, without the prior consent of the Master Trust, on behalf of the Sub-Trust, and it will not register the Preferred Stock with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date.

7.2    The Master Trust, on behalf of the Sub-Trust, hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the ABC Securities whether by operation of merger, reorganization or otherwise and it will not register the ABC Securities with the Securities and Exchange Commission under the Securities Act of 1933, as amended.

7.3    Ambac Assurance hereby covenants and agrees that any Preferred Stock delivered to the Master Trust, on behalf of the Sub-Trust, shall rank, at the time of delivery, (a) senior to the common stock of Ambac Assurance and (b) senior to or pari passu with the most senior preferred shares of Ambac then authorized by its Restated Articles of Amendment or then issued and outstanding; provided that this covenant may be amended with the consent of Ambac Assurance and at least a Majority in Face Amount (as defined in the Declaration) of the ABC Securities.

7.4    Ambac Assurance hereby covenants and agrees that if Ambac Assurance’s financial strength rating is ever lowered while this Agreement remains effective, Ambac Assurance shall provide written notice to the Trustee, on behalf of the Sub-Trust, of such lowered rating.

7.5    Ambac Assurance hereby covenants and agrees that it will not pay a dividend on its common stock pursuant to the first and second provisos of Section 4 of its Restated Articles of Incorporation unless it receives written assurance from Ambac Financial Group, Inc. that it will use such dividends for the purposes permitted by such provisos. Such written assurance shall provide that the holders of the Preferred Stock shall be third party beneficiaries of, and entitled to enforce, the provisions of such assurance as if they were parties

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thereto. The agreements and rights set forth in this Section 7.5 shall survive the exercise by Ambac Assurance of its rights under this Agreement, the issuance of the Preferred Stock and the liquidation of the Sub-Trust.

8. This Agreement to Govern

If there is any inconsistency between any provision of this Agreement and any other agreement, the provisions of this Agreement shall prevail to the extent of such inconsistency but not otherwise.

9. Representations and Warranties

9.1    The Master Trust represents and warrants to Ambac Assurance, on behalf of the Sub-Trust, that, as of the date hereof:

(a)  the Master Trust is duly organized and validly existing under the Delaware Business Trust Act and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)  the Sub-Trust has been duly formed by the Master Trust in accordance with its Declaration;

(c)  its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

(d)  it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(e)  it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

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(f)  its obligations under this Agreement are valid, binding and enforceable at law;

(g)  it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(h)  it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(i)  each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(j)  no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by the Master Trust, on behalf of the Sub-Trust, of the transactions contemplated by this Agreement; and

(k)  assuming compliance with the transfer restrictions with respect to the ABC Securities set forth in the Declaration, neither the Sub-Trust nor the Master Trust is required to register with the Securities and Exchange Commission as an investment company under the Investment Company Act of 1940, as amended.

9.2    Ambac Assurance represents and warrants to the Master Trust, on behalf of the Sub-Trust, that, as of the date hereof:

(a)  it is duly organized and validly existing as a corporation under the corporate law statutes of the State of Wisconsin and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)  its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

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(c)  it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(d)  it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

(e)  its obligations under this Agreement are valid, binding and enforceable at law;

(f)  it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(g)  it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(h)  each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(i)  no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by Ambac Assurance of the transactions contemplated by this Agreement and the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to the terms hereof need not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended; and

(j)  as of the Put Option Payment Date, the Preferred Stock will be duly authorized for issuance and sale to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement and, when issued and delivered by Ambac Assurance pursuant to this Agreement against payment of the Put Option Price, will be validly issued, fully paid and nonassessable; the Preferred Stock will conform in all respects to the terms of the Preferred Stock set forth in the Restated Articles of Incorporation of Ambac Assurance attached hereto as Annex C; and the Preferred Stock will not be subject to preemptive or other similar rights.

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10. Severability

10.1    Any provision of this Agreement which is or becomes illegal, invalid or unenforceable in any jurisdiction may be severed from the other provisions of this Agreement without invalidating the remaining provisions hereof, and any such illegality, invalidity or unenforceability shall not invalidate or render illegal or unenforceable such provision in any other jurisdiction.

11. Notices

11.1    Each communication to be made hereunder shall be deemed to have been given (i) five (5) days after deposit of such communication with a reputable national courier service addressed to such party at its address specified below (or at such other address as such party shall specify to the other party hereto in writing) or (ii) when transmitted by facsimile to such party at its facsimile number specified below (or at such other facsimile number as such party shall specify to the other party hereto in writing):

If to Ambac Assurance at:

Ambac Assurance Corporation

One State Street Plaza

New York, New York 10004

Attention:    Robert Starr, Treasurer

Facsimile:    (212) 208-3108

Copy to:    Kevin Doyle, General Counsel

If to the Master Trust or Sub-Trust at:

The Bank of New York (Delaware)

P.O. Box 6973

White Clay Center

Route 273

Newark, Delaware 19714

Attention:    Kristine Gullo

Facsimile:    (302) 283-8279

Copies to:

The Bank of New York

Corporate Trust Administration

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5 Penn Plaza

New York, NY 10001

Attention:    Dealing and Trading Group

Facsimile:    (212) 896-7295

12. Counterparts

This Agreement may be executed in any number of counterparts and by the different parties hereto on separate counterparts each of which when executed and delivered shall constitute an original, but all the counterparts shall together constitute but one and the same instrument.

13. Benefit of Agreement and Disclaimer

13.1    This Agreement shall enure to the benefit of each party hereto and its successors and assigns and transferees; provided that neither party hereto may transfer its rights and obligations hereunder, by operation of law or otherwise, without the prior written consent of the other party.

14. Amendment and Assignment

14.1    This Agreement may not be amended or modified in any respect, nor may any provision be waived, without the written agreement of both parties. No waiver by one party of any obligation of the other hereunder shall be considered a waiver of any other obligation of such party.

14.2    Neither the Master Trust, on behalf of the Sub-Trust, nor Ambac Assurance may assign its rights or obligations under this Agreement to any other person, except that Ambac Assurance may assign its rights and obligations under this Agreement to another person as a result of a merger of Ambac Assurance with another person or as a result of a sale of all or substantially all of the assets of Ambac Assurance to another person if the other person expressly assumes all of the rights and obligations of Ambac Assurance under this Agreement; and immediately following the merger or sale of substantially all of its assets, the rating of the substitute preferred stock or the unsecured debt obligations of the other person is at least as high as the credit rating of the Preferred Stock or the general unsecured debt obligations of Ambac Assurance, as the case may be (or if no such ratings exist, the financial strength rating of Ambac Assurance) immediately prior to the merger or sale.

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15. Governing Law

15.1    THIS AGREEMENT SHALL IN ALL RESPECTS BE GOVERNED BY, AND CONSTRUED IN ACCORDANCE WITH, THE LAWS OF THE STATE OF NEW YORK.

16. Jurisdiction

16.1    Each of the parties hereto irrevocably submits to the non-exclusive jurisdiction of the courts of the State of New York in respect of any action or proceeding arising out of or in connection with this Agreement (“Proceedings”). Each of the parties hereto irrevocably waives, to the fullest extent permitted by applicable law, any objection that it may now or hereafter have to the laying of the venue of any such Proceedings in the courts of the State of New York and any claim that any Proceeding brought in any such court has been brought in an inconvenient forum. Each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance agrees that it shall at all times have an authorized agent in the State of New York upon whom process may be served in connection with any Proceedings, and each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance hereby authorizes and appoints the Trustee to accept service of all legal process arising out of or connected with this Agreement in the State of New York and service on such person (or substitute) shall be deemed to be service on the Master Trust, on behalf of the Sub-Trust, or Ambac Assurance, as the case may be. Except upon such a substitution, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall not revoke any such authority or appointment and shall at all times maintain an agent for service of process in the State of New York. If for any reason such person shall cease to act as agent for the service of process, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall promptly appoint another such agent, and shall forthwith notify each other of such appointment. The submission to jurisdiction reflected in this paragraph shall not (and shall not be construed so as to) limit the right of any person to take Proceedings in any court of competent jurisdiction, nor shall the taking of Proceedings in any one or more jurisdictions preclude the taking of Proceedings in any other jurisdiction (whether concurrently or not) if and to the extent permitted by law.

17. Limitation of Liability

17.1    It is expressly understood that (a) this Agreement is executed and delivered by The Bank of New York (Delaware), not individually or personally but solely as Trustee, in the exercise of the powers and authority conferred and vested in it under the Declaration, (b) each of the representations, undertakings and agreements herein made on the part of the Master Trust, on behalf of the Sub-Trust, is made and intended not as personal representations,

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undertakings and agreements by The Bank of New York (Delaware), but is made and intended for the purpose of binding only the Master Trust, on behalf of the Sub-Trust, and (c) under no circumstances shall The Bank of New York (Delaware) be personally liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Master Trust, on behalf of the Sub-Trust, under this Agreement or the other related documents.

18. Replacement of Broker-Dealer

18.1    Ambac Assurance shall have the right to direct the Trustee to replace the Broker-Dealer at any time that Ambac Assurance believes, in the reasonable good faith exercise of its discretion, that the continued service of such Broker-Dealer could have an adverse impact on the rights and benefits conferred on Ambac Assurance pursuant to this Agreement.

18.2    In the event Ambac Assurance elects to exercise its right described in Section 18.1, Ambac Assurance shall propose to the Trustee a replacement Broker-Dealer. The Trustee shall enter into an agreement with such replacement Broker-Dealer, unless it has a reasonable basis for failing to do so, in which case the parties shall repeat such process until an acceptable Broker-Dealer is so selected.

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IN WITNESS WHEREOF the parties hereto have caused this Put Option Agreement to be duly executed as of the day and year first above written.

ANCHORAGE FINANCE MASTER TRUST, on behalf of its series, Anchorage Finance Sub-Trust II,
By:	The Bank of New York (Delaware), not in its individual capacity but solely as Trustee
By:
	Name: Title:

AMBAC ASSURANCE CORPORATION
By:
	Name: Title:

ANNEX A

Form of Put Notice

To: Anchorage Finance Sub-Trust II

c/o Bank of New York (Delaware)

P.O. Box 6973

502 White Clay Center

Route 273

Newark, Delaware 19714

with a copy to:

The Bank of New York

5 Penn Plaza

New York, New York 10001

Attention: Dealing and Trading Group

Date:

Ladies and Gentlemen:

We refer to the put option agreement dated May 23, 2002 (as heretofore amended, the “Put Option Agreement”) entered into between us and you. Terms defined in the Put Option Agreement (except where otherwise defined herein) shall have the same respective meanings herein.

This notice is the notice for the purposes of Section 3.2(a) of the Put Option Agreement. We hereby require you to pay the Put Option Price on the Put Option Payment Date, which shall be [                    ] to the following account:

[         ]

Yours faithfully,

for and on behalf of

Ambac Assurance Corporation

Put Option Premium Certificate

Ambac Assurance Corporation

Put Option on Auction Market Preferred Shares

1.	Distribution Period: [first day of Period]-[last day of Period]: [number of days in period–generally 28]
2.	Auction Rate determined for the Distribution Period on [insert date of Auction].                         0.000000%                     $ (0)
3.
	Issuer	Ratings	Purchase Price	Yield to Maturity	Interest
	One Corp	A1+/P1
	Two Corp	A1+/P1
	Three Corp	A1+/P1
	Four Corp	A1+/P1
	Five Corp	A1+/P1
	Six Corp	A1+/P1
	Seven Corp	A1+/P1
	Eight Corp	A1+/P1
	Nine Corp	A1/P1
	Ten Corp	A1/P1
4.			000,000,000	0.0%	$  0.0
5.	Applicable Federal Funds Effective Rate: 0.00%			0.0%	$  0.0
6.	Broker-Dealer Fee			0.0%	$(0.0)
7.	Trustee, Custodian and IPA Fees			0.0%	$(0.0)
8.	Asset Management Fee			0.0%	$(0.0)
9.	Tax Matters Partner Fee			0.0%	$(0.0)
10.	Servicing Agent Fee			0.0%	$(0.0)
11.	Other Fees and Expenses for the Distribution Period, if any			0.0%	$(0.0)
12.	Computation of Put Premium Due on [insert Distribution Payment Date] by 11:00 a.m. New York Time:			0.0%	$(0.0)
13.	The asset manager is in compliance with the investment policy.

EX-10.29

EXHIBIT 10.29

PUT OPTION AGREEMENT

between

AMBAC ASSURANCE CORPORATION

and

ANCHORAGE FINANCE MASTER TRUST,

ON BEHALF OF ITS SERIES

ANCHORAGE FINANCE SUB-TRUST III

Dated as of May 23, 2002

Preamble

This Put Option Agreement, dated as of May 23, 2002 (the “Agreement”), is by and between Ambac Assurance Corporation, a Wisconsin corporation (“Ambac Assurance”) and Anchorage Finance Master Trust (the “Master Trust”), a Delaware business trust, on behalf of its series, Anchorage Finance Sub-Trust III (the “Sub-Trust”).

Recitals

WHEREAS, Ambac Assurance is authorized to issue 4,000 shares of non-cumulative, perpetual preferred stock designated “Auction Market Preferred Shares,” which shares shall not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date (defined below) (the “Preferred Stock”); and

WHEREAS, Ambac Assurance and the Master Trust, on behalf of the Sub-Trust, desire to enter into a binding agreement pursuant to which Ambac Assurance will have the right to sell, at its option, the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, and the Master Trust, on behalf of the Sub-Trust, will have an obligation to purchase the Preferred Stock upon Ambac Assurance’s exercise of its option and upon the other terms and conditions agreed upon by the parties.

NOW THEREFORE, the parties hereto agree as follows:

1.    Definitions; Interpretation

1.1    The words “herein,” “hereof” and “hereunder” and other words of similar import refer to this Agreement as a whole and not to any particular section, clause or other subdivision, and references to “Sections” refer to Sections of this Agreement except as otherwise expressly provided.

1.2    In this Agreement:

“ABC Securities” has the meaning set forth in the Declaration.

“Agreement” has the meaning set forth above in the Preamble.

“Ambac Assurance” has the meaning set forth above in the Preamble.

“Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

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“Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Broker-Dealer” has the meaning set forth in the Declaration.

“Business Day” has the meaning set forth in the Declaration.

“Closing Date” means the date of this Agreement.

“Declaration” means the Declaration of Trust governing the Master Trust, as the same may be amended or restated from time to time.

“Default” has the meaning set forth in the Declaration.

“Delayed Auction” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Distribution Rate” means, for each Delayed Auction Period, an amount equal to (a) the yield anticipated to be earned during such period on the Trust Property, minus (b) the anticipated expenses of the Sub-Trust for such Delayed Auction Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Delayed Put Option Premium is determined.

“Delayed Put Option Premium” has the meaning set forth in Section 5.1.

“Delayed Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Distribution Rate” means, for each Distribution Period, an amount equal to (a) the Projected Yield for such period, minus (b) the anticipated expenses of the Sub-Trust for such Distribution Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Put Option Premium is determined. The Distribution Rate for

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each Distribution Period will be calculated on the Auction Date occurring on the last Business Day prior to such Distribution Period.

“Distribution Payment Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Distribution Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Federal Funds Effective Rate” has the meaning set forth in the Declaration.

“Holder” has the meaning set forth in the Declaration.

“Overnight Rate of Return” means the rate earned on the earnings on the principal of the Trust Property from each Auction Date to the Distribution Payment Date occurring on the next Business Day, which shall be equal to the Federal Funds Effective Rate in effect as of the Business Day prior to the date of the determination of the Put Option Premium with respect to the Distribution Period for which such Put Option Premium is calculated.

“Preferred Stock” has the meaning set forth above in the Recitals.

“Projected Yield” means all amounts of interest (including accreted interest) and other payments due and payable (upon maturity or otherwise) on the principal amount of the Trust Property (excluding any repayment of principal) held by the Sub-Trust during the respective Distribution Period, plus the amount of interest anticipated to be earned based on the Overnight Rate of Return, as calculated on or prior to 11:00 a.m. on the Auction Date for each respective Distribution Period.

“Put Notice” means a written notice substantially in the form attached hereto as Annex A.

“Put Option Premium” has the meaning set forth in Section 5.

“Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Put Option Payment Date” has the meaning set forth in Section 3.2(a).

“Put Option Price” has the meaning set forth in Section 4.1.

“Sub-Trust” has the meaning set forth above in the Preamble.

“Tax Matters Partner” has the meaning set forth in the Declaration.

“Trust Property” has the meaning set forth in the Declaration.

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“Trustee” has the meaning set forth in the Declaration.

In this Agreement, any reference to a “company” shall be construed so as to include any corporation, trust, partnership, limited liability company or other legal entity, wheresoever incorporated or established.

1.3    In this Agreement, save where the contrary is indicated, any reference to:

(a)    this Agreement or any other agreement or document shall be construed as a reference to this Agreement or, as the case may be, such other agreement or document as the same may have been, or may from time to time be, amended, varied, novated or supplemented in accordance with its terms; and

(b)    a statute shall be construed as a reference to such statute as the same may have been, or may from time to time be, amended or re-enacted.

1.4    In this Agreement, any definition shall be equally applicable to both the singular and plural forms of the defined terms.

2. Put Option; Term

2.1    In consideration of the payment of the Put Option Premium and the Delayed Put Option Premium, if any, the Master Trust, on behalf of the Sub-Trust, hereby grants to Ambac Assurance the right to require the Master Trust, on behalf of the Sub-Trust, to purchase the Preferred Stock on the terms set forth in this Agreement.

2.2    This Agreement and the put option created hereby shall remain in effect until the earlier to occur of the following:

(a)    Ambac Assurance terminates this agreement by delivering a written notice to the Master Trust, on behalf of the Sub-Trust, stating that Ambac Assurance is terminating the Agreement on the next succeeding Auction Date that follows the notice by at least three (3) Business Days and indicating the Auction Date on which the termination shall become effective. Delivery of a termination notice by Ambac Assurance shall be irrevocable; and

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(b)     Ambac Assurance fails to make payment of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured within five (5) Business Days.

2.3    This Agreement shall terminate upon Ambac Assurance’s exercise of its rights under Section 3 and the payment of the Put Option Price under Section 4, provided, however, that Section 7.5 shall survive such termination.

3. Exercise of Put Option

3.1    The Master Trust, on behalf of the Sub-Trust, agrees that it shall, upon exercise of the option as provided in Section 3.2, purchase the Preferred Stock from Ambac Assurance for a purchase price equal to the Put Option Price, which Put Option Price shall be payable on the Put Option Payment Date in accordance with Section 4.

3.2    (a)    Ambac Assurance may exercise the option at any time upon three (3) Business Days’ notice after the date hereof and prior to the termination of this Agreement by serving a Put Notice on the Master Trust, on behalf of the Sub-Trust, specifying a payment date (the “Put Option PaymentDate”), which shall be the next Distribution Payment Date on or after the third Business Day after service of the Put Notice on the Master Trust, on behalf of the Sub-Trust. Any notice of exercise provided pursuant to this Section 3.2(a) shall be irrevocable.

(b)    On the Put Option Payment Date, Ambac Assurance shall convey to the Master Trust, on behalf of the Sub-Trust, or its designee Preferred Stock with an aggregate liquidation preference equal to the aggregate face amount of the ABC Securities outstanding on the Put Option Payment Date. In addition, the number of shares of Preferred Stock delivered shall equal the number of ABC Securities outstanding on the Put Option Payment Date. The Preferred Stock shall be delivered free and clear of any defect in title, together with all transfer and registration documents (or all notices, instructions or other communications) as are necessary to convey title to the Preferred Stock to the Master Trust, on behalf of the Sub-Trust (or its nominee).

(c)    For avoidance of doubt, (1) any cash received by the Master Trust, on behalf of the Sub-Trust, as interest or other payments earned on the principal amount of the Trust Property (net of fees and expenses and excluding any repayment of principal) and not distributed to Holders as of the Put Option Payment Date shall be distributed to Holders and shall not be used to purchase shares of Preferred Stock; and (2) the amount of Preferred Stock purchased from Ambac Assurance shall be reduced by the amount, if any, by which the aggregate face

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amount of ABC Securities is reduced pursuant to principal or interest losses on Trust Property as a result of Defaults as required by the operation of Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A on or before the Put Option Payment Date.

4. Payments

4.1    Upon receipt of a Put Notice, the Master Trust will allow the then current assets of the Sub-Trust to mature, and will deliver the proceeds attributable to principal received upon maturity of the assets (after satisfying the Sub-Trust’s creditors, if any, and after any principal returned to holders of the ABC Securities pursuant to Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A) to Ambac Assurance on the Put Option Payment Date. The amount of such payment shall be referred to herein as the “Put Option Price.”

4.2    Payment by the Master Trust, on behalf of the Sub-Trust, of the Put Option Price shall be made on or prior to 3:00 p.m. on the Put Option Payment Date and to the account of Ambac Assurance specified in the Put Notice.

4.3    Payment of the Put Option Price by the Master Trust, on behalf of the Sub-Trust, shall be made as provided in Section 4.1 and Section 4.2 without setoff, claim, recoupment, deduction or counterclaim; provided, however, that if Ambac Assurance exercises its option under Section 3 hereof at any time that it has failed to pay all or a portion of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured on or before the Put Option Payment Date, the Master Trust, on behalf of the Sub-Trust, shall be entitled to set off against the Put Option Price such unpaid portion of the Put Option Premium or the Delayed Put Option Premium, as the case may be.

5. Put Option Premium

5.1    In consideration for the Master Trust’s agreement to purchase the Preferred Stock on behalf of the Sub-Trust in accordance with the terms of this Agreement, Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars, on each Distribution Payment Date, an amount equal to the product of (A) the Auction Rate on the ABC Securities for the respective Distribution Period less the Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the Sub-Trust outstanding at the time the Put Option Premium is calculated and (C) a fraction, the numerator of which will be the

7

number of calendar days in the respective Distribution Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Put Option Premium.”

If there is a Default during any Distribution Period, then Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars on each Distribution Payment Date following receipt of the Delayed Put Option Premium Certificate an amount, as determined by the Trustee, equal to the product of (A) the Delayed Auction Rate on the ABC Securities for the Delayed Auction Period less the Delayed Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the respective Sub-Trust outstanding at the time the Delayed Put Option Premium is calculated and (C) a fraction, the numerator of which will be the number of calendar days in the respective Delayed Auction Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Delayed Put Option Premium.”

5.2    The amount of the Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Put Option Premium Certificate”), substantially in the form attached hereto as Annex B, to Ambac Assurance prior to 5:00 p.m. on each Auction Date. The amount of the Delayed Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Delayed Put Option Premium Certificate”) to Ambac Assurance prior to 5:00 p.m. on the Delayed Auction Date. The Put Option Premium Certificate, and any Delayed Put Option Premium Certificate, also shall set forth the eligible assets held by the Sub-Trust, the anticipated yield earned on each such asset, any anticipated fees to be paid or incurred by the Trustee on behalf of the Trust and the computation of the Put Option Premium, or the Delayed Put Option Premium, as the case may be, in each case for the respective Distribution Period and the Delayed Auction Period, respectively, and shall be in the form attached hereto as Annex B.

5.3    If the Put Option Premium, or the Delayed Put Option Premium, if any, is not paid on the date on which it is due, interest shall accrue thereon at a rate equal to the maximum rate then in effect, during the five (5) day cure period set forth in Section 2.2(b) hereof until such Put Option Premium, or Delayed Put Option Premium, is paid.

6. Obligations Absolute

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6.1    The Master Trust, on behalf of the Sub-Trust, acknowledges that, provided Ambac Assurance has complied with the terms of this Agreement, the obligations of the Master Trust, on behalf of the Sub-Trust, undertaken under this Agreement are absolute, irrevocable and unconditional irrespective of any circumstances whatsoever, including any defense otherwise available to the Master Trust, on behalf of the Sub-Trust, in equity or at law, including, without limitation, the defense of fraud, any defense based on the failure of Ambac Assurance to disclose any matter, whether or not material, to the Master Trust, on behalf of the Sub-Trust, or any other person, and any defense of breach of warranty or misrepresentation, and irrespective of any other circumstance which might otherwise constitute a legal or equitable discharge or defense of an insurer, surety or guarantor under any and all circumstances. The enforceability and effectiveness of this Agreement and the liability of the Master Trust, on behalf of the Sub-Trust, and the rights, remedies, powers and privileges of Ambac Assurance under this Agreement shall not be affected, limited, reduced, discharged or terminated, and the Master Trust, on behalf of the Sub-Trust, hereby expressly waives, to the fullest extent permitted by applicable law, any defense now or in the future arising by reason of:

(a)    the illegality, invalidity or unenforceability of all or any part of the Declaration;

(b)    any action taken by Ambac Assurance;

(c)    any change in the direct or indirect ownership or control of Ambac Assurance or of any shares or ownership interests thereof;

(d)    any other circumstance whatsoever that might otherwise constitute a legal or equitable discharge or defense of or for the Master Trust, on behalf of the Sub-Trust;

provided, however, that notwithstanding the provisions of this Section 6.1, the Master Trust, on behalf of the Sub-Trust, shall have no further obligations under this Agreement after the termination of this Agreement. In addition, the breach of any covenant made in this Agreement by the Master Trust, on behalf of the Sub-Trust, shall not terminate this Agreement or limit the rights of Ambac Assurance hereunder.

6.2    For the avoidance of doubt, no failure or delay by Ambac Assurance in exercising its rights hereunder shall operate as a waiver of its rights hereunder (except as specifically provided in this Agreement, including, without limitation, in respect of the notice periods and payment dates set forth in Section 3.2(a)) and, subject to the termination of this Agreement not having occurred, Ambac Assurance may continue to exercise its rights hereunder at any time.

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7. Covenants

7.1    Ambac Assurance hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the Preferred Stock whether by operation of merger, reorganization or otherwise, without the prior consent of the Master Trust, on behalf of the Sub-Trust, and it will not register the Preferred Stock with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date.

7.2    The Master Trust, on behalf of the Sub-Trust, hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the ABC Securities whether by operation of merger, reorganization or otherwise and it will not register the ABC Securities with the Securities and Exchange Commission under the Securities Act of 1933, as amended.

7.3    Ambac Assurance hereby covenants and agrees that any Preferred Stock delivered to the Master Trust, on behalf of the Sub-Trust, shall rank, at the time of delivery, (a) senior to the common stock of Ambac Assurance and (b) senior to or pari passu with the most senior preferred shares of Ambac then authorized by its Restated Articles of Amendment or then issued and outstanding; provided that this covenant may be amended with the consent of Ambac Assurance and at least a Majority in Face Amount (as defined in the Declaration) of the ABC Securities.

7.4    Ambac Assurance hereby covenants and agrees that if Ambac Assurance’s financial strength rating is ever lowered while this Agreement remains effective, Ambac Assurance shall provide written notice to the Trustee, on behalf of the Sub-Trust, of such lowered rating.

7.5    Ambac Assurance hereby covenants and agrees that it will not pay a dividend on its common stock pursuant to the first and second provisos of Section 4 of its Restated Articles of Incorporation unless it receives written assurance from Ambac Financial Group, Inc. that it will use such dividends for the purposes permitted by such provisos. Such written assurance shall provide that the holders of the Preferred Stock shall be third party beneficiaries of, and entitled to enforce, the provisions of such assurance as if they were parties

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thereto. The agreements and rights set forth in this Section 7.5 shall survive the exercise by Ambac Assurance of its rights under this Agreement, the issuance of the Preferred Stock and the liquidation of the Sub-Trust.

8. This Agreement to Govern

If there is any inconsistency between any provision of this Agreement and any other agreement, the provisions of this Agreement shall prevail to the extent of such inconsistency but not otherwise.

9. Representations and Warranties

9.1    The Master Trust represents and warrants to Ambac Assurance, on behalf of the Sub-Trust, that, as of the date hereof:

(a)    the Master Trust is duly organized and validly existing under the Delaware Business Trust Act and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)    the Sub-Trust has been duly formed by the Master Trust in accordance with its Declaration;

(c)    its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

(d)    it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(e)    it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

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(f)    its obligations under this Agreement are valid, binding and enforceable at law;

(g)    it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(h)    it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(i)    each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(j)    no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by the Master Trust, on behalf of the Sub-Trust, of the transactions contemplated by this Agreement; and

(k)    assuming compliance with the transfer restrictions with respect to the ABC Securities set forth in the Declaration, neither the Sub-Trust nor the Master Trust is required to register with the Securities and Exchange Commission as an investment company under the Investment Company Act of 1940, as amended.

9.2    Ambac Assurance represents and warrants to the Master Trust, on behalf of the Sub-Trust, that, as of the date hereof:

(a)    it is duly organized and validly existing as a corporation under the corporate law statutes of the State of Wisconsin and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)    its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

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(c)    it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(d)    it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

(e)    its obligations under this Agreement are valid, binding and enforceable at law;

(f)    it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(g)    it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(h)    each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(i)    no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by Ambac Assurance of the transactions contemplated by this Agreement and the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to the terms hereof need not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended; and

(j)    as of the Put Option Payment Date, the Preferred Stock will be duly authorized for issuance and sale to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement and, when issued and delivered by Ambac Assurance pursuant to this Agreement against payment of the Put Option Price, will be validly issued, fully paid and nonassessable; the Preferred Stock will conform in all respects to the terms of the Preferred Stock set forth in the Restated Articles of Incorporation of Ambac Assurance attached hereto as Annex C; and the Preferred Stock will not be subject to preemptive or other similar rights.

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10. Severability

10.1    Any provision of this Agreement which is or becomes illegal, invalid or unenforceable in any jurisdiction may be severed from the other provisions of this Agreement without invalidating the remaining provisions hereof, and any such illegality, invalidity or unenforceability shall not invalidate or render illegal or unenforceable such provision in any other jurisdiction.

11. Notices

11.1    Each communication to be made hereunder shall be deemed to have been given (i) five (5) days after deposit of such communication with a reputable national courier service addressed to such party at its address specified below (or at such other address as such party shall specify to the other party hereto in writing) or (ii) when transmitted by facsimile to such party at its facsimile number specified below (or at such other facsimile number as such party shall specify to the other party hereto in writing):

If to Ambac Assurance at:

Ambac Assurance Corporation

One State Street Plaza

New York, New York 10004

Attention:    Robert Starr, Treasurer

Facsimile:    (212) 208-3108

Copy to:     Kevin Doyle, General Counsel

If to the Master Trust or Sub-Trust at:

The Bank of New York (Delaware)

P.O. Box 6973

White Clay Center

Route 273

Newark, Delaware 19714

Attention:    Kristine Gullo

Facsimile:    (302) 283-8279

Copies to:

The Bank of New York

Corporate Trust Administration

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5 Penn Plaza

New York, NY 10001

Attention:    Dealing and Trading Group

Facsimile:    (212) 896-7295

12. Counterparts

This Agreement may be executed in any number of counterparts and by the different parties hereto on separate counterparts each of which when executed and delivered shall constitute an original, but all the counterparts shall together constitute but one and the same instrument.

13. Benefit of Agreement and Disclaimer

13.1    This Agreement shall enure to the benefit of each party hereto and its successors and assigns and transferees; provided that neither party hereto may transfer its rights and obligations hereunder, by operation of law or otherwise, without the prior written consent of the other party.

14. Amendment and Assignment

14.1    This Agreement may not be amended or modified in any respect, nor may any provision be waived, without the written agreement of both parties. No waiver by one party of any obligation of the other hereunder shall be considered a waiver of any other obligation of such party.

