424B5 1 d424b5.htm PROSPECTUS SUPPLEMENT Prospectus Supplement
Table of Contents

Filed Pursuant to Rule 424(b)(5)
Registration No. 333-131888

This prospectus supplement relates to an effective registration statement under the Securities Act of 1933, but it is not complete and may be changed. This is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED MARCH 5, 2008

PRELIMINARY PROSPECTUS SUPPLEMENT TO PROSPECTUS DATED JANUARY 16, 2008

             Shares

LOGO

Ambac Financial Group, Inc.

Common Stock

 

 

This is an offering of common stock by Ambac Financial Group, Inc. Our common stock is listed on the New York Stock Exchange under the symbol “ABK.” The closing price of our common stock on the New York Stock Exchange on March 4, 2008 was $10.72 per share.

We are making a concurrent offering of Equity Units pursuant to a separate prospectus supplement. The completion of the Equity Units Offering is contingent on the completion of this common stock offering.

You should carefully read this prospectus supplement, the accompanying prospectus and any free writing prospectus prepared by us, together with the documents we incorporate by reference, before you invest in our common stock.

Investing in our common stock involves a high degree of risk. You should not invest unless you can afford to lose your entire investment. See “ Risk Factors” beginning on page S-7 of this prospectus supplement to read about factors you should consider before buying shares of our common stock. You should also consider the risk factors described in the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, and in the documents we incorporate herein by reference.

 

       Price to
      Public      
     Underwriting
Discounts and
      Commissions(1)      
     Proceeds to
Ambac Financial
          Group, Inc.          

Per Share

     $                  $                  $            

Total

     $                  $                  $            
(1)   Included in this calculation of “Underwriting Discounts and Commissions” is the structuring fee paid to Credit Suisse Securities (USA) LLC equal to 1% of gross proceeds raised in any capital-raising transaction by the Company. See “Underwriting—Other Relationships” in this prospectus supplement for additional information.

We have granted the underwriters a 30-day option to purchase up to              additional shares solely to cover over-allotments, if any.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities, or determined if this prospectus supplement or the accompanying prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

Delivery of the shares to purchasers will be made on or about March     , 2008.

Joint Book Running Managers

 

Credit Suisse  

Citi

Banc of America Securities LLC  

UBS Securities LLC

 

 

 

  Keefe, Bruyette & Woods  

BNY Capital Markets

    KeyBanc Capital Markets

The date of this prospectus supplement is March     , 2008


Table of Contents

TABLE OF CONTENTS

 

PROSPECTUS SUPPLEMENT

     Page

ABOUT THIS PROSPECTUS SUPPLEMENT

   S-ii

FORWARD-LOOKING STATEMENTS

   S-ii

PROSPECTUS SUPPLEMENT SUMMARY

   S-1

RISK FACTORS

   S-7

USE OF PROCEEDS

   S-22

CAPITALIZATION

   S-23

EQUITY UNITS OFFERING

   S-24

PRICE RANGE OF COMMON STOCK AND DIVIDENDS

   S-26

DISCUSSION OF CERTAIN PORTFOLIO RISKS

   S-27

CERTAIN UNITED STATES FEDERAL INCOME TAX CONSEQUENCES FOR NON-US HOLDERS

   S-38

UNDERWRITING

   S-41

WHERE YOU CAN FIND MORE INFORMATION

   S-47

LEGAL OPINIONS

   S-47

EXPERTS

   S-48
PROSPECTUS   
     Page

ABOUT THIS PROSPECTUS

   1

AMBAC FINANCIAL GROUP, INC.

   1

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

   3

USE OF PROCEEDS

   4

RATIO OF EARNINGS TO FIXED CHARGES

   5

DESCRIPTION OF SECURITIES

   6

Description of Capital Stock

   6

Description of Depositary Shares

   8

Description of Debt Securities

   11

Description of Warrants

   21

Description of Stock Purchase Contracts and Stock Purchase Units

   22

WHERE YOU CAN FIND MORE INFORMATION

   23

LEGAL OPINIONS

   24

EXPERTS

   25

 

 

Our annual report on Form 10-K for the fiscal year ended December 31, 2007

is attached to this prospectus supplement.

 

S-i


Table of Contents

ABOUT THIS PROSPECTUS SUPPLEMENT

This document consists of three parts. The first part is the prospectus supplement, which describes the specific terms of this offering. The second part is the prospectus, which describes more general information, some of which may not apply to this offering. The third part is our Annual Report on Form 10-K (the “Form 10-K”) for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for additional information and disclosure. You should read this prospectus supplement, the accompanying prospectus and the Form 10-K, together with the other documents identified under the heading “Where You Can Find More Information” on page S-46 of this prospectus supplement.

If the information set forth in this prospectus supplement differs in any way from the information set forth in the accompanying prospectus, you should rely on the information set forth in this prospectus supplement.

You should rely only on the information contained in or incorporated by reference in this prospectus supplement, the accompanying prospectus, the Form 10-K and any free writing prospectus with respect to this offering filed by us with the Securities and Exchange Commission (the “SEC”). This prospectus supplement may be used only for the purpose for which it has been prepared. No one is authorized to give information other than that contained in this prospectus supplement and in the documents referred to in this prospectus supplement and which are made available to the public. We have not, and the underwriters have not, authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it.

We are not, and the underwriters are not, making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should not assume that the information appearing in this prospectus supplement, the accompanying prospectus, the Form 10-K, any free writing prospectus prepared by us or any document incorporated by reference is accurate as of any date other than the date of the applicable document. Our business, financial condition, results of operations and prospects may have changed since that date. Neither this prospectus supplement, the accompanying prospectus nor the Form 10-K constitutes an offer, or an invitation on our behalf or on behalf of the underwriters, to subscribe for and purchase any of the securities and may not be used for or in connection with an offer or solicitation by anyone in any jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation.

FORWARD-LOOKING STATEMENTS

In this prospectus supplement and the accompanying prospectus, we have included statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “estimate,” “expect,” “project,” “plan,” “believe,” “anticipate,” “intend,” “planned,” “potential” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” “could,” and “may,” or the negative of those expressions or verbs, identify forward-looking statements. We caution readers that these statements are not guarantees of future performance. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, which, may by their nature be inherently uncertain and some of which may be outside our control. These statements may relate to plans and objectives with respect to the future, among other things which may change. We are alerting you to the possibility that our actual results may differ, possibly materially, from the expected objectives or anticipated results that may be suggested, expressed or implied by these forward-looking statements. Important factors that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements include, among others, those discussed under “Risk Factors” in this prospectus supplement and those discussed under “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement.

 

S-ii


Table of Contents

Any or all of management’s forward-looking statements here or in other publications may turn out to be wrong and are based on Ambac’s management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) changes in the economic, credit, foreign currency or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide credit markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) changes in our business plan, including changes resulting from our decision to discontinue writing new business in the financial services area, to significantly reduce new underwriting of structured finance business and to discontinue all new underwritings of structured finance business for six months; (7) the policies and actions of the United States and other governments; (8) changes in capital requirements whether resulting from downgrades in our insured portfolio or changes in rating agencies’ rating criteria or other reasons; (9) changes in Ambac’s and/or Ambac Assurance’s credit or financial strength ratings; (10) changes in accounting principles or practices relating to the financial guarantee industry or that may impact Ambac’s reported financial results; (11) inadequacy of reserves established for losses and loss expenses; (12) default by one or more of Ambac Assurance’s portfolio investments, insured issuers, counterparties or reinsurers; (13) credit risk throughout our business, including large single exposures to reinsurers; (14) market spreads and pricing on insured collateralized debt obligations (“CDOs”) and other derivative products insured or issued by Ambac; (15) credit risk related to residential mortgage securities and CDOs; (16) the risk that holders of debt securities or counterparties on credit default swaps (“CDS”) or other similar agreements seek to declare events of default or seek judicial relief or bring claims alleging violation or breach of covenants by Ambac or one of its subsidiaries; (17) the risk that our underwriting and risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (18) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting, or FAS 133, to the portion of our credit enhancement business which is executed in credit derivative form; (19) operational risks, including with respect to internal processes, risk models, systems and employees; (20) the risk of decline in market position; (21) the risk that market risks impact assets in our investment portfolio; (22) credit and liquidity risk due to unscheduled and unanticipated withdrawals on investment agreements; (23) changes in prepayment speeds on insured asset-backed securities (“ABS”); (24) factors that may influence the amount of installment premiums paid to Ambac; (25) the risk that we may be required to raise additional capital, which could have a dilutive effect on our outstanding equity capital and/or future earnings; (26) our ability or inability to raise additional capital, including the risks that regulatory or other approvals for any plan to raise capital are not obtained, or that various conditions to such a plan, either imposed by third parties or imposed by Ambac or its Board of Directors, are not satisfied and thus potentially necessary capital raising transactions do not occur, or the risk that for other reasons the Company cannot accomplish any potentially necessary capital raising transactions, including the transactions contemplated hereby; (27) the risk that Ambac’s holding company structure and certain regulatory and other constraints, including adverse business performance, affect Ambac’s ability to pay dividends and make other payments; (28) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on our business, operations, financial position, profitability or cash flows; (29) other factors discussed under “Risk Factors” in this prospectus supplement, described in the Risk Factors section in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 and also disclosed from time to time by Ambac in its subsequent reports on Form 10-Q and Form 8-K, which are or will be available on the Ambac website at www.ambac.com and at the SEC’s website, www.sec.gov; and (30) other risks and uncertainties that have not been identified at this time. Readers are cautioned that forward-looking statements speak only as of the date they are made and that Ambac does not undertake to update forward-looking statements to reflect circumstances or events that arise after the date the statements are made. You are therefore advised to consult any further disclosures we make on related subjects in Ambac’s reports to the SEC.