14.2    Neither the Master Trust, on behalf of the Sub-Trust, nor Ambac Assurance may assign its rights or obligations under this Agreement to any other person, except that Ambac Assurance may assign its rights and obligations under this Agreement to another person as a result of a merger of Ambac Assurance with another person or as a result of a sale of all or substantially all of the assets of Ambac Assurance to another person if the other person expressly assumes all of the rights and obligations of Ambac Assurance under this Agreement; and immediately following the merger or sale of substantially all of its assets, the rating of the substitute preferred stock or the unsecured debt obligations of the other person is at least as high as the credit rating of the Preferred Stock or the general unsecured debt obligations of Ambac Assurance, as the case may be (or if no such ratings exist, the financial strength rating of Ambac Assurance) immediately prior to the merger or sale.

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15. Governing Law

15.1    THIS AGREEMENT SHALL IN ALL RESPECTS BE GOVERNED BY, AND CONSTRUED IN ACCORDANCE WITH, THE LAWS OF THE STATE OF NEW YORK.

16. Jurisdiction

16.1    Each of the parties hereto irrevocably submits to the non-exclusive jurisdiction of the courts of the State of New York in respect of any action or proceeding arising out of or in connection with this Agreement (“Proceedings”). Each of the parties hereto irrevocably waives, to the fullest extent permitted by applicable law, any objection that it may now or hereafter have to the laying of the venue of any such Proceedings in the courts of the State of New York and any claim that any Proceeding brought in any such court has been brought in an inconvenient forum. Each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance agrees that it shall at all times have an authorized agent in the State of New York upon whom process may be served in connection with any Proceedings, and each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance hereby authorizes and appoints the Trustee to accept service of all legal process arising out of or connected with this Agreement in the State of New York and service on such person (or substitute) shall be deemed to be service on the Master Trust, on behalf of the Sub-Trust, or Ambac Assurance, as the case may be. Except upon such a substitution, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall not revoke any such authority or appointment and shall at all times maintain an agent for service of process in the State of New York. If for any reason such person shall cease to act as agent for the service of process, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall promptly appoint another such agent, and shall forthwith notify each other of such appointment. The submission to jurisdiction reflected in this paragraph shall not (and shall not be construed so as to) limit the right of any person to take Proceedings in any court of competent jurisdiction, nor shall the taking of Proceedings in any one or more jurisdictions preclude the taking of Proceedings in any other jurisdiction (whether concurrently or not) if and to the extent permitted by law.

17. Limitation of Liability

17.1    It is expressly understood that (a) this Agreement is executed and delivered by The Bank of New York (Delaware), not individually or personally but solely as Trustee, in the exercise of the powers and authority conferred and vested in it under the Declaration, (b) each of the representations, undertakings and agreements herein made on the part of the Master Trust, on behalf of the Sub-Trust, is made and intended not as personal representations,

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undertakings and agreements by The Bank of New York (Delaware), but is made and intended for the purpose of binding only the Master Trust, on behalf of the Sub-Trust, and (c) under no circumstances shall The Bank of New York (Delaware) be personally liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Master Trust, on behalf of the Sub-Trust, under this Agreement or the other related documents.

18. Replacement of Broker-Dealer

18.1    Ambac Assurance shall have the right to direct the Trustee to replace the Broker-Dealer at any time that Ambac Assurance believes, in the reasonable good faith exercise of its discretion, that the continued service of such Broker-Dealer could have an adverse impact on the rights and benefits conferred on Ambac Assurance pursuant to this Agreement.

18.2    In the event Ambac Assurance elects to exercise its right described in Section 18.1, Ambac Assurance shall propose to the Trustee a replacement Broker-Dealer. The Trustee shall enter into an agreement with such replacement Broker-Dealer, unless it has a reasonable basis for failing to do so, in which case the parties shall repeat such process until an acceptable Broker-Dealer is so selected.

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IN WITNESS WHEREOF the parties hereto have caused this Put Option Agreement to be duly executed as of the day and year first above written.

ANCHORAGE FINANCE MASTER TRUST, on behalf of its series, Anchorage Finance Sub-Trust III,
By:	The Bank of New York (Delaware), not in its individual capacity but solely as Trustee
By:
Name:
Title:
AMBAC ASSURANCE CORPORATION
By:
Name:
Title:

ANNEX A

Form of Put Notice

To: Anchorage Finance Sub-Trust III

c/o Bank of New York (Delaware)

P.O. Box 6973

502 White Clay Center

Route 273

Newark, Delaware 19714

with a copy to:

The Bank of New York

5 Penn Plaza

New York, New York 10001

Attention: Dealing and Trading Group

Date:

Ladies and Gentlemen:

We refer to the put option agreement dated May 23, 2002 (as heretofore amended, the “Put Option Agreement”) entered into between us and you. Terms defined in the Put Option Agreement (except where otherwise defined herein) shall have the same respective meanings herein.

This notice is the notice for the purposes of Section 3.2(a) of the Put Option Agreement. We hereby require you to pay the Put Option Price on the Put Option Payment Date, which shall be [                        ] to the following account:

[              ]

Yours faithfully,

for and on behalf of

Ambac Assurance Corporation

Put Option Premium Certificate

Ambac Assurance Corporation

Put Option on Auction Market Preferred Shares

1.	Distribution Period: [first day of Period]-[last day of Period]: [number of days in period—generally 28]
2.	Auction Rate determined for the Distribution Period on [insert date of Auction].                         0.000000%                     $ (0)
3.
	Issuer	Ratings	Purchase Price	Yield to Maturity	Interest
	One Corp	A1+/P1
	Two Corp	A1+/P1
	Three Corp	A1+/P1
	Four Corp	A1+/P1
	Five Corp	A1+/P1
	Six Corp	A1+/P1
	Seven Corp	A1+/P1
	Eight Corp	A1+/P1
	Nine Corp	A1/P1
	Ten Corp	A1/P1
4.			000,000,000	0.0%	$  0.0
5.	Applicable Federal Funds Effective Rate: 0.00%			0.0%	$  0.0
6.	Broker-Dealer Fee			0.0%	$(0.0)
7.	Trustee, Custodian and IPA Fees			0.0%	$(0.0)
8.	Asset Management Fee			0.0%	$(0.0)
9.	Tax Matters Partner Fee			0.0%	$(0.0)
10.	Servicing Agent Fee			0.0%	$(0.0)
11.	Other Fees and Expenses for the Distribution Period, if any			0.0%	$(0.0)
12.	Computation of Put Premium Due on [insert Distribution Payment Date] by 11:00 a.m. New York Time:			0.0%	$(0.0)
13.	The asset manager is in compliance with the investment policy.

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EX-10.30

EXHIBIT 10.30

PUT OPTION AGREEMENT

between

AMBAC ASSURANCE CORPORATION

and

ANCHORAGE FINANCE MASTER TRUST,

ON BEHALF OF ITS SERIES

ANCHORAGE FINANCE SUB-TRUST IV

Dated as of May 23, 2002

Preamble

This Put Option Agreement, dated as of May 23, 2002 (the “Agreement”), is by and between Ambac Assurance Corporation, a Wisconsin corporation (“Ambac Assurance”) and Anchorage Finance Master Trust (the “Master Trust”), a Delaware business trust, on behalf of its series, Anchorage Finance Sub-Trust IV (the “Sub-Trust”).

Recitals

WHEREAS, Ambac Assurance is authorized to issue 4,000 shares of non-cumulative, perpetual preferred stock designated “Auction Market Preferred Shares,” which shares shall not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date (defined below) (the “Preferred Stock”); and

WHEREAS, Ambac Assurance and the Master Trust, on behalf of the Sub-Trust, desire to enter into a binding agreement pursuant to which Ambac Assurance will have the right to sell, at its option, the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, and the Master Trust, on behalf of the Sub-Trust, will have an obligation to purchase the Preferred Stock upon Ambac Assurance’s exercise of its option and upon the other terms and conditions agreed upon by the parties.

NOW THEREFORE, the parties hereto agree as follows:

1.    Definitions; Interpretation

1.1    The words “herein,” “hereof” and “hereunder” and other words of similar import refer to this Agreement as a whole and not to any particular section, clause or other subdivision, and references to “Sections” refer to Sections of this Agreement except as otherwise expressly provided.

1.2    In this Agreement:

“ABC Securities” has the meaning set forth in the Declaration.

“Agreement” has the meaning set forth above in the Preamble.

“Ambac Assurance” has the meaning set forth above in the Preamble.

“Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

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“Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Broker-Dealer” has the meaning set forth in the Declaration.

“Business Day” has the meaning set forth in the Declaration.

“Closing Date” means the date of this Agreement.

“Declaration” means the Declaration of Trust governing the Master Trust, as the same may be amended or restated from time to time.

“Default” has the meaning set forth in the Declaration.

“Delayed Auction” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Auction Rate” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Delayed Distribution Rate” means, for each Delayed Auction Period, an amount equal to (a) the yield anticipated to be earned during such period on the Trust Property, minus (b) the anticipated expenses of the Sub-Trust for such Delayed Auction Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Delayed Put Option Premium is determined.

“Delayed Put Option Premium” has the meaning set forth in Section 5.1.

“Delayed Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Distribution Rate” means, for each Distribution Period, an amount equal to (a) the Projected Yield for such period, minus (b) the anticipated expenses of the Sub-Trust for such Distribution Period, provided that such amount shall be annualized and expressed as an annual rate with respect to the aggregate face amount of the ABC Securities outstanding on the date the Put Option Premium is determined. The Distribution Rate for

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each Distribution Period will be calculated on the Auction Date occurring on the last Business Day prior to such Distribution Period.

“Distribution Payment Date” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Distribution Period” has the meaning set forth in the General Terms of the ABC Securities attached to the Declaration as Appendix A.

“Federal Funds Effective Rate” has the meaning set forth in the Declaration.

“Holder” has the meaning set forth in the Declaration.

“Overnight Rate of Return” means the rate earned on the earnings on the principal of the Trust Property from each Auction Date to the Distribution Payment Date occurring on the next Business Day, which shall be equal to the Federal Funds Effective Rate in effect as of the Business Day prior to the date of the determination of the Put Option Premium with respect to the Distribution Period for which such Put Option Premium is calculated.

“Preferred Stock” has the meaning set forth above in the Recitals.

“Projected Yield” means all amounts of interest (including accreted interest) and other payments due and payable (upon maturity or otherwise) on the principal amount of the Trust Property (excluding any repayment of principal) held by the Sub-Trust during the respective Distribution Period, plus the amount of interest anticipated to be earned based on the Overnight Rate of Return, as calculated on or prior to 11:00 a.m. on the Auction Date for each respective Distribution Period.

“Put Notice” means a written notice substantially in the form attached hereto as Annex A.

“Put Option Premium” has the meaning set forth in Section 5.

“Put Option Premium Certificate” has the meaning set forth in Section 5.2.

“Put Option Payment Date” has the meaning set forth in Section 3.2(a).

“Put Option Price” has the meaning set forth in Section 4.1.

“Sub-Trust” has the meaning set forth above in the Preamble.

“Tax Matters Partner” has the meaning set forth in the Declaration.

“Trust Property” has the meaning set forth in the Declaration.

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“Trustee” has the meaning set forth in the Declaration.

In this Agreement, any reference to a “company” shall be construed so as to include any corporation, trust, partnership, limited liability company or other legal entity, wheresoever incorporated or established.

1.3    In this Agreement, save where the contrary is indicated, any reference to:

(a)    this Agreement or any other agreement or document shall be construed as a reference to this Agreement or, as the case may be, such other agreement or document as the same may have been, or may from time to time be, amended, varied, novated or supplemented in accordance with its terms; and

(b)    a statute shall be construed as a reference to such statute as the same may have been, or may from time to time be, amended or re-enacted.

1.4    In this Agreement, any definition shall be equally applicable to both the singular and plural forms of the defined terms.

2. Put Option; Term

2.1    In consideration of the payment of the Put Option Premium and the Delayed Put Option Premium, if any, the Master Trust, on behalf of the Sub-Trust, hereby grants to Ambac Assurance the right to require the Master Trust, on behalf of the Sub-Trust, to purchase the Preferred Stock on the terms set forth in this Agreement.

2.2    This Agreement and the put option created hereby shall remain in effect until the earlier to occur of the following:

(a)    Ambac Assurance terminates this agreement by delivering a written notice to the Master Trust, on behalf of the Sub-Trust, stating that Ambac Assurance is terminating the Agreement on the next succeeding Auction Date that follows the notice by at least three (3) Business Days and indicating the Auction Date on which the termination shall become effective. Delivery of a termination notice by Ambac Assurance shall be irrevocable; and

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(b)    Ambac Assurance fails to make payment of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured within five (5) Business Days.

2.3    This Agreement shall terminate upon Ambac Assurance’s exercise of its rights under Section 3 and the payment of the Put Option Price under Section 4, provided, however, that Section 7.5 shall survive such termination.

3. Exercise of Put Option

3.1    The Master Trust, on behalf of the Sub-Trust, agrees that it shall, upon exercise of the option as provided in Section 3.2, purchase the Preferred Stock from Ambac Assurance for a purchase price equal to the Put Option Price, which Put Option Price shall be payable on the Put Option Payment Date in accordance with Section 4.

3.2    (a)    Ambac Assurance may exercise the option at any time upon three (3) Business Days’ notice after the date hereof and prior to the termination of this Agreement by serving a Put Notice on the Master Trust, on behalf of the Sub-Trust, specifying a payment date (the “Put Option Payment Date”), which shall be the next Distribution Payment Date on or after the third Business Day after service of the Put Notice on the Master Trust, on behalf of the Sub-Trust. Any notice of exercise provided pursuant to this Section 3.2(a) shall be irrevocable.

(a)    On the Put Option Payment Date, Ambac Assurance shall convey to the Master Trust, on behalf of the Sub-Trust, or its designee Preferred Stock with an aggregate liquidation preference equal to the aggregate face amount of the ABC Securities outstanding on the Put Option Payment Date. In addition, the number of shares of Preferred Stock delivered shall equal the number of ABC Securities outstanding on the Put Option Payment Date. The Preferred Stock shall be delivered free and clear of any defect in title, together with all transfer and registration documents (or all notices, instructions or other communications) as are necessary to convey title to the Preferred Stock to the Master Trust, on behalf of the Sub-Trust (or its nominee).

(b)    For avoidance of doubt, (1) any cash received by the Master Trust, on behalf of the Sub-Trust, as interest or other payments earned on the principal amount of the Trust Property (net of fees and expenses and excluding any repayment of principal) and not distributed to Holders as of the Put Option Payment Date shall be distributed to Holders and shall not be used to purchase shares of Preferred Stock; and (2) the amount of Preferred Stock purchased from Ambac Assurance shall be reduced by the amount, if any, by which the aggregate face

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amount of ABC Securities is reduced pursuant to principal or interest losses on Trust Property as a result of Defaults as required by the operation of Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A on or before the Put Option Payment Date.

4. Payments

4.1    Upon receipt of a Put Notice, the Master Trust will allow the then current assets of the Sub-Trust to mature, and will deliver the proceeds attributable to principal received upon maturity of the assets (after satisfying the Sub-Trust’s creditors, if any, and after any principal returned to holders of the ABC Securities pursuant to Section 6.1(j) of the Declaration and Section 6(b) of the General Terms of the ABC Securities attached to the Declaration as Appendix A) to Ambac Assurance on the Put Option Payment Date. The amount of such payment shall be referred to herein as the “Put Option Price.”

4.2    Payment by the Master Trust, on behalf of the Sub-Trust, of the Put Option Price shall be made on or prior to 3:00 p.m. on the Put Option Payment Date and to the account of Ambac Assurance specified in the Put Notice.

4.3    Payment of the Put Option Price by the Master Trust, on behalf of the Sub-Trust, shall be made as provided in Section 4.1 and Section 4.2 without setoff, claim, recoupment, deduction or counterclaim; provided, however, that if Ambac Assurance exercises its option under Section 3 hereof at any time that it has failed to pay all or a portion of the Put Option Premium or the Delayed Put Option Premium, if any, and such failure has not been cured on or before the Put Option Payment Date, the Master Trust, on behalf of the Sub-Trust, shall be entitled to set off against the Put Option Price such unpaid portion of the Put Option Premium or the Delayed Put Option Premium, as the case may be.

5. Put Option Premium

5.1    In consideration for the Master Trust’s agreement to purchase the Preferred Stock on behalf of the Sub-Trust in accordance with the terms of this Agreement, Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars, on each Distribution Payment Date, an amount equal to the product of (A) the Auction Rate on the ABC Securities for the respective Distribution Period less the Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the Sub-Trust outstanding at the time the Put Option Premium is calculated and (C) a fraction, the numerator of which will be the

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number of calendar days in the respective Distribution Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Put Option Premium.”

If there is a Default during any Distribution Period, then Ambac Assurance agrees to pay to the Master Trust, on behalf of the Sub-Trust, in US dollars on each Distribution Payment Date following receipt of the Delayed Put Option Premium Certificate an amount, as determined by the Trustee, equal to the product of (A) the Delayed Auction Rate on the ABC Securities for the Delayed Auction Period less the Delayed Distribution Rate for such Distribution Period, (B) the aggregate face amount of the ABC Securities of the respective Sub-Trust outstanding at the time the Delayed Put Option Premium is calculated and (C) a fraction, the numerator of which will be the number of calendar days in the respective Delayed Auction Period, and the denominator of which will be 360 days.

The amount derived in accordance with such formula shall be known herein as the “Delayed Put Option Premium.”

5.2    The amount of the Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Put Option Premium Certificate”), substantially in the form attached hereto as Annex B, to Ambac Assurance prior to 5:00 p.m. on each Auction Date. The amount of the Delayed Put Option Premium shall be calculated by the Trustee and delivered in writing (the “Delayed Put Option Premium Certificate”) to Ambac Assurance prior to 5:00 p.m. on the Delayed Auction Date. The Put Option Premium Certificate, and any Delayed Put Option Premium Certificate, also shall set forth the eligible assets held by the Sub-Trust, the anticipated yield earned on each such asset, any anticipated fees to be paid or incurred by the Trustee on behalf of the Trust and the computation of the Put Option Premium, or the Delayed Put Option Premium, as the case may be, in each case for the respective Distribution Period and the Delayed Auction Period, respectively, and shall be in the form attached hereto as Annex B.

5.3    If the Put Option Premium, or the Delayed Put Option Premium, if any, is not paid on the date on which it is due, interest shall accrue thereon at a rate equal to the maximum rate then in effect, during the five (5) day cure period set forth in Section 2.2(b) hereof until such Put Option Premium, or Delayed Put Option Premium, is paid.

6. Obligations Absolute

8

6.1    The Master Trust, on behalf of the Sub-Trust, acknowledges that, provided Ambac Assurance has complied with the terms of this Agreement, the obligations of the Master Trust, on behalf of the Sub-Trust, undertaken under this Agreement are absolute, irrevocable and unconditional irrespective of any circumstances whatsoever, including any defense otherwise available to the Master Trust, on behalf of the Sub-Trust, in equity or at law, including, without limitation, the defense of fraud, any defense based on the failure of Ambac Assurance to disclose any matter, whether or not material, to the Master Trust, on behalf of the Sub-Trust, or any other person, and any defense of breach of warranty or misrepresentation, and irrespective of any other circumstance which might otherwise constitute a legal or equitable discharge or defense of an insurer, surety or guarantor under any and all circumstances. The enforceability and effectiveness of this Agreement and the liability of the Master Trust, on behalf of the Sub-Trust, and the rights, remedies, powers and privileges of Ambac Assurance under this Agreement shall not be affected, limited, reduced, discharged or terminated, and the Master Trust, on behalf of the Sub-Trust, hereby expressly waives, to the fullest extent permitted by applicable law, any defense now or in the future arising by reason of:

(a)    the illegality, invalidity or unenforceability of all or any part of the Declaration;

(b)    any action taken by Ambac Assurance;

(c)    any change in the direct or indirect ownership or control of Ambac Assurance or of any shares or ownership interests thereof;

(d)    any other circumstance whatsoever that might otherwise constitute a legal or equitable discharge or defense of or for the Master Trust, on behalf of the Sub-Trust;

provided, however, that notwithstanding the provisions of this Section 6.1, the Master Trust, on behalf of the Sub-Trust, shall have no further obligations under this Agreement after the termination of this Agreement. In addition, the breach of any covenant made in this Agreement by the Master Trust, on behalf of the Sub-Trust, shall not terminate this Agreement or limit the rights of Ambac Assurance hereunder.

6.2    For the avoidance of doubt, no failure or delay by Ambac Assurance in exercising its rights hereunder shall operate as a waiver of its rights hereunder (except as specifically provided in this Agreement, including, without limitation, in respect of the notice periods and payment dates set forth in Section 3.2(a)) and, subject to the termination of this Agreement not having occurred, Ambac Assurance may continue to exercise its rights hereunder at any time.

9

7. Covenants

7.1    Ambac Assurance hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the Preferred Stock whether by operation of merger, reorganization or otherwise, without the prior consent of the Master Trust, on behalf of the Sub-Trust, and it will not register the Preferred Stock with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on or before the Put Option Payment Date.

7.2    The Master Trust, on behalf of the Sub-Trust, hereby covenants and agrees that, at all times prior to the earlier of the termination of this Agreement or completion of the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement, it shall not amend, restate, revise or otherwise alter the rights, terms and preferences of the ABC Securities whether by operation of merger, reorganization or otherwise and it will not register the ABC Securities with the Securities and Exchange Commission under the Securities Act of 1933, as amended.

7.3    Ambac Assurance hereby covenants and agrees that any Preferred Stock delivered to the Master Trust, on behalf of the Sub-Trust, shall rank, at the time of delivery, (a) senior to the common stock of Ambac Assurance and (b) senior to or pari passu with the most senior preferred shares of Ambac then authorized by its Restated Articles of Amendment or then issued and outstanding; provided that this covenant may be amended with the consent of Ambac Assurance and at least a Majority in Face Amount (as defined in the Declaration) of the ABC Securities.

7.4    Ambac Assurance hereby covenants and agrees that if Ambac Assurance’s financial strength rating is ever lowered while this Agreement remains effective, Ambac Assurance shall provide written notice to the Trustee, on behalf of the Sub-Trust, of such lowered rating.

7.5    Ambac Assurance hereby covenants and agrees that it will not pay a dividend on its common stock pursuant to the first and second provisos of Section 4 of its Restated Articles of Incorporation unless it receives written assurance from Ambac Financial Group, Inc. that it will use such dividends for the purposes permitted by such provisos. Such written assurance shall provide that the holders of the Preferred Stock shall be third party beneficiaries of, and entitled to enforce, the provisions of such assurance as if they were parties

10

thereto. The agreements and rights set forth in this Section 7.5 shall survive the exercise by Ambac Assurance of its rights under this Agreement, the issuance of the Preferred Stock and the liquidation of the Sub-Trust.

8. This Agreement to Govern

If there is any inconsistency between any provision of this Agreement and any other agreement, the provisions of this Agreement shall prevail to the extent of such inconsistency but not otherwise.

9. Representations and Warranties

9.1    The Master Trust represents and warrants to Ambac Assurance, on behalf of the Sub-Trust, that, as of the date hereof:

(a)    the Master Trust is duly organized and validly existing under the Delaware Business Trust Act and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)    the Sub-Trust has been duly formed by the Master Trust in accordance with its Declaration;

(c)    its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

(d)    it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(e)    it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

11

(f)    its obligations under this Agreement are valid, binding and enforceable at law;

(g)    it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(h)    it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(i)    each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(j)    no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by the Master Trust, on behalf of the Sub-Trust, of the transactions contemplated by this Agreement; and

(k)    assuming compliance with the transfer restrictions with respect to the ABC Securities set forth in the Declaration, neither the Sub-Trust nor the Master Trust is required to register with the Securities and Exchange Commission as an investment company under the Investment Company Act of 1940, as amended.

9.2    Ambac Assurance represents and warrants to the Master Trust, on behalf of the Sub-Trust, that, as of the date hereof:

(a)    it is duly organized and validly existing as a corporation under the corporate law statutes of the State of Wisconsin and has the power and authority to own its assets and to conduct the activities which it conducts;

(b)    its entry into, exercise of its rights and/or performance of or compliance with its obligations under this Agreement do not and will not violate (1) any law to which it is subject, (2) any of its constitutional documents or (3) any agreement to which it is a party or which is binding on it or its assets;

12

(c)    it has the power to enter into, exercise its rights and perform and comply with its obligations under this Agreement and has taken all necessary action to authorize the execution, delivery and performance of this Agreement;

(d)    it will obtain and maintain in effect and comply with the terms of all necessary consents, registrations and the like of or with any government or other regulatory body or authority applicable to this Agreement;

(e)    its obligations under this Agreement are valid, binding and enforceable at law;

(f)    it is not in default under any agreement to which it is a party or by which it or its assets is or are bound and no litigation, arbitration or administrative proceedings are current or pending, which default, litigation, arbitration or administrative proceedings are material in the context of this Agreement;

(g)    it is not necessary or advisable in order to ensure the validity, effectiveness, performance or enforceability of this Agreement that any document be filed, registered or recorded in any public office or elsewhere;

(h)    each of the above representations and warranties will be correct and complied with in all respects during the term of this Agreement;

(i)    no consent, approval, authorization or order of any court or governmental authority, agency, commission or commissioner or other regulatory authority is required for the consummation by Ambac Assurance of the transactions contemplated by this Agreement and the sale of the Preferred Stock to the Master Trust, on behalf of the Sub-Trust, pursuant to the terms hereof need not be registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended; and

(j)    as of the Put Option Payment Date, the Preferred Stock will be duly authorized for issuance and sale to the Master Trust, on behalf of the Sub-Trust, pursuant to this Agreement and, when issued and delivered by Ambac Assurance pursuant to this Agreement against payment of the Put Option Price, will be validly issued, fully paid and nonassessable; the Preferred Stock will conform in all respects to the terms of the Preferred Stock set forth in the Restated Articles of Incorporation of Ambac Assurance attached hereto as Annex C; and the Preferred Stock will not be subject to preemptive or other similar rights.

13

10. Severability

10.1    Any provision of this Agreement which is or becomes illegal, invalid or unenforceable in any jurisdiction may be severed from the other provisions of this Agreement without invalidating the remaining provisions hereof, and any such illegality, invalidity or unenforceability shall not invalidate or render illegal or unenforceable such provision in any other jurisdiction.

11. Notices

11.1    Each communication to be made hereunder shall be deemed to have been given (i) five (5) days after deposit of such communication with a reputable national courier service addressed to such party at its address specified below (or at such other address as such party shall specify to the other party hereto in writing) or (ii) when transmitted by facsimile to such party at its facsimile number specified below (or at such other facsimile number as such party shall specify to the other party hereto in writing):

If to Ambac Assurance at:

Ambac Assurance Corporation

One State Street Plaza

New York, New York 10004

Attention:    Robert Starr, Treasurer

Facsimile:    (212) 208-3108

Copy to:    Kevin Doyle, General Counsel

If to the Master Trust or Sub-Trust at:

The Bank of New York (Delaware)

P.O. Box 6973

White Clay Center

Route 273

Newark, Delaware 19714

Attention:    Kristine Gullo

Facsimile:    (302) 283-8279

Copies to:

The Bank of New York

Corporate Trust Administration

14

5 Penn Plaza

New York, NY 10001

Attention:    Dealing and Trading Group

Facsimile:    (212) 896-7295

12. Counterparts

This Agreement may be executed in any number of counterparts and by the different parties hereto on separate counterparts each of which when executed and delivered shall constitute an original, but all the counterparts shall together constitute but one and the same instrument.

13. Benefit of Agreement and Disclaimer

13.1    This Agreement shall enure to the benefit of each party hereto and its successors and assigns and transferees; provided that neither party hereto may transfer its rights and obligations hereunder, by operation of law or otherwise, without the prior written consent of the other party.

14. Amendment and Assignment

14.1    This Agreement may not be amended or modified in any respect, nor may any provision be waived, without the written agreement of both parties. No waiver by one party of any obligation of the other hereunder shall be considered a waiver of any other obligation of such party.

14.2    Neither the Master Trust, on behalf of the Sub-Trust, nor Ambac Assurance may assign its rights or obligations under this Agreement to any other person, except that Ambac Assurance may assign its rights and obligations under this Agreement to another person as a result of a merger of Ambac Assurance with another person or as a result of a sale of all or substantially all of the assets of Ambac Assurance to another person if the other person expressly assumes all of the rights and obligations of Ambac Assurance under this Agreement; and immediately following the merger or sale of substantially all of its assets, the rating of the substitute preferred stock or the unsecured debt obligations of the other person is at least as high as the credit rating of the Preferred Stock or the general unsecured debt obligations of Ambac Assurance, as the case may be (or if no such ratings exist, the financial strength rating of Ambac Assurance) immediately prior to the merger or sale.

15

15. Governing Law

15.1    THIS AGREEMENT SHALL IN ALL RESPECTS BE GOVERNED BY, AND CONSTRUED IN ACCORDANCE WITH, THE LAWS OF THE STATE OF NEW YORK.

16. Jurisdiction

16.1    Each of the parties hereto irrevocably submits to the non-exclusive jurisdiction of the courts of the State of New York in respect of any action or proceeding arising out of or in connection with this Agreement (“Proceedings”). Each of the parties hereto irrevocably waives, to the fullest extent permitted by applicable law, any objection that it may now or hereafter have to the laying of the venue of any such Proceedings in the courts of the State of New York and any claim that any Proceeding brought in any such court has been brought in an inconvenient forum. Each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance agrees that it shall at all times have an authorized agent in the State of New York upon whom process may be served in connection with any Proceedings, and each of the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance hereby authorizes and appoints the Trustee to accept service of all legal process arising out of or connected with this Agreement in the State of New York and service on such person (or substitute) shall be deemed to be service on the Master Trust, on behalf of the Sub-Trust, or Ambac Assurance, as the case may be. Except upon such a substitution, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall not revoke any such authority or appointment and shall at all times maintain an agent for service of process in the State of New York. If for any reason such person shall cease to act as agent for the service of process, the Master Trust, on behalf of the Sub-Trust, and Ambac Assurance shall promptly appoint another such agent, and shall forthwith notify each other of such appointment. The submission to jurisdiction reflected in this paragraph shall not (and shall not be construed so as to) limit the right of any person to take Proceedings in any court of competent jurisdiction, nor shall the taking of Proceedings in any one or more jurisdictions preclude the taking of Proceedings in any other jurisdiction (whether concurrently or not) if and to the extent permitted by law.

17. Limitation of Liability

17.1    It is expressly understood that (a) this Agreement is executed and delivered by The Bank of New York (Delaware), not individually or personally but solely as Trustee, in the exercise of the powers and authority conferred and vested in it under the Declaration, (b) each of the representations, undertakings and agreements herein made on the part of the Master Trust, on behalf of the Sub-Trust, is made and intended not as personal representations,

16

undertakings and agreements by The Bank of New York (Delaware), but is made and intended for the purpose of binding only the Master Trust, on behalf of the Sub-Trust, and (c) under no circumstances shall The Bank of New York (Delaware) be personally liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Master Trust, on behalf of the Sub-Trust, under this Agreement or the other related documents.

18. Replacement of Broker-Dealer

18.1    Ambac Assurance shall have the right to direct the Trustee to replace the Broker-Dealer at any time that Ambac Assurance believes, in the reasonable good faith exercise of its discretion, that the continued service of such Broker-Dealer could have an adverse impact on the rights and benefits conferred on Ambac Assurance pursuant to this Agreement.

18.2    In the event Ambac Assurance elects to exercise its right described in Section 18.1, Ambac Assurance shall propose to the Trustee a replacement Broker-Dealer. The Trustee shall enter into an agreement with such replacement Broker-Dealer, unless it has a reasonable basis for failing to do so, in which case the parties shall repeat such process until an acceptable Broker-Dealer is so selected.

17

IN WITNESS WHEREOF the parties hereto have caused this Put Option Agreement to be duly executed as of the day and year first above written.

ANCHORAGE FINANCE MASTER TRUST, on behalf of its series, Anchorage Finance Sub-Trust IV,
By:	The Bank of New York (Delaware), not in its individual capacity but solely as Trustee
By:
Name:
Title:
AMBAC ASSURANCE CORPORATION
By:
Name:
Title:

ANNEX A

Form of Put Notice

To: Anchorage Finance Sub-Trust IV

c/o Bank of New York (Delaware)

P.O. Box 6973

502 White Clay Center

Route 273

Newark, Delaware 19714

with a copy to:

The Bank of New York

5 Penn Plaza

New York, New York 10001

Attention: Dealing and Trading Group

Date:

Ladies and Gentlemen:

We refer to the put option agreement dated May 23, 2002 (as heretofore amended, the “Put Option Agreement”) entered into between us and you. Terms defined in the Put Option Agreement (except where otherwise defined herein) shall have the same respective meanings herein.

This notice is the notice for the purposes of Section 3.2(a) of the Put Option Agreement. We hereby require you to pay the Put Option Price on the Put Option Payment Date, which shall be [                                                 ] to the following account:

[              ]

Yours faithfully,

for and on behalf of

Ambac Assurance Corporation

Put Option Premium Certificate

Ambac Assurance Corporation

Put Option on Auction Market Preferred Shares

1.	Distribution Period: [first day of Period]-[last day of Period]: [number of days in period—generally 28]
2.	Auction Rate determined for the Distribution Period on [insert date of Auction].                         0.000000%                     $ (0)
3.
	Issuer	Ratings	Purchase Price	Yield to Maturity	Interest
	One Corp	A1+/P1
	Two Corp	A1+/P1
	Three Corp	A1+/P1
	Four Corp	A1+/P1
	Five Corp	A1+/P1
	Six Corp	A1+/P1
	Seven Corp	A1+/P1
	Eight Corp	A1+/P1
	Nine Corp	A1/P1
	Ten Corp	A1/P1
4.			000,000,000	0.0%	$  0.0
5.	Applicable Federal Funds Effective Rate: 0.00%			0.0%	$  0.0
6.	Broker-Dealer Fee			0.0%	$(0.0)
7.	Trustee, Custodian and IPA Fees			0.0%	$(0.0)
8.	Asset Management Fee			0.0%	$(0.0)
9.	Tax Matters Partner Fee			0.0%	$(0.0)
10.	Servicing Agent Fee			0.0%	$(0.0)
11.	Other Fees and Expenses for the Distribution Period, if any			0.0%	$(0.0)
12.	Computation of Put Premium Due on [insert Distribution Payment Date] by 11:00 a.m. New York Time:			0.0%	$(0.0)
13.	The asset manager is in compliance with the investment policy.

EX-12.01

EXHIBIT 12.01

Ambac Financial Group, Inc.

Ratio of Earnings to Fixed Charges

(In thousands, except ratios)

	Years Ended December 31,
	2002		2001		2000		1999		1998
Earnings:
Income before income taxes	$	564,190	$	568,727	$	482,124	$	404,658	$	328,912
Interest expense		43,724		40,442		37,477		36,525		32,761
Portion of rentals deemed to be interest		2,126		1,972		1,859		1,782		1,846
Earnings	$	610,040	$	611,141	$	521,460	$	442,965	$	363,519
Fixed Charges:
Interest Expense	$	43,724	$	40,442	$	37,477	$	36,525	$	32,761
Portion of rentals deemed to be interest		2,126		1,972		1,859		1,782		1,846
Fixed Charges	$	45,850	$	42,414	$	39,336	$	38,307	$	34,607
Ratio of earnings to fixed charges		13.3		14.4		13.3		11.6		10.5

EX-13.01

4                

    5

6    

Ambac Financial Group, Inc. and Subsidiaries

	2002			2001			2000
	(Dollars in millions, except per share amounts)
STATEMENT OF OPERATIONS HIGHLIGHTS
Gross premiums written	$	904.0		$	683.3		$	483.1
Net premiums earned and other credit enhancement fees		500.3			400.4			323.4
Net investment income		297.3			267.8			241.0
Interest income from investment and payment agreements		255.0			249.9			303.2
Financial services—other revenue		30.6			37.8			42.5
Total revenue		971.8			960.4			904.3
Losses and loss adjustment expenses		26.7			20.0			15.0
Financial guarantee underwriting and operating expenses		76.5			68.0			55.2
Interest expense from investment and payment agreements		231.3			235.4			283.0
Financial services—other expenses		22.2			21.8			24.8
Interest expense		43.7			40.4			37.5
Net income		432.6			432.9			366.2
Net income per share:
Basic		4.08			4.10			3.49
Diluted		3.97			3.97			3.41
Return on equity1		13.1	%		15.5	%		15.9	%
Return on equity2		15.7	%		15.9	%		15.6	%
Cash dividends declared per common share		0.380			0.340			0.307
BALANCE SHEET HIGHLIGHTS
Total investments, at fair value	$	12,539.3		$	10,287.9		$	8,323.9
Prepaid reinsurance		296.1			267.7			242.6
Total assets		15,355.5			12,339.5			10,120.2
Unearned premiums		2,128.8			1,780.3			1,546.3
Losses and loss adjustment expense reserve		172.1			151.1			132.4
Obligations under investment agreements, investment repurchase agreements and payment agreements		7,282.9			5,511.9			4,892.9
Debentures		616.7			619.3			424.1
Total stockholders’ equity		3,625.2			2,983.7			2,596.1

¹ Defined as net income divided by average stockholders’ equity.

² Defined as net income excluding realized gains/losses divided by average stockholders’ equity, exclusive of unrealized gains/losses on the investment portfolio.

    7

FINANCIAL HIGHLIGHTS

1999			1998			1997			1996			1995			1994			1993
$	445.2		$	361.0		$	286.2		$	247.2		$	193.3		$	189.9		$	318.3
	268.3			213.0			154.0			136.6			111.8			117.5			152.0
	209.3			186.2			159.7			144.9			131.0			117.1			104.6
	323.2			281.9			200.3			165.2			137.4			106.0			51.6
	28.0			31.2			21.6			11.3			3.4			2.8			—
	832.8			720.6			568.4			607.4			409.9			366.4			370.6
	11.0			6.0			2.9			3.8			3.4			2.6			(1.8	)
	48.8			46.7			40.7			37.2			34.5			32.8			34.5
	299.5			263.6			186.7			154.5			127.7			92.4			43.0
	25.8			35.5			28.0			12.0			7.8			6.1			2.0
	36.5			32.8			21.3			20.9			20.9			18.8			15.8
	307.9			254.0			223.0			276.3			167.6			141.1			179.3
	2.94			2.42			2.12			2.63			1.59			1.34			1.69
	2.88			2.37			2.09			2.60			1.58			1.32			1.68
	15.0	%		12.8	%		12.8	%		18.3	%		13.8	%		13.2	%		18.3	%
	15.1	%		14.2	%		12.7	%		13.2	%		12.8	%		14.0	%		16.9	%
	0.280			0.253			0.230			0.205			0.185			0.165			0.150
$	8,962.5		$	8,748.4		$	6,915.1		$	5,200.5		$	4,441.6		$	3,764.2		$	3,132.7
	218.0			199.9			183.5			168.8			153.4			139.9			161.3
	11,344.6			11,212.3			8,291.7			5,876.4			5,309.3			4,287.0			3,807.2
	1,431.1			1,294.2			1,179.0			991.2			903.0			836.6			782.8
	121.0			115.8			103.3			60.6			66.0			65.7			64.0
	6,140.3			5,956.8			4,321.0			2,754.6			2,426.9			2,025.3			1,477.7
	424.0			423.9			223.9			223.8			223.7			223.7			223.6
	2,018.5			2,096.1			1,872.5			1,615.0			1,404.0			1,033.5			1,099.7

    25

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

GENERAL

Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world.

The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for 2002, 2001 and 2000, and its financial condition as of December 31, 2002 and 2001. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services. Management has identified the accounting for loss and loss adjustment expenses and the valuation of financial instruments as critical accounting policies. These policies are discussed in the applicable sections of this document. This discussion should be read in conjunction with the consolidated financial statements and notes thereon included elsewhere in this report.

Materials in this annual report may contain information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements present Ambac’s expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future operating or financial performance.

Any or all of Ambac’s forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) the policies and actions of the United States and other governments and (7) other risks and uncertainties that have not been identified at this time. Ambac is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to consult any further disclosures we make on related subjects in Ambac’s reports to the Securities and Exchange Commission.

RESULTS OF OPERATIONS

Consolidated Net Income. Ambac’s net income in 2002 was $432.6 million or $3.97 per diluted share flat, compared to $432.9 million or $3.97 per diluted share in 2001. Ambac’s income before income taxes was $564.2 million in 2002, a 1% decrease from income before income taxes of $568.7 million in 2001. Of the $564.2 million of income before income taxes in 2002, $712.9 million was from Financial Guarantee, $(102.8) million from Financial Services and $(45.9) million from Corporate. Corporate consists primarily of Ambac’s interest expense. That compares to income (loss) before income taxes in 2001 of $583.9 million, $27.4 million and $(42.6) million from Financial Guarantee, Financial Services and Corporate, respectively. Financial guarantee income before income taxes increased as a result of (i) higher net premiums earned and other credit enhancement fees, (ii) higher net investment income and (iii) higher net realized investment gains, offset by (i) higher unrealized losses on credit derivative contracts, (ii) higher operating expenses and (iii) a higher provision for losses and loss adjustment expenses. The Financial Services decline is primarily attributable to net realized investment losses of $134.1 million.

Ambac’s net income in 2001 increased 18% from $366.2 million, and 16% from $3.41 per diluted share, in 2000. This increase was attributable to growth in Financial Guarantee operating income partially offset by a decline in Financial Services net income. Ambac’s 2001 income before income taxes increased 18% from $482.1 million in 2000. Income (loss) before income taxes in 2000 consisted of $495.2 million from Financial Guarantee, $28.7 million from Financial Services and $(41.8) million from Corporate.

FINANCIAL GUARANTEE

Ambac provides financial guarantees for debt obligations through its principal operating subsidiary Ambac Assurance Corporation, as well as credit protection in the form of structured credit derivatives through Ambac Credit Products LLC, a wholly-owned subsidiary of Ambac Assurance. Ambac provides these services in three principal markets: public finance, structured finance and international finance.

Public finance obligations are bonds issued by states, municipalities and other governmental or not-for-profit entities located in the United States (“Public Finance”). Bond proceeds are used to finance or refinance a broad spectrum of

26    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

public purpose initiatives, including education, utility, transportation, health care and other general purpose projects. Although Ambac generally guarantees the full range of Public Finance obligations, Ambac concentrates on those deals that require more structuring skills. Certain projects, which had been financed by the local or U.S. government alone are now being financed through public-private partnerships. In these transactions, debt service on the bonds, rather than being paid solely by tax revenues or other governmental funds, are being paid from a variety of revenue sources, including revenues derived from the project itself. Examples of these deals include stadium financings, student housing and military housing.

Structured finance obligations include the securitization of a variety of asset types such as mortgages, home equity loans, leases and pooled debt obligations originated in the United States (“Structured Finance”). Currently, the largest component of Ambac’s Structured Finance business relates to the securitization of mortgages and home equity loans. Another target area in Structured Finance is the credit enhancement of pooled debt obligations including structured credit derivatives. These transactions involve the securitization of a portfolio of corporate bonds and loan obligations and asset-backed securities (the “Securitized Assets”). Ambac’s exposure to these Securitized Assets is mitigated through first loss protection. Typically, first loss protection is in the form of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), which allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations.

International finance obligations include public purpose infrastructure projects and asset-backed securities originated outside of the United States (“International Finance”). Ambac’s emphasis internationally has been on Western Europe, Japan and Australia. In the United Kingdom, Ambac has participated extensively in the Private Finance Initiative whereby the government has been privatizing certain activities. In Japan, Ambac has an alliance with Sampo Japan Financial Guarantee Insurance Co. Ltd. Ambac also participates in developing markets through certain structures such as pooled debt obligations or future flow transactions. Future flow transactions essentially securitize future revenue streams derived from operating receivables or the sale of commodities.

Gross Par Value Written. Ambac Assurance guaranteed $116.4 billion of par value bonds during 2002, an increase of 29% from $90.1 billion in 2001. Par value written during 2001 increased 17% compared to $77.0 billion written during 2000. Par value written during 2002 comprised $43.7 billion from the guarantee of Public Finance obligations, $47.5 billion from Structured Finance obligations and $25.2 billion from International Finance obligations, versus $33.2 billion, $37.4 billion and $19.5 billion, respectively, in 2001 and $19.6 billion, $33.9 billion and $23.5 billion, respectively, in 2000. The 2002 increase in guaranteed Public Finance obligations was affected by a 25% increase in total Public Finance issuance, an increase in insured market penetration from 47% in 2001 to 49% in 2002, partially offset by a decrease in Ambac’s Public Finance market share during the period from 25% in 2001 to 21% in 2002. The increase in total issuance was largely the result of the lower interest rate environment causing an increase in both the refinancing and new money components of the market during 2002. The increase in guaranteed Structured Finance obligations during 2002 resulted from higher mortgage-backed guarantees and greater penetration into other consumer asset-backed markets (auto rental and credit card securitizations). International Finance obligations guaranteed during 2002 increased primarily due to higher structured credit derivatives written.

The following table provides a breakdown of guaranteed net par outstanding by market sector:

	2002		2001
	(Dollars in billions)
Public Finance	$	206.5	$	185.0
Structured Finance		105.0		88.7
International Finance		67.7		44.3
Total net par outstanding	$	379.2	$	318.0

    27

Gross Premiums Written. Ambac receives insurance premiums either upfront at policy issuance or on an installment basis over the life of the transaction. The collection method is determined at the time of policy issuance. Gross premiums written in 2002 were $904.0 million, an increase of 32% from $683.3 million in 2001. Up-front premiums written in 2002 were $552.6 million, an increase of 25% from $440.8 million. This increase is a result of increased business activity in Public and Structured Finance, partially offset by lower up-front International Finance gross premiums written. Installment premiums written in 2002 were $351.4 million, an increase of 45% from $242.5 million in 2001. The growth in installment premiums is due to the growing book of business in all segments with written premiums of $99.5 million from transactions guaranteed in 2002. Gross premiums written in 2001 increased 41% from $483.1 million in 2000. This is a result of increased business activity in all markets, particularly Public Finance. The following table sets forth the amounts of gross premiums written and related gross par written by type:

	2002				2001				2000
	Gross Premiums Written		Gross Par Written		Gross Premiums Written		Gross Par Written		Gross Premiums Written		Gross Par Written
	(Dollars in millions)
Public Finance:
Up-front	$	462.1	$	39,283	$	323.7	$	30,414	$	160.5	$	17,536
Installment		42.2		4,448		25.4		2,797		20.1		2,101
Total Public Finance		504.3		43,731		349.1		33,211		180.6		19,637
Structured Finance:
Up-front		57.9		3,498		40.6		3,016		82.8		3,641
Installment		204.6		43,947		152.5		34,437		116.7		30,224
Total Structured Finance		262.5		47,445		193.1		37,453		199.5		33,865
International Finance:
Up-front		32.6		1,662		76.5		2,965		52.6		3,103
Installment		104.6		23,539		64.6		16,504		50.4		20,379
Total International Finance		137.2		25,201		141.1		19,469		103.0		23,482
Total	$	904.0	$	116,377	$	683.3	$	90,133	$	483.1	$	76,984
Total up-front	$	552.6	$	44,443	$	440.8	$	36,395	$	295.9	$	24,280
Total installment		351.4		71,934		242.5		53,738		187.2		52,704
Total	$	904.0	$	116,377	$	683.3	$	90,133	$	483.1	$	76,984

Adjusted Gross Premiums. Adjusted gross premiums written, which is not promulgated under accounting principles generally accepted in the United States of America (“GAAP”), is used by management, equity analysts and investors to measure the financial results of Ambac. Adjusted gross premiums written, which Ambac reports as analytical data, is defined as gross (direct and assumed) up-front premiums written plus the present value of estimated future installment premiums written on insurance policies and structured credit derivatives issued in the period. The definition of adjusted gross premiums written used by Ambac may differ from definitions of adjusted gross premiums written used by other public holding companies of financial guarantee insurers. Adjusted gross premiums written were $1,299.5 million in 2002, up 33% from $974.3 million in 2001. The increase was due to increased activity in all markets. Public Finance adjusted gross premiums were $552.8 million in 2002, up 51% from $366.9 million in 2001. This increase resulted from higher issuance, and higher insured penetration, partially offset by a decrease in market share, as discussed above under “Gross Par Value Written.” Structured Finance adjusted gross premiums were $441.2 million in 2002, up 39% from $318.5 million in 2001. This increase resulted from strong business activity in pooled debt, investor-owned utility and consumer asset-backed transactions, particularly mortgage, auto and credit card asset types. International Finance adjusted gross premiums were $305.5 million in 2002, up 6% from $288.9 million in 2001.

International Finance business continues to be dominated by large transactions with the top ten deals comprising $149.1 million and $153.3 million in 2002 and 2001, respectively. These deals represent 49% and 53% of total International Finance adjusted gross premiums written for 2002 and 2001, respectively. The activity in 2002 was represented by a broad spectrum of bond types, specifically utilities, commercial asset-backed securitizations, private finance initiatives in the United Kingdom and future flow transactions. Adjusted gross premiums written in 2001 increased 37% from $710.7 million in 2000. The increase in 2001 was due to increased activity in all markets. The aggregate net present value, calculated at a 7% discount rate, of estimated future installment premiums was $1,342.2 million at December 31, 2002, up 36% from $986.8 million at December 31, 2001.

Ceded Premiums Written. Ceded premiums written in 2002 were $113.5 million, up 19% from $95.5 million in 2001. Ceded premiums written as a percentage of gross premiums written were 13% and 14% for 2002 and 2001, respectively. This decline was primarily due to lower ceded premiums of Public Finance transactions. Ceded premiums written in 2001 were up 18% from $80.8 million in 2000. The increase in ceded premiums written in 2001 was largely due to higher cessions of Public Finance premiums pursuant to a reinsurance surplus share treaty that Ambac Assurance implemented during 2001,

28    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

partially offset by lower cessions on International Finance transactions. Ceded premiums written were 17% of gross premiums written in 2000.

The reinsurance of risk does not relieve Ambac of its original liability to its policyholders. In the event that any of Ambac’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac would be liable for such defaulted amounts. To minimize exposure to significant losses from reinsurers, Ambac (i) evaluates the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts and (iii) has certain termination triggers that can be exercised by Ambac in the event of a rating downgrade of a reinsurer. Ambac held letters of credit and collateral amounting to approximately $135.7 million from its reinsurers as of December 31, 2002. The following table provides ceded par outstanding by financial strength rating of Ambac’s reinsurers, on a Standard and Poor’s (“S&P”) basis:

	2002		2001
	(Dollars in billions)
AAA	$	23.8	$	38.3
AA		20.4		0.9
Total	$	44.2	$	39.2

During 2002, S&P lowered the financial strength rating of a number of Ambac’s reinsurers from AAA to AA. Additionally, on January 13, 2003 S&P lowered the financial strength rating of AXA Re Finance S.A. from AAA to BBB. This downgrade was attributable to AXA Re Finance S.A.’s decision to cease writing new financial guarantee business. At December 31, 2002, par ceded to AXA Re Finance S.A. was $8.3 billion. The downgrade of AXA Re Finance S.A. has triggered Ambac’s ability to terminate all Ambac/AXA Re’s reinsurance agreements. Ambac is currently exploring all options on this book of business.

Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees during 2002 were $500.3 million, an increase of 25% from $400.4 million in 2001. This increase was primarily the result of the larger Financial Guarantee book of business, higher refundings, calls, and other accelerations of previously insured obligations (collectively referred to as “refundings”) during the year and higher other credit enhancement fees earned from the structured credit derivatives business.

When an issue insured by Ambac Assurance has been refunded or called, any remaining unearned premium (net of refunding credits, if any) is earned at that time. Earnings on refundings typically relate to transactions where the premium is paid up-front for the life of the policy. Refunding levels vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. Net premiums earned during 2002 included $52.0 million (net income per diluted share effect of $0.27) from refundings of previously insured issues. Net premiums earned in 2001 included $38.6 million (net income per diluted share effect of $0.20) from refundings. The current low interest rate environment has prompted the relatively high level of accelerated earnings. When interest rates rise in the future, accelerated earnings should decline.

Excluding the effect of accelerated earnings related to refundings, normal net premiums earned (which is defined as net premiums earned less refundings) in 2002 were $419.5 million, an increase of 23% from $340.1 million in 2001. Normal net premiums earned for the year ended December 31, 2002 increased 14%, 19% and 56% for Public, Structured and International Finance, respectively, from the year ended December 31, 2001. Public Finance earned premium growth resulted from increased activity in that market over the year, enhanced by the continued focus on structured and innovative municipal transactions. Normal earned premium growth for Structured Finance continues to be driven by strong writings in consumer asset-backed transactions partially offset by the continued high level of pay-downs of the existing mortgage-backed book. International Finance net earned premium growth resulted from strong activity in pooled debt obligations, future flow and asset-backed transactions.

Other credit enhancement fees in 2002, which is primarily comprised of fees received from the structured credit derivatives product, were $28.8 million, an increase of 33% from $21.7 million in 2001. This increase was due to rapid growth in the structured credit derivative business in 2001 and 2002.

Net premiums earned and other credit enhancement fees during 2001 increased 24% from $323.4 million in 2000. This increase was primarily the result of the larger Financial Guarantee book of business, higher refundings and higher other credit enhancement fees earned from the structured credit derivatives business. Net premiums earned in 2000 included $22.2 million (net income per diluted share effect of $0.12) from refundings. Excluding the effect of accelerated earnings related to refundings, normal net premiums earned in 2001 increased 18% from $289.0 million in 2000. Other credit enhancement fees increased 78% from $12.2 million in 2000.

The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:

	2002		2001		2000
	(Dollars in millions)
Public Finance	$	156.3	$	137.2	$	126.4
Structured Finance		174.7		146.3		119.4
International Finance		88.5		56.6		43.2
Total normal premiums earned		419.5		340.1		289.0
Refundings		52.0		38.6		22.2
Total net premiums earned		471.5		378.7		311.2
Other credit enhancement fees		28.8		21.7		12.2
Total net premiums earned and other credit enhancement fees	$	500.3	$	400.4	$	323.4

    29

Net Investment Income. Net investment income in 2002 was $297.3 million, an increase of 11% from $267.8 million in 2001. The increase was attributable to: (i) the growth of the investment portfolio resulting from the growth in the Financial Guarantee book of business, partially offset by a lower reinvestment rate due to the current interest rate environment; and (ii) a capital contribution from Ambac Financial Group, Inc. to Ambac Assurance totaling approximately $176 million during the fourth quarter of 2001. The contribution was in the form of taxable investment securities. Investments in tax-exempt securities amounted to 71% of the total fair value of the portfolio as of December 31, 2002, versus 65% and 72% as of December 31, 2001 and December 31, 2000, respectively. The average pre-tax yield-to-maturity on the investment portfolio was 5.18% as of December 31, 2002 compared with 5.74% and 6.20% at December 31, 2001 and 2000, respectively. Net investment income in 2001 increased 11% from $241.0 million in 2000. This increase was primarily attributable to the growth of the investment portfolio resulting from the growth in the Financial Guarantee book of business, partially offset by a lower reinvestment rate due to the interest rate environment, and a capital contribution from Ambac Financial Group, Inc. to Ambac Assurance during the fourth quarter of 2001 as mentioned above.

Net Realized Investment Gains. Net realized investment gains in 2002 were $40.9 million, compared to net realized gains of $2.1 million and $0.7 million in 2001 and 2000, respectively. The following table details amounts included in net realized gains:

	2002		2001			2000
	(Dollars in millions)
Net gains on securities sold	$	39.1	$	5.3		$	4.2
Foreign exchange gains (losses) on investments		1.8		(3.2	)		(3.5	)
Net realized gains	$	40.9	$	2.1		$	0.7

Net gains on securities sold are generated as a result of the ongoing management of the investment portfolio. Foreign exchange gains and losses result from investing in short-term foreign currency denominated securities.

Net Unrealized Losses on Credit Derivative Contracts. Net unrealized losses on credit derivative contracts in 2002 were $27.9 million, compared to net unrealized losses of $3.6 million and $4.1 million in 2001 and 2000, respectively. The change in estimated fair value of structured credit derivative contracts reflects net mark-to-market gains and losses due to changes in credit spreads on the underlying obligations. Additionally, realized net losses paid on structured credit derivatives totaled $5.8 million in the year ended December 31, 2002, compared with none in 2001 and 2000.

Other Income. Other income in 2002 was $5.5 million, an increase of 6% from $5.2 million in 2001. Included in other income are deal structuring fees and commitment fees. Other income increased 18% in 2001 from $4.4 million in 2000.

Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses in 2002 were $26.7 million, versus $20.0 million in 2001 and $15.0 million in 2000. Losses and loss adjustment expenses are based upon estimates of the ultimate aggregate losses inherent in the Financial Guarantee portfolio. In most instances, claim payments are forecasted in advance as a result of Ambac’s active surveillance of the insured book of business. Based upon company and industry experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The insured party has the right to a claim under Ambac’s financial insurance policy at the first scheduled debt service date of the defaulted obligation. The trustee for the insured obligation notifies Ambac of the payment default so that a claim payment can be made. The trustee reports payment defaults at or prior to the scheduled payment date. Subsequent claims would be paid if payment defaults continue and would be based on the originally scheduled interest and principal payment schedule.

The liability for losses and loss adjustment expenses consists of case basis credit and active credit reserves. Case basis credit reserves are established for losses on guaranteed obligations that have already defaulted. These reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under collateral and subrogation rights. As noted above, the payment pattern and ultimate costs are fixed and determinable on an individual claim basis (i.e., the originally scheduled debt service of the insured obligation). Ambac discounts these reserves in accordance with discount rates prescribed or permitted by state regulatory authorities. In addition, we, consistent with industry practice, establish and accrue an active credit reserve, which is separate from the case basis credit reserves noted above. We believe, based on our active surveillance of the insured portfolio, along with historical defaults and related loss data and current economic factors, that additional losses are inherent in our portfolio. Current economic factors considered include estimates of current defaults and recovery values from collateral or subrogation rights. The active credit reserve is established based upon probable debt service defaults from incurred losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on management’s review of each credit. Active surveillance of the insured portfolio enables Ambac to track credit migration of insured obligations from period to period.

30    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

Our Surveillance group, which is comprised of senior credit professionals, all of whom are independent from transaction execution, is responsible for extensive ongoing review of every credit Ambac has exposure to. At least monthly, Senior Finance and Credit Management meets with Surveillance to review the status of their work. During the monthly review, Senior Management determines the adequacy of Ambac’s loss reserves and makes any necessary adjustments. The following table summarizes Ambac’s loss reserves split between case basis credit loss reserves and active credit reserves at December 31, 2002 and 2001:

	2002		2001
	(Dollars in millions)
Net loss and loss adjustment expense reserves:
Case basis credit reserves*	$	49.0	$	23.4
Active credit reserves		118.6		126.7
Total	$	167.6	$	150.1

* After netting reinsurance recoverable on unpaid losses amounting to $4.6 million and $1.0 million in 2002 and 2001, respectively.

The following table summarizes the changes in the total net loss reserves for the years ended December 31, 2002 and 2001:

	2002			2001
	(Dollars in millions)
Beginning balance of net loss reserves	$	150.1		$	131.3
Additions to loss reserves		26.7			20.0
Losses paid		(11.1	)		(2.6	)
Recoveries of paid losses from reinsurers		1.3			—
Recoveries of previously paid losses		0.6			1.4
Ending balance of net loss reserves	$	167.6		$	150.1

At December 31, 2002 case basis credit reserves are sufficient to cover required debt service through 2026 totaling $69.5 million. Annual debt service payments are $17.5 million, $18.9 million, $6.1 million, $3.7 million and $3.6 million for 2003, 2004, 2005, 2006 and 2007, respectively. Additions (reductions) made to the case basis credit reserve totaled $25.6 million, $(0.1) million and $12.7 million in 2002, 2001 and 2000, respectively. The increase in the 2002 case basis credit reserve is primarily attributable to credit deterioration on a mortgage-backed issue. At December 31, 2002, case basis credit reserves were $26.1 million for this issue. Additionally, Ambac paid $3.4 million relating to this issue in 2002.

The following tables provide details of net losses paid for the years ended December 31, 2002, 2001 and 2000 and net case reserves at December 31, 2002 and December 31, 2001:

	2002		2001		2000
	(Dollars in millions)
Net losses paid:
Public Finance	$	6.4	$	2.6	$	4.6
Structured Finance		3.4		—		—
International Finance		—		—		—
Total	$	9.8	$	2.6	$	4.6

	2002		2001
	(Dollars in millions)
Net case basis credit reserves:
Public Finance	$	19.0	$	23.4
Structured Finance		26.1		—
International Finance		3.9		—
Total	$	49.0	$	23.4

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

Underwriting and Operating Expenses. Underwriting and operating expenses of $76.5 million in 2002 increased by 13% from $68.0 million in 2001. Underwriting and operating expenses in 2001 increased 23% from $55.2 million in 2000. Underwriting and operating expenses consist of gross underwriting and operating expenses, less the deferral to future periods of expenses and reinsurance commissions related to the acquisition of new insurance contracts, plus the amortization of previously deferred expenses and reinsurance commissions. In 2002, gross underwriting and operating expenses were $117.7 million, an increase of 19% from $99.3 million in 2001. During 2001, gross underwriting and operating expenses increased 12% from $88.6 million in 2000. The increases in gross underwriting and operating expenses in both 2002 and 2001 reflect the overall increased business activity in those years and are primarily attributable to higher compensation costs related to the addition of staff and higher premium taxes. Underwriting and operating expenses deferred were $73.1 million, $59.5 million, and $55.8 million in 2002, 2001 and 2000, respectively. The amortization of previously deferred expenses and reinsurance commissions was $32.3 million, $28.2 million, and $22.5 million in 2002, 2001 and 2000, respectively. The high level of refundings contributed to the increase in amortization of previously deferred expenses in 2002 as any deferred costs associated with a refunded issue is fully amortized at the time of refunding.

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FINANCIAL SERVICES

Through its Financial Services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate swaps, total return swaps, funding conduits, investment advisory and cash management services, to municipalities and their authorities, school districts, health care organizations and asset-backed issuers.

Financial Services net revenue is defined and analyzed by management as gross interest income less gross interest expense from investment and payment agreements plus other revenue, and excludes net realized and unrealized losses. Net revenues in 2002 increased 4% to $54.3 million from $52.2 million in 2001. This increase is primarily due to higher investment agreement net interest income due to higher interest rate spreads and higher volume, partially offset by lower interest rate swap revenues. Revenues from investment advisory and cash management decreased 3% in 2002 compared to 2001. Net revenues in 2001 decreased 17% from $62.7 million in 2000. This decrease in net revenue from 2000 to 2001 was primarily due to lower revenues from interest rate swaps and lower investment agreement net interest income due to lower interest rate spreads, partially offset by higher volume. Revenues from investment advisory and cash management increased 6% in 2001 compared to 2000.