 

S-iii


Table of Contents

PROSPECTUS SUPPLEMENT SUMMARY

The following summary highlights selected information contained elsewhere in this prospectus supplement and may not contain all of the information that is important to you. We encourage you to read this prospectus supplement and the accompanying prospectus, together with the documents identified under the heading “Where You Can Find More Information” on page S-46 of this prospectus supplement, in their entirety. You should pay special attention to the “Risk Factors” section of this prospectus supplement. Unless otherwise mentioned or unless the context requires otherwise, all references in this prospectus supplement to “Ambac,” “we,” “us,” “our,” the “Company” or similar references mean Ambac Financial Group, Inc. and its subsidiaries.

Ambac Financial Group, Inc.

Ambac, 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 was incorporated on April 29, 1991. Ambac’s activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services. Ambac provides financial guarantees for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation, or Ambac Assurance. Ambac Assurance is the successor to the founding financial guarantee insurance company, which wrote the first bond insurance policy in 1971. As an alternative to financial guarantee insurance, credit protection is provided by Ambac Credit Products, a subsidiary of Ambac Assurance, in credit derivative format. Through its financial services subsidiaries, Ambac has provided financial and investment products including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to its clients of the financial guarantee business.

As a holding company, Ambac is largely dependent on dividends from Ambac Assurance to pay dividends on its capital stock, to pay principal and interest on its indebtedness and to pay its operating expenses. Dividends from Ambac Assurance are subject to certain insurance regulatory restrictions. For more information, see “Insurance Regulatory Matters—Dividend Restrictions—Wisconsin” and “Management’s Discussion and Analysis—Liquidity and Capital Resources” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information.

Our principal executive offices are located at One State Street Plaza, New York, New York 10004 and our telephone number is (212) 668-0340.

Recent Developments

Ratings Agencies

Currently, Ambac Assurance has triple-A financial strength ratings from Moody’s Investors Services, Inc. (“Moody’s”) and Standard and Poor’s Rating Services (“S&P”), and a double-A rating from Fitch Inc. (“Fitch”) (downgraded from triple-A on January 18, 2008). These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement and are essential to Ambac Assurance’s ability to compete in the financial guarantee business. See “Rating Agencies” in Part I, Item 1 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information. Considering the high levels of delinquencies and defaults within residential mortgage loans, each of these rating agencies began a review of the capital adequacy of the financial guarantee industry in the fall of 2007. In late December 2007, following the rating agency reviews, Ambac Assurance’s triple-A rating was affirmed by both S&P (with “negative outlook”) and Moody’s; however, Fitch placed Ambac’s triple-A rating on “rating watch negative” and stated that Ambac Assurance had a modeled $1 billion capital shortfall. On January 16, 2008, Moody’s put Ambac Assurance’s triple-A rating on review for possible downgrade. On January 18, 2008, S&P placed Ambac Assurance’s triple-A financial strength rating on Credit Watch Negative. On January 18, 2008,

 

 

S-1


Table of Contents

Fitch downgraded Ambac Assurance’s insurance financial strength rating to double-A (“rating watch negative”). On February 25, 2008, S&P reaffirmed Ambac Assurance’s triple A rating, but kept it on Credit Watch Negative. On February 29, 2008, Moody’s publicly announced that it is continuing a review for possible downgrade that was initiated on January 16, 2008. Based on an updated assessment of Ambac Assurance’s mortgage risk, Moody’s believes that Ambac Assurance’s capital exceeds the minimum Aaa standard but falls below the Aaa target level. Moody’s further stated that Ambac is actively pursuing capital strengthening activities that, if successful, are expected to result in Ambac Assurance meeting Moody’s current estimate of the Aaa target level. There have been a number of recent developments with respect to ratings actions by the rating agencies. In light of the ongoing nature of ratings actions or announcements by the rating agencies, one should consult announcements by the rating agencies, the websites of the rating agencies and Ambac’s website for the then current publicly available information. These ratings actions have had a significant impact on Ambac Assurance’s ability to compete in the financial guarantee business. Please see Part I, Item 1 “Business—Business Segments—Financial Guarantee” and “Business—Business Segments—Competition” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further discussion as to its impact on the U.S. public finance, structured finance and international markets.

Currently, Ambac Financial Group’s long-term senior unsecured debt is rated “AA” by S&P (with “negative outlook”), “Aa2” by Moody’s (review for possible downgrade) and “A” by Fitch (“rating watch negative”).

As a result of the rating agency actions described above, as well as significant disruption in the capital markets and investor concern with respect to our financial position, we have been able to write only a limited amount of new financial guarantee business since November 2007, and we have written virtually no new business thus far in 2008.

Business Restructuring

In recent months, we have undertaken a review of all our business units. In conducting this review, we considered the risk exposure within each business (including our view of the probability of default, the potential loss given default and the relevant correlations), the risk adjusted returns over the course of an economic cycle and Ambac’s franchise value and competitive advantages.

As a result of this review, in connection with our efforts to raise capital and maintain our triple-A ratings from Moody’s and S&P, we expect to:

 

   

Execute all financial guarantee insurance business through Ambac Assurance Corporation and Ambac UK Limited;

 

   

Emphasize our public finance business (including municipal finance, healthcare and global utilities) and refocus our structured finance business (including the global infrastructure market, student loans, leasing and asset finance and structured insurance). Many of the above businesses will be subject to revised underwriting and risk management guidelines and reduced net retention limits;

 

   

Suspend underwriting all structured finance businesses (domestic and international) for six months in order to accumulate capital;

 

   

Discontinue underwriting certain structured finance businesses (domestic and international), including:

 

   

Collateralized debt obligations, collateralized loan obligations and other arbitrage-driven transactions,

 

   

All mortgage-backed securities,

 

   

Whole business securitizations, including franchise fee securitizations and intellectual property royalty securitizations,

 

 

S-2


Table of Contents
   

Auto loan and lease securitizations and rental car fleet securitizations,

 

   

Structured energy transactions,

 

   

Pooled aircraft securitizations,

 

   

Credit card receivables and small business loan securitizations, and

 

   

Emerging market transactions, including future flow transactions and other on-shore securitizations;

 

   

Discontinue the execution of credit enhancement transactions in credit default swap, total return swap or other derivative format;

 

   

Discontinue writing new Financial Services business; and

 

   

Focus on reducing single risk concentrations across our portfolio.

 

   

We also have reduced the quarterly dividend payable on our common shares to $.01 per share.

The structured finance businesses that we are intending to discontinue were included in our historical net premiums earned, loss and loss expenses, mark-to-market on credit derivatives and credit enhancement production (“CEP”) as follows:

 

$ in millions    2005     2006     2007  
     Amount     % of Total     Amount    % of Total     Amount     % of Total  

Net Premium Earned

   $ 341     39 %   $ 358    41 %   $ 359     39 %

Loss and Loss Expenses

     (9 )   6       36    (181 )     (293 )   114  

Mark-to-market gains (losses) on credit derivatives

     14     100       9    100       (6,004 )   100  

CEP

     412     33       475    37       492     35  

See “Discussion of Certain Portfolio Risks—Mark-to-Market Losses with Respect to Credit Derivatives” for further discussion.