Net realized investment losses in 2002 were $134.1 million, resulting primarily from a write-down of asset-backed notes issued by National Century Financial Enterprises, Inc. (“NCFE”). These notes, which were rated triple-A until October 25, 2002, have defaulted and NCFE filed for protection under Chapter 11 of the U.S. Bankruptcy Code in November 2002. The NCFE notes, which are backed by health care receivables, have been written down to approximately 20% of par value, which represents Ambac’s best estimate of its future recovery based on existing facts and circumstances.

Financial Services other expenses in 2002 were $22.2 million, an increase of 2% from $21.8 million in 2001. Other expenses in 2001 decreased 12% from $24.8 million in 2000.

CORPORATE ITEMS

Interest Expense. Interest expense was $43.7 million, $40.4 million and $37.5 million in 2002, 2001 and 2000, respectively. The 2002 increase is primarily attributable to Ambac’s issuance of $200 million in debentures in October 2001, partially offset by lower bank fees associated with capital facilities.

Income Taxes. Income taxes for 2002 were at an effective rate of 23.3%, compared to 23.9% and 24.1% for 2001 and 2000, respectively. The decrease in the effective tax rate in 2002 as compared to 2001 is primarily due to the NCFE loss and the related reduction in taxable profits. The decrease in the effective tax rate in 2001 as compared to 2000 is due to a favorable settlement of a state income tax audit, partially offset by increased underwriting profits.

LIQUIDITY AND CAPITAL RESOURCES

Ambac Financial Group, Inc. Liquidity. Ambac’s liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon: (i) Ambac Assurance’s ability to pay dividends or make other payments to Ambac; (ii) external financings; and (iii) investment income from its investment portfolio. Pursuant to Wisconsin insurance laws, Ambac Assurance may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. Based upon these tests, without regulatory approval, the maximum amount that will be available during 2003 for payment by Ambac Assurance is approximately $223 million. During 2002, Ambac Assurance paid dividends of $78.0 million on its common stock to Ambac.

Ambac’s principal uses of liquidity are for the payment of its operating expenses, income taxes, interest on its debt, dividends on its shares of common stock, purchases of its common stock in the open market and capital investments in its subsidiaries. Ambac contributed $50 million to Ambac Capital Corporation during 2002. Based on the amount of dividends that it expects to receive from Ambac Assurance and other subsidiaries during 2003, and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its needs over the next twelve months, including the ability to pay dividends on its common stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance’s ability to declare and pay dividends to Ambac may be influenced by a variety of factors including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although management believes that Ambac will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be able to dividend amounts sufficient to pay all of Ambac’s operating expenses, debt service obligations and dividends on its common stock.

32    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

Ambac Assurance Liquidity. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claims paid, reinsurance premiums, taxes, dividends to Ambac, and capital investments in its subsidiaries. Management believes that Ambac Assurance’s operating liquidity needs can be funded exclusively from its operating cash flow. The principal sources of Ambac Assurance’s liquidity are gross premiums written, scheduled investment maturities, net investment income and receipts from structured credit derivatives.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment agreement obligations pursuant to defined terms, net obligations under interest rate swaps and related hedges, operating expenses, income taxes, and dividends to Ambac. Management believes that its Financial Services liquidity needs can be funded primarily from its operating cash flow and the maturity of its invested assets. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities of securities from its investment portfolio (which are invested with the objective of matching the maturity schedule of its obligations under the investment agreements), net receipts from interest rate swaps and related hedges, and fees for investment management services. Additionally, from time to time, liquidity needs of the Financial Services subsidiaries are satisfied by short-term intercompany loans from Ambac Assurance. The investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average quality rating of Aa/AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity exposure. Financial Services subsidiaries maintain a portion of their assets in short-term investments and repurchase agreements in order to meet unexpected liquidity needs.

Credit Facilities. Ambac and Ambac Assurance have a revolving credit facility with six major international banks for $300 million, which expires in July 2003 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of December 31, 2002 and 2001, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $1.75 billion.

Capital Support. Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to 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. If the put option were exercised, the preferred stock holdings of Ambac Assurance would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. If exercised, Ambac Assurance would receive up to $800 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual preferred stock. Ambac Assurance pays a floating put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s, respectively.

Stock Repurchase Program. The Board of Directors of Ambac has authorized the establishment of a stock repurchase program that permits the repurchase of up to 12,000,000 shares of Ambac’s common stock. During 2002, Ambac acquired approximately 695,000 shares for an aggregate amount of $41.1 million. Since inception of the Stock Repurchase Program, Ambac has acquired approximately 8,967,000 shares for an aggregate amount of $265.9 million.

Balance Sheet. Total assets as of December 31, 2002 were $15.36 billion, an increase of 24% from $12.34 billion at December 31, 2001. This increase was due primarily to cash generated from business written during 2002 and higher volume in the guaranteed investment agreement business. Stockholders’ equity as of December 31, 2002 was $3.63 billion, an increase of 22% from $2.98 billion at year-end 2001. The increase stemmed primarily from net income for the year and an increase in the fair market value of the investment portfolio due to a decline in interest rates during the year.

    33

The following table summarizes the composition of the fair value of Ambac’s investment portfolio by segment at December 31, 2002 and 2001:

	Financial Guarantee			Financial Services			Corporate			Total
	(Dollars in millions)
2002:
Fixed income securities:
Municipal obligations	$	4,470.1		$	417.8		$	—		$	4,887.9
Corporate obligations		432.5			1,136.8			—			1,569.3
Foreign government obligations		120.6			—			—			120.6
U.S. government obligations		101.6			6.6			—			108.2
Mortgage and asset-backed securities (includes U.S. government agency obligations)		846.0			4,048.0			17.6			4,911.6
Other		1.7			—			0.6			2.3
		5,972.5			5,609.2			18.2			11,599.9
Short-term		284.3			71.6			39.9			395.8
		6,256.8			5,680.8			58.1			11,995.7
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities (includes U.S. government agency obligations)		—			543.6			—			543.6
Total investments	$	6,256.8		$	6,224.4		$	58.1		$	12,539.3
Percent total		49.9	%		49.6	%		0.5	%		100	%
2001:
Fixed income securities:
Municipal obligations	$	3,540.3		$	144.5		$	—		$	3,684.8
Corporate obligations		656.2			674.4			—			1,330.6
Foreign government obligations		96.6			—			—			96.6
U.S. government obligations		54.8			6.0			17.5			78.3
Mortgage and asset-backed securities (including U.S. government agency obligations)		735.2			2,530.4			13.3			3,278.9
Other		1.4			—			0.8			2.2
		5,084.5			3,355.3			31.6			8,471.4
Short-term		170.6			225.2			19.2			415.0
		5,255.1			3,580.5			50.8			8,886.4
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities (including U.S. government agency obligations)		—			1,401.5			—			1,401.5
Total investments	$	5,255.1		$	4,982.0		$	50.8		$	10,287.9
Percent total		51.1	%		48.4	%		0.5	%		100	%

Ambac has a formal review process for all securities in its investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include: (i) securities whose market values have declined by 20% or more below amortized cost for a continuous period of at least six months; (ii) recent credit downgrades by rating agencies; (iii) the financial condition of the issuer; (iv) whether scheduled interest payments are past due; and (v) whether Ambac has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in Accumulated Other Comprehensive Income in stockholders’ equity on our Consolidated Balance Sheets. If we believe the decline is “other than temporary,” we write-down the carrying value of the investment and record a loss on our Consolidated Statements of Operations. Ambac’s assessment of a decline in value includes management’s current judgment of the factors noted above. If that judgment changes in the future, Ambac may ultimately record a loss after having originally concluded that the decline in value was temporary. The following table summarizes the total pre-tax gross unrealized loss recorded in Accumulated Other Comprehensive Income in stockholders’ equity at December 31, 2002 and 2001 by investment category:

	2002 Gross Unrealized Losses		2001 Gross Unrealized Losses
	(Dollars in millions)
Fixed income securities:
Municipal obligations	$	4.6	$	29.8
Corporate obligations		27.8		42.6
Foreign government obligations		—		1.1
U.S. government obligations		0.3		1.2
Mortgage and asset-backed securities		4.3		20.8
Total	$	37.0	$	95.5

34    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

The following table summarizes, for all securities in an unrealized loss position as of December 31, 2002 and 2001, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position:

	2002				2001
	Estimated Fair Value		Gross Unrealized Losses		Estimated Fair Value		Gross Unrealized Losses
	(Dollars in millions)
Municipal obligations in continuous unrealized loss for:
0–6 months	$	146.1	$	2.4	$	1,010.2	$	23.6
7– 12 months		0.9		0.3		0.4		0.1
Greater than 12 months		26.9		1.9		91.9		6.1
		173.9		4.6		1,102.5		29.8
Corporate obligations in continuous unrealized loss for:
0–6 months		461.1		7.5		339.5		10.4
7– 12 months		18.5		2.2		4.5		0.4
Greater than 12 months		106.7		18.1		258.0		31.8
		586.3		27.8		602.0		42.6
Foreign government obligations in continuous unrealized loss for:
0–6 months		1.6		—		44.6		1.1
7– 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		1.6		—		44.6		1.1
U.S. government obligations in continuous unrealized loss for:
0–6 months		15.9		0.3		18.3		1.2
7– 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		15.9		0.3		18.3		1.2
Mortgage and asset-backed securities in continuous unrealized loss for:
0–6 months		576.8		3.2		1,348.6		18.2
7– 12 months		11.7		0.1		—		—
Greater than 12 months		33.1		1.0		15.2		2.6
		621.6		4.3		1,363.8		20.8
Total	$	1,399.3	$	37.0	$	3,131.2	$	95.5

There were no individual securities with material unrealized losses as of December 31, 2002 and 2001. As of December 31, 2002 below investment grade securities and non-rated securities which were in an unrealized loss position had a fair value of $46.7 million and unrealized loss of $5.0 million, which represented 3% of the total fair value and 14% of total pre-tax unrealized losses shown in the above table. As of December 31, 2001 below investment grade securities and non-rated securities which were in an unrealized loss position had a fair value of $26.9 million and an unrealized loss of $5.3 million, which represented 1% of the total fair value and 6% of total pre-tax unrealized loss as shown in the above table.

    35

The following table summarizes amortized cost and fair value for all securities in an unrealized loss position as of December 31, 2002 and 2001, by contractual maturity date:

	2002				2001
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
	(Dollars in millions)
Municipal obligations:
Due in one year or less	$	—	$	—	$	1.5	$	1.2
Due after one year through five years		—		—		0.1		0.1
Due after five years through ten years		10.8		10.6		298.7		294.7
Due after ten years		167.7		163.3		832.0		806.5
		178.5		173.9		1,132.3		1,102.5
Corporate obligations:
Due in one year or less		—		—		—		—
Due after one year through five years		228.7		223.0		12.7		12.5
Due after five years through ten years		29.6		29.3		70.3		69.3
Due after ten years		355.8		334.0		561.6		520.2
		614.1		586.3		644.6		602.0
Foreign government obligations:
Due in one year or less		1.6		1.6		—		—
Due after one year through five years		—		—		45.4		44.4
Due after five years through ten years		—		—		—		—
Due after ten years		—		—		0.3		0.2
		1.6		1.6		45.7		44.6
U.S. government obligations:
Due in one year or less		—		—		0.8		0.8
Due after one year through five years		16.2		15.9		—		—
Due after five years through ten years		—		—		—		—
Due after ten years		—		—		18.7		17.5
		16.2		15.9		19.5		18.3
Mortgage and asset-backed securities		625.9		621.6		1,384.6		1,363.8
Total	$	1,436.3	$	1,399.3	$	3,226.7	$	3,131.2

The investment portfolio includes non-publicly traded securities with a carrying value of $148 million. Fair values for these securities are based on quotes obtained from brokers, if available. For those fixed rate securities where broker quotes were not available, fair values are based on internal valuation models. For floating rate securities where broker quotes were not available, fair values are based on the lower of amortized cost or internal valuation models. Key inputs to the internal valuation models include maturity date, coupon and generic yield curves for industry and credit rating characteristics that closely match those characteristics of the specific investment securities being valued. The valuation results from these models could differ materially from amounts that would actually be realized in the market.

36    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

The following table summarizes, for all securities sold at a loss during 2002 and 2001, the aggregate fair value and realized loss by length of time those securities were continuously in an unrealized loss position prior to the sales date:

	2002				2001
	Estimated Fair Value		Gross Realized Losses		Estimated Fair Value		Gross Realized Losses
	(Dollars in millions)
Municipal obligations in continuous unrealized loss for:
0–6 months	$	20.2	$	0.4	$	38.6	$	0.4
7– 12 months		—		—		1.0		—
Greater than 12 months		0.8		—		92.3		3.3
		21.0		0.4		131.9		3.7
Corporate obligations in continuous unrealized loss for:
0–6 months		45.9		0.6		34.9		2.4
7– 12 months		—		—		—		—
Greater than 12 months		42.1		9.0		31.9		1.9
		88.0		9.6		66.8		4.3
Foreign government obligations in continuous unrealized loss for:
0–6 months		—		—		12.4		1.2
7– 12 months		6.8		0.1		—		—
Greater than 12 months		—		—		—		—
		6.8		0.1		12.4		1.2
U.S. government obligations in continuous unrealized loss for:
0–6 months		—		—		16.6		1.0
7– 12 months		18.0		0.7		—		—
Greater than 12 months		—		—		—		—
		18.0		0.7		16.6		1.0
Mortgage and asset-backed securities in continuous unrealized loss for:
0–6 months		215.3		1.0		74.2		0.7
7– 12 months		4.0		—		—		—
Greater than 12 months		3.8		—		48.8		2.2
		223.1		1.0		123.0		2.9
Other securities in continuous unrealized loss for:
0–6 months		37.0		1.3		184.7		7.7
7– 12 months		—		—		—		—
Greater than 12 months		—		—		—		—
		37.0		1.3		184.7		7.7
Total	$	393.9	$	13.1	$	535.4	$	20.8

As noted in the “Results of Operations” section, included in 2002 net realized losses was an impairment write-down of $139.7 million, which was excluded from the table above. There were no impairment write-downs during 2001 and 2000. The remaining net realized losses included in the 2002, 2001 and 2000 Consolidated Statements of Operations were the result of security sales made in the usual course of business in order to achieve Ambac’s investment objectives for the Financial Guarantee and Financial Services investment portfolios discussed below.

Ambac’s investment objectives for the Financial Guarantee portfolio are to maintain an investment duration that closely approximates the expected duration of related financial guarantee liabilities and achieve the highest after-tax net investment income, while maintaining a conservative credit risk profile. The Financial Guarantee investment portfolio is subject to internal investment guidelines, which are approved by Ambac’s Board of Directors. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

    37

The following table provides the ratings distribution of the Financial Guarantee investment portfolio at December 31, 2002 and 2001:

Rating(1):	2002		2001
AAA(2)	73	%	65	%
AA	16		19
A	7		11
BBB	1		2
Below investment grade	1		<1
Not rated	2		3
	100	%	100	%

⁽¹⁾ Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.

⁽²⁾ Includes U.S. Treasury and agency obligations, which comprised approximately 15% and 13% of the Financial Guarantee investment portfolio as of December 31, 2002 and 2001, respectively.

Approximately 98% and 85% of the mortgage and asset-backed securities in the Financial Guarantee portfolio is composed of securities issued by various U.S. government agencies, as of December 31, 2002 and 2001, respectively.

Short-term investments in the Financial Guarantee portfolio consisted primarily of money market funds, foreign and domestic time deposits, and discount notes.

The Financial Services investment portfolio consists primarily of assets funded with the proceeds from the issuance of investment agreement liabilities. The investment objectives of the portfolio are to match the investment security maturity schedule to the maturity schedule of related liabilities under the investment agreements and achieve the highest after-tax net investment income. The investment portfolio is subject to internal investment guidelines, which are approved by Ambac’s Board of Directors. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.

The following table provides the ratings distribution of the Financial Services investment portfolio at December 31, 2002 and 2001:

Rating(1):	2002		2001
AAA(2)	88	%	88	%
AA	2		4
A	6		6
BBB	3		2
Below investment grade	1		<1
Not rated	—		<1
	100	%	100	%

⁽¹⁾ Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.

⁽²⁾ Includes U.S. Treasury and agency obligations, which comprised approximately 44% and 34% of the Financial Services investment portfolio as of December 31, 2002 and 2001, respectively.

Approximately 59% and 69% of the mortgage and asset-backed securities in the Financial Services portfolio is composed of securities issued by various U.S. government agencies, as of December 31, 2002 and 2001, respectively.

Short-term investments in the Financial Services portfolio consisted of money market funds.

Ambac enters into derivative contracts classified as held for trading purposes. Changes in the fair value of derivative contracts classified as held for trading purposes are recognized immediately in net income. In determining fair value, Ambac uses information provided by independent external sources or, when independent information is not available, internal valuation models are used. Internal valuation models include estimates, made by management, which utilize current and historical market data. The valuation results from internal models could differ materially from amounts that would be realized in the market. The net fair value of derivative contracts classified as held for trading purposes was $56 million at December 31, 2002. Of that amount, $(9) million was determined using internal valuation models and $65 million was provided by external sources. Contracts with maturities in excess of 5 years accounted for $83 million of the net fair value. Contracts with maturities of 5 years or less accounted for $(27) million of net fair value.

Special Purpose Entities. Ambac has transferred third-party debt obligations to two special purpose entities. The business purpose of these entities is to provide some of our financial guarantee clients with funding for their debt obligations. These special purpose entities meet the characteristics of Qualifying Special Purpose Entities (“QSPEs”) in accordance with Statement of Financial Accounting Standards 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The QSPEs are not consolidated in Ambac’s consolidated financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to (i) purchasing assets from Ambac, which are defined in the governing documents of the QSPEs, (ii) issuing Medium Term Notes (“MTNs”) to fund such purchase, (iii) executing derivative hedges and (iv) providing related administrative services. The QSPEs hold only passive debt obligations transferred to it by Ambac, passive derivative financial instruments used for hedging purposes and cash collected from assets that it holds pending distribution to the MTN holders. The QSPEs do not hold equity or other types of securities that would allow for voting rights, significant influence of contractual options such as the right to unconditionally put or call a financial instrument. The legal documents that established the QSPEs or created the beneficial interests in the transferred assets do not permit the sale or other disposal of the transferred financial assets except for disposals in automatic response to the terms of such financial assets (this would include only issuer call provisions). These required disposals are outside the control of Ambac, its affiliates and the QSPEs. Beneficial interest holders do not have the rights to put their beneficial interest back to the QSPEs.

As of December 31, 2002, there have been 12 individual transactions processed through the QSPEs. In each case, Ambac sells fixed income debt obligations issued by third parties to the QSPEs. Ambac receives cash consideration for all assets transferred to the QSPEs. Ambac surrenders control over the transferred debt obligations. There are no agreements that entitle or obligate Ambac to repurchase or redeem assets. The QSPEs are structured as bankruptcy remote entities. Ambac management believes that the assets transferred represent a true sale and the

38    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

assets held by the QSPEs are beyond the reach of Ambac and its creditors, even in bankruptcy or other receivership. Legal counsel has concurred with management’s belief and has provided Ambac true sale and non-substantive consolidation opinions. The purchase by the QSPEs is financed through the issuance of MTNs, which are collateralized by the purchased assets. Derivative contracts may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase debt obligations. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued and the derivative contracts used. As of December 31, 2002, Ambac Assurance had financial guarantee insurance policies issued for all assets owned, MTNs issued and derivative contracts used by the QSPEs.

Ambac’s exposure under these financial guarantee insurance policies is included in the disclosure in Note 12 “Guarantees in Force” to the consolidated financial statements. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. To date, no losses have been recognized. Under the terms of an Administrative Agency Agreement, Ambac provides some administrative services, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during 2002, 2001 and 2000 were $350.0 million, $793.4 million and $159.9 million, respectively. No gains or losses were recognized on these sales. As of December 31, 2002, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $1,347.3 million, $1,263.5 million and $91.0 million, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums and other fees for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $19.3 million, $23.7 million and $3.2 million for the years ended December 31, 2002, 2001 and 2000, respectively. Ambac received fees for providing administrative services amounting to $0.1 million, $0.3 million and $0.2 million for 2002, 2001 and 2000, respectively.

Cash Flows. Net cash provided by operating activities was $805.5 million, $671.8 million and $481.3 million during 2002, 2001 and 2000, respectively. These cash flows were primarily provided by the Financial Guarantee operations. Net cash provided by (used in) financing activities was $1,650.2 million, $760.8 million and $(1,226.0) million during 2002, 2001 and 2000, respectively. Financing activities for the years ended 2002 and 2001 included $1,442.0 million and $621.4 million, respectively, in net investment agreements issued (net of investment agreement draws). Financing activity for the year ended 2000 included $1,217.8 million used by the investment agreement business for net draws paid (net of investment agreements issued). Net cash (used in) provided by investing activities was $(2,506.4) million, $(1,401.4) million and $776.5 million, respectively. These investing activities were primarily net purchases of investment securities during 2002 and 2001, and principally net proceeds from sales and maturities of investment securities during 2000. Total cash (used in) provided by operating, investing and financing activities was $(50.8) million, $31.2 million and $31.8 million during 2002, 2001 and 2000, respectively.

Material Commitments. Ambac has made no commitments for material capital expenditures within the next twelve months.

RISK MANAGEMENT

In the ordinary course of business, Ambac, through its affiliates, manages a variety of risks, principally 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.

Credit Risk. Ambac is exposed to credit risk in various capacities including as an issuer of financial guarantees, as counterparty to derivative and other financial contracts and as a holder of investment securities. Ambac’s Portfolio Risk Management Committee (“PRMC”) employs various procedures and controls to monitor and manage credit risk. The PRMC is comprised of senior risk professionals and senior management of Ambac. Its purview is enterprise-wide and its focus is on risk limits and measurement, concentration and correlation of risk, and the attribution of economic and regulatory capital in a portfolio context.

All financial guarantees and structured credit derivatives issued are subject to a formal underwriting process. Various factors affecting the credit worthiness of the underlying obligation are evaluated during the underwriting process. Senior credit personnel approve all transactions prior to issuing a financial guarantee. Subsequent to issuance of a financial guarantee, Ambac periodically performs reviews of exposures according to a schedule based on the risk profile of the guaranteed obligations. Proactive credit remediation can help secure rights and remedies which mitigate losses in the event of default.

Ambac manages credit risk associated with its investment portfolio through adherence to specific investment guidelines. These guidelines establish limits based upon single risk concentration limits and minimum credit rating standards. Additionally, senior credit personnel monitor the portfolio on a continuous basis. Credit risk relating to derivative positions (other than structured credit derivatives discussed below) primarily concern counterparty default. Counterparty default exposure is mitigated through the use of industry standard collateral posting agreements. For counterparties subject to such

    39

collateral posting agreements, collateral is posted when a derivative counterparty’s credit exposure exceeds contractual limits.

Market Risk. Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac’s financial instruments are interest rate risk, basis risk (e.g., taxable interest rates relative to tax-exempt interest rates, discussed below) and credit spread risk. Below we discuss each of these risks and the specific types of financial instruments impacted. Senior managers in Ambac’s Risk Analysis and Reporting group are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. Ambac utilizes various systems, models and stress test scenarios to monitor and manage market risk. This process includes frequent analyses of both parallel and nonparallel shifts in the yield curve, “Value-at-Risk” (“VaR”) and changes in credit spreads. These models include estimates, made by management, which utilize current and historical market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.

Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities, investment agreement liabilities, debentures, and certain derivative contracts (primarily interest rate swaps and futures) used for hedging purposes. The following table summarizes the estimated change in fair value (based primarily on the valuation models discussed above) on the net balance of Ambac’s investment securities, investment agreement liabilities, debentures and derivative hedges, assuming immediate changes in interest rates at specified levels at December 31, 2002 and 2001:

Change in Interest Rates	Estimated Net Fair Value		Estimated Change in Net Fair Value
	(Dollars in Millions)
2002:
300 basis point rise	$	4,386	$	(1,116	)
200 basis point rise		4,773		(729	)
100 basis point rise		5,141		(361	)
Base scenario		5,502		—
100 basis point decline		5,837		335
200 basis point decline		6,143		641
300 basis point decline		6,419		917
2001:
300 basis point rise	$	3,616	$	(1,075	)
200 basis point rise		3,987		(704	)
100 basis point rise		4,344		(347	)
Base scenario		4,691		—
100 basis point decline		5,063		372
200 basis point decline		5,426		735
300 basis point decline		5,780		1,089

Ambac, through its affiliate Ambac Financial Services, L.P., is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. Ambac Financial Services manages its business with the goal of being market neutral to changes in overall interest rates, while seeking to profit from retaining some basis risk. Ambac’s municipal interest rate swap portfolio may be adversely affected by changes in basis. If actual or projected tax-exempt interest rates change in relation to taxable interest rates, Ambac will experience a mark-to-market gain or loss. Most municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac against certain forms of tax reform, thus mitigating its basis risk. The estimation of potential losses arising from adverse changes in market relationships, known as VaR, is a key element in management’s monitoring of basis risk for the municipal interest rate swap portfolio. Ambac has developed a VaR methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. Ambac’s methodology estimates VaR using a 300-day historical “look back” period. This means that changes in market values are simulated using market inputs from the past 300 days. For the years ended December 31, 2002 and 2001, Ambac’s VaR, for its interest rate swap portfolio, calculated at a ninety-nine percent confidence level, averaged approximately $0.7 million and $0.9 million, respectively. Ambac’s VaR ranged from a high of $1.5 million to a low of $0.3 million in 2002, and from a high of $1.9 million to a low of $0.4 million in 2001. Ambac supplements its VaR methodology, which is a good risk management tool in normal markets, by performing rigorous stress testing to measure the potential for losses in abnormally volatile markets. The stress tests include (i) parallel and non-parallel shifts in the yield curve and (ii) immediate changes in normal basis relationships, such as those between taxable and tax-exempt markets.

Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding structured credit derivative contracts. Ambac, through its affiliate Ambac Credit Products, enters into structured credit derivative contracts. These contracts require Ambac Credit Products to make payments upon the occurrence of certain defined credit events relating to an underlying obligation (generally a fixed income obligation). If credit spreads of the underlying obligations change, the market value of the related structured credit derivative changes. As such, Ambac Credit Products could experience mark-to-market gains or losses. Market liquidity could also impact valuations. Changes in credit spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligations. Ambac Credit Product’s structures its contracts with partial hedges from various financial institutions or with first loss protection. Such structuring mitigates Ambac Credit Product’s risk of loss and reduces the price volatility of these financial instruments. Personnel in Ambac’s Structured Finance Surveillance group monitor credit spread risk. Additionally, management models the potential impact of credit spread changes on the value of its contracts. The following table summarizes the estimated change in fair value (based primarily on the valuation models discussed above) on the net

40    

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

balance of Ambac’s net structured credit derivative position assuming immediate changes in credit spreads at specified levels at December 31, 2002 and 2001:

Change in Credit Spreads	Estimated Net Fair Value			Estimated Gain/(Loss)
	(Dollars in Millions)
2002:
75 basis point widening	$	(60	)	$	(29	)
50 basis point widening		(50	)		(19	)
25 basis point widening		(41	)		(10	)
Base scenario		(31	)		—
25 basis point narrowing		(28	)		3
50 basis point narrowing		(24	)		7
75 basis point narrowing		(22	)		9
2001:
75 basis point widening	$	(26	)	$	(18	)
50 basis point widening		(19	)		(11	)
25 basis point widening		(13	)		(5	)
Base scenario		(8	)		—
25 basis point narrowing		(7	)		1
50 basis point narrowing		(5	)		3
75 basis point narrowing		(3	)		5

Other financial instruments that may be adversely affected by changes in credit spreads include certain total return swap contracts, which are entered into by Ambac through its affiliate, Ambac Capital Services. These contracts require Ambac Capital Services to pay a specified spread in excess of LIBOR in exchange for receiving the total return of an underlying fixed income obligation over a specified period of time. If credit spreads of the underlying obligations change, the market value of the related total return swaps changes and Ambac Capital Services could experience mark-to-market gains or losses. For the year ended December 31, 2002, the estimated unrealized losses for Ambac’s total return swap portfolio for a 25 basis point and 50 basis point widening of credit spreads were $7.3 million and $14.0 million, respectively. For the year ended December 31, 2002 the estimated unrealized gains for Ambac’s total return swap portfolio for a 25 basis point and 50 basis point narrowing were $7.2 million and $11.1 million, respectively.

Liquidity Risk. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is present in financial guarantee contracts, structured credit derivatives, investment agreements, interest rate swaps and futures contracts. Ambac Assurance manages its liquidity risk by maintaining a comprehensive daily analysis of projected cash flows. Additionally, Ambac Assurance maintains a minimum level of cash and short-term investments at all times. Ambac Credit Products manage the liquidity risk inherent in the structured credit derivative portfolio by holding cash and short-term investments and closely matching the dates that derivative payments are made and received. The investment agreement business manages liquidity risk by matching the maturity schedules of its invested assets, including hedges, with the maturity schedules of its investment agreement liabilities. Additionally, Ambac’s policy is to maintain a minimum level of cash and short-term assets equivalent to a specified percentage of its investment agreement liabilities outstanding. Ambac Financial Services maintains cash and short-term investments, closely matches the dates swap payments are made and received, and limits the amount of risk hedged with futures contracts. See additional discussion in “Liquidity and Capital Resources” section.

Operational Risk. Operational risk relates to the potential for loss caused by a breakdown in information, communication and settlement systems. Ambac mitigates operational risk by maintaining systems (and system backup) and procedures to monitor transactions and positions, documentation and confirmation of transactions, and compliance with regulations.

Legal Risk. Legal risks attendant to Ambac’s businesses include uncertainty with respect to the enforceability of the obligations insured by Ambac Assurance and the security therefore, as well as uncertainty with respect to the enforceability of the obligations of Ambac’s counterparties, including contractual provisions intended to reduce exposure by providing for the offsetting or netting of mutual obligations. Ambac seeks to remove or minimize such uncertainties through continuous consultation with internal and external legal advisers to analyze and understand the nature of legal risk, to improve documentation and to strengthen transaction structure.

    41

Report on Management’s Responsibilities

The management of Ambac Financial Group, Inc. is responsible for the integrity and objectivity of the consolidated financial statements and all other financial information presented in this Annual Report and for assuring that such information fairly presents the consolidated financial position and operating results of Ambac Financial Group, Inc. The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America using management’s best estimates and judgment. The financial information presented elsewhere in this Annual Report is consistent with that in the consolidated financial statements.

Ambac Financial Group, Inc. maintains a system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded against loss or unauthorized use and that the financial records are reliable for use in preparing financial statements and maintaining accountability of assets. Qualified and professional financial personnel maintain and monitor these internal controls on a continuous basis. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control should not exceed the related benefits.

Ambac Financial Group, Inc.’s consolidated financial statements have been audited by KPMG LLP, independent auditors, whose audits were made in accordance with auditing standards generally accepted in the United States of America and included a review of internal accounting controls to the extent necessary to express an opinion on the fairness of the consolidated financial statements.

The Audit Committee of the Board of Directors, comprised solely of outside directors, meets regularly with financial and risk management, the independent auditors and the internal auditors to review the work and procedures of each. The independent auditors and the internal auditors have free access to the Audit Committee, without the presence of management, to discuss the results of their work and their considerations of Ambac and its subsidiaries and the quality of Ambac Financial Group, Inc.’s financial reporting. The Board of Directors, upon recommendation of the Audit Committee, appoints the independent auditors, subject to stockholder approval.

/S/    PHILLIP B. LASSITER

Phillip B. Lassiter

Chairman and Chief Executive Officer

/S/    THOMAS J. GANDOLFO

Thomas J. Gandolfo

Senior Vice President and Chief Financial Officer

January 21, 2003

Independent Auditors’ Report

To the Board of Directors and Stockholders

Ambac Financial Group, Inc.

We have audited the accompanying Consolidated Balance Sheets of Ambac Financial Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related Consolidated Statements of Operations, Stockholders’ Equity and Cash Flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of Ambac Financial Group, Inc.’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ambac Financial Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.

/S/    KPMG LLP

KPMG LLP

New York, New York

January 21, 2003

42    

Consolidated Balance Sheets

Ambac Financial Group, Inc. and Subsidiaries

	December 31,
	2002			2001
	(Dollars in Thousands, Except Share Amounts)
ASSETS:
Investments:
Fixed income securities, at fair value (amortized cost of $11,133,313 in 2002 and $8,355,596 in 2001)	$	11,597,623		$	8,469,157
Fixed income securities pledged as collateral, at fair value (amortized cost of $537,711 in 2002 and $1,393,193 in 2001)		543,572			1,401,528
Short-term investments, at cost (approximates fair value)		395,761			415,002
Other, at fair value		2,354			2,163
Total investments		12,539,310			10,287,850
Cash		25,816			76,580
Securities purchased under agreements to resell		260,818			11,200
Receivable for investment agreements		169			4,101
Receivable for securities sold		6,936			8,922
Investment income due and accrued		142,406			157,408
Reinsurance recoverable on paid and unpaid losses		4,842			1,021
Prepaid reinsurance		296,126			267,655
Deferred acquisition costs		174,055			163,477
Loans		843,809			901,194
Derivative product assets		1,010,081			383,959
Other assets		51,170			76,176
Total assets	$	15,355,538		$	12,339,543
LIABILITIES AND STOCKHOLDERS’ EQUITY:
Liabilities:
Unearned premiums	$	2,128,847		$	1,780,272
Losses and loss adjustment expense reserve		172,137			151,114
Ceded reinsurance balances payable		16,930			10,146
Obligations under investment and payment agreements		6,434,497			4,089,777
Obligations under investment repurchase agreements		848,358			1,422,151
Securities sold under agreement to repurchase		132,235			425,000
Deferred income taxes		185,641			123,077
Current income taxes		44,807			98,145
Debentures		616,715			619,315
Accrued interest payable		81,252			84,225
Derivative product liabilities		836,146			314,583
Other liabilities		154,640			175,135
Payable for securities purchased		78,154			62,915
Total liabilities		11,730,359			9,355,855
Stockholders’ equity:
Preferred stock, par value $0.01 per share; authorized shares—4,000,000; issued and outstanding shares—none		—			—
Common stock, par value $0.01 per share; authorized shares— 200,000,000 at December 31, 2002 and December 31, 2001; issued shares—106,211,467 at December 31, 2002 and 106,020,537 at December 31, 2001		1,062			1,060
Additional paid-in capital		550,289			538,135
Accumulated other comprehensive income		265,427			62,476
Retained earnings		2,820,281			2,403,473
Common stock held in treasury at cost, 220,876 shares at December 31, 2002 and 436,488 at December 31, 2001		(11,880	)		(21,456	)
Total stockholders’ equity		3,625,179			2,983,688
Total liabilities and stockholders’ equity	$	15,355,538		$	12,339,543

See accompanying Notes to Consolidated Financial Statements.

    43

Consolidated Statements of Operations

Ambac Financial Group, Inc. and Subsidiaries

	Years Ended December 31,
	2002			2001			2000
	(Dollars in Thousands Except Share Amounts)
REVENUES:
Financial Guarantee:
Gross premiums written	$	904,032		$	683,296		$	483,082
Ceded premiums written		(113,542	)		(95,534	)		(80,789	)
Net premiums written	$	790,490		$	587,762		$	402,293
Net premiums earned	$	471,534		$	378,734		$	311,276
Other credit enhancement fees		28,775			21,661			12,157
Net premiums earned and other credit enhancement fees		500,309			400,395			323,433
Net investment income		297,297			267,847			241,047
Net realized investment gains		40,918			2,124			681
Net unrealized losses on credit derivative contracts		(27,877	)		(3,588	)		(4,111	)
Other income		5,531			5,180			4,371
Financial Services:
Interest from investment and payment agreements		255,007			249,903			303,165
Other revenue		30,550			37,770			42,513
Net realized investment losses		(134,097	)		(3,026	)		(9,110	)
Net unrealized losses on derivative hedge contracts		(839	)		—			—
Corporate:
Net investment income		3,537			3,426			2,137
Other revenue		—			901			179
Net realized investment gains (losses)		1,482			(564	)		8
Total revenues		971,818			960,368			904,313
EXPENSES:
Financial Guarantee:
Losses and loss adjustment expenses		26,700			20,000			15,000
Underwriting and operating expenses		76,548			67,989			55,235
Financial Services:
Interest from investment and payment agreements		231,304			235,448			283,003
Other expenses		22,182			21,815			24,805
Interest		43,724			40,442			37,477
Corporate		7,170			5,947			6,669
Total expenses		407,628			391,641			422,189
Income before income taxes		564,190			568,727			482,124
Provision for income taxes		131,596			135,821			115,952
Net income	$	432,594		$	432,906		$	366,172
Net income per share:
Basic	$	4.08		$	4.10		$	3.49
Diluted	$	3.97		$	3.97		$	3.41
Weighted average number of common shares outstanding:
Basic		105,951,603			105,705,957			105,031,473
Diluted		109,066,046			108,948,133			107,415,430

See accompanying Notes to Consolidated Financial Statements.

44    

Consolidated Statements of Stockholders’ Equity

Ambac Financial Group, Inc. and Subsidiaries

	Years Ended December 31,
	2002						2001						2000
	(Dollars in Thousands)
RETAINED EARNINGS:
Balance at January 1	$	2,403,473					$	2,035,209					$	1,713,446
Net income		432,594		$	432,594			432,906		$	432,906			366,172		$	366,172
Dividends declared—common stock		(40,251	)					(35,937	)					(32,213	)
Exercise of stock options		24,465						(28,705	)					(12,196	)
Balance at December 31	$	2,820,281					$	2,403,473					$	2,035,209
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):
Balance at January 1	$	62,476					$	45,154					$	(187,540	)
Unrealized gains on securities, $339,039, $39,542, and $373,291, pre-tax in 2002, 2001 and 2000, respectively (1)					214,943						23,643						234,178
Cumulative effect of accounting change					—						(880	)					—
Loss on derivative hedges					(14,171	)					(4,371	)					—
Foreign currency gain (loss)					2,179						(1,070	)					(1,484	)
Other comprehensive income		202,951			202,951			17,322			17,322			232,694			232,694
Total comprehensive income				$	635,545					$	450,228					$	598,866
Balance at December 31	$	265,427					$	62,476					$	45,154
PREFERRED STOCK:
Balance at January 1 and December 31	$	—					$	—					$	—
COMMON STOCK:
Balance at January 1	$	1,060					$	1,060					$	707
Issuance of stock		2						—						—
Stock split effected as dividend		—						—						353
Balance at December 31	$	1,062					$	1,060					$	1,060
ADDITIONAL PAID-IN CAPITAL:
Balance at January 1	$	538,135					$	533,558					$	525,012
Exercise of stock options		16,320						13,045						8,899
Issuance of stock		4,287						—						—
Capital issuance costs		(8,453	)					(8,468	)					—
Stock split effected as dividend		—						—						(353	)
Balance at December 31	$	550,289					$	538,135					$	533,558
COMMON STOCK HELD IN TREASURY AT COST:
Balance at January 1	$	(21,456	)				$	(18,867	)				$	(33,175	)
Cost of shares acquired		(41,101	)					(40,876	)					(23,618	)
Shares issued under equity plans		50,677						38,287						37,926
Balance at December 31	$	(11,880	)				$	(21,456	)				$	(18,867	)
TOTAL STOCKHOLDERS’ EQUITY AT DECEMBER 31	$	3,625,179					$	2,983,688					$	2,596,114
(1) Disclosure of reclassification amount:
Unrealized holding gains arising during period	$	154,065					$	25,817					$	230,985
Less: reclassification adjustment for net (losses) gains included in net income		(60,878	)					2,174						(3,193	)
Net unrealized gains on securities	$	214,943					$	23,643					$	234,178

See accompanying Notes to Consolidated Financial Statements.

    45

Consolidated Statements of Cash Flows

Ambac Financial Group, Inc. and Subsidiaries

	Years Ended December 31,
	2002			2001			2000
	(Dollars in Thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	432,594		$	432,906		$	366,172
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,466			3,479			3,614
Amortization of bond premium and discount		8,872			(15,916	)		(12,972	)
Current income taxes		(53,338	)		72,517			797
Deferred income taxes		(52,110	)		4,991			24,300
Deferred acquisition costs		(10,578	)		(10,053	)		(18,100	)
Unearned premiums, net		320,104			208,931			90,587
Losses and loss adjustment expenses		17,202			18,739			10,379
Ceded reinsurance balances payable		6,784			(746	)		(4,136	)
Investment income due and accrued		15,002			(26,716	)		(2,024	)
Accrued interest payable		(2,973	)		(6,350	)		(567	)
Net realized investment losses		91,697			1,466			8,421
Net unrealized losses on credit derivative contracts and derivative hedge contracts		28,716			3,588			4,111
Other, net		50			(15,005	)		10,746
Net cash provided by operating activities		805,488			671,831			481,328
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of bonds		3,380,488			2,243,276			1,636,904
Proceeds from matured bonds		2,204,670			2,538,173			1,843,482
Purchases of bonds		(7,588,477	)		(6,497,633	)		(2,502,176	)
Change in short-term investments		19,241			(161,483	)		(32,623	)
Securities purchased under agreements to resell		(249,618	)		244,586			(152,786	)
Securities sold under agreements to repurchase		(292,637	)		425,000			—
Loans		57,385			(205,943	)		(9,763	)
Other, net		(37,456	)		12,580			(6,553	)
Net cash (used in) provided by investing activities		(2,506,404	)		(1,401,444	)		776,485
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividends paid		(40,251	)		(35,937	)		(32,213	)
Proceeds from issuance of investment agreements		3,585,538			3,044,900			1,637,935
Payments for investment agreement draws		(2,143,557	)		(2,423,516	)		(2,855,766	)
Proceeds from issuance of debentures		—			193,700			—
Payment agreements		243,009			175			9,763
Payment for buyback of debentures		—			(7,500	)		—
Capital issuance costs		(8,452	)		(8,468	)		—
Issuance of common stock		4,289			—			—
Purchases of treasury stock		(41,101	)		(40,876	)		(23,618	)
Proceeds from sale of treasury stock		50,677			38,287			37,926
Net cash provided by (used in) financing activities		1,650,152			760,765			(1,225,973	)
NET CASH FLOW		(50,764	)		31,152			31,840
Cash and cash pledged as collateral at January 1		76,580			45,428			13,588
Cash and cash pledged as collateral at December 31	$	25,816		$	76,580		$	45,428
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes	$	159,500		$	45,268		$	82,400
Interest expense on debt	$	48,260		$	44,632		$	34,304
Interest expense on investment agreements	$	218,195		$	231,498		$	286,589

See accompanying Notes to Consolidated Financial Statements.

46    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

1 BACKGROUND

Ambac Financial Group, Inc. is a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world. Ambac’s principal operating subsidiary, Ambac Assurance Corporation, a leading provider of financial guarantees for public finance and structured finance obligations, has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch Inc., and Rating and Investment Information, Inc. Ambac’s Financial Services segment provides financial and investment products including investment agreements, interest rate swaps, funding conduits, investment advisory and cash management services, principally to its clients which include municipalities and other public entities, school districts, health care organizations and asset-backed issuers.

2 SIGNIFICANT ACCOUNTING POLICIES

The accompanying consolidated financial statements of Ambac and subsidiaries have been prepared on the basis of accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant accounting policies of Ambac are described below:

Consolidation: The consolidated financial statements include the accounts of Ambac and its subsidiaries. All significant inter-company balances have been eliminated.

Investments: Ambac’s investment portfolio is accounted for on a trade-date basis and consists primarily of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based primarily on quotes obtained from independent market sources. When quotes are not available, valuation models are used to estimate fair value. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a component of “Accumulated Other Comprehensive Income (Loss)” in stockholders’ equity and are computed using amortized cost as the basis. If management believes that an unrealized loss is “other than temporary,” the carrying value of the investment is reduced and a realized investment loss is recorded in the Consolidated Statement of Operations. For purposes of computing amortized cost, premiums and discounts are accounted for using the interest method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the securities. For bonds purchased at a price above par value that have call features, premiums are amortized to the most likely call dates as determined by management. For premium bonds that do not have call features, such premiums are amortized over the remaining terms of the securities. Premiums and discounts on mortgage-backed and asset-backed securities are adjusted for the effects of actual and anticipated prepayments. Realized gains and losses on the sale of investments are determined on the basis of specific identification.

Securities Purchased under Agreements to Resell and Securities Sold Under Agreements to Repurchase: Securities purchased under agreements to resell are collateralized investment transactions, and are recorded at their contracted resale amounts, plus accrued interest. Ambac takes possession of the collateral underlying those agreements and monitors its market value on a daily basis and, when necessary, requires prompt transfer of additional collateral to reflect current market value. Securities sold under agreements to repurchase are collateralized financing transactions, and are recorded at their contracted resale amounts, plus accrued interest. Ambac nets securities purchased under agreements to resell and securities sold under agreements to repurchase that are executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria. At December 31, 2002 and 2001, collateral underlying securities purchased under agreements to resell had an average credit rating of triple-A. These agreements have a weighted average maturity of less than 30 days.

Deferred Acquisition Costs: Certain financial guarantee costs incurred, primarily related to the production of business, have been deferred. These costs include direct and indirect expenses related to underwriting, marketing and policy issuance, rating agency fees and premium taxes, net of reinsurance ceding commissions. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned, and such amortization amounted to $32,336, $28,203 and $22,472 for 2002, 2001 and 2000, respectively. Deferred acquisition costs, net of such amortization, amounted to $10,578, $10,053 and $18,100 for 2002, 2001 and 2000, respectively.

    47

Loans: Loans are reported at their outstanding unpaid principal balances, net of any deferred fees and fair value hedge adjustments. These fair value hedge adjustments are discussed further in “Derivative Contracts used for Hedging Purposes” below. Interest income is accrued on the unpaid principal balance. Deferred fees are amortized to income over the contractual life of the loan using the interest method or the straight-line method if not materially different.

Losses and Loss Adjustment Expense Reserve: The reserve for losses and loss adjustment expenses consists of the active credit reserve and case basis loss and loss adjustment expense reserves. The active credit reserve is established based upon probable debt service defaults from incurred losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on managements review of each credit. When defaults occur, case basis credit loss reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. These reserves are discounted in accordance with discount rates prescribed or permitted by state regulatory authorities. During 2002, 2001 and 2000, paid losses were $11,143, $2,595, and $4,622, respectively. All or parts of case basis loss reserves are allocated from any active credit reserves available. During 2002, 2001 and 2000, salvage amounts received were $553, $1,333 and $0, respectively.

Management believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net cost of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates.

Obligations under Investment and Payment Agreements and Investment Repurchase Agreements: Obligations under investment and payment agreements and investment repurchase agreements are recorded as liabilities on the Consolidated Balance Sheets at the face value of the agreement. The carrying value of these obligations is adjusted for draws paid and interest credited to the account as well as any fair value hedge adjustments. These fair value hedge adjustments are discussed further in “Derivative Contracts used for Hedging Purposes” below. Unsettled agreements are accrued on a trade-date basis on the Consolidated Balance Sheets at the time of commitment. Interest expense is computed based upon daily outstanding settled liability balances at rates and periods specified in the agreements. Net interest income relating to investment and payment agreements and investment repurchase agreements is included as a component of Financial Services revenue.

Net Premiums Earned: Up-front insurance premiums written are received for an entire bond issue. A bond issue may contain several maturities. The premium is allocated to each bond maturity proportionally, based on total principal amount guaranteed and is recognized on a straight-line basis over the term of each maturity. Installment insurance premiums written are recognized over each installment period, generally one year or less. When an issue insured by Ambac Assurance has been refunded or called, the remaining unrecognized premium (net of refunding credits, if any) is recognized at that time.

Financial Services Revenue: Ambac’s Financial Services other revenues includes the following products:

Interest rate swaps and total return swaps—Ambac provides interest rate swaps principally to states, municipalities and municipal authorities in connection with their financings. Ambac also enters into total return swaps with various financial institutions. All interest rate swaps and total return swap revenues are accounted for as “Derivative Contracts Held for Trading Purposes,” which is discussed in the Derivatives section below.

Investment advisory and cash management—Ambac provides investment advisory and administrative services for money market funds that are primarily offered to qualified participants including school districts, health care service providers and municipalities. Cash management services include the distribution of money market funds, as well as the brokering of short-term fixed income securities trades on behalf of Ambac clients. Fees from investment advisory and cash management services are based on percentages of the average daily net assets of the money market funds serviced as well as a broker mark-up on short-term fixed income securities trades. Fees from investment advisory and cash management services are recognized when earned, consistent with the accrual basis of accounting.

Depreciation and Amortization: Depreciation of furniture and fixtures and electronic data processing equipment is charged over the estimated useful lives of the respective assets, ranging from three to five years, using the straight-line method. Amortization of leasehold improvements is charged over the lesser of ten years or the remaining term of the operating leases, ranging from four to ten years, using the straight-line method.

48    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

Postretirement and Postemployment Benefits: Ambac provides various postretirement and postemployment benefits, including pension, and health and life benefits covering substantially all employees who meet certain age and service requirements. Ambac accounts for these benefits under the accrual method of accounting. Amounts related to the defined benefit pension plan and postretirement health benefits are charged based on actuarial determinations.

Foreign Currency: Financial statement accounts expressed in foreign currencies are translated into U.S. dollars in accordance with FAS Statement 52, “Foreign Currency Translation” (“SFAS 52”). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using exchange rates in effect at the balance sheet dates and the related translation adjustments are recorded as a separate component of comprehensive income, net of any related taxes. Functional currencies are generally the currencies of the local operating environment. Income statement accounts expressed in functional currencies are translated using average exchange rates. Foreign currency transaction gains and losses, arising primarily from short-term investment securities denominated in foreign currencies, are reflected in net income. The Consolidated Statements of Operations include pre-tax gains (losses) from such foreign exchange items of $1,485, $(3,389) and $(3,748) for 2002, 2001 and 2000, respectively.

Income Taxes: Ambac files a consolidated Federal income tax return with its subsidiaries. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.

Stock Compensation Plans: In 1997, Ambac adopted the Ambac 1997 Equity Plan. Under this plan, awards are granted to eligible employees of Ambac in the form of non-qualified stock options or other stock-based awards. Ambac accounts for its incentive stock options and stock-based awards under FAS Statement 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123 permits a company to choose either the fair value based method of accounting as defined in the Statement or the intrinsic value based method of accounting as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), for its stock-based compensation plans. Ambac has elected to account for its plans using the intrinsic value based method for all periods presented. Accordingly, since the fair value of the options at grant date equals the exercise price, no compensation cost has been recognized for its fixed stock option plan. Had compensation cost for Ambac’s stock-based compensation plan been determined consistent with the fair value based method of FAS 123, Ambac’s net income, earnings per share and earnings per diluted share for the years ended December 31, 2002, 2001 and 2000, would have been reduced to the pro-forma amounts indicated below:

	2002		2001		2000
Net Income:
As reported	$	432,594	$	432,906	$	366,172
Compensation expense, net of tax	$	12,599	$	13,596	$	8,591
Pro-forma	$	419,995	$	419,310	$	357,581
Earnings per share:
As reported	$	4.08	$	4.10	$	3.49
Pro-forma	$	3.96	$	3.97	$	3.40
Earnings per diluted share:
As reported	$	3.97	$	3.97	$	3.41
Pro-forma	$	3.85	$	3.85	$	3.33

Derivative Contracts: In June 1998 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Certain Hedging Activities.” In June 2000 the FASB issued SFAS 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS 133.” SFAS 133 and SFAS 138 require all derivative instruments be recorded on the balance sheet at their respective fair values. SFAS 133 and SFAS 138 are effective for all fiscal quarters of all fiscal years beginning after June 30, 2000; Ambac adopted SFAS 133 and SFAS 138 on January 1, 2001. In accordance with the transition provisions of SFAS 133, Ambac recorded transition adjustment losses of $880 (net of related income tax) in “Accumulated Other Comprehensive Income” and $408 (net of related income tax) in net income in 2001.

        All derivative instruments are recognized in the Consolidated Balance Sheets as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments are measured at estimated fair value. The fair values of derivative instruments are determined by broker quotes or valuation models when broker quotes are not available. Valuation models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.

    49

Derivative Contracts used for Hedging Purposes: Interest rate and currency swaps are utilized to hedge exposure to changes in fair value of assets or liabilities resulting from changes in interest rates and foreign exchange rates, respectively. These interest rate and currency swap hedges are referred to as “fair value” hedges. Gains and losses on fair value hedges are recognized currently in net income. The gain or loss on the hedged asset or liability attributable to the hedged risk (interest rate or foreign exchange risk) adjusts the carrying amount of the hedged item and is recognized currently in net income. If the fair value hedge is fully effective, the gain or loss on the interest rate or currency swap will exactly offset the gain or loss on the hedged item. If exact offset is not achieved, the difference would be the effect of hedge ineffectiveness, which is recognized currently in net income. During 2002, the net amount of hedge ineffectiveness, reported in “Net unrealized losses on derivative hedge contracts” in the Consolidated Statements of Operations was a loss of $1,020. In addition, a gain of $5,959 representing the time value component of the derivative instruments was excluded from the assessment of hedge effectiveness and reported in “Financial Services Interest Expense from Investment and Payment Agreements” in the Consolidated Statements of Operations. There was no hedge ineffectiveness reported in net income for 2001 and 2000.

Interest rate swaps are also utilized to hedge the exposure to variable interest rates. These interest rate swap hedges are referred to as “cash flow” hedges. Gains and losses on interest rate swaps designated as cash flow hedges are reported in “Accumulated Other Comprehensive Income” in stockholders’ equity, until earnings are affected by the variability in cash flows of the designated hedged item. During 2002, 2001 and 2000, there was no hedge ineffectiveness reported in net income for cash flow hedges.

Ambac discontinues hedge accounting prospectively when it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative expires, is sold or terminated. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value hedge, Ambac continues to carry the derivative on the balance sheet at its fair value, and no longer adjusts the hedged asset or liability for changes in fair value. The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as other components of the carrying amount of that asset or liability. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective cash flow hedge, Ambac continues to carry the derivative on the balance sheet at its fair value. The net derivative gain or loss related to a discontinued cash flow hedge (recognized during the period of hedge effectiveness) will continue to be reported in Accumulated Other Comprehensive Income and amortized into net income as a yield adjustment to the previously designated asset or liability. If the previously designated asset or liability is sold or matures, the net derivative gain or loss related to a discontinued cash flow hedge reported in Accumulated Other Comprehensive Income will be reclassified into net income immediately. All subsequent changes in fair values of derivatives previously designated as cash flow hedges will be recognized currently in net income. As of December 31, 2002, $660 of deferred losses on derivative instruments reported in Accumulated Other Comprehensive Income are expected to be reclassified to net income during the next twelve months. Transactions and events expected to occur over the next twelve months that will necessitate reclassifying these derivative losses include the repricing of a variable-rate investment agreement.

Derivative Contracts Classified as Held for Trading Purposes: Ambac, through its subsidiary Ambac Financial Services, L.P., provides interest rate swaps to states, municipalities and their authorities, and other entities in connection with their financings. Ambac Capital Services enters into total return swaps with professional counterparties. Total return swaps are only used for fixed income obligations which meet Ambac Assurance’s credit underwriting criteria. Ambac, through its subsidiary Ambac Credit Products LLC, enters into structured credit derivative transactions with various financial institutions. Ambac Financial Services’ interest rate swaps and futures contracts, Ambac Capital Services’ total return swaps and Ambac Credit Products’ structured credit derivatives are classified as held for trading purposes. These contracts are recorded on trade date at fair value. Changes in fair value are recorded as a component of “Financial Services Other Revenue” for interest rate swaps, total return swaps and futures contracts in the accompanying Consolidated Statement of Operations. The fee component of structured credit derivatives is reflected in Other Credit Enhancement Fees in the accompanying Consolidated Statements of Operations. The mark-to-market gain or loss associated with credit spread changes on structured credit derivatives is reflected in Net Unrealized Losses on Credit Derivative Contracts in the accompanying Consolidated Statements of Operations.

All derivative contracts used for hedging purposes and classified as held for trading purposes are recorded on the Consolidated Balance Sheets on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. Gross asset and gross liability balances for all derivatives are recorded as Derivative Product Assets or Derivative Product Liabilities on the Consolidated Balance Sheets.

50    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

Special Purpose Entities: Ambac has transferred third-party debt obligations to two special purpose entities. The business purpose of these entities is to provide some of our financial guarantee clients with funding for their debt obligations. These special purpose entities meet the characteristics of Qualifying Special Purpose Entities (“QSPEs”) in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The QSPEs are not consolidated in Ambac’s consolidated financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to (i) purchasing assets from Ambac, which are defined in the governing documents of the QSPEs, (ii) issuing Medium Term Notes (“MTNs”) to fund such purchase, (iii) executing derivative hedges and (iv) providing related administrative services. The QSPEs hold only passive debt obligations transferred to it by Ambac, passive derivative financial instruments used for hedging purposes and cash collected from assets that it holds pending distribution to the MTN holders. The QSPEs do not hold equity or other types of securities that would allow for voting rights, significant influence or contractual options such as the right to unconditionally put or call a financial instrument. The legal documents that established the QSPEs or created the beneficial interests in the transferred assets do not permit the sale or other disposal of the transferred financial assets except for disposals in automatic response to the terms of such financial assets (this would include only issuer call provisions). These required disposals are outside the control of Ambac, its affiliates and the QSPEs. Beneficial interest holders do not have the rights to put their beneficial interest back to the QSPEs.

As of December 31, 2002, there have been 12 individual transactions processed through the QSPEs. In each case, Ambac sells fixed income debt obligations issued by third parties to the QSPEs. Ambac receives cash consideration for all assets transferred to the QSPEs. Ambac surrenders control over the transferred debt obligations. There are no agreements that entitle or obligate Ambac to repurchase or redeem assets. The QSPEs are structured as bankruptcy remote entities. Ambac management believes that the assets transferred represent a true sale and the assets held by the QSPEs are beyond the reach of Ambac and its creditors, even in bankruptcy or other receivership. Legal counsel has concurred with management’s belief and has provided Ambac true sale and non-substantive consolidation opinions. The purchase by the QSPEs is financed through the issuance of MTNs, which are collateralized by the purchased assets. Derivative contracts may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase debt obligations. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued and the derivative contracts used. As of December 31, 2002, Ambac Assurance had financial guarantee insurance policies issued for all assets owned, MTNs issued and derivative contracts used by the QSPEs.

Ambac’s exposure under these financial guarantee insurance policies is included in the disclosure in Note 12 “Guarantees in Force” to the consolidated financial statements. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. To date, no losses have been recognized. Under the terms of an Administrative Agency Agreement, Ambac provides some administrative services, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during 2002, 2001 and 2000 were $350,000, $793,438 and $159,937, respectively. No gains or losses were recognized on these sales. As of December 31, 2002, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $1,347,287, $1,263,530 and $90,958, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums written and other fees for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $19,255, $23,682 and $3,204 for the years ended December 31, 2002, 2001 and 2000, respectively. Ambac received fees for providing administrative services amounting to $80, $302 and $180 for 2002, 2001 and 2000, respectively.

Net Income Per Share: Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during the year. Diluted net income per share is computed similar to basic net income per share except that the weighted average shares outstanding are increased to include 3,114,443, 3,242,176 and 2,383,957 additional shares from the assumed conversion of dilutive stock options and restricted stock units at December 31, 2002, 2001 and 2000, respectively. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercises were used to acquire shares of common stock at the average market price during the year.

    51

Accounting Standards: In December 2002, the FASB issued FAS Statement 148, “Accounting for Stock-Based Compensation Transition and Disclosure” (“SFAS 148”). SFAS 148 amends FAS Statement 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. SFAS148 also requires more prominent disclosures in both annual and interim financial statements about the method used and the effects of the stock-based compensation. Ambac will adopt the fair value based method of accounting for stock-based compensation, using the prospective transition method, on January 1, 2003.

In January 2003, the FASB issued FAS Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 clarifies the consolidation rules to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 requires variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated. FIN 46 requires disclosures for entities that have either a primary or significant variable interest in a variable interest entity. Ambac is required to adopt the consolidation provisions of FIN 46 on July 1, 2003. Based upon Ambac’s current assessment, it does not have a significant variable interest in any Variable Interest Entity affected by this Interpretation.

Reclassifications: Certain reclassifications have been made to prior years’ amounts to conform to the current year’s presentation.

3 INVESTMENTS

The amortized cost and estimated fair value of investments in fixed income securities and short-term investments at December 31, 2002 and 2001 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
2002:
Fixed income securities:
Municipal obligations	$	4,587,545	$	304,995	$	4,638	$	4,887,902
Corporate obligations		1,532,859		64,219		27,764		1,569,314
Foreign government obligations		108,071		12,562		33		120,600
U.S. government obligations		104,966		3,563		336		108,193
Mortgage and asset-backed securities (includes U.S. government agency obligations)		4,799,872		115,601		3,859		4,911,614
Short-term		395,761		—		—		395,761
		11,529,074		500,940		36,630		11,993,384
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities (includes U.S. government agency obligations)		537,711		6,260		399		543,572
Total	$	12,066,785	$	507,200	$	37,029	$	12,536,956
2001:
Fixed income securities:
Municipal obligations	$	3,580,822	$	133,745	$	29,769	$	3,684,798
Corporate obligations		1,342,990		30,245		42,646		1,330,589
Foreign government obligations		97,109		629		1,138		96,600
U.S. government obligations		75,703		3,750		1,199		78,254
Mortgage and asset-backed securities (includes U.S. government agency obligations)		3,258,972		36,643		16,699		3,278,916
Short-term		415,002		—		—		415,002
		8,770,598		205,012		91,451		8,884,159
Fixed income securities pledged as collateral:
Mortgage and asset-backed securities (includes U.S. government agency obligations)		1,393,193		12,417		4,082		1,401,528
Total	$	10,163,791	$	217,429	$	95,533	$	10,285,687

52    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The amortized cost and estimated fair value of fixed income securities and short-term investments at December 31, 2002, by contractual maturity, were as follows:

	Amortized Cost		Estimated Fair Value
Due in one year or less	$	479,271	$	482,008
Due after one year through five years		796,429		824,868
Due after five years through ten years		895,574		960,295
Due after ten years		4,557,928		4,814,599
		6,729,202		7,081,770
Mortgage and asset-backed securities		5,337,583		5,455,186
	$	12,066,785	$	12,536,956

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

There were no individual securities with material unrealized losses as of December 31, 2002 and 2001.

Securities carried at $6,240 and $5,964 at December 31, 2002 and 2001, respectively, were deposited by Ambac with governmental authorities or designated custodian banks as required by laws affecting insurance companies.

Net investment income from the Financial Guarantee segment was comprised of the following:

	2002			2001			2000
Fixed income securities	$	297,741		$	260,302		$	232,876
Short-term investments		2,831			9,996			9,904
Total investment income		300,572			270,298			242,780
Investment expense		(3,275	)		(2,451	)		(1,733	)
Net investment income	$	297,297		$	267,847		$	241,047

The Financial Guarantee segment had gross realized gains of $48,529, $12,100 and $9,633 in 2002, 2001 and 2000, respectively, and gross realized losses of $7,611, $9,975 and $8,952 in 2002, 2001 and 2000, respectively. Included in the above is a net foreign exchange gain of $1,850 in 2002 and net foreign exchange losses of $3,161 and $3,509 in 2001 and 2000, respectively, related to investments in certain high-grade foreign currency denominated securities.