Credit enhancement production, a non-GAAP measure, is used by management, equity analysts and investors as an indication of new business production in the period. Credit enhancement production, which Ambac reports as analytical data, is defined as gross (direct and assumed) up-front premiums plus the present value of estimated installment premiums on insurance policies and structured credit derivatives issued in the period. The discount rate used to measure the present value of estimated installment premiums was 7.0% in the first, second, third and fourth quarters of 2005, 5.1%, 5.6%, 6.0% and 5.4% in the first, second, third and fourth quarters of 2006, respectively and 5.4%, 5.4%, 5.8% and 5.6% in the first, second, third and fourth quarters of 2007, respectively. The definition of credit enhancement production used by Ambac may differ from definitions of credit enhancement production (or similar terms) used by other public holding companies of financial guarantors. The following table reconciles credit enhancement production to gross premiums written calculated in accordance with GAAP:

 

$ in millions    2005     2006     2007  

Credit enhancement production

   $ 412     $ 475     $ 492  

Present value of estimated installment premiums written on insurance policies and structured credit derivatives issued in the period

     (410 )     (472 )     (486 )
                        

Gross up-front premiums written

   $ 2     $ 3     $ 6  

Gross installment premiums written on insurance policies

     335       332       317  
                        

Gross premiums written

   $ 337     $ 335     $ 323  

Notwithstanding this business restructuring, management remains confident that Ambac Assurance’s claims paying ability is adequate to support policyholder liabilities.

 

 

S-3


Table of Contents

This common stock offering, along with the Equity Units Offering, is part of a capital raising strategy focused on maintaining Ambac Assurance’s triple-A financial strength rating from Moody’s and S&P. We do not anticipate that the completion of this offering and the Equity Units Offering will result in S&P or Moody’s assigning a “stable” outlook to our triple A ratings nor Fitch upgrading our double A financial strength rating to triple-A. In the event that we do not maintain our triple-A ratings from Moody’s and S&P, we believe that we can execute a significantly reduced business plan and operate with double-A ratings that will include Structured Finance, International and reinsurance across a variety of bond types; we would be unlikely to write a significant amount of business in Public Finance, however. In that circumstance, we expect to accumulate capital and position ourselves to regain our triple-A ratings. Ambac will continue to work closely with the regulators and the rating agencies to design and implement a strategy to address the credit issues within its portfolio and to preserve and grow the business franchise.

Certain First Quarter 2008 Financial Developments

The following information is based largely on our unaudited monthly financial data for and as of January 31, 2008. Certain of the following information, including, without limitation, the mark-to-market losses, is subject to adjustment based on various factors and developments, including, without limitation, changes in the fair market value of, among other items, our credit derivative portfolio.

 

   

Mark-to-market losses on credit derivatives and total return swaps are estimated to be approximately $650 million for the month of January 2008 reflecting wider credit spreads across nearly all asset classes, especially in CDO of ABS containing greater than 25% RMBS exposure which widened an average of 72 basis points, contributing $461 million to the January 2008 mark-to-market loss. Market conditions which give rise to such losses have continued into February 2008. If these conditions persist or worsen through the end of the first quarter, we would expect to incur a material net loss for the quarter. See “Discussion of Certain Portfolio Risks—Mark-to-Market Losses with Respect to Credit Derivatives” for further discussion.

 

   

Net unrealized losses in our investment portfolio increased from approximately $68 million as of December 31, 2007 to approximately $104 million as of January 31, 2008; this increase in net unrealized losses resulted from:

 

   

the increase in our net unrealized losses from approximately $287 million as of December 31, 2007 to approximately $439 million as of January 31, 2008 in that portion of our investment portfolio associated with our Financial Services business, which is offset in part by

 

   

an increase in net unrealized gains from approximately $219 million as of December 31, 2007 to approximately $335 million as of January 31, 2008 in that portion of our investment portfolio associated with our Financial Guarantee business.

 

   

Refunding activity in January 2008 occurred at a slower pace than we have experienced in prior quarters, amounting to approximately $3 million.

 

   

As a result of the rating agency actions described above, as well as significant disruption in the capital markets and investor concern with respect to our financial position, we have been able to write only a limited amount of new financial guarantee business since November 2007, and we have written virtually no new business thus far in 2008.

 

   

Our claim payments for January 2008 amounted to approximately $9 million.

 

   

There has been significant disruption in the municipal bond market, in which we are a major investor. Such disruption, if it continues, could require us to recognize additional unrealized losses, which could be material, with respect to our municipal bond investment portfolio.

 

 

S-4


Table of Contents

The Offering

 

Issuer

Ambac Financial Group, Inc.

 

Common stock offered

             shares

 

Common stock outstanding after the offering

             shares

 

Underwriters’ option to purchase additional shares

Up to              shares

 

New York Stock Exchange symbol

ABK

 

Concurrent Equity Units Offering

We are making a concurrent offering of Equity Units pursuant to a separate prospectus supplement. The Equity Units Offering and this common stock offering are not contingent on one another. See “Equity Units Offering.”

 

Use of proceeds

We intend to contribute the net proceeds of this offering, as well as the net proceeds of the concurrent offering of Equity Units, to Ambac Assurance in order to increase its capital position, less approximately $100 million, which we intend to retain at Ambac Financial Group, Inc. to provide incremental holding company liquidity to pay principal and interest on its indebtedness, to pay its operating and other expenses and to pay dividends on its capital stock. See “Use of Proceeds.”

 

Risk factors

Investing in our common stock involves a high degree of risk. You should not invest unless you can afford to lose your entire investment. See “Risk Factors” in this prospectus supplement, the accompanying prospectus and in the documents incorporated by reference herein, including our Annual Report on Form 10-K for the year ended December 31, 2007, which is also attached to this prospectus supplement.

The number of shares of our common stock to be outstanding after this offering is based on 101,633,722 shares outstanding at February 8, 2008. The number of outstanding shares excludes:

 

   

176,019 shares of our common stock available under the Ambac 1997 Non-Employee Directors Equity Plan of which 144,810 shares are available for future awards of restricted stock and restricted stock units;

 

   

3,541,733 shares available under the Ambac 1997 Equity Plan of which 994,756 shares are available for future awards other than options and stock appreciation rights;

 

   

5,054,928 shares of our common stock reserved for issuance upon exercise of stock options previously granted pursuant to the Ambac 1997 Equity Plan with a weighted average exercise price of $55.10 per share at February 8, 2008;

 

   

3,229,655 shares of our common stock reserved for settlement of restricted stock and restricted stock units previously granted pursuant to the Ambac 1997 Equity Plan at February 8, 2008; and

 

   

up to              shares, which is the maximum amount of shares that we would be required to issue upon the settlement in common stock on                     , 2011 of the stock purchase contracts comprising a portion of the Equity Units being offered concurrently.

Unless otherwise specified, this prospectus supplement assumes no exercise of the underwriters’ option to purchase additional shares.

 

 

S-5


Table of Contents

Summary Financial Information

The following summary consolidated statement of operations data for the years ended December 31, 2005, 2006 and 2007, and the consolidated balance sheet data as of December 31, 2006 and 2007, have been derived from our audited consolidated financial statements incorporated by reference in this prospectus supplement and included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement. The following summary consolidated statement of operations data for the years ended December 31, 2003 and 2004, and the consolidated balance sheet data as of December 31, 2003, 2004 and 2005 have been derived from our audited consolidated financial statements not included or incorporated by reference in this prospectus supplement. This information is only a summary and should be read together with the consolidated financial statements, the related notes and other financial information incorporated by reference in this prospectus supplement.

 

     Years Ended December 31,  
(Dollars in millions, except per share amounts)    2003     2004     2005     2006     2007  

Statement of Operations Data Highlights

          

Gross premiums written

   $ 1,143.7     $ 1,048.3     $ 1,096.0     $ 996.7     $ 1,031.4  

Net premiums earned and other credit enhancement fees

     667.3       764.5       866.4       871.4       917.9  

Net investment income

     321.1       355.3       378.1       423.9       465.0  

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

     —         17.7       13.6       9.1       (6,004.4 )

Interest income from investment and payment agreements

     212.0       198.8       270.3       391.7       445.3  

Financial services—other revenue

     20.6       26.4       15.8       16.6       6.9  

Total revenue

     1,272.2       1,401.6       1,614.1       1,832.1       (4,214.9 )

Losses and loss expenses

     53.4       69.6       149.9       20.0       256.1  

Financial guarantee underwriting and operating expenses

     92.0       106.6       117.7       133.7       139.3  

Interest expense from investment and payment agreements

     196.3       168.9       239.3       359.9       420.0  

Financial services—other expenses

     12.1       14.7       13.7       12.4       12.2  

Interest expense

     54.2       54.3       55.9       75.3       85.7  

Net income

     618.9       724.6       751.0       875.9       (3,248.2 )

Net income (loss) per share:

          

Basic

     5.81       6.61       6.94       8.22       (31.56 )

Diluted

     5.66       6.53       6.87       8.15       (31.56 )

Return on equity

     15.7 %     15.6 %     14.4 %     15.1 %     (76.7 )%

Cash dividends declared per common share

     0.420       0.470       0.550       0.660       0.780  
     As of December 31,  
     2003     2004     2005     2006     2007  

Balance Sheet Data

          

Total investments, at fair value

   $ 13,776.3     $ 14,422.3     $ 15,591.9     $ 17,433.6     $ 18,395.7  

Prepaid reinsurance

     325.5       297.3       303.4       315.5       489.0  

Total assets

     16,557.1       17,672.5       18,545.9       20,267.8       23,565.0  

Unearned premiums

     2,531.8       2,765.2       2,941.0       3,037.5       3,123.9  

Losses and loss expense reserve

     189.4       254.1       304.1       220.1       484.3  

Derivative liabilities

     946.2       1,213.5       807.5       667.1       6,685.5  

Obligations under investment, investment repurchase and payment agreements

     7,076.4       7,080.7       7,252.8       8,356.9       8,706.4  

Long-term debt

     791.8       791.8       1,191.7       991.8       1,669.9  

Total stockholders’ equity

     4,265.1       5,035.0       5,388.2       6,189.6       2,279.9  

 

 

S-6


Table of Contents

RISK FACTORS

Your investment in the shares will involve significant risks described below. In consultation with your own financial and legal advisors, you should carefully consider the information included in or incorporated by reference in this prospectus supplement and the accompanying prospectus, and pay special attention to the following discussion of risks relating to the shares before deciding whether an investment in the securities offered hereby is suitable for you. The shares will not be an appropriate investment for you if you are not knowledgeable about significant features of the securities offered hereby or financial matters in general. You should not purchase the shares unless you understand, and know that you can bear, these investment risks.

There can be no assurance that we will maintain our financial strength ratings, even if we are successful in raising capital through this common stock offering and the concurrent Equity Unit Offering.

This common stock offering and the concurrent Equity Unit Offering are part of a capital raising strategy focused on maintaining Ambac Assurance’s triple-A financial strength ratings from Moody’s and S&P. While we expect that the additional capital raised from these offerings will enable us to maintain such ratings, at the present time, we do not anticipate that the completion of this offering or the Equity Units Offering will result in S&P or Moody’s assigning a “stable” outlook to our triple-A ratings nor Fitch upgrading our double-A financial strength rating to triple-A. Furthermore, there are various factors, including those discussed in the second following risk factor and elsewhere in this “Risk Factors” section, that could result in our financial strength and other ratings being downgraded or being subject to downgrade in the future. Accordingly, there can be no assurance that we will not seek to raise capital, including through additional issuance of equity, in the future.

There have been a number of recent developments with respect to ratings actions by the rating agencies. In light of the ongoing nature of ratings actions or announcements by the rating agencies, investors should consult announcements by the rating agencies, the websites of the rating agencies and Ambac’s website for the then-current publicly available information.

As a result of market conditions, rating agency actions and investor concern with respect to our financial position, our ability to write new business has been severely limited since November 2007, and we have written virtually no new business thus far in 2008.

In January and February 2008, we booked only a de minimis amount of new business. There can be no assurance that our business will improve or return to normal (or better) levels or, if they do improve, as to the timing of such improvements or return to normal levels.

The placement of our financial strength rating on negative credit watch by S&P and on review for possible downgrade by Moody’s and the downgrade by Fitch has had a material adverse effect on our competitive position and our ability to write new business. A further downgrade of the financial strength rating of Ambac Assurance would materially adversely affect our business and prospects and, consequently, our results of operations and financial condition.

Ambac Assurance’s ability to attract new business and to compete with other triple A-rated financial guarantors has, to date, been highly dependent on the triple-A financial strength ratings assigned to it by the rating agencies. Historically, our insurance companies have held triple-A financial strength ratings from Moody’s, S&P and Fitch. The objective of these ratings is to provide an opinion on an insurer’s financial strength and its ability and intent to pay under its insurance policies and contracts in accordance with their terms. The rating is not specific to any particular policy or contract. Financial strength ratings do not refer to an insurer’s ability to meet non-insurance obligations and are not a “market rating” or a recommendation to buy, hold or sell any security.

In the fall of 2007, each of the major rating agencies began a review of the capital adequacy of the financial guaranty industry. In late December, following the rating agency reviews, Ambac’s triple-A rating was affirmed by both S&P (with “negative outlook”) and Moody’s; however, Fitch placed Ambac’s AAA ratings on rating watch negative and stated that Ambac had a modeled $1 billion capital shortfall. On January 16, 2008, Moody’s

 

S-7


Table of Contents

put Ambac’s Aaa rating on review for possible downgrade. On January 18, 2008, Fitch downgraded Ambac’s insurance financial strength rating to AA, Credit Watch Negative. In addition, on January 18, 2008, S&P put Ambac’s AAA rating on Credit Watch Negative. On February 25, 2008, S&P reaffirmed Ambac Assurance’s triple-A rating, but kept it on Credit Watch Negative. On February 29, 2008, Moody’s publicly announced that it was continuing a review for possible downgrade that was initiated on January 16, 2008. To the extent that Ambac is unable to raise sufficient capital over the near term in relation to its increased capital needs, or is unable to satisfy other rating agency criteria, the ratings assigned to it and to Ambac Assurance by the rating agencies could be lowered. There can be no assurance that the proceeds of this offering and the Equity Units Offering will be sufficient to obtain or maintain triple A ratings. Furthermore, there can be no assurance that Ambac Assurance will not be required by any of the rating agencies to raise additional capital in order to maintain ratings in the future, nor can there be any assurance that we will be able to raise any such additional capital in the future. In addition, failure to replace our interim CEO with a permanent CEO on a timely basis could have an adverse effect on our ratings.

If Ambac Assurance’s ratings were reduced to double-A by S&P and Moody’s, there is no assurance that we could successfully execute the reduced double-A business plan as we envision; failure to do so may eliminate the possibility of a ratings upgrade and could result in further ratings downgrades. In addition, further adverse ratings action by Fitch could have an adverse effect on our business and operations. We believe downgrades below a double-A rating by the major rating agencies would, if our competitors were not similarly downgraded, further and materially reduce our ability to write new business.

As a result of the rating agency actions described above, as well as significant disruption in the capital markets and investor concern with respect to our financial position, we have been able to write only a limited amount of new financial guarantee business since November 2007 and we have written virtually no new business thus far in 2008. Any further downgrade in our financial strength ratings could have a material adverse effect on our long-term competitive position and our prospects for future business. See Part I, Item 1, “Business—Rating Agencies” and Part II, Item 7, “Management’s Discussion and Analysis—Credit Ratings and Collateral” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information.

A downgrade of the financial strength rating of Ambac Assurance would result in significant collateral-posting obligations in respect of investment agreements and interest rate swap and currency swap transactions, and/or withdrawals or terminations of such transactions.