The Financial Services segment had gross realized gains of $10,313, $7,526 and $5,605 in 2002, 2001 and 2000, respectively, and gross realized losses of $144,520, $10,551 and $14,715 in 2002, 2001 and 2000, respectively. Included in 2002 realized losses was an impairment write-down of $139,731 to the carrying value of asset-backed notes issued by National Century Financial Enterprises, Inc. (“NCFE”). These notes, which were rated triple-A until October 25, 2002, have defaulted and NCFE filed for protection under Chapter 11 of the U.S. Bankruptcy Code in November of 2002. The NCFE securities, which are backed by health care receivables, have been written down to approximately 20% of amortized cost, which represents management’s best estimate of its future recovery based on existing facts and circumstances. There were no impairment write-downs during 2001 or 2000.

        As of December 31, 2002 and 2001, Ambac held securities purchased under agreements to resell. A portion of the securities obtained under these agreements were then pledged to Ambac’s investment agreement counterparties (including counterparties with agreements structured as investment repurchase agreements). Such securities may not then be repledged by the investment agreement counterparty to another entity. In addition, Ambac sold securities subject to repurchase in the normal course of business. Ambac’s counterparties under these agreements have the right to pledge or rehypothecate the securities, which were sold. The following table presents (i) the carrying value of repurchase agreements, (ii) the fair value of securities underlying these agreements, and (iii) the fair value of securities pledged by Ambac to investment agreement counter-parties from securities purchased under agreements to resell at December 31, 2002 and 2001.

	Carrying Value		Fair Value of Underlying Securities		Fair Value of Securities Pledged to Investment Agreement Counterparties
2002:
Securities purchased under agreements to resell	$	260,818	$	266,156	$	100,679
Securities sold under agreements to repurchase		132,235		136,890		n.a.
2001:
Securities purchased under agreements to resell	$	11,200	$	11,566	$	—
Securities sold under agreements to repurchase		425,000		446,410		n.a.

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In conjunction with its investment agreement business, Ambac routinely enters into security collateral swaps, whereby repurchase and reverse repurchase agreements are entered into simultaneously with the same counterparty. Under the terms of the security collateral swap agreements, both Ambac and the counterparties have identical rights to pledge or rehypothecate the securities sold or purchased under the agreement. Ambac routinely pledges the securities obtained under the security collateral swap agreements to investment agreement counterparties. Such securities may not then be repledged by the investment agreement counterparty to another entity. The fair value of the underlying securities of all collateral swap arrangements and the fair value of securities pledged to investment agreement counterparties under security collateral swap arrangements at December 31, 2002 and 2001 were as follows:

	Fair Value of Security Collateral Swaps		Fair Value of Securities Pledged to Investment Agreement Counterparties
2002:
Securities purchased under agreements to resell	$	395,370	$	357,830
Securities sold under agreements to repurchase		406,592		n.a.
2001:
Securities purchased under agreements to resell	$	960,335	$	738,195
Securities sold under agreements to repurchase		955,118		n.a.

The fair value of securities sold by Ambac under agreements to repurchase in the normal course of business and under security collateral swap arrangements have been classified separately as “Fixed income securities pledged as collateral” on the Consolidated Balance Sheets.

As of December 31, 2002 and 2001, Ambac had pledged securities from its investment portfolio with a fair value of $1,887,710 and $1,544,461 to investment agreement counterparties. Securities pledged to investment and payment agreement counterparties are maintained in either a tri-party collateral account with Ambac’s custodian bank or a segregated trust account.

Under the terms of certain interest rate swap and structured credit derivative agreements, Ambac and its counterparties may be required to pledge collateral to the other resulting from changes in the estimated fair value of those positions. The following amounts were pledged under these agreements at December 31, 2002 and 2001:

	Pledged to Ambac from its Counterparties				Pledged by Ambac to its Counterparties
	2002		2001		2002		2001
Cash	$	4,159	$	34,200	$	—	$	—
Securities		100,323		5,127		155,943		—

4 LOANS

In the normal course of business, Ambac extended loans for the following purposes:

Structured municipal transactions: Loans have been extended to customers participating in certain structured municipal transactions. The loans are collateralized with cash in amounts adequate to repay the loan balance. Equipment and other assets underlying the transactions serve as additional collateral for the loans. Ambac acts as the payment custodian and holds the funds posted as collateral. At December 31, 2002 and 2001 the loan balances outstanding and collateral held were $687,901 and $695,426, respectively. As of December 31, 2002 and 2001 the interest rates on these loans ranged from 6.25% to 8.42%. The range of expected final maturity dates of these loans was May 2004 to January 2027 as of December 31, 2002.

Project financing: Ambac has purchased loans which finance an infrastructure project which is secured by the assets underlying that project. As of December 31, 2002 and 2001, the interest rates on these loans ranged from 5.28% to 7.03%. The loan balances outstanding were $145,708 and $181,768 as of December 31, 2002 and 2001, respectively. The range of expected maturity dates of these loans was July 2014 to July 2019 as of December 31, 2002 and 2001.

Investment partnerships: Ambac has senior secured short-term loans outstanding to certain investment partnerships which invest in diversified portfolios of assets, primarily high-yield debt obligations and bank loans. The loans are collateralized with a first priority lien and security interest in the invested assets. As of December 31, 2002, Ambac has an outstanding loan balance of $10,200 with an interest rate of 2.44%. The expected maturity of this loan was January 2003. As of December 31, 2001, Ambac had an outstanding loan balance of $24,000 with interest rates ranging from 2.94% to 4.94%. The range of maturity dates for these loans was January 2002 to March 2002.

54    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

5 REINSURANCE

In the ordinary course of business, Ambac Assurance cedes exposures under various reinsurance contracts primarily designed to minimize losses from large risks and to protect capital and surplus. The effect of reinsurance on premiums written and earned was as follows:

	Years Ended December 31,
	2002						2001						2000
	Written			Earned			Written			Earned			Written			Earned
Direct	$	871,070		$	515,119		$	632,413		$	410,392		$	440,111		$	334,908
Assumed		32,962			41,486			50,883			38,825			42,971			32,530
Ceded		(113,542	)		(85,071	)		(95,534	)		(70,483	)		(80,789	)		(56,162	)
Net premiums	$	790,490		$	471,534		$	587,762		$	378,734		$	402,293		$	311,276

The reinsurance of risk does not relieve the ceding insurer of its original liability to its policyholders. In the event that all or any of the reinsurers are unable to meet their obligations to Ambac Assurance under the existing reinsurance agreements, Ambac Assurance would be liable for such defaulted amounts. To minimize its exposure to significant losses from reinsurers, Ambac Assurance (i) evaluates the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts and (iii) has certain termination triggers that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. Additionally, as of December 31, 2002, Ambac Assurance held bank letters of credit and collateral amounting to approximately $135,681 from its reinsurers to cover liabilities ceded under the aforementioned reinsurance contracts. For the years ended December 31, 2002, 2001 and 2000, reinsurance recoveries, which reduced loss and loss expenses incurred, amounted to $1,334, $0 and $0, respectively. Reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 2002 and 2001 were $242 and $0, respectively. As of December 31, 2002, prepaid reinsurance of approximately $181,378 was associated with Ambac Assurance’s three largest reinsurers. Ambac pledged cash and fixed income securities to foreign insurers of $11,166 and $9,295 at December 31, 2002 and 2001, respectively, related to business assumed from those insurers.

6 LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVE

As discussed in note 2, Ambac Assurance’s liability for losses and loss adjustment expenses consists of case basis and active credit reserves. Following is a summary of the activity in the case basis credit and active credit reserve accounts and the components of the liability for loss and loss adjustment expense reserves:

	2002			2001			2000
Case basis credit loss and loss adjustment expense reserves:
Balance at January 1	$	24,384		$	24,466		$	10,726
Less: reinsurance recoverables		1,021			1,011			—
Net Balance at January 1		23,363			23,455			10,726
Incurred related to:
Current year		36,365			38			16,000
Prior years		(1,480	)		1,131			1,350
Total incurred		34,885			1,169			17,350
Paid related to:
Current year		5,740			—			—
Prior years		3,516			1,261			4,621
Total paid		9,256			1,261			4,621
Net balance at December 31		48,992			23,363			23,455
Plus reinsurance recoverables		4,600			1,021			1,011
Balance at December 31		53,592			24,384			24,466
Active credit reserve:
Balance at January 1		126,730			107,899			110,249
Net provision for losses		26,700			20,000			15,000
Transfers (to) from case reserves		(34,885	)		(1,169	)		(17,350	)
Balance at December 31		118,545			126,730			107,899
Total	$	172,137		$	151,114		$	132,365

    55

7 STOCKHOLDERS’ EQUITY

Ambac is authorized to issue 200,000,000 shares of Common Stock, par value $0.01 per share, of which 106,211,467 were issued as of December 31, 2002. Ambac is also authorized to issue 4,000,000 shares of Preferred Stock, $0.01 par value per share, none of which was issued and outstanding as of December 31, 2002.

Dividends declared per share amounted to $0.38, $0.34 and $0.31 in 2002, 2001 and 2000, respectively.

The Board of Directors of Ambac has authorized the establishment of a stock repurchase program that permits the repurchase of up to 12,000,000 shares of Ambac’s Common Stock. As of December 31, 2002, approximately 8,967,000 shares had been repurchased under this program for an aggregate amount of $265,927.

Stockholder Rights Plan: Ambac adopted a Stockholder Rights Plan under which stockholders received (after giving effect to two stock splits since adoption of the Plan) one Right for each three shares of Common Stock owned. Each Right entitles the registered holder to purchase from Ambac one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share, at a purchase price of $190 per share. The Rights generally detach and become exercisable when any person or group acquires 20% or more (or announces a tender offer for 20% or more) of Ambac’s Common Stock, at which time each Right (other than those held by the acquiring company) will entitle the holder to receive that number of shares of Common Stock of Ambac with a value of two times the exercise price of the Right. If Ambac is acquired in a merger or other business combination transaction in which Ambac is not the surviving corporation or 50% or more of Ambac’s assets, cash flow or earning power is sold or transferred, each Right will entitle the holder to receive that number of shares of stock of the acquiring company having a value equal to two times the exercise price of the Right. The Rights, which expire on January 31, 2006, are redeemable in whole, but not in part, by action of the Board of Directors of Ambac at a price of $0.01 per Right at any time prior to their becoming exercisable.

8 COMMITMENTS AND CONTINGENCIES

Ambac is responsible for leases on the rental of office space. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:

	Amount
2003	$	5,990
2004		7,529
2005		7,036
2006		6,882
2007		6,131
All later years		88,523
	$	122,091

Rent expense for the aforementioned leases amounted to $6,377, $5,916 and $5,578 for the years ended December 31, 2002, 2001 and 2000, respectively. Total future rental receipts under sublease agreements are estimated at $1,077.

9 INSURANCE REGULATORY RESTRICTIONS

Ambac Assurance is subject to insurance regulatory requirements of the States of Wisconsin and New York, and the other jurisdictions in which it is licensed to conduct business.

Ambac Assurance’s ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin. Wisconsin insurance law restricts the payment of dividends in any 12-month period without regulatory approval to the lesser of (a) 10% of policyholders’ surplus as of the preceding December 31 and (b) the greater of (i) statutory net income for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year and (ii) the aggregate of statutory net income for three calendar years preceding the date of the dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Based upon these restrictions, at December 31, 2002, the maximum amount that will be available during 2003 for payment of dividends by Ambac Assurance is approximately $223,000. Ambac Assurance paid cash dividends of $78,000, $68,000 and $59,800 on its common stock in 2002, 2001 and 2000, respectively.

56    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The New York Financial Guarantee Insurance Law establishes single risk limits applicable to obligations insured by Ambac Assurance. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits compare the insured net par outstanding and average annual debt service, net of reinsurance and collateral, for a single risk to the insurer’s qualified statutory capital, which is defined as the sum of the insurer’s policyholders’ surplus and contingency reserves. As of December 31, 2002 and 2001, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Ambac Assurance’s statutory financial statements are prepared on the basis of accounting practices prescribed or permitted by the Wisconsin Insurance Department. Effective January 1, 2001, Wisconsin adopted the National Association of Insurance Commissioners’ statutory accounting practices (“NAIC SAP”) as a component of its prescribed accounting practices. The adoption of the NAIC SAP did not have a material effect on Ambac Assurance’s statutory capital. Wisconsin’s accounting practice for changes to the contingency reserve differ from those practices of NAIC SAP. Under NAIC SAP, contributions to and releases from the contingency reserve are recorded via a direct charge or credit to surplus. Under the Wisconsin Administrative Code, contributions to and release from the contingency reserve are to be recorded through underwriting income. Ambac Assurance received permission of the Wisconsin Insurance Commissioner to record contributions to and release from the contingency reserve in accordance with NAIC SAP. Statutory surplus is the same using each of these accounting practices. Statutory net income is higher than if Ambac Assurance had reported the net contributions in accordance with the Wisconsin Administrative Code by $169,015, $183,269 and $154,175 for 2002, 2001 and 2000, respectively.

Statutory capital and surplus was $2,227,438 and $1,996,284 at December 31, 2002 and 2001, respectively. Qualified statutory capital was $3,736,336 and $3,261,935 at December 31, 2002 and 2001, respectively. Statutory net income for Ambac Assurance was $486,246, $394,559 and $381,328 for 2002, 2001 and 2000, respectively. Statutory capital and surplus differs from stockholders’ equity determined under GAAP principally due to statutory accounting rules that treat loss reserves, premiums earned, policy acquisition costs, and deferred income taxes differently.

10 INCOME TAXES

Ambac’s provision for income taxes is comprised of the following:

	2002			2001		2000
Current taxes	$	182,244		$	123,036	$	91,779
Deferred taxes		(50,648	)		12,785		24,173
	$	131,596		$	135,821	$	115,952

The total effect of income taxes on income and stockholders’ equity for the years ended December 31, 2002 and 2001 was as follows:

	2002			2001
Total income taxes charged to income	$	131,596		$	135,821
Income taxes charged (credited) to stockholders’ equity:
Unrealized gains on investment securities		114,674			12,051
Exercise of stock options		(16,320	)		(13,045	)
Total charged (credited) to stockholders’ equity		98,354			(994	)
Total effect of income taxes	$	229,950		$	134,827

The tax provisions in the accompanying Consolidated Statements of Operations reflect effective tax rates differing from prevailing Federal corporate income tax rates. The following is a reconciliation of these differences:

	2002			%		2001			%		2000			%
Tax computed at statutory rate	$	197,467		35.0	%	$	199,054		35.0	%	$	168,743		35.0	%
Reductions in expected tax resulting from:
Tax-exempt interest		(63,211	)	(11.2	)		(59,644	)	(10.5	)		(50,479	)	(10.5	)
Other, net		(2,660	)	(0.5	)		(3,589	)	(0.6	)		(2,312	)	(0.4	)
Income tax expense	$	131,596		23.3	%	$	135,821		23.9	%	$	115,952		24.1	%

    57

The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 2002 and 2001 are presented below:

	2002			2001
Deferred tax liabilities:
Contingency reserve	$	226,957		$	163,957
Unrealized gains on bonds		147,334			32,659
Deferred acquisition costs		60,110			56,783
Unearned premiums and credit fees		55,404			57,419
Investments		7,462			6,799
Other		7,198			7,148
Total deferred tax liabilities		504,465			324,765
Deferred tax assets:
Tax and loss bonds		191,371			128,371
Loss reserves		40,536			42,904
Compensation		29,674			26,703
Investment impairment loss		48,906			—
Other		8,337			3,710
Sub-total deferred tax assets		318,824			201,688
Valuation allowance		—			—
Total deferred tax assets		318,824			201,688
Net deferred tax liabilities	$	(185,641	)	$	(123,077	)

Ambac believes that no valuation allowance is necessary in connection with the deferred tax assets.

11 EMPLOYEE BENEFITS

Pensions: Ambac has a defined benefit pension plan covering substantially all employees of Ambac. The benefits are based on years of service and the employee’s highest salary during five consecutive years of employment within the last ten years of employment. Ambac’s funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service-to-date, but also for those expected to be earned in the future.

The table below sets forth a reconciliation of the beginning and ending projected benefit obligation, beginning and ending balances of the fair value of plan assets, and the funded status of the plan as of December 31, 2002 and 2001.

	2002			2001
Change in Projected Benefit Obligation:
Projected benefit obligation at beginning of year	$	14,360		$	12,669
Service cost		1,397			1,031
Interest cost		922			853
Actuarial loss (gain)		1,605			(189	)
Benefits paid		(254	)		(254	)
Other		—			250
Projected benefit obligation at end of year	$	18,030		$	14,360
Change in Plan Assets:
Fair value of plan assets at beginning of year	$	12,831		$	11,957
Actual return on plan assets		(1,556	)		(872	)
Company contributions		1,500			2,000
Benefits paid		(254	)		(254	)
Fair value of plan assets at end of year	$	12,521		$	12,831
Funded status	$	(5,509	)	$	(1,529	)
Unrecognized loss (gain)		5,512			1,132
Unrecognized prior service cost		(249	)		(379	)
Unrecognized net transition asset		—			—
Pension liability included in other liabilities	$	(246	)	$	(776	)

Net pension costs for 2002, 2001 and 2000 included the following components:

	2002			2001			2000
Service cost	$	1,397		$	1,031		$	892
Interest cost on expected benefit obligation		992			853			829
Expected return on plan assets		(1,289	)		(1,286	)		(1,056	)
Amortization of unrecognized transition asset		—			—			—
Amortization of prior service cost		(131	)		(151	)		(151	)
Recognized net actuarial (gain) loss		—			(78	)		(12	)
Net periodic pension cost	$	969		$	369		$	502

58    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The discount rate used in the determination of the actuarial present value for the projected benefit obligation was 6.5% and 7.0% for 2002 and 2001, respectively. The expected long-term rate of return on assets was 8.75% and 9.25% for 2002 and 2001, respectively. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.5% for both 2002 and 2001.

Substantially all employees of Ambac are covered by a defined contribution plan (the “Savings Incentive Plan”), for which contributions and costs are determined as 6% of each eligible employee’s eligible base salary, plus a matching company contribution of 50% on contributions up to 6% of base salary made by eligible employees to the Savings Incentive Plan. The total cost of the Savings Incentive Plan was $2,565, $3,037 and $2,471 in 2002, 2001 and 2000, respectively.

Annual Incentive Program: Ambac has an annual incentive program that provides for awards to key officers and employees based upon predetermined criteria. The cost of the program for the years ended December 31, 2002, 2001 and 2000 amounted to $33,481, $27,823 and $22,725, respectively.

Postretirement Health Care and Other Benefits: Ambac provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded.

Postretirement benefits expense was $119, $175 and $358 in 2002, 2001 and 2000, respectively. The unfunded accumulated postretirement benefit obligation was $961 and the related accrued postretirement liability was $2,425 as of December 31, 2002.

The assumed health care cost trend rates range from 10.0% in 2003, decreasing ratably to 6.0% in 2009. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase the accumulated postretirement benefit obligation at December 31, 2002 by $175 and the 2002 benefit expense by $55. The discount rate used to measure the accumulated postretirement benefit obligation and 2002 expense was 6.5%.

12 GUARANTEES IN FORCE

The par amount of financial guarantees outstanding, net of reinsurance, was $379,211,000 and $318,043,000 at December 31, 2002 and 2001, respectively. As of December 31, 2002 and 2001, the guarantee portfolio was diversified by type of guaranteed bond as shown in the following table:

	Net Par Amount Outstanding
	2002		2001
	(Dollars in Millions)
Public Finance:
Lease and tax-backed revenue	$	60,118	$	52,102
General obligation		41,359		39,664
Utility revenue		33,289		29,513
Health care revenue		20,675		19,003
Transportation revenue		15,218		13,000
Higher education		14,138		11,854
Housing revenue		8,345		7,476
Student loans		7,629		7,249
Other		5,723		5,103
Total Public Finance		206,494		184,964
Structured Finance:
Mortgage-backed and home equity		49,262		42,723
Asset-backed and conduits		25,977		20,687
Investor-owned utilities		14,285		11,642
Pooled debt obligations(1)		9,178		7,068
Other		6,290		6,612
Total Structured Finance		104,992		88,732
International Finance:
Pooled debt obligations(1)		45,697		27,206
Asset-backed and conduits		9,232		6,185
Mortgage-backed and home equity		4,828		2,602
Investor-owned and public utilities		3,680		2,878
Sovereign/sub-sovereign		1,916		1,299
Other		2,372		4,177
Total International Finance		67,725		44,347
	$	379,211	$	318,043

⁽¹⁾ Pooled debt obligations include $43,701 and $26,123 of structured credit derivatives at December 31, 2002 and December 31, 2001, respectively.

As of December 31, 2002 and 2001, the International Finance guaranteed portfolio is shown in the following table by location of risk:

	Net Par Amount Outstanding
	2002		2001
	(Dollars in Millions)
Germany	$	10,556	$	5,804
United Kingdom		9,289		6,531
Australia		2,486		1,623
Japan		2,393		1,167
France		1,001		1,155
Mexico		668		654
Internationally diversified		36,454		23,312
Other international		4,878		4,101
Total International Finance	$	67,725	$	44,347

    59

Internationally diversified includes pooled debt obligations. Such obligations represent pools of geographically diversified exposures which includes components of domestic exposure.

Direct financial guarantees in force (principal and interest) was $632,194,000 and $542,458,000 at December 31, 2002 and 2001, respectively. Net financial guarantees in force (after giving effect to reinsurance) was $557,422,000 and $476,190,000 as of December 31, 2002 and 2001, respectively.

In the United States, California and New York were the states with the highest aggregate net par amounts in force, accounting for 8.8% and 5.6% of the total at December 31, 2002. No other state accounted for more than five percent. The highest single insured risk represented less than 1% of aggregate net par amount outstanding.

13 FAIR VALUE OF FINANCIAL INSTRUMENTS

The following fair value amounts were determined by using independent market information when available, and valuation models when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating market values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount Ambac could realize in a current market exchange.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Investments: The fair values of fixed income investments are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. When quotes are not available, fair values are estimated based upon internal valuation models.

Short-term investments and cash: The fair values of short-term investments and cash are assumed to approximate amortized cost.

Other: The fair value of other investments, primarily mutual funds, are based on quoted market prices received from a nationally recognized pricing service.

Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell is assumed to approximate carrying value.

Investment income due and accrued: The fair value of investment income due and accrued is assumed to approximate carrying value.

Loans: The fair values of loans extended for structured municipal transactions, project financings and investment partnerships are assumed to approximate carrying value.

Derivative contracts used for hedging purposes: The fair values of cash flow hedges and fair value hedges (interest rate and currency swaps), as defined in Note 2, are based on quoted dealer prices, current settlement values, or pricing models.

Derivative contracts held for trading purposes: The fair values of interest rate swaps, total return swaps and structured credit derivative transactions, as discussed in Note 2, are based on quoted dealer prices, current settlement values, or valuation models.

Obligations under investment, repurchase and payment agreements: The fair value of the liability for investment agreements and repurchase agreements is estimated based upon internal valuation models. The fair value of payment agreements is assumed to approximate carrying value.

Securities sold under agreements to repurchase: The fair value of securities sold under agreements to repurchase is assumed to approximate carrying value.

Debentures: The fair value of the debentures is based on quoted market prices.

Accrued interest payable: The fair value of accrued interest payable is assumed to approximate carrying value.

Liability for net financial guarantees written: The fair value of the liability for those financial guarantees written is based on the estimated cost to reinsure those exposures at current market rates, which amount consists of the current unearned premium reserve, less an estimated ceding commission thereon.

        Other financial guarantee insurance policies have been written on an installment basis, where the future premiums to be received by Ambac are determined based on the outstanding exposure at the time the premiums are due. The fair value of Ambac Assurance’s liability under its installment premium policies is measured using the present value of estimated future installment premiums, less an estimated ceding commission. The estimate of the amounts and timing of the future installment premiums is based on contractual premium rates, debt service schedules and expected run-off scenarios. This measure is used as an estimate of the cost to reinsure Ambac Assurance’s liability under these policies.

60    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The carrying amount and estimated fair value of financial instruments are presented below:

	As of December 31,
	2002				2001
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(Dollars in Millions)
Financial assets:
Fixed income securities	$	11,598	$	11,598	$	8,469	$	8,469
Fixed income securities pledged as collateral		544		544		1,402		1,402
Short-term investments		396		396		415		415
Other Investments		2		2		2		2
Cash		26		26		77		77
Securities purchased under agreements to resell		261		261		11		11
Investment income due and accrued		142		142		157		157
Loans		844		844		901		889
Derivative product assets:
Hedging purposes		118		118		12		12
Trading purposes		892		892		373		373
Financial liabilities:
Obligations under investment, repurchase and payment agreements		7,283		7,617		5,512		5,597
Securities sold under agreements to repurchase		132		132		425		425
Debentures		617		681		619		651
Accrued interest payable		81		81		84		84
Derivative product liabilities:
Hedging purposes		—		—		3		3
Trading purposes		836		836		312		312
Liability for financial guarantees written:
Gross		2,128		1,490		1,780		1,246
Net of reinsurance		1,832		1,282		1,513		1,059
Gross installment premiums		—		1,110		—		818
Net installment premiums		—		940		—		691

    61

14 LONG-TERM DEBT AND LINES OF CREDIT

The carrying value of long-term debt was as follows:

	As of December 31,
	2002		2001
9 3/8% Debentures, due 2011	$	142,136	$	144,757
7 1/2% Debentures, due 2023		74,579		74,558
7.00% Debentures, due 2051		200,000		200,000
7.08% Debentures, due 2098		200,000		200,000
	$	616,715	$	619,315

The debentures due on August 1, 2011 were issued on August 8, 1991 in the principal amount of $150,000 and bear interest of 9 ³/8%, payable on February 1 and August 1 of each year and are non-callable. In July 2001, Ambac extinguished $7,500, thereby reducing the principal amount of the debt to $142,500.

The debentures due on May 1, 2023 were issued on May 11, 1993 in the principal amount of $75,000 and bear interest of 7 ¹/2%, payable on May 1 and November 1 of each year and are non-callable.

The debentures due on October 17, 2051 were issued on October 18, 2001 in the principal amount of $200,000 and bear interest of 7.00%, payable on March 31, June 30, September 30 and December 31 of each year. The debentures may not be redeemed prior to October 17, 2006 and were sold at 100% of their principal amount. On or after October 17, 2006, Ambac may redeem the debentures, in whole at any time or in part from time to time, at 100% of their principal amount, plus accrued interest to the date of redemption.

The debentures due on March 31, 2098 were issued on April 1, 1998 in the principal amount of $200,000 and bear interest of 7.08%, payable on March 31, June 30, September 30 and December 31 of each year. The debentures may not be redeemed prior to March 31, 2003 and were sold at 100% of their principal amount. On or after March 31, 2003, Ambac may redeem the debentures, in whole at any time or in part from time to time, at 100% of their principal amount, plus accrued interest to the date of redemption.

Ambac and Ambac Assurance have a revolving credit facility with six major international banks for $300,000, which expires in July 2003 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of December 31, 2002 and 2001, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $1.75 billion.

Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to 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. If the put option were exercised, the preferred stock holdings of Ambac Assurance would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. If exercised, Ambac Assurance would receive up to $800,000 in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual preferred stock. Ambac Assurance pays a floating put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s respectively.

62    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

15 OBLIGATIONS UNDER INVESTMENT AGREEMENTS AND PAYMENT AGREEMENTS

Obligations under investment agreements, including those structured in the form of repurchase contracts, are recorded on a trade-date basis. Certain obligations may be called at various times prior to maturity at the option of the counterparty. As of December 31, 2002, the interest rates on these agreements ranged from 1.25% to 8.14% with an average yield of 4.45%. As of December 31, 2001, the interest rates on these agreements ranged from 2.00% to 8.14% with an average yield of 5.47%. Obligations under investment agreements and investment repurchase agreements, excluding fair value hedge adjustments, were as follows:

	As of December 31,
	2002		2001
Settled	$	6,227,879	$	4,785,899
Unsettled		169		4,101
	$	6,228,048	$	4,790,000

Net payments due under settled investment agreements in each of the next five years ending December 31, and the periods thereafter, based on expected draw dates, are as follows:

	Principal Amount
2003	$	1,575,150
2004		1,061,816
2005		415,068
2006		746,924
2007		638,338
All later years		1,790,583
	$	6,227,879

Obligations under payment agreements represent funds received by Ambac from certain municipal customers. These funds serve as collateral for loans extended by Ambac in connection with certain structured municipal transactions. In connection with these transactions, Ambac is obligated to make periodic agreed upon payments. As of December 31, 2002 and 2001, the interest rates on these obligations ranged from 6.25% to 8.42%. Net payments due under payment agreements in each of the next five years ending December 31, and the periods thereafter, based on contractual payment dates, are as follows:

	Principal Amount
2003	$	15,702
2004		23,568
2005		17,200
2006		21,611
2007		23,425
All later years		586,395
	$	687,901

Ambac also has obligations under certain payment agreements that represent funds received from various investors and used by Ambac to purchase high credit quality fixed income municipal investment securities. As of December 31, 2002, the interest rates on these obligations ranged from 0.95% to 1.92%. The balance outstanding at December 31, 2002 was $250,534. These payment agreements are directly secured by the related municipal investment securities. Under the terms of these payment agreements the investors have the contractual right to redeem their investment at any time, within five business days notice to Ambac.

    63

16 COMMON STOCK INCENTIVES

The Ambac 1997 Equity Plan (the “Equity Plan”) provides for the granting of stock options, stock appreciation rights, restricted stock units, performance units and other awards that are valued or determined by reference to the Common Stock. Stock options awarded to employees are exercisable and expire as specified at the time of grant. Such options do not have a per share exercise price less than the fair market value of a share of Common Stock on the date of grant or have a term in excess of ten years from the date of the grant. Ambac also maintains the Ambac 1997 Non-Employee Directors Equity Plan, which provides awards of stock options and restricted stock units to non-employee members of the Ambac’s Board of Directors. The number of options and their exercise price, and the number of restricted stock units awarded to each non-employee director under the Directors Equity Plan are determined by formula. As of December 31, 2002, approximately 3,711,000 shares were available for future grant under the Equity Plan and the Directors Equity Plan. A summary of option activity is as follows:

	2002				2001				2000
	Shares		Weighted Average Exercise Price		Shares		Weighted Average Exercise Price		Shares		Weighted Average Exercise Price
Outstanding at beginning of year	6,218,869		$	34.70	5,694,711		$	27.86	5,490,716		$	24.99
Granted	1,544,254		$	59.01	1,763,615		$	50.37	1,796,052		$	32.57
Exercised	(1,128,095	)	$	23.58	(1,184,329	)	$	25.52	(1,327,754	)	$	20.87
Forfeited	(116,779	)	$	52.66	(55,128	)	$	40.33	(264,303	)	$	33.35
Outstanding at end of year	6,518,249		$	42.06	6,218,869		$	34.70	5,694,711		$	27.86
Exercisable	4,151,277				3,786,156				3,051,448

	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding at December 31, 2002	Weighted Average Remaining Contract Life	Weighted Average Exercise Price		Number Exercisable at December 31, 2002	Weighted Average Exercise Price
$13 to 30	1,239,909	1.7	$	23.77	1,239,909	$	23.77
$31 to 47	2,051,611	3.5	$	33.65	1,899,973	$	33.83
$48 to 66	3,226,729	5.1	$	54.44	1,011,395	$	51.88
	6,518,249				4,151,277

The weighted-average fair value (determined as of the date of the grants) of options granted in 2002, 2001 and 2000 was $20.61 per share, $17.37 per share, and $11.78 per share, respectively. The fair value of each option grant issued was estimated as of the date of the grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for grants in 2002, 2001 and 2000, respectively: (i) dividend yield of 0.61%, 0.65% and 0.92%; (ii) expected volatility of 31.9%, 32.7% and 30.3%; (iii) risk-free interest rates of 4.2%, 4.8% and 6.5%; and (iv) expected lives of approximately five years.

17 SEGMENT INFORMATION

Ambac has two reportable segments, as follows: (1) Financial Guarantee, which provides financial guarantees (including structured credit derivatives) for public finance and structured finance obligations; and (2) Financial Services, which provides investment agreements, interest rate swaps, total return swaps, funding conduits, and investment advisory and cash management services.

Ambac’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.

        The accounting policies of the segments are described in Note 2, “Significant Accounting Policies.” Pursuant to insurance and indemnity agreements, Ambac Assurance guarantees the swap and investment agreement obligations of those financial services subsidiaries. Intersegment revenues include the premiums earned under those agreements. Such premiums are determined as if they were premiums to third parties, that is, at current market prices.

Information provided below for “Corporate and Other” relates to Ambac Financial Group, Inc. corporate activities. Corporate and other revenue from unaffiliated customers consists primarily of interest income. Intersegment revenues consist of dividends received.

64    

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands, Except Share Amounts)

The following table is a summary of the financial information by reportable segment as of and for the years ended December 31, 2002, 2001 and 2000:

	Financial Guarantee		Financial Services			Corporate and Other			Intersegment Eliminations			Total Consolidated
2002:
Revenues:
Unaffiliated customers	$	816,178	$	150,621		$	5,019		$	—		$	971,818
Intersegment		7,984		(4,477	)		81,500			(85,007	)		—
Total revenues	$	824,162	$	146,144		$	86,519		$	(85,007	)	$	971,818
Income before income taxes:
Unaffiliated customers	$	712,930	$	(102,865	)	$	(45,875	)	$	—		$	564,190
Intersegment		8,920		(2,489	)		80,192			(86,623	)		—
Total income before income taxes	$	721,850	$	(105,354	)	$	34,317		$	(86,623	)	$	564,190
Identifiable assets	$	7,049,290	$	8,231,967		$	74,281		$	—		$	15,355,538
2001:
Revenues:
Unaffiliated customers	$	671,958	$	284,647		$	3,763		$	—		$	960,368
Intersegment		5,006		(3,882	)		69,000			(70,124	)		—
Total revenues	$	676,964	$	280,765		$	72,763		$	(70,124	)	$	960,368
Income before income taxes:
Unaffiliated customers	$	583,969	$	27,384		$	(42,626	)	$	—		$	568,727
Intersegment		5,304		(3,933	)		67,612			(68,983	)		—
Total income before income taxes	$	589,273	$	23,451		$	24,986		$	(68,983	)	$	568,727
Identifiable assets	$	5,960,900	$	6,306,900		$	71,743		$	—		$	12,339,543
2000:
Revenues:
Unaffiliated customers	$	565,421	$	336,568		$	2,324		$	—		$	904,313
Intersegment		3,827		(3,259	)		63,844			(64,412	)		—
Total revenues	$	569,248	$	333,309		$	66,168		$	(64,412	)	$	904,313
Income before income taxes:
Unaffiliated customers	$	495,186	$	28,760		$	(41,822	)	$	—		$	482,124
Intersegment		3,827		(3,201	)		63,844			(64,470	)		—
Total income before income taxes	$	499,013	$	25,559		$	22,022		$	(64,470	)	$	482,124
Identifiable assets	$	4,870,075	$	5,193,747		$	56,398		$	—		$	10,120,220

The following tables summarize gross premiums written and net premiums earned and other credit enhancement fees included in the Financial Guarantee segment, by location of risk for the years ended December 31, 2002 2001 and 2000:

	2002		2001		2000
Gross premiums written:
United States	$	766,778	$	535,725	$	373,269
United Kingdom		38,495		40,650		19,325
Japan		22,033		12,204		7,655
Mexico		16,513		16,285		16,232
Australia		9,379		7,308		27,647
Germany		1,207		483		418
France		884		856		970
Internationally diversified		16,841		30,615		14,754
Other international		31,902		39,170		22,812
Total:	$	904,032	$	683,296	$	483,082

	2002		2001		2000
Net premiums earned and other credit enhancement fees:
United States	$	382,409	$	318,480	$	264,445
United Kingdom		19,287		11,043		7,138
Japan		17,941		8,939		6,252
Mexico		7,720		7,540		7,461
Australia		4,945		3,761		3,058
Germany		4,808		2,092		1,052
France		1,174		1,116		1,133
Internationally diversified		40,926		33,706		24,434
Other international		21,099		13,718		8,460
Total:	$	500,309	$	400,395	$	323,433

Internationally diversified includes components of domestic exposure.

    65

18 QUARTERLY FINANCIAL INFORMATION (unaudited)

	First		Second		Third		Fourth		Full Year
2002:
Gross premiums written	$	149,361	$	195,683	$	205,110	$	353,878	$	904,032
Net premiums written		129,812		170,978		178,256		311,444		790,490
Net premiums earned and other credit enhancement fees		109,942		120,206		129,703		140,458		500,309
Financial guarantee net investment income		72,547		73,593		75,895		75,262		297,297
Financial services revenue, net		16,591		10,966		13,582		13,114		54,253
Losses and loss adjustment expenses		5,700		5,900		6,100		9,000		26,700
Financial guarantee underwriting and operating expenses		18,561		18,603		18,467		20,917		76,548
Financial services expenses		5,136		5,699		5,380		5,967		22,182
Income before income taxes		155,381		158,942		177,796		72,071		564,190
Net income		116,952		119,761		131,691		64,190		432,594
Net income per share:
Basic		1.11		1.13		1.24		0.61		4.08
Diluted	$	1.07	$	1.09	$	1.21	$	0.59	$	3.97
2001:
Gross premiums written	$	109,667	$	236,668	$	152,918	$	184,043	$	683,296
Net premiums written		96,966		212,901		117,044		160,851		587,762
Net premiums earned and other credit enhancement fees		89,769		98,407		103,895		108,324		400,395
Financial guarantee net investment income		64,476		65,058		67,318		70,995		267,847
Financial services revenue, net		14,459		11,767		10,231		15,768		52,225
Losses and loss adjustment expenses		4,600		4,800		5,100		5,500		20,000
Financial guarantee underwriting and operating expenses		16,643		17,426		16,602		17,318		67,989
Financial services expenses		5,631		5,973		5,023		5,188		21,815
Income before income taxes		128,871		140,146		144,322		155,388		568,727
Net income		97,515		107,637		111,008		116,746		432,906
Net income per share:
Basic		0.92		1.02		1.05		1.11		4.10
Diluted	$	0.90	$	0.99	$	1.02	$	1.07	$	3.97

Stockholder Information

CORPORATE HEADQUARTERS: AMBAC FINANCIAL GROUP, INC. One State Street Plaza New York, New York 10004 Tel: 212-668-0340 Fax: 212-509-9190 OTHER LOCATIONS: LONDON Hasilwood House 60 Bishopsgate London EC2N 4BE, England Tel: 44 207 786 4300 Fax: 44 207 786 4343 SYDNEY ABN AMRO Tower, L31 88 Phillip Street Sydney 2000 NSW, Australia Tel: 61 2 8211 0430 Fax: 61 2 8211 0555 Managing Director: Nancy S. Fox	TOKYO Otemachi Financial Center  17th Floor 5-4, Otemachi 1-chome, Chiyoda-ku, Tokyo 100-0004 Japan Tel: 03 5219 2127 Fax: 03 5219 2129 Representative Director: Hideshi Amemiya CADRE FINANCIAL SERVICES, INC. AMBAC SECURITIES, INC. 905 Marconi Avenue Ronkonkoma, New York 11779 Tel: 631-467-0200 Fax: 631-580-8806	ANNUAL MEETING OF STOCKHOLDERS The Annual Meeting of Stockholders of Ambac Financial Group, Inc. will be held on Tuesday, May 6, 2003, at 11:30 a.m. in New York City. Detailed information about the meeting is contained in the Notice of Annual Meeting and Proxy Statement to be sent to each stockholder of record as of March 11, 2003. The Company estimates that it has approximately 45,000 stockholders. FORM 10-K A copy of the Company’s 2002 Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission, may be obtained without charge by writing to: Ambac Financial Group, Inc. Attn: Investor Relations One State Street Plaza New York, New York 10004
TRANSFER AGENT, REGISTRAR AND DIVIDEND PAYING AGENT Citibank, N.A. 111 Wall Street, 5th Floor New York, New York 10043 212-657-5997	INDEPENDENT AUDITORS KPMG LLP New York, New York STOCK LISTING Ambac Financial Group, Inc. common stock is listed on the New York Stock Exchange under the ticker symbol ABK. [ABK LISTED NYSE LOGO]	INVESTOR RELATIONS Thomas J. Gandolfo Senior Vice President and Chief Financial Officer Peter R. Poillon First Vice President 212-208-3333 1-800-221-1854 ppoillon@ambac.com

COMMON STOCK DATA

	2002 Market Price					2001 Market Price
Three Months Ended	High	Low	Close	Dividends Per Share		High	Low	Close	Dividends Per Share
March 31	63.85	55.05	59.07	$	0.0900	64.00	44.25	63.43	$	0.0800
June 30	71.25	57.19	67.20	$	0.0900	63.75	51.91	58.20	$	0.0800
September 30	68.87	49.86	53.89	$	0.1000	61.80	42.20	54.71	$	0.0900
December 31	65.45	49.90	56.24	$	0.1000	58.90	47.02	57.86	$	0.0900

“Financial peace of mind” is a trademark of Ambac Financial Group, Inc.

Designed and Produced by Taylor & Ives, Inc. NYC

EX-21.01

Exhibit 21.01

List of Subsidiaries of Ambac Financial Group, Inc.

The following is a list of significant and other subsidiaries of Ambac Financial Group, Inc. The state of incorporation of each subsidiary is included in parentheses after its name.

Ambac Assurance Corporation (Wisconsin)

Ambac Assurance UK Limited (United Kingdom Insurance Company)

Ambac Capital Corporation (Delaware)

Ambac Capital Funding, Inc. (Delaware)

Ambac Credit Products, LLC (Delaware)

Ambac Investments, Inc. (Delaware)

Ambac Financial Services Holdings, Inc. (Delaware)

Ambac Financial Services, L.P. (Delaware)

EX-24.01

EXHIBIT 24.01

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director and officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Phillip B. Lassiter

Phillip B. Lassiter

EX-24.02

EXHIBIT 24.02

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Michael A. Callen

Michael A. Callen

EX-24.03

EXHIBIT 24.03

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Renso L. Caporali

Renso L. Caporali

EX-24.04

EXHIBIT 24.04

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as her true and lawful attorney-in-fact and agent, with full power of substitution, for her and in her name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Jill M. Considine

Jill M. Considine

EX-24.05

EXHIBIT 24.05

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Richard Dulude

Richard Dulude

EX-24.06

EXHIBIT 24.06

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Anne G. Gill and Kevin J. Doyle, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Thomas J. Gandolfo

Thomas J. Gandolfo

EX-24.07

EXHIBIT 24.07

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director and officer of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Robert J. Genader

Robert J. Genader

EX-24.08

EXHIBIT 24.08

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ W. Grant Gregory

W. Grant Gregory

EX-24.09

EXHIBIT 24.09

AMBAC FINANCIAL GROUP, INC.

Power of Attorney

KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Ambac Financial Group, Inc., a Delaware corporation, hereby constitutes and appoints each of Thomas J. Gandolfo and Anne G. Gill, as her true and lawful attorney-in-fact and agent, with full power of substitution, for her and in her name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission and the New York Stock Exchange, and any and all amendments thereto, and any and all instruments and documents filed as a part of or in connection with the said Form 10-K or amendments thereto, and does hereby grant unto each said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that each said attorney-in-fact and agent shall do or cause to be done by virtue hereof.

IN WITNESS WHEREOF, the undersigned has subscribed these presents as of this          day of March, 2003.

/s/ Laura S. Unger

Laura S. Unger

EX-99.01

EXHIBIT 99.01

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

(a wholly-owned subsidiary of Ambac Financial Group, Inc.)

Consolidated Financial Statements

December 31, 2002 and 2001

Independent Auditors’ Report

The Board of Directors

Ambac Assurance Corporation:

We have audited the accompanying consolidated balance sheets of Ambac Assurance Corporation and subsidiaries (a wholly owned subsidiary of Ambac Financial Group, Inc.) as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholder’s equity and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of Ambac Assurance Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ambac Assurance Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.

/s/ KPMG LLP

KPMG LLP

New York, New York

January 21, 2003

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2002 and 2001

(Dollars in Thousands Except Share Data)

	2002		2001
ASSETS
Investments:
Fixed income securities, at fair value (amortized cost of $5,866,488 in 2002 and $4,955,542 in 2001)	$	6,223,062	$	5,083,039
Short-term investments, at cost (approximates fair value)		287,315		185,943
Other, at fair value		1,394		1,394
Total investments		6,511,771		5,270,376
Cash		15,876		33,678
Securities purchased under agreements to resell		57,753		—
Receivable for securities sold		230		281
Investment income due and accrued		80,825		73,456
Reinsurance recoverable on paid and unpaid losses		4,842		1,021
Prepaid reinsurance		296,126		267,655
Deferred acquisition costs		174,055		163,477
Derivative product assets		1,010,081		383,959
Other assets		43,821		44,332
Total assets	$	8,195,380	$	6,238,235
LIABILITIES AND STOCKHOLDER’S EQUITY
Liabilities:
Unearned premiums	$	2,137,460	$	1,790,084
Losses and loss adjustment expense reserve		172,137		151,114
Ceded reinsurance balances payable		16,930		10,146
Obligations under payment agreements		250,534		—
Deferred income taxes		232,269		147,642
Current income taxes		41,375		126,039
Note payable to affiliate		59,600		63,500
Payable for securities purchased		70,761		26,097
Derivative product liabilities		953,772		325,922
Other liabilities		178,479		120,968
Total liabilities		4,113,317		2,761,512
Stockholder’s equity:
Preferred stock, par value $1,000 per share; authorized shares — 285,000; issued and outstanding shares — none		—		—
Common stock, par value $2.50 per share; authorized shares — 40,000,000; issued and outstanding shares — 32,800,000 at December 31, 2002 and December 31, 2001		82,000		82,000
Additional paid-in capital		920,146		928,094
Accumulated other comprehensive income		231,436		80,556
Retained earnings		2,848,481		2,386,073
Total stockholder’s equity		4,082,063		3,476,723
Total liabilities and stockholder’s equity	$	8,195,380	$	6,238,235

See accompanying Notes to Consolidated Financial Statements.

1

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations

(Dollars in Thousands)

	Years Ended December 31,
	2002			2001			2000
Revenues:
Financial Guarantee:
Gross premiums written	$	908,890		$	687,457		$	485,685
Ceded premiums written		(113,542	)		(95,534	)		(80,789	)
Net premiums written	$	795,348		$	591,923		$	404,896
Net premiums earned	$	477,592		$	383,042		$	314,507
Other credit enhancement fees		28,775			21,661			12,157
Net premiums earned and other credit enhancement fees		506,367			404,703			326,664
Net investment income		297,266			267,618			241,047
Net realized investment gains		40,918			2,124			681
Net unrealized losses on credit derivative contracts		(27,877	)		(3,588	)		(4,111	)
Other income		4,996			4,655			4,228
Financial Services		18,502			22,421			29,489
Total revenues		840,172			697,933			597,998
Expenses:
Financial Guarantee:
Losses and loss adjustment expenses		26,700			20,000			15,000
Underwriting and operating expenses		76,804			69,748			57,883
Interest expense		2,035			4,676			4,027
Financial Services		5,256			4,104			5,270
Total expenses		110,795			98,528			82,180
Income before income taxes		729,377			599,405			515,818
Income tax expense:
Current taxes		184,010			146,796			103,812
Deferred taxes		4,959			656			24,324
Total income taxes		188,969			147,452			128,136
Net income	$	540,408		$	451,953		$	387,682

See accompanying Notes to Consolidated Financial Statements.

2

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Stockholder’s Equity

(Dollars In Thousands)

	Years Ended December 31,
	2001					2002						2000
Retained Earnings:
Balance at January 1	$	2,386,073				$	2,002,120					$	1,674,238
Net income		540,408		$	540,408		451,953		$	451,953			387,682		$	387,682
Dividends declared – common stock		(78,000	)				(68,000	)					(59,800	)
Balance at December 31	$	2,848,481				$	2,386,073					$	2,002,120
Accumulated Other Comprehensive Income (Loss):
Balance at January 1	$	80,556				$	81,616					$	(92,049	)
Unrealized gains (losses) on securities, $229,078, $(787), and $269,460, pre-tax, in 2002, 2001 and 2000, respectively) (1)					148,701					(511	)					175,149
Foreign currency loss					2,179					(549	)					(1,484	)
Other comprehensive (loss) income		150,880			150,880		(1,060	)		(1,060	)		173,665			173,665
Total comprehensive income				$	691,288				$	450,893					$	561,347
Balance at December 31	$	231,436				$	80,556					$	81,616
Common Stock:
Balance at January 1 and December 31	$	82,000				$	82,000					$	82,000
Additional Paid-in Capital:
Balance at January 1	$	928,094				$	760,006					$	751,522
Capital contribution		—					176,193						—
Capital issuance costs		(8,453	)				(8,468	)					—
Exercise of stock options		505					363						8,484
Balance at December 31	$	920,146				$	928,094					$	760,006
Total Stockholder’s Equity at December 31	$	4,082,063				$	3,476,723					$	2,925,742

(1)  Disclosure of reclassification amount:	2002		2001			2000
Unrealized holding gains arising during period	$	174,295	$	2,924		$	177,873
Less: reclassification adjustment for net gains included in net income		25,394		3,435			2,724
Net unrealized (losses) gains on securities	$	148,901	$	(511	)	$	175,149

See accompanying Notes to Consolidated Financial Statements.

3

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Stockholder’s Equity

(Dollars In Thousands)

	Years Ended December 31,
	2002			2001			2000
Cash flows from operating activities:
Net income	$	540,408		$	451,953		$	387,682
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,881			2,881			2,925
Amortization of bond premium and discount		(4,685	)		(7,615	)		(5,507	)
Current income taxes		(84,664	)		94,731			(2,474	)
Deferred income taxes		4,557			1,079			24,667
Deferred acquisition costs		(10,578	)		(10,053	)		(18,100	)
Unearned premiums, net		318,905			208,783			89,944
Losses and loss adjustment expenses		17,202			18,739			10,379
Ceded reinsurance balances payable		6,784			(746	)		(4,136	)
Net realized investment gains		(40,918	)		(2,124	)		(681	)
Net unrealized losses on credit derivative contracts		27,877			3,588			4,111
Other, net		(4,228	)		(10,868	)		14,862
Net cash provided by operating activities		773,541			750,348			503,672
Cash flows from investing activities:
Proceeds from sales of bonds		1,228,101			505,688			638,613
Proceeds from matured bonds		316,822			239,669			119,592
Purchases of bonds		(2,363,358	)		(1,523,590	)		(1,135,069	)
Change in short-term investments		(101,372	)		32,562			(11,384	)
Securities purchased under agreements to resell		(6,003	)		25,016			(25,016	)
Other, net		(25,715	)		(6,645	)		(5,611	)
Net cash used in investing activities		(951,525	)		(727,300	)		(418,875	)
Cash flows from financing activities:
Dividends paid		(78,000	)		(68,000	)		(59,800	)
Capital issuance costs		(8,452	)		(8,468	)		—
Payment agreements		250,534			—			—
Long-term financing from affiliates		(3,900	)		63,500			—
Short-term financing from affiliates		—			—			(7,930	)
Net cash used in financing activities		160,182			(12,968	)		(67,730	)
Net cash flow		(17,802	)		10,080			17,067
Cash at January 1		33,678			23,598			6,531
Cash at December 31	$	15,876		$	33,678		$	23,598
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes	$	206,833		$	51,289		$	96,116
Interest expense on affiliate financings	$	1,139		$	229		$	15

Supplemental disclosure of non-cash financing activities:

Ambac Assurance received capital contributions from its parent company in November 2001 in the form of fixed income securities amounting to $176,193.

See accompanying Notes to Consolidated Financial Statements.

4

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

1    BACKGROUND

Ambac Assurance Corporation is a leading provider of financial guarantees to clients in both the public and private sectors around the world. Ambac Assurance provides financial guarantees on public finance and structured finance obligations. Ambac Assurance has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch, Inc., and Rating and Investment Information, Inc. Insurance policies insured by Ambac Assurance guarantee payment when due of the principal of and interest on the obligation guaranteed. Ambac Assurance is a wholly owned subsidiary of Ambac Financial Group, Inc., a holding company whose subsidiaries provide financial guarantees and financial services to clients in both the public and private sectors around the world.

2    SIGNIFICANT ACCOUNTING POLICIES

The accompanying consolidated financial statements of Ambac Assurance and subsidiaries have been prepared on the basis of accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant accounting policies of Ambac Assurance are as described below:

CONSOLIDATION:

The accompanying consolidated financial statements include the accounts of Ambac Assurance and its subsidiaries. The following companies have been consolidated with these financial statements: Ambac Assurance UK Limited, Ambac Credit Products, LLC, Connie Lee Holdings, Inc., Ambac Private Holdings, LLC, Ambac Financial Services, L.P., Ambac Capital Services, LLC and Ambac Japan Co., Ltd. All significant intercompany balances have been eliminated.

INVESTMENTS:

Ambac Assurance’s investment portfolio is accounted for on a trade-date basis and consists primarily of investments in fixed income securities that are considered available-for-sale and are carried at fair value. Fair value is based primarily on quotes obtained from independent market sources. When quotes are not available, valuation models are used to estimate fair value. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Short-term investments are carried at cost, which approximates fair value. Unrealized gains and losses, net of deferred income taxes, are included as a component of “Accumulated Other Comprehensive Income” in stockholder’s equity and are computed using amortized cost as the basis. If management believes that an unrealized loss is “other than temporary”, the carrying value of the investment is reduced and a realized investment loss is recorded in the Consolidated Statement of Operations. For purposes of computing amortized cost, premiums and discounts are accounted for using the interest method. For bonds purchased at a price below par value, discounts are accreted over the remaining term of the securities. For bonds purchased at a price above par value which have call features, premiums are amortized to the most likely call dates as determined by management. For premium bonds that do not have call features, such

5

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

premiums are amortized over the remaining terms of the securities. Premiums and discounts on mortgage-backed and asset-backed securities are adjusted for the effects of actual and anticipated prepayments. Realized gains and losses on the sale of investments are determined on the basis of specific identification.

SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL:

Securities purchased under agreements to resell are collateralized investment transactions, and are recorded at their contracted resale amounts, plus accrued interest. Ambac Assurance takes possession of the collateral underlying those agreements and monitors its market value on a daily basis and, when necessary, requires prompt transfer of additional collateral to reflect current market value. At December 31, 2002, collateral underlying securities purchased under agreements to resell had an average credit rating of triple-A and a weighted average maturity of less than 30 days.

DEFERRED ACQUISITION COSTS:

Certain financial guarantee costs incurred, primarily related to the production of business, have been deferred. These costs include direct and indirect expenses related to underwriting, marketing and policy issuance, rating agency fees and premium taxes, net of reinsurance ceding commissions. The deferred acquisition costs are being amortized over the periods in which the related premiums are earned, and such amortization amounted to $32,336, $28,203 and $22,472 for 2002, 2001 and 2000, respectively. Deferred acquisition costs, net of such amortization, amounted to $10,578, $10,053 and $18,100 for 2002, 2001 and 2000, respectively.

LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVE:

The reserve for losses and loss adjustment expenses consists of the active credit reserve and case basis credit loss and loss adjustment expense reserves. The active credit reserve is established based upon probable debt service defaults from incurred losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on managements review of each credit. When defaults occur, case basis credit loss reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. These reserves are discounted in accordance with discount rates prescribed or permitted by state regulatory authorities. During 2002, 2001 and 2000, paid losses were $11,143, $2,595, and $4,622, respectively. All or parts of case basis credit loss reserves are allocated from any active credit reserves available. During 2002, 2001 and 2000, salvage amounts received were $553, $1,333 and $0, respectively.

Management believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net cost of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates.

OBLIGATIONS UNDER PAYMENT AGREEMENTS:

Ambac Assurance has obligations under certain payment agreements that represent funds received from various investors and used by Ambac Assurance to purchase high credit quality fixed income municipal investment securities. Obligations under payment agreements are recorded as liabilities on the Consolidated Balance Sheets at the face value of the agreement. Interest expense is

6

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

computed based upon daily outstanding settled liabilities balances, at rates and periods specified in the agreements. Net interest income related to payment agreements is included as a component of Financial Services revenue. As of December 31, 2002 the interest rates on these obligations ranged from 0.95% to 1.92%. These payment agreements are directly secured by the related municipal investment securities. Under the terms of these payment agreements the investors have the contractual right to redeem their investment at any time, within five business days notice to Ambac Assurance.

NET PREMIUMS EARNED:

Up-front insurance premiums written are received for an entire bond issue. A bond issue may contain several maturities. The premium is allocated to each bond maturity proportionally, based on total principal amount guaranteed and is recognized on a straight-line basis over the term of each maturity. Installment insurance premiums written are recognized over each installment period, generally one year or less. When an issue insured by Ambac Assurance has been refunded or called, the remaining unrecognized premium (net of refunding credits, if any) is recognized at that time.

FINANCIAL SERVICES REVENUE:

Ambac Assurance provides interest rate swaps principally to states, municipalities and municipal authorities in connection with their financings. Ambac Assurance also enters into total return swaps with various financial institutions. All interest rate swaps and total return swap revenues are accounted for as “Derivative Contracts Held for Trading Purposes,” which is discussed in the Derivatives section below.

DEPRECIATION AND AMORTIZATION:

Depreciation of furniture and fixtures and electronic data processing equipment is provided over the estimated useful lives of the respective assets, ranging from three to five years, using the straight-line method. Amortization of leasehold improvements is charged over the remaining term of the operating leases, ranging from four to ten years, using the straight-line method.

POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS:

Ambac Financial Group, through its subsidiaries, provides various postretirement and postemployment benefits, including pension, and health and life benefits covering substantially all employees who meet certain age and service requirements. Ambac Assurance accounts for these benefits under the accrual method of accounting. Amounts related to the defined benefit pension plan and postretirement health benefits are charged based on actuarial determinations.

FOREIGN CURRENCY:

Financial statement accounts expressed in foreign currencies are translated into U.S. dollars in accordance with FAS Statement 52, “Foreign Currency Translation” (“SFAS 52”). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using exchange rates in effect at the balance sheet dates and the related translation adjustments are recorded as a separate component of comprehensive income, net of any related taxes. Functional currencies are generally the currencies of the local operating environment. Income statement accounts expressed in functional currencies are translated using average exchange rates. Foreign currency transaction gains and losses arising primarily from short-

7

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

term investment securities denominated in foreign currencies are reflected in net income. The Consolidated Statements of Operations include pre-tax gains (losses) from such foreign exchange items of $1,402, $(3,370) and $(3,748) for 2002, 2001 and 2000, respectively.

INCOME TAXES:

Pursuant to a tax sharing agreement, Ambac Assurance is included in Ambac Financial Group, Inc.’s consolidated Federal income tax return. The tax sharing agreement provides for the determination of tax expense or benefit based on the contribution of Ambac Assurance to Ambac Financial Group’s consolidated Federal income tax liability, computed substantially as if Ambac Assurance filed a separate Federal income tax return. The tax liability due is settled quarterly, with a final settlement taking place after the filing of the consolidated Federal income tax return. Ambac Assurance files its own state income tax returns.

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.

STOCK COMPENSATION PLANS:

Ambac Assurance participates in Ambac Financial Group’s equity plan. Under this plan, awards are granted to eligible employees of Ambac Assurance in the form of incentive stock options or other stock-based awards. Other than the tax benefits derived from this plan, pursuant to the tax sharing agreement, no other recognition is given by Ambac Assurance.

DERIVATIVE CONTRACTS:

In June 1998 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Certain Hedging Activities.” In June 2000 the FASB issued SFAS 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS 133.” SFAS 133 and SFAS 138 require all derivative instruments be recorded on the balance sheet at their respective fair values. SFAS 133 and SFAS 138 are effective for all fiscal quarters of all fiscal years beginning after June 30, 2000; Ambac Assurance adopted SFAS 133 and SFAS 138 on January 1, 2001. In accordance with the transition provisions of SFAS 133, Ambac Assurance determined that it did not have an effect on the consolidated financial statements.

All derivative instruments are recognized in the Consolidated Balance Sheets as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments are measured at estimated fair value. The fair values of derivative instruments are determined by broker quotes or valuation models when broker quotes are not available. Valuation models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.

8

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Ambac Assurance, through its affiliate Ambac Financial Services, is a provider of interest rate swaps to states, municipalities and their authorities, and other entities in connection with their financings. Ambac Assurance, through its subsidiary Ambac Capital Services, enters into total return swaps with professional counterparties. Total return swaps are only used for fixed income obligations, which meet Ambac Assurance’s credit underwriting criteria. Ambac Assurance, through its subsidiary Ambac Credit Products, enters into structured credit derivative transactions with various financial institutions. Ambac Financial Services’ interest rate swaps and futures contracts, Ambac Capital Services’ total return swaps and Ambac Credit Products’ structured credit derivatives are classified as held for trading purposes. These contracts are recorded on trade date at fair value. Changes in fair value are recorded as a component of Financial Services income for interest rate swaps, total return swaps and futures contracts in the accompanying Consolidated Statements of Operations. The fee component of structured credit derivatives is reflected in Other Credit Enhancement Fees in the accompanying Consolidated Statements of Operations. The mark-to-market gain or loss associated with credit spread changes on structured credit derivatives is reflected in Net unrealized losses on credit derivative contracts in the accompanying Consolidated Statements of Operations.

All derivative contracts are recorded on the Consolidated Balance Sheets on a gross basis; assets and liabilities are netted by customer only when a legal right of set-off exists. Gross asset and gross liability balances for all derivatives are recorded as Derivative Product Assets or Derivative Product Liabilities on the Consolidated Balance Sheets.

SPECIAL PURPOSE ENTITIES:

Ambac Financial Group has transferred third-party debt obligations to two special purpose entities. The business purpose of these entities is to provide some of our financial guarantee clients with funding for their debt obligations. These special purpose entities meet the characteristics of Qualifying Special Purpose Entities (“QSPEs”) in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. The QSPEs are not consolidated in Ambac Financial Group’s consolidated financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac Financial Group. Ambac Financial Group, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to (i) purchasing assets from Ambac Financial Group, which are defined in the governing documents of the QSPEs, (ii) issuing Medium Term Notes (“MTNs”) to fund such purchase, (iii) executing derivative hedges and (iv) providing related administrative services. The QSPEs hold only passive debt obligations transferred to it by Ambac Financial Group, passive derivative financial instruments used for hedging purposes and cash collected from assets that it holds pending distribution to the MTN holders. The QSPEs do not hold equity or other types of securities that would allow for voting rights, significant influence or contractual options such as the right to unconditionally put or call a financial instrument. The legal documents that established the QSPEs or created the beneficial interests in the transferred assets do not permit the sale or other disposal of the transferred financial assets except for disposals in automatic response to the terms of such financial assets (this would include only issuer call provisions). These required disposals are outside the control of Ambac Financial Group, its affiliates and the QSPEs. Beneficial interest holders do not have the rights to put their beneficial interest back to the QSPEs.