Most investment agreements and interest rate swap and currency swap transactions provide certain remedies to the counterparty in the event of a downgrade of Ambac Assurance’s financial strength rating, typically to A1 by Moody’s or A+ by S&P. In most cases, we are required to post collateral or otherwise enhance our credit to the A1 or A+ rating level. These collateral-posting obligations could have a material adverse effect on our liquidity. Additionally, it is likely that Ambac Assurance would need to lend or contribute investment assets or cash to the Financial Services businesses in order to satisfy these collateral-posting obligations. Any such loans or contributions would be subject to the prior consent of the Office of the Commissioner of the State of Wisconsin; there can be no assurance that we would obtain such consent. If we fail to post collateral as required or if Ambac Assurance’s financial strength rating is downgraded below A3 by Moody’s or A+ by S&P, counterparties are entitled to terminate the transactions. Upon such terminations, we could liquidate securities with unrealized mark-to-market losses which could have a material adverse effect on our liquidity and lead to further downgrades. See Part II, Item 7, “Management’s Discussion and Analysis—Credit Ratings and Collateral” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information.

Ultimate actual claim payments on our CDO of ABS, CDO-squared and other credit derivative exposures could materially exceed on a present value basis our current disclosed estimates of impairment.

For the year ended December 31, 2007, Ambac reported a total of $6.0 billion of mark-to-market losses on credit derivative exposures, including estimated credit impairment of approximately $1.1 billion related to certain

 

S-8


Table of Contents

collateralized debt obligations of asset-backed securities (“CDO of ABS”) backed primarily by mezzanine level subprime residential mortgage-backed securities (“Subprime MBS”) and “CDO squared” transactions which are backed by CDO of ABS transactions comprised of Subprime MBS that have recently been internally downgraded to below investment grade. See “Discussion of Certain Portfolio Risks—Mark-to-Market Losses with Respect to Credit Derivatives” for further discussion. An estimate for credit impairment has been established because it is management’s expectation that Ambac will have to make claim payments on these exposures in the future. Such credit impairment estimates are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default and the severity of loss upon default of the CDOs. The purpose of credit impairment estimates is to capture management’s expectation about future claims and do not reflect management’s expectations about stressed or “worst case” outcomes. Credit impairment estimates are only established when management has observed significant credit deterioration, in most cases, when the underlying credit is considered below investment grade. We do not estimate impairment for performing credits. Many factors will affect ultimate performance or impairment of our credit derivative exposures, including volatility in the capital markets, conditions in the residential housing and residential mortgage markets and downgrades by the rating agencies of mortgage-backed securities within our CDO of ABS exposures. Accordingly, there can be no assurance that the actual payments we are ultimately required to make in respect of our CDO of ABS, CDO squared and other credit derivative exposures will not materially exceed our current disclosed estimates.

Uncertainty with respect to the ultimate performance of certain of our credit derivative exposures may result in substantial changes to our impairment estimates. Correspondingly, such changes to would affect our financial position possibly materially and adversely.

Various third-party market participants, including several underwriters in this offering and in the concurrent Equity Units Offering, have made estimates of our losses, estimates of credit impairments and mark-to-market losses that in some cases materially exceed the amounts we have reported.

Various third-party securities analysts and other market participants have made estimates of our loss and credit impairment amounts under various scenarios. In light of various factors, including, without limitation, the volatility in the capital markets, the limited liquidity for certain classes of securities and the various assumptions about the future that are inherent in making such estimates, including estimates regarding the performance of RMBS and the housing market more generally, these third-party estimates vary widely. We have been informed by certain of the underwriters in this offering and the concurrent Equity Units Offering that their estimates of our losses and mark-to-market losses, which include estimates of our credit impairment, materially exceed the corresponding amounts shown in the stress cases of S&P discussed below in “Discussion of Certain Portfolio Risks—Rating Agency Perspective on Stress Testing Ambac’s Capital Adequacy,” and, in some cases, materially exceed the sum of the mark-to-market losses we have reported plus the amount of our loss reserve estimates. In the event that our ultimate losses and credit impairments approach some of these third-party estimates, such losses and credit impairments would have a materially adverse effect on our performance and financial position. In addition, we can provide no assurance that we would be able to maintain our triple-A ratings from Moody’s and S&P or our double-A from Fitch if our losses and credit impairments approached or exceeded these third-party estimates, even if such actual losses and credit impairments were less than the stress losses currently modeled by those rating agencies; we can also provide no assurance regarding at what level our financial strength would be if such a downgrade were to occur.

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

Loss reserves established with respect to our non-derivative financial guarantee insurance business are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default and the severity of loss upon default. Loss reserves are only established when management has observed significant credit deterioration, in most cases, when the underlying credit is considered below

 

S-9


Table of Contents

investment grade. We do not record loss reserves for performing credits. Furthermore, the objective of establishing loss reserve estimates is not to reflect the worst possible outcome. As such, there can be no assurance that the actual losses in our financial guarantee insurance portfolio will not exceed our loss reserves. A further description of our accounting for loss and loss expenses can be found in Note 2 of the notes to our consolidated financial statements included in Item 8 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement.

Uncertainty with respect to the ultimate performance of certain of our insured exposures may result in substantial changes in loss reserves. Correspondingly, such changes to loss reserves would affect our reported earnings.

Changes in the rating agencies’ capital models and rating methodology with respect to financial guarantee insurers and issuers may further adversely affect our business results and prospects.

Recent reviews by each of Moody’s, S&P and Fitch stemming from the uncertainties relating to ultimate losses in the mortgage market have resulted in an increase in the level of capital the agencies require Ambac Assurance to hold against insured Residential Mortgage Backed Securities (“RMBS”) and CDOs of asset-backed securities (“ABS”). Such actions have resulted in a downgrade of Ambac Assurance’s financial strength rating by Fitch from AAA to AA and a change in outlook to Credit Watch Negative and Review for Possible Downgrade from S&P and Moody’s respectively. See Part I, Item 1, “Business—Rating Agencies” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for additional details regarding rating agency actions. As a result of the actions taken by each of the agencies, Ambac is exploring methods for enhancing its capital base. Additional changes in the rating agencies capital models and rating methodology, whether resulting from further losses or uncertainty in the mortgage market or other factors, could require us to hold more capital against specified credit risks in our insured portfolio. These requirements could place incremental stress on our rating and force us to raise additional capital, which could result in lower returns on equity.

Changes in the rating agencies’ capital models and rating methodology with respect to financial guarantee insurers could also impose limitations on the areas and amount of new financial guarantee business in which we engage.

In addition, changes in the rating agencies’ capital models or rating methodology applied to issuers could adversely affect our business results and prospects. For example, ratings agencies could begin to rate municipal bond issuers on the significantly less stringent rating scales currently applied to rate corporate bonds. In such case, many municipal issuers whose bonds might have been lower rated on the municipal scale might receive a triple-A rating on the corporate scale, possibly adversely affecting the demand for, and pricing of, financial guarantee insurance for such bonds.

Also, even in the absence of changes in the ratings agencies’ capital models or rating methodology applied to municipal issuers, investors and other market participants could come to view non-triple-A rated municipal bonds as having the same financial strength as triple-A rated corporate bonds, therefore possibly adversely affecting the demand for, and pricing of, financial guarantee insurance for such bonds.

Collectively, changes in the rating agencies’ rating methodology may result in a downgrade of Ambac Assurance’s financial strength rating despite meeting the agencies’ currently prescribed capital metrics for a triple-A rating.

A downgrade of our long term credit ratings could adversely affect our liquidity and increase our borrowing costs.

Our long-term senior unsecured debt is rated “AA” by S&P and “Aa2” by Moody’s. On December 14, 2007, Moody’s affirmed our long-term senior debt rating. On December 19, 2007, S&P affirmed our long-term senior

 

S-10


Table of Contents

unsecured debt rating with a negative outlook. On December 21, 2007, Fitch placed our AA long-term senior unsecured debt rating on “rating watch negative.” On January 16, 2008, Moody’s placed our long-term senior unsecured debt rating on review for possible downgrade. On January 18, 2008, Fitch downgraded our AA long-term senior unsecured debt rating to A, and AA- subordinated debt rating to A-. On January 18, 2007, S&P placed our AA long-term senior unsecured debt rating on Credit Watch Negative. On February 25, 2008, S&P affirmed our long-term senior unsecured debt rating, which remains on Credit Watch Negative. On February 29, 2008, Moody’s stated that it is continuing its review for possible downgrade.

Our access to external sources of financing, as well as the cost of that financing, could be adversely affected by a deterioration of our long-term debt ratings. Long-term debt ratings are influenced by a number of factors, including, but not limited to: financial leverage on an absolute basis or relative to our peers, the composition of the balance sheet and/or capital structure, material changes in earning trends and volatility, inability to dividend monies from Ambac Assurance and our competitive position. Material deterioration in any one or a combination of these factors could result in a downgrade of our credit ratings, thus increasing the cost of and/or limiting the availability of unsecured financing. Moreover, if our need for capital arises because of significant sudden losses, the occurrence of these losses may make it more difficult for us to raise the necessary capital. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition would be adversely affected.

Our holding company structure and certain regulatory and other constraints, including adverse business performance, could affect our ability to pay dividends and make other payments.

We are a holding company and have no substantial operations of our own or assets other than our ownership of Ambac Assurance, our principal operating subsidiary, and certain other smaller subsidiaries. As such, we are largely dependent on dividends from Ambac Assurance to, among other things, pay dividends on our capital stock, pay principal and interest on our indebtedness, pay our operating expenses and make capital investment in our subsidiaries. Wisconsin insurance regulations restrict the amount of dividends that may be paid by Ambac Assurance without the consent of the regulator. Adverse business circumstances or changes in regulatory policy could impact Ambac Assurance’s ability to pay us dividends in an amount sufficient for us to pay dividends on our capital stock. Ambac Assurance reported a reduction in policyholders’ surplus of $380.7 million on a statutory basis for the year ended December 31, 2007. Because of the regulatory tests applicable to the payment of extraordinary dividends, the amount of dividends that may be paid by Ambac Assurance to us without regulatory consent would be reduced as a result of this reduction in policyholders’ surplus. The amount of dividends that we expect Ambac Assurance to pay to us in 2008 does not constitute an extraordinary dividend and therefore no regulatory consent would be required for the payment of such non-extraordinary dividends. Further, the inability of Ambac Assurance to pay dividends in an amount sufficient to enable us to meet our cash requirements at the holding company level could affect our ability to repay our debt and/or raise capital or otherwise have a material adverse effect on our operations. See Part I, Item 1 “Business—Insurance Regulatory—Dividend Restrictions—Wisconsin” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information.

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

We are exposed to the risk that issuers of debt which we have insured (or with respect to which we have written credit derivatives), issuers of debt which we hold in our investment portfolio, reinsurers and other contract counterparties (including derivative counterparties) may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure, fraud or other reasons. These credit risks could cause increased losses and loss reserves, estimates of credit impairments and mark-to-market losses with respect to credit derivatives in our financial guarantee business; we could be required by the rating agencies to hold additional capital against insured exposures whether or not Ambac Assurance is downgraded by the rating agencies; and we could experience losses and decreases in the value of our investment portfolio and, therefore,

 

S-11


Table of Contents

our financial strength. See “Discussion of Certain Portfolio Risks—Mark-to-Market Losses with Respect to Credit Derivatives” for further discussion. Such credit risks may be in the form of large single risk exposures to particular issuers, reinsurers or counterparties; losses caused by catastrophic events (including terrorist acts and natural disasters); or losses in respect of different, but correlated, credit exposures.

As of December 31, 2007, we have credit exposure to our reinsurance counterparties through reinsurance contracts of approximately $88.1 billion or 14% of our gross par outstanding. No single reinsurance counterparty represents more than 16% of the $88.1 billion in par ceded, except for Assured Guaranty Re Limited to which we have reinsured $34.6 billion of par. In the event that we are required to make claim payments on policies that have been reinsured, we are at risk that such counterparties will fail to fulfill their payment obligations to us. In addition, downgrades to the credit ratings of our reinsurance counterparties may result in the reduction of rating agency capital credit provided by those reinsurance contracts, and could therefore result in a downgrade of our own credit ratings. The ratings agencies currently are reviewing the monoline financial guaranty reinsurers. For additional information on our reinsurers, see Item 7A, “Risk Management—Credit Risk” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement. Finally, a material deterioration in the capital levels of our reinsurance counterparties could reduce the amount of statutory capital relief provided by our reinsurance arrangements, and could result in our failure to meet our own statutory capital requirements. See the table included in “Quantitative and Qualitative Disclosures About Market Risk—Credit Risk” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for additional information on the financial strength ratings of Ambac’s reinsurers as well as the amount of amounts due from such reinsurers that are not secured by collateral.

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

We have insured, and written credit default swaps (“CDS”), with respect to, RMBS (including transactions composed of second lien mortgage products, Home Equity Line of Credit (“HELOCs”) and closed end second mortgage loans) and CDOs of ABS and are thus exposed to credit risk associated with those asset classes. Performance of these transactions can be adversely affected by general economic conditions, including recession, rising unemployment rates, declining house prices, increasing foreclosure rates and unavailability of consumer credit; mortgage product attributes, such as interest rate adjustments and balloon payment obligations; borrower and/or originator fraud; financial difficulty experienced by mortgage servicers; and, particularly in the case of CDOs of ABS, transaction-specific factors such as the lack of control of the underlying collateral security which can result in a senior creditor determining to liquidate underlying assets to the disadvantage of mezzanine and subordinated creditors and disputes between creditors with respect to the interpretation of legal documents governing the particular transaction.

Transactions within Ambac Assurance’s insured RMBS and CDO portfolios also may be downgraded, placed on watch or subject to other actions by the three rating agencies that have granted Ambac Assurance its claims-paying ratings. Such ratings or other actions could require Ambac Assurance to maintain a material amount of additional capital to support the exposures it has insured. This could require us to:

 

   

Raise additional capital, if available, on terms and conditions that may be unfavorable;

 

   

Curtail the production of new business; or pay to reinsure or otherwise transfer certain of its risk exposure.

RMBS and CDOs of ABS exposures which we have written in the form of CDS are subject to FAS 133, which requires that these transactions be recorded at fair value. Changes in estimated fair values relative to our credit derivative book have caused decreases in the value of such credit derivative transactions; those changes in value are reported in our financial statements and have therefore affected our reported earnings. Similarly, further decreases or increases in estimated fair values in the future can affect our reported earnings. Changes in the estimated fair values of these CDS can be caused by general market conditions, perception of credit risk generally and events affecting particular credit derivative transactions (including those described above) and actual impairment.

 

S-12


Table of Contents

While further deterioration in performance of the subprime mortgage sector is generally expected, the extent and duration of any future continued deterioration of the credit markets is unknown, as is the impact, if any, on potential claim payments and ultimate losses of the securities within Ambac Assurance’s portfolio. In addition, there can be no assurance that any of the governmental or private sector initiatives designed to address such credit deterioration in the markets will be implemented, and there is no way to know the effect that any such initiatives could have on the credit performance over time of the actual securities that Ambac Assurance insures.

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

Our recently announced intention to suspend or discontinue our activities and to revise our underwriting criteria in the structured finance sector and to discontinue our activities in Financial Services will adversely affect our business results and future earnings relative to historical levels.

As described more fully above in “Prospectus Supplement Summary—Recent Developments,” in connection with our efforts to raise capital and maintain our triple-A ratings from Moody’s and S&P, we expect to make a number of changes to our businesses. As a result, certain businesses in which we currently operate will be suspended or discontinued, and other businesses de-emphasized or subject to new limitations. These changes will result in decreased revenues, credit enhancement production and net income relative to historical levels and decreased cash flow to meet our obligations. There can be no assurance that these changes will be deemed sufficient by the rating agencies to maintain our ratings or that we will be able to replace the loss of business production with our on-going businesses. Further, these changes could lead to certain disruptions in our on-going businesses. Management time and attention will be diverted to managing these changes rather than concentrating fully on running the on-going businesses and our employees may be distracted.

Revenues would be adversely impacted due to a decline in realization of installment premiums.

Due to the installment nature of a significant percentage of its premium income, Ambac Assurance has an embedded future revenue stream. The amount of installment premiums actually realized by Ambac Assurance could be reduced in the future due to factors such as early termination of insurance contracts, accelerated prepayments of underlying obligations or insufficiency of cash flows. Such a reduction would result in lower revenues.

General economic and other conditions can adversely affect our business results and prospects.