As of December 31, 2002, there have been 12 individual transactions processed through the QSPEs. In each case, Ambac Financial Group sells fixed income debt obligations issued by third parties to the

9

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

QSPEs. Ambac Financial Group receives cash consideration for all assets transferred to the QSPEs. Ambac Financial Group surrenders control over the transferred debt obligations. There are no agreements that entitle or obligate Ambac Financial Group to repurchase or redeem assets. The QSPEs are structured as bankruptcy remote entities. Ambac Financial Group management believes that the assets transferred represent a true sale and the assets held by the QSPEs are beyond the reach of Ambac Financial Group and its creditors, even in bankruptcy or other receivership. Legal counsel has concurred with management’s belief and has provided Ambac Financial Group true sale and non-substantive consolidation opinions. The purchase by the QSPEs is financed through the issuance of MTNs, which are collateralized by the purchased assets. Derivative contracts may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase debt obligations. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued and the derivative contracts used. As of December 31, 2002, Ambac Assurance had financial guarantee insurance policies issued for all assets owned, MTNs issued and derivative contracts used by the QSPEs.

Ambac Assurance’s exposure under these financial guarantee insurance policies is included in the disclosure in Note 10 “Guarantees in Force” to the consolidated financial statements. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac Assurance’s Consolidated Statements of Operations. To date, no losses have been recognized. Under the terms of an Administrative Agency Agreement, Ambac Financial Group provides some administrative services, primarily collecting amounts due on the obligations and making interest payments on the MTNs.

Assets sold to the QSPEs during 2002, 2001 and 2000 were $350,000, $793,438 and $159,937, respectively. No gains or losses were recognized on these sales. As of December 31, 2002, the estimated fair value of financial assets, MTN liabilities and derivative hedge liabilities were $1,347,287, $1,263,530 and $90,958, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by Ambac Financial Group management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums and other fees for issuing financial guarantee policies on the assets, MTNs and derivative contracts of $19,255, $23,682 and $3,204 for the years ended December 31, 2002, 2001 and 2000, respectively. Ambac Financial Group received fees for providing administrative services amounting to $80, $302 and $180 for 2002, 2001 and 2000, respectively.

ACCOUNTING STANDARDS:

In January 2003, the FASB issued FAS Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 clarifies the consolidation rules to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 requires variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated. FIN 46 requires disclosures for entities that have either a primary or significant variable interest in a variable interest entity. Ambac Assurance is required to adopt the consolidation provisions of FIN 46 on July 1, 2003. Based upon Ambac Assurance’s current assessment,

10

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

it does not have a significant variable interest in any Variable Interest Entity affected by this Interpretation.

RECLASSIFICATIONS:

Certain reclassifications have been made to prior years’ amounts to conform to the current year’s presentation.

3    INVESTMENTS

The amortized cost, gross unrealized gains and losses, and estimated fair value of investments in fixed income securities and short-term investments at December 31, 2002 and 2001 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
2002
Municipal obligations	$	4,439,062	$	287,765	$	4,494	$	4,722,333
Corporate obligations		405,070		30,406		2,982		432,494
Foreign government obligations		108,071		12,562		33		120,600
U.S. government obligations		99,178		2,765		336		101,607
Mortgage and asset-backed securities (includes U.S. government agency obligations)		815,107		30,929		8		846,028
Short-term		287,315		—		—		287,315
	$	6,153,803	$	364,427	$	7,853	$	6,510,377
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
2001
Municipal obligations	$	3,439,356	$	129,826	$	28,887	$	3,540,295
Corporate obligations		644,216		22,762		10,777		656,201
Foreign government obligations		97,108		629		1,137		96,600
U.S. government obligations		51,182		3,582		—		54,764
Mortgage and asset-backed securities (includes U.S. government agency obligations)		723,680		13,018		1,519		735,179
Short-term		185,943		—		—		185,943
	$	5,141,485	$	169,817	$	42,320	$	5,268,982

11

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The amortized cost and estimated fair value of fixed income securities and short-term investments at December 31, 2002, by contractual maturity, were as follows:

	Amortized Cost		Estimated Fair Value
2002
Due in one year or less	$	370,825	$	373,563
Due after one year through five years		473,878		506,523
Due after five years through ten years		762,045		821,410
Due after ten years		3,731,948		3,962,853
		5,338,696		5,664,349
Mortgage and asset-backed securities (includes U.S. government agency obligations)		815,107		846,028
	$	6,153,803	$	6,510,377

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

Securities carried at $6,240 and $5,964 at December 31, 2002 and 2001 respectively, were deposited by Ambac Assurance with governmental authorities or designated custodian banks as required by laws affecting insurance companies.

Net investment income of Ambac Assurance comprised the following:

	2002			2001			2000
Fixed income securities	$	297,740		$	260,074		$	232,876
Short-term investments		2,801			9,995			9,904
Total investment income		300,541			270,069			242,780
Investment expense		(3,275	)		(2,451	)		(1,733	)
Net investment income	$	297,266		$	267,618		$	241,047

Net realized investment gains in 2002 were $40,918, compared to net realized investment gains of $2,124 and $681 in 2001 and 2000, respectively. The following table details amounts included in net realized gains:

	2002			2001			2000
Gross realized gains on securities sold	$	45,344		$	8,672		$	8,517
Gross realized losses on securities sold		(6,276	)		(3,388	)		(4,327	)
Foreign exchange gains (losses) on investments		1,850			(3,160	)		(3,509	)
Net realized gains	$	40,918		$	2,124		$	681

12

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

4    REINSURANCE

In the ordinary course of business, Ambac Assurance cedes exposures under various reinsurance contracts primarily designed to minimize losses from large risks and to protect capital and surplus. The effect of reinsurance on premiums written and earned was as follows:

	Year Ended December 31,
	2002						2001						2000
	Written			Earned			Written			Earned			Written			Earned
Direct	$	875,928		$	521,177		$	636,574		$	414,700		$	442,714		$	338,139
Assumed		32,962			41,486			50,883			38,825			42,971			32,530
Ceded		(113,542	)		(85,071	)		(95,534	)		(70,483	)		(80,789	)		(56,162	)
Net premiums	$	795,348		$	477,592		$	591,923		$	383,042		$	404,896		$	314,507

The reinsurance of risk does not relieve the ceding insurer of its original liability to its policyholders. In the event that all or any of the reinsurers are unable to meet their obligations to Ambac Assurance under the existing reinsurance agreements, Ambac Assurance would be liable for such defaulted amounts. To minimize its exposure to significant losses from reinsurers, Ambac Assurance (i) evaluates the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts and (iii) has certain termination triggers that can be exercised by Ambac Assurance in the event of a rating downgrade of a reinsurer. Additionally, as of December 31, 2002, Ambac Assurance held bank letters of credit and collateral amounting to approximately $135,681 from its reinsurers to cover liabilities ceded under the aforementioned reinsurance contracts. For the years ended December 31, 2002, 2001 and 2000, reinsurance recoveries, which reduced loss and loss expenses incurred, amounted to $1,334, $0 and $0, respectively. Reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 2002 and 2001 were $242 and $0, respectively. As of December 31, 2002, prepaid reinsurance of approximately $181,378 was associated with Ambac Assurance’s three largest reinsurers. Ambac pledged cash and fixed income securities to foreign insurers of $11,166 and $9,295 at December 31, 2002 and 2001, respectively, related to business assumed from those insurers.

5    LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVE

As discussed in note 2, Ambac Assurance’s liability for losses and loss adjustment expenses consists of case basis and active credit reserves. Following is a summary of the activity in the case basis credit and active credit reserve accounts and the components of the liability for loss and loss adjustment expense reserves:

13

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

	2002			2001			2000
Case basis credit loss and loss adjustment expense reserves:
Balance at January 1	$	24,384		$	24,466		$	10,726
Less: reinsurance recoverables		1,021			1,011			—
Net Balance at January 1		23,363			23,455			10,726
Incurred related to:
Current year		36,365			38			16,000
Prior years		(1,480	)		1,131			1,350
Total incurred		34,885			1,169			17,350
Paid related to:
Current year		5,740			—			—
Prior years		3,516			1,261			4,621
Total paid		9,256			1,261			4,621
Net balance at December 31		48,992			23,363			23,455
Plus reinsurance recoverables		4,600			1,021			1,011
Balance at December 31		53,592			24,384			24,466
Active credit reserve:
Balance at January 1		126,730			107,899			110,249
Net provision for losses		26,700			20,000			15,000
Transfers to case reserves		(34,885	)		(1,169	)		(17,350	)
Balance at December 31		118,545			126,730			107,899
Total	$	172,137		$	151,114		$	132,365

6    COMMITMENTS AND CONTINGENCIES

Ambac Assurance is responsible for leases on the rental of office space. The lease agreements, which expire periodically through September 2019, contain provisions for scheduled periodic rent increases and are accounted for as operating leases. An estimate of future net minimum lease payments in each of the next five years ending December 31, and the periods thereafter, is as follows:

	Amount
2003	$	5,316
2004		6,854
2005		6,868
2006		6,882
2007		6,131
All later years		88,523
	$	120,574

Rent expense for the aforementioned leases amounted to $6,377, $5,916 and $5,549 for the years ended December 31, 2002, 2001 and 2000, respectively.

7    INSURANCE REGULATORY

Ambac Assurance is subject to the insurance regulatory requirements of the States of Wisconsin and New York, and the other jurisdictions in which it is licensed to conduct business.

14

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Ambac Assurance’s ability to pay dividends is generally restricted by law and subject to approval by the Office of the Commissioner of Insurance of the State of Wisconsin. Wisconsin insurance law restricts the payment of dividends in any 12-month period without regulatory approval to the lesser of (a) 10% of policyholders’ surplus as of the preceding December 31 and (b) the greater of (i) statutory net income for the calendar year preceding the date of dividend, minus realized capital gains for that calendar year and (ii) the aggregate of statutory net income for three calendar years preceding the date of the dividend, minus realized capital gains for those calendar years and minus dividends paid or credited within the first two of the three preceding calendar years. Based upon these restrictions, at December 31, 2002, the maximum amount that will be available during 2003 for payment of dividends by Ambac Assurance is approximately $223,000. Ambac Assurance paid cash dividends of $78,000, $68,000 and $59,800 on its common stock in 2002, 2001 and 2000, respectively.

The New York Financial Guarantee Insurance Law establishes single risk limits applicable to obligations insured by Ambac Assurance. Such limits are specific to the type of insured obligation (for example, municipal or asset-backed). The limits compare the insured net par outstanding and average annual debt service, net of reinsurance and collateral, for a single risk to the insurer’s qualified statutory capital, which is defined as the sum of the insurer’s policyholders’ surplus and contingency reserves. As of December 31, 2002 and 2001, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Ambac Assurance’s statutory financial statements are prepared on the basis of accounting practices prescribed or permitted by the Wisconsin Insurance Department. Effective January 1, 2001, Wisconsin adopted the National Association of Insurance Commissioners’ statutory accounting practices (“NAIC SAP”) as a component of its prescribed accounting practices. The adoption of the NAIC SAP did not have a material effect on Ambac Assurance’s statutory capital. Wisconsin’s accounting practice for changes to the contingency reserve differ from those practices of NAIC SAP. Under NAIC SAP, contributions to and releases from the contingency reserve are recorded via a direct charge or credit to surplus. Under the Wisconsin Administrative Code, contributions to and release from the contingency reserve are to be recorded through underwriting income. Ambac Assurance received permission of the Wisconsin Insurance Commissioner to record contributions to and release from the contingency reserve in accordance with NAIC SAP. Statutory surplus is the same using each of these accounting practices. Statutory net income is higher than if Ambac Assurance had reported the net contributions in accordance with the Wisconsin Administrative Code by $169,015, $183,269 and $154,175 for 2002, 2001 and 2000, respectively.

Statutory capital and surplus differs from stockholder’s equity determined under GAAP principally due to statutory accounting rules that treat loss reserves, premiums earned, policy acquisition costs, and deferred income taxes differently. The following is a reconciliation of consolidated stockholder’s equity presented on a GAAP basis for Ambac Assurance and its consolidated subsidiaries to statutory capital and surplus for Ambac Assurance:

15

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

	For the Years Ended December 31,
	2002			2001
Ambac Assurance Corporation GAAP stockholder’s equity	$	4,082,063		$	3,476,723
Mandatory contingency reserve		(1,508,898	)		(1,265,652	)
GAAP loss reserves		118,545			126,730
Unearned premium reserve		(376,957	)		(345,284	)
Deferred acquisition costs		(174,055	)		(163,477	)
Income taxes		271,570			178,191
Tax and loss bonds		191,139			128,371
Unrealized losses on investments		(360,469	)		(139,587	)
Other		(15,500	)		269
Statutory capital and surplus	$	2,227,438		$	1,996,284

Statutory net income was $486,246, $394,559 and $381,328 for 2002, 2001 and 2000, respectively.

8    INCOME TAXES

The total effect of income taxes on income and stockholder’s equity for the years ended December 31, 2002 and 2001 was as follows:

	2002			2001
Total income taxes charged to income	$	188,969		$	147,452
Income taxes (credited) charged to stockholder’s equity:
Unrealized gains (losses) on bonds		80,177			(275	)
Exercise of stock options		(505	)		(363	)
Total charged (credited) to stockholder’s equity		79,672			(638	)
Total effect of income taxes	$	268,641		$	146,814

The tax provisions in the accompanying Consolidated Statements of Operations reflect effective tax rates differing from prevailing Federal corporate income tax rates. The following is a reconciliation of these differences:

	2002			%		2001			%		2000			%
Computed expected tax at statutory rate	$	255,282		35.0	%	$	209,792		35.0	%	$	180,536		35.0	%
Reductions in expected tax resulting from:
Tax-exempt interest		(63,065	)	(8.6	)		(59,644	)	(10.0	)		(50,479	)	(9.8	)
Other, net		(3,248	)	(0.5	)		(2,696	)	(0.4	)		(1,921	)	(0.4	)
Income tax expense	$	188,969		25.9	%	$	147,452		24.6	%	$	128,136		24.8	%

16

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities and deferred tax assets at December 31, 2002 and 2001 are presented below:

	2002		2001
Deferred tax liabilities:
Contingency reserve	$	226,957	$	163,957
Unrealized gains on bonds		124,801		44,624
Deferred acquisition costs		60,110		56,783
Unearned premiums and credit fees		55,500		57,516
Other		7,984		6,099
Total deferred tax liabilities		475,352		328,979
Deferred tax assets:
Tax and loss bonds		191,371		128,371
Loss reserves		40,535		42,903
Compensation		7,047		5,859
Other		4,130		4,204
Sub-total deferred tax assets		243,083		181,337
Valuation allowance		—		—
Total deferred tax assets		243,083		181,337
Net deferred tax liabilities	$	232,269	$	147,642

Ambac Assurance believes that no valuation allowance is necessary in connection with the deferred tax assets.

9    EMPLOYEE BENEFITS

Pensions:

Ambac Financial Group has a defined benefit pension plan covering substantially all employees of Ambac. The benefits are based on years of service and the employee’s highest salary during five consecutive years of employment within the last ten years of employment. Ambac Financial Group’s funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service-to-date but also for those expected to be earned in the future.

The table below sets forth a reconciliation of the beginning and ending projected benefit obligation, beginning and ending balances of the fair value of plan assets, and the funded status of the plan as of December 31, 2002 and 2001:

17

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

	2002			2001
Change in Projected Benefit Obligation:
Projected benefit obligation at beginning of year	$	14,360		$	12,669
Service cost		1,397			1,031
Interest cost		922			853
Actuarial loss (gain)		1,605			(189	)
Benefits paid		(254	)		(254	)
Other		—			250
Projected benefit obligation at end of year	$	18,030		$	14,360
Change in Plan Assets:
Fair value of plan assets at beginning of year	$	12,831		$	11,957
Actual return on plan assets		(1,556	)		(872	)
Ambac Financial Group contributions		1,500			2,000
Benefits paid		(254	)		(254	)
Fair value of plan assets at end of year	$	12,521		$	12,831
Funded status	$	(5,509	)	$	(1,529	)
Unrecognized loss (gain)		5,512			1,132
Unrecognized prior service cost		(249	)		(379	)
Pension liability	$	(246	)	$	(776	)

Ambac Financial Group’s net pension costs for the years ended December 31, 2002, 2001 and 2000 included the following components:

	2002			2001			2000
Service cost	$	1,397		$	1,031		$	892
Interest cost on expected benefit obligation		992			853			829
Expected return on plan assets		(1,289	)		(1,286	)		(1,056	)
Amortization of unrecognized transition asset		—			—			—
Amortization of prior service cost		(131	)		(151	)		(151	)
Recognized net actuarial (gain) loss		—			(78	)		(12	)
Net periodic pension cost	$	969		$	369		$	502

Pension expense is allocated to each of Ambac Financial Group’s subsidiaries based on percentage of payroll. Pension expense recorded by Ambac Assurance amounted to $812, $281 and $375 in 2002, 2001 and 2000, respectively.

The discount rate used in the determination of the actuarial present value for the projected benefit obligation was 6.5% and 7.0% for 2002 and 2001, respectively. The expected long-term rate of return on assets was 8.75% and 9.25% for 2002 and 2001, respectively. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.5% for both 2002 and 2001.

Substantially all employees of Ambac Financial Group and its subsidiaries are covered by a defined contribution plan (the “Savings Incentive Plan”), for which contributions and costs are determined as 6% of each eligible employee’s eligible base salary, plus a matching company contribution of 50% on contributions up to 6% of base salary made by eligible employees to the Savings Incentive

18

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Plan. The total cost of the Savings Incentive Plan to Ambac Assurance was $2,019, $2,188 and $1,940 in 2002, 2001 and 2000, respectively.

    Annual Incentive Program:

Ambac Financial Group has an annual incentive program that provides for awards to key officers and employees based upon predetermined criteria. Ambac Assurance’s cost of the program for the years ended December 31, 2002, 2001 and 2000 amounted to $30,190, $24,927 and $21,055, respectively.

    Postretirement Health Care and Other Benefits:

Ambac Financial Group provides certain medical and life insurance benefits for retired employees and eligible dependents. All plans are contributory. None of the plans are currently funded.

Ambac Assurance’s postretirement benefits expense was $73, $113 and $328 in 2002, 2001 and 2000, respectively. Ambac Financial Group’s unfunded accumulated postretirement benefit obligation was $961, and the related accrued postretirement liability was $2,425 as of December 31, 2002.

The assumed health care cost trend rates range from 10.0% in 2003, decreasing ratably to 6.0% in 2009. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase Ambac Financial Group’s accumulated postretirement benefit obligation at December 31, 2002 by $175 and Ambac Financial Group’s 2002 benefit expense by $55. The discount rate used to measure the accumulated postretirement benefit obligation and 2002 expense was 6.5%.

10    GUARANTEES IN FORCE

The par amount of financial guarantees outstanding, for non-affiliates, were $423,454,000 and $357,219,000 at December 31, 2002 and 2001, respectively. The par amount of financial guarantees outstanding, for non-affiliates, net of reinsurance, were $379,211,000 and $318,043,000 at December 31, 2002 and 2001, respectively. As of December 31, 2002 and 2001, the guarantee portfolio was diversified by type of guaranteed bond as shown in the following table:

19

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

	Net Par Amount Outstanding
(Dollars in Millions)	2002		2001
Public Finance:
Lease and tax-backed revenue	$	60,118	$	52,102
General obligation		41,359		39,664
Utility revenue		33,289		29,513
Health care revenue		20,675		19,003
Transportation revenue		15,218		13,000
Higher education		14,138		11,854
Housing revenue		8,345		7,476
Student loans		7,629		7,249
Other		5,723		5,103
Total Public Finance		206,494		184,964
Structured Finance:
Mortgage-backed and home equity		49,262		42,723
Asset-backed and conduits		25,977		20,687
Investor-owned utilities		14,285		11,642
Pooled debt obligations (1)		9,178		7,068
Other		6,290		6,612
Total Structured Finance		104,992		88,732
International Finance:
Pooled debt obligations (1)		45,697		27,206
Asset-backed and conduits		9,232		6,185
Mortgage-backed and home equity		4,828		2,602
Investor-owned and public utilities		3,680		2,878
Sovereign/sub-sovereign		1,916		1,299
Other		2,372		4,177
Total International Finance		67,725		44,347
	$	379,211	$	318,043

(1) Pooled debt obligations include $43,701 and $26,123 of structured credit derivatives at December 31, 2002 and December 31, 2001, respectively.

As of December 31, 2002 and 2001, the International Finance guarantee portfolio is shown in the following table by location of risk:

	Net Par Amount Outstanding
(Dollars in Millions)	2002		2001
Germany	$	10,556	$	5,804
United Kingdom		9,289		6,531
Australia		2,486		1,623
Japan		2,393		1,167
France		1,001		1,155
Mexico		668		654
Internationally diversified		36,454		23,312
Other international		4,878		4,101
Total International Finance	$	67,725	$	44,347

Internationally diversified includes pooled debt obligations. Such obligations represent pools of geographically diversified exposures which includes components of domestic exposure.

20

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Direct financial guarantees in force (principal and interest) were $632,194,000 and $542,458,000 at December 31, 2002 and 2001, respectively. Net financial guarantees in force (after giving effect to reinsurance) were $557,422,000 and $476,190,000 as of December 31, 2002 and 2001, respectively.

In the United States, California and New York were the states with the highest aggregate net par amounts in force, accounting for 8.8% and 5.6% of the total at December 31, 2002. No other state accounted for more than five percent. The highest single insured risk represented less than 1% of aggregate net par amount insured.

11    FAIR VALUES OF FINANCIAL INSTRUMENTS

The following fair value amounts were determined by using independent market information when available, and valuation models when market quotes were not available. In cases where specific market quotes are unavailable, interpreting market data and estimating market values require considerable judgment by management. Accordingly, the estimates presented are not necessarily indicative of the amount Ambac Assurance could realize in a current market exchange.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Investments: The fair values of fixed income investments are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. When quotes are not available, fair values are estimated based upon internal valuation models.

Short-term investments, other investments and cash: The fair values of short-term investments, other investments and cash are assumed to approximate amortized cost.

Securities purchased under agreements to resell: The fair value of securities purchased under agreements to resell is assumed to approximate carrying value.

Investment income due and accrued: The fair value of investment income due and accrued is assumed to approximate carrying value.

Derivative contracts held for trading purposes: The fair values of interest rate swaps, total return swaps and structured credit derivative transactions, as discussed in Note 2, are based on quoted dealer prices, current settlement values, or valuation models.

Obligations under payment agreements: The fair value of payment agreements is assumed to approximate carrying value.

Note payable to affiliate: The fair value of the note payable is assumed to equal carrying value.

Liability for net financial guarantees written: The fair value of the liability for those financial guarantees written is based on the estimated cost to reinsure those exposures at current market rates, which amount consists of the current unearned premium reserve, less an estimated ceding commission thereon.

21

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Other financial guarantee insurance policies have been written on an installment basis, where the future premiums to be received by Ambac Assurance are determined based on the outstanding exposure at the time the premiums are due. The fair value of Ambac Assurance’s liability under its installment premium policies is measured using the present value of estimated future installment premiums, less an estimated ceding commission. The estimate of the amounts and timing of the future installment premiums is based on contractual premium rates, debt service schedules and expected run-off scenarios. This measure is used as an estimate of the cost to reinsure Ambac Assurance’s liability under these policies.

The carrying amount and estimated fair value of financial instruments are presented below:

	As of December 31,
	2002				2001
(Dollars in Millions)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial assets:
Fixed income securities	$	6,223	$	6,223	$	5,083	$	5,083
Short-term investments		287		287		186		186
Other investments		1		1		1		1
Cash		16		16		34		34
Securities purchased under agreements to resell		58		58		—		—
Investment income due and accrued		81		81		73		73
Derivative product assets:
Trading purposes		1,010		1,010		384		384
Financial liabilities:
Obligations under payments agreements		250		250		—		—
Note payable to affiliate		60		60		64		64
Derivative product liabilities:
Trading purposes		954		954		326		326
Liability for financial guarantees written:
Gross (up-front)		2,137		1,496		1,790		1,253
Net (up-front)		1,841		1,289		1,522		1,065
Gross installment premiums		—		1,110		—		818
Net installment premiums		—		940		—		691

12    LONG-TERM DEBT AND LINES OF CREDIT

At December 31, 2002, Ambac Private Holdings had an unsecured note payable to an affiliate, Ambac Investments, Inc. with a carrying value of $59,600 and a maturity date of October 30, 2006. This note pays interest quarterly at 0.2% below three month LIBOR, currently at 1.20%.

22

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

Ambac Financial Group and Ambac Assurance have a revolving credit facility with six major international banks for $300,000, which expires in July 2003 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of December 31, 2002 and 2001, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac Financial Group: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $1.75 billion.

Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to 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. If the put option were exercised, the preferred stock holdings of Ambac Assurance would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. If exercised, Ambac Assurance would receive up to $800,000 in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual preferred stock. Ambac Assurance pays a floating put option fee. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s respectively.

13    RELATED PARTY TRANSACTIONS

During 2002 and 2001, Ambac Assurance guaranteed the timely payment of principal and interest on obligations under investment agreements and investment repurchase agreements issued by its affiliates. As of December 31, 2002 and 2001, the aggregate amount of investment agreements and investment repurchase agreements insured was $6,266,847 and $4,831,601, respectively, including accrued interest. These guarantees are collateralized by investment securities, accrued interest receivable, securities purchased under agreements to resell, cash and cash equivalents and other financial assets, which as of December 31, 2002 and 2001, had a fair value of $6,461,770 and $4,924,367, respectively, in the aggregate. During 2002 and 2001, Ambac Assurance recorded gross premiums written of $4,858 and $4,162, and net premiums earned of $6,058 and $4,309, respectively, related to these agreements.

During 2002 and 2001, several interest rate swap transactions were executed between Ambac Financial Services and its affiliates (other than Ambac Assurance). As of December 31, 2002 and 2001, these contracts had an outstanding notional amount of approximately $1,013,000 and $986,000, respectively. As of December 31, 2002 and 2001, Ambac Financial Services recorded a liability of $8,673 and an asset of $4,909, respectively, related to these transactions.

In 2001, Ambac Assurance received a capital contribution in the form of fixed income securities amounting to $176,193 from Ambac Financial Group.

23

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

14    SEGMENT INFORMATION

Ambac Assurance has two reportable segments, as follows: (1) financial guarantee, which provides financial guarantees (including structured credit derivatives) for public finance and structured finance obligations; and (2) financial services, which provides payment agreements, interest rate and total return swaps.

Ambac Assurance’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.

The accounting policies of the segments are described in Note 2 “Significant Accounting Policies”. Pursuant to insurance and indemnity agreements between Ambac Financial Services and Ambac Assurance, Ambac Financial Services’ payment obligations under its swap agreements are guaranteed by Ambac Assurance. Additionally, the payment obligations of Ambac Financial Services’ counterparties, under their swap agreements with Ambac Financial Services, are guaranteed by Ambac Assurance pursuant to insurance and indemnity agreements. Intersegment revenues include the premiums earned under those agreements. Such premiums are determined as if they were premiums to third parties, that is, at current market prices.

The following table is a summary of the financial information by reportable segment as of and for the years ended December 31, 2002, 2001 and 2000:

24

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

	Financial Guarantee		Financial Services			Intersegment Eliminations			Total Consolidated
2002:
Revenues:
External customers	$	821,670	$	18,502		$	—		$	840,172
Intersegment		1,329		—			(1,329	)		—
Total revenues	$	822,999	$	18,502		$	(1,329	)	$	840,172
Income before income taxes:
External customers	$	716,131	$	13,246		$	—		$	729,377
Intersegment		1,329		(1,329	)		—			—
Total income before income taxes	$	717,460	$	11,917		$	—		$	729,377
Identifiable assets	$	7,035,850	$	1,159,530		$	—		$	8,195,380
2001:
Revenues:
External customers	$	675,512	$	22,421		$	—		$	697,933
Intersegment		697		—			(697	)		—
Total revenues	$	676,209	$	22,421		$	(697	)	$	697,933
Income before income taxes:
External customers	$	581,088	$	18,317		$	—		$	599,405
Intersegment		697		(697	)		—			—
Total income before income taxes	$	581,785	$	17,620		$	—		$	599,405
Identifiable assets	$	5,960,900	$	277,335		$	—		$	6,238,235
2000:
Revenues:
External customers	$	568,509	$	29,489		$	—		$	597,998
Intersegment		582		—			(582	)		—
Total revenues	$	569,091	$	29,489		$	(582	)	$	597,998
Income before income taxes:
External customers	$	491,599	$	24,219		$	—		$	515,818
Intersegment		582		(582	)		—			—
Total income before income taxes	$	492,181	$	23,637		$	—		$	515,818
Identifiable assets	$	4,870,075	$	192,564		$	—		$	5,062,639

25

AMBAC ASSURANCE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollar Amounts in Thousands)

The following table summarizes gross premiums written and net premiums earned and other credit enhancement fees included in the financial guarantee segment, by location of risk for the years ended December 31, 2002, 2001 and 2000.

	2002		2001		2000
Gross premiums written:
United States	$	770,883	$	539,886	$	375,872
United Kingdom		39,248		40,650		19,325
Japan		22,033		12,204		7,655
Mexico		16,513		16,285		16,232
Australia		9,379		7,308		27,647
Germany		1,207		483		418
France		884		856		970
Internationally diversified		16,841		30,615		14,754
Other international		31,902		39,170		22,812
Total:	$	908,890	$	687,457	$	485,685
Net premiums earned and other credit enhancement fees:
United States	$	387,714	$	322,788	$	267,676
United Kingdom		20,040		11,043		7,138
Japan		17,941		8,939		6,252
Mexico		7,720		7,540		7,461
Australia		4,945		3,761		3,058
Germany		4,808		2,092		1,052
France		1,174		1,116		1,133
Internationally diversified		40,926		33,706		24,434
Other international		21,099		13,718		8,460
Total:	$	506,367	$	404,703	$	326,664

Internationally diversified includes components of domestic exposure.

26

EX-99.02

EXHIBIT 99.02

Certification of CFO Pursuant to

18 U.S.C. Section 1350,

as Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Ambac Financial Group, Inc. (the “Company”) for the year ending December 31, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Thomas J. Gandolfo, as Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that, to the best of my knowledge:

(1)    The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)    The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/S/    THOMAS J. GANDOLFO
Name:	Thomas J. Gandolfo
Title:	Senior Vice President and Chief Financial Officer
Date:	March 28, 2003

This certification accompanies the Report pursuant to § 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the Company for purposes of §18 of the Securities Exchange Act of 1934, as amended.

EX-99.03

EXHIBIT 99.03

Certification of CEO Pursuant to

18 U.S.C. Section 1350,

as Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Ambac Financial Group, Inc. (the “Company”) for the year ending December 31, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Phillip B. Lassiter, as Chief Executive Officer of the Company hereby certifies, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge:

(1)    The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)    The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/S/    PHILLIP B. LASSITER
Name:	Phillip B. Lassiter
Title:	Chairman and Chief Executive Officer
Date:	March 28, 2003

This certification accompanies the Report pursuant to § 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the Company for purposes of §18 of the Securities Exchange Act of 1934, as amended.