Changes in general economic and other conditions can impact our business, including recessions; increases in corporate, municipal and/or consumer bankruptcies; changes in interest rate levels; a continued downturn in the U.S. housing market and commercial real estate market; continued dislocation and lack of liquidity in the credit and financial markets; changes in domestic and international laws, including tax laws and bankruptcy laws; intervention by governments or courts in financial markets, including the imposition of limits on the ability of mortgagees to foreclose on defaulted mortgage loans and/or to increase interest rates on mortgage loans in accordance with original contract terms; wars and terrorist acts; natural disasters, including earthquakes, floods, windstorms and wildfires; rising energy, fuel and utility costs; could adversely affect the performance of our insured portfolio and our investment portfolio, e.g., leading to increases in losses and loss reserves in our insured portfolio and decreases in the value of our investment portfolio and, therefore, our financial strength. Furthermore, reduction in the volume of capital markets transactions; levels of competition; and changes in investor perception of credit risk could adversely impact the volume and pricing of financial guarantee insurance transactions and therefore adversely impact our business prospects.

 

S-13


Table of Contents

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

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

Decreases in prevailing interest rate levels can adversely affect the demand for, and pricing of, financial guarantee insurance, since lower absolute interest rates have historically tended to reduce credit spreads and, therefore, the savings realized by issuers by using our core product. Additionally, decreasing interest rates could result in early terminations of financial guarantee insurance policies in respect of which we are paid on an installment basis and do not receive a termination premium, thus reducing premium earned in respect of these transactions. Decreases in prevailing interest rates would also reduce investment income.

The financial guarantee business is highly competitive and adverse publicity may affect demand for financial guaranty products.

The financial guarantee business is highly competitive and we expect it to remain so in the near future. We face competition from other financial guarantors and alternatives to third-party credit enhancement. Such alternatives include bank financing, senior/subordinated securitization structures, letters of credit, guarantees and credit derivatives provided primarily by foreign and domestic banks.

In light of the recent developments described above in “Prospectus Supplement Summary—Recent Developments,” Ambac Assurance has been placed at a competitive disadvantage in all three of the financial guarantee markets: public finance, structured finance and international. In particular, it has been placed at a significant disadvantage to two of its competitors, Financial Security Assurance Inc. (“FSA Guarantee”) and Assured Guaranty, which are the only principal competitors in the financial guarantee market who have had their triple-A financial strength ratings affirmed “stable” by all three of the major ratings agencies.

Additionally, we could encounter additional competition in the future from new entrants to the financial guarantee insurance market. For example, Berkshire Hathaway recently publicly announced its entrance into the financial guarantee business. See Part I, Item 1, “Business—Competition” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information.

As a result of the uncertainty regarding the financial stability of financial guarantors (including ourselves), the proportion of newly issued public finance obligations which are insured has dropped dramatically recently. For example, certain municipal issuers, including the State of California, for which Ambac has historically written significant amounts of financial guarantees, have recently discontinued or significantly curtailed their use of insurance for new issues, or indicated their intent to do so. While public finance insured market penetration was 57% in 2005, 48% in 2006 and 47% in 2007, public finance insured market penetration dropped to approximately 30% in December 2007 and 27% in January 2008. If penetration levels remain at that level, new business public finance production for Ambac will be reduced significantly.

In addition, our performance is largely dependent on the talents and efforts of highly skilled individuals. Over the past few years, there has been increased competition in the financial guarantee business for qualified employees. Our business could be adversely affected if we are unable to attract new employees and retain and motivate our existing employees.

 

S-14


Table of Contents

Adequate capital support and liquidity may not be available.

Financial guarantee insurers, including Ambac Assurance, typically rely on providers of lines of credit, reinsurers, contingent capital facilities and similar support mechanisms (often referred to as “soft capital”) to supplement their “hard capital.” The ratings of soft capital providers directly affect the level of capital credit which the rating agencies attribute to the financial guarantee insurer when rating its financial strength. We intend to maintain soft capital facilities with providers having ratings adequate to provide the desired capital credit, although no assurance can be given that one or more of the rating agencies will not downgrade or withdraw the applicable ratings of such providers in the future. In addition, we cannot assure that an acceptable replacement provider would be available in that event. Reductions by the rating agencies in the amount of capital credit that we receive in respect of soft capital facilities would require us to procure additional capital sources, potentially at higher costs.

Our underwriting and risk management policies and practices in the past have not anticipated unforeseen risks and/or the magnitude of potential for loss as the result of foreseen risks.

As described in Part I, Item 1, “Business—Risk Management” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, we have established underwriting and risk management policies and practices which seek to mitigate our exposure to credit risk in our insured portfolio. These policies and practices in the past have not insulated us from risks that were unforeseen and which had unanticipated loss severity, and such policies and practices may not do so in the future. There can be no assurance that these policies and practices will be adequate to avoid future losses. We also rely on internally and externally developed complex financial models which additionally may have been reviewed by third parties to analyze and predict performance of the insured obligations. Flaws in these financial models and/or faulty assumptions used by these financial models could lead to increased losses and loss reserving.

Our net income and earnings have become more volatile due to the application of fair value accounting, or FAS 133, to the portion of our credit enhancement business which is executed in credit derivative form.

FAS 133 requires that credit derivative transactions be recorded at fair value. Since quoted market prices for the contracts that we execute are not available, we estimate fair value by using modeling methodologies which are less precise than using quoted market prices. Changes in estimated fair values relative to our credit derivative book have caused decreases in the value of such credit derivative transactions; those changes in value are reported in our financial statements and have therefore affected our reported earnings. Similarly, further decreases or increases in estimated fair values in the future can affect our reported earnings. Changes in estimated fair values can be caused by general market conditions, uncertainty regarding the ultimate outcome of subprime mortgage losses and the quality of high yield corporate loans, perception of credit risk generally and events affecting particular credit derivative transactions (e.g. impairment or improvement of specific reference entities or reference obligations).

Changes to accounting rules relating to the financial guarantee industry could have a material adverse affect on us and our industry.

On April 18, 2007, the FASB issued an Exposure Draft for public comment entitled “Accounting for Financial Guarantee Insurance Contracts”, an interpretation of SFAS 60 “Accounting and Reporting by Insurance Enterprises.” The comment period ended on June 18, 2007 and a roundtable with interested parties was held on September 4, 2007. The FASB has concluded its re-deliberations of the Exposure Draft and expects to issue a final standard in the first quarter of 2008.

Under the Exposure Draft, Ambac believes that the cumulative effect of initially applying the revenue recognition provisions to our upfront paying policies could have a material adverse effect on our financial statements. Additionally, the revenue recognition for upfront paying insurance transactions originated after the

 

S-15


Table of Contents

standard’s effective date would be materially different than our current premium revenue recognition methodology. Ambac continues to evaluate the implications of the Exposure Draft with regard to income recognition on installment paying policies, claim liabilities and deferred acquisition costs on its financial statements.

Under the FASB’s re-deliberations, Ambac would be required to recognize premium revenue, for both upfront and installment paying policies, based on applying a fixed percentage of premium to the amount of exposure outstanding at each reporting date (referred to as the level-yield approach), rather than being recognized over the term of each maturity for upfront paying policies. For installment paying policies, the FASB’s re-deliberations also require that the discount, equating to the difference between gross installment premiums and the present value of installment premiums, be accreted through the income statement. Ambac has not yet evaluated the implications of the FASB’s re-deliberations.

We are subject to the compliance requirements of the federal securities laws.

We are subject to extensive regulation under the federal securities laws, both as a registrant under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) and in the conduct of our financial guarantee insurance business. In the event that we were unable to comply with the federal securities laws, we would likely be unable to access the public capital markets, which would make it more difficult for us to raise the necessary capital and/or increase the cost of capital. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition would be adversely affected. Additionally, if we are unable to comply with the securities laws, Ambac Assurance would likely be unable to insure transactions in the public capital markets, which would have an adverse impact on our business and operating results.

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

Our principal subsidiary, Ambac Assurance, is subject to the insurance laws and regulations of each jurisdiction in which it is licensed. Ambac UK Limited, the subsidiary through which we write financial guarantee insurance in the United Kingdom and in the European Union, is regulated by the Financial Services Authority. Failure to comply with applicable insurance laws and regulations could expose us to fines, the loss of insurance licenses in certain jurisdictions and/or the inability of Ambac Assurance to dividend monies to us, all of which could have an adverse impact on our business results and prospects. Additionally, if the cost of complying with these insurance laws and regulations increases materially, this could impact our business results.

The New York Insurance Department has indicated that it is undertaking a review of the laws and regulations that are applicable to Ambac Assurance and to other monoline financial guarantee insurance companies. As a result of any changes to such laws and regulations or the New York Insurance Department’s interpretation thereof, Ambac Assurance could become subject to further restrictions on the types and amounts of business that it is authorized to insure, especially in the structured finance area. Any such restrictions could have a material effect on the amount of premiums that Ambac earns in the future. Additionally, any changes to such laws and regulations could subject Ambac Assurance to increased reserving and capital requirements or more stringent regulation generally, which could materially adversely affect our financial condition, results of operations and future business. See “Business—Insurance Regulatory Matters” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information.

In recent weeks, the New York Insurance Department and other governmental officials have expressed concern that participants in the financial guarantee industry, including Ambac, take actions to augment their capital and maintain credit ratings and warned that, in the absence of such actions, regulatory action may be necessary to protect policyholders. Insurance regulatory authorities’ responsibility is to protect policyholders, not

 

S-16


Table of Contents

shareholders. We believe this capital raising is responsive to the regulators’ concerns at this time, but there can be no assurance insurance regulators or other authorities will not take actions that are adverse to the interests of our shareholders.

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

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

We may be required to raise additional capital which could have a dilutive effect on our outstanding equity capital and/or future earnings.

We may be required to raise additional capital as the result of rating agency capital requirements, unanticipated losses in our insured portfolio and/or diminution in our earnings prospects. Any future equity offerings could be dilutive to our existing shareholders or could result in the issuance of securities that have rights, preferences and privileges that are senior to those of our other securities. We may also engage in additional reinsurance or risk transfer transactions such as the one we completed with Assured Guaranty Re Limited in December 2007. Further, any capital raising in the form of reinsurance, or other risk transfer transactions of the existing portfolio, will have a dilutive effect on our future earnings. There can be no assurance that we will be able to consummate any capital raising transactions, or as to the terms of any of the currently proposed transactions.

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

Our subsidiary, Ambac Assurance, is a Wisconsin corporation and is subject to the insurance and regulatory laws of the State of Wisconsin. Under Wisconsin insurance holding company laws, there is a presumption that a holder of 10% or more of our voting stock controls Ambac Assurance and any such acquisition of control requires the prior approval of the Office of the Commissioner of Insurance of the State of Wisconsin. Section 4.5 of our amended and restated certificate of incorporation provides that no stockholder may cast votes with respect to 10% or more of our voting stock, regardless of the actual number of shares of voting stock beneficially held by the stockholder. In addition, any voting stock held by a stockholder in excess of 10% will not count in the calculation of or toward a quorum at any meeting of stockholders. In order to avoid these restrictions, a stockholder who acquires or owns 10% or more of our voting stock must have such acquisition or ownership previously approved by the Office of the Commissioner of Insurance of the State of Wisconsin or file a disclaimer of “control” approved by such office.

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

Changes in tax laws impacting marginal tax rates and/or the preferred tax treatment of municipal obligations could adversely impact our business.

Tax legislation which imposes a “flat tax” or otherwise changes the tax preference of municipal obligations under current law could adversely affect the market value of municipal obligations. In large part, our investment portfolio is invested in tax-exempt municipal obligations; as such, the value of our investment portfolio could be adversely affected by any such legislation. Additionally, any such changes in tax law could reduce the difference

 

S-17


Table of Contents

between tax-exempt interest rates and taxable rates. This reduction could adversely impact the financial performance of our interest rate swap business, since, in certain interest swap transactions, we have assumed the “basis risk” between tax-exempt and taxable interest rates in that business. See Part I, Item 1, “Business—Derivative Products” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, for further information.

Decline in our market position can adversely affect our business prospects.

Perceptions of the financial strength of Ambac Assurance and its affiliates, as well as perception of the financial strength of financial guarantee insurers generally, affects demand for financial guarantee insurance. Recent actions by the rating agencies with respect to our ratings and the ratings of other financial guarantee insurers; further credit deterioration in our insured portfolio and/or increases to our loss reserves; widening of CDS spreads with respect to Ambac Assurance; adverse publicity concerning us and the financial guarantee industry in general and decline of our stock price can contribute to a perception of impaired financial strength and thus a decline in our market position and trading value of Ambac guaranteed obligations, including guaranteed auction rate and variable rate debt obligations. A sustained decline in trading values could result in early termination of financial guarantee insurance policies in respect of which we are paid on an installment basis, thus reducing premium earned in respect of these transactions. Ambac and the financial guarantee insurance industry generally, have suffered a loss of confidence among issuers and fixed income investors and as such, demand for our products has been adversely affected. A sustained loss of confidence would have a materially adverse effect on earnings.

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

Our investment portfolio has been adversely affected by events and developments in the capital markets, including decreased market liquidity for investment assets; market perception of increased credit risk with respect to the types of securities held in our investment portfolio and corresponding credit spread-widening with respect to our investment assets; and extension of the duration of investment assets. Our investment portfolio may be further adversely affected by these and other events and developments in capital markets, including interest rate movements; downgrades of credit ratings of issuers of investment assets and/or financial guarantee insurers which insure investment assets; and foreign exchange movements which impact investment assets. At December 31, 2007, approximately 33% of our investment portfolio is insured by financial guarantors, including Ambac. Please refer to the table in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Balance Sheet” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, representing the fair value and weighted-average underlying rating, excluding the financial guarantee, of the insured securities at December 31, 2007.

 

S-18


Table of Contents

Based on the previously described rating agency actions by Moody’s, S&P and Fitch which occurred during January 2008, management subsequently identified certain investment securities in the Financial Services investment portfolio to potentially sell in order to satisfy additional collateral posting requirements upon a further ratings downgrade and/or to meet potential liquidity needs. We recorded an impairment charge through income on the portion of those securities which were in an unrealized loss position at December 31, 2007. Please refer to Part II, Item 7—Results of Operations—Financial Services, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for further information. The impairments in value in the remaining investment portfolio are not deemed other-than-temporary, as such the remaining unrealized losses have been recognized in other comprehensive income. The following table summarizes amortized cost and estimated fair value of investments at December 31, 2007:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair Value

2007:

           

Fixed income securities:

           

Municipal obligations

   $ 8,550,895    $ 231,099    $ 18,176    $ 8,763,818

Corporate obligations

     768,277      25,792      10,393      783,676

Foreign obligations

     303,655      13,861      90      317,426

U.S. government obligations

     134,639      3,376      —        138,015

U.S. agency obligations

     619,634      63,239      105      682,768

Mortgage-backed securities

     4,595,122      7,786      353,218      4,249,690

Asset-backed securities

     2,598,529      11,432      43,029      2,566,932

Short-term

     879,039      28      —        879,067

Other

     13,571      839      132      14,278
                           

Total investments

   $ 18,463,361    $ 357,452    $ 425,143    $ 18,395,670
                           

To the extent that we are required to liquidate large blocks of investment assets in order to pay claims under financial guarantee insurance policies to make payments under investment agreements and/or to collateralize our obligations under investment agreements and interest rate swaps, such investment assets would likely be sold at discounted prices which could be less than the December 31, 2007 fair values shown in the above table.

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

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

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

Recently, Ambac, and certain of its present and former officers and directors, have been named in lawsuits that allege violations of the federal securities laws and/or state law. At least four federal securities putative class action suits have been filed. The first of these, captioned Reimer v. Ambac Financial Group, Inc., et al. (filed on or about January 16, 2008 in the United States District Court for the Southern District of New York, case No. 08 CV 411) purports to be brought on behalf of purchasers of Ambac’s common stock from October 19, 2005 to November 26, 2007. The suit alleges, among other things, that the defendants issued materially false and

 

S-19


Table of Contents

misleading statements regarding our business and financial results related to guarantees of CDO and Mortgage Backed Securities (“MBS”) transactions. Three other suits, Babic v. Ambac Financial Group Inc. et al. (filed on or about February 7, 2008 in the United States District Court for the Southern District of New York, case No. 08 CV 1273), Parker v. Ambac Financial Group, Inc. et al (filed on or about February 22, 2008 in the United States District Court for the Southern District of New York, case No. 08 CV 1825) and Minneapolis Firefighters’ Relief Association v. Ambac Financial Group, Inc. et al. (filed on or about February 26, 2008 in the United States District Court for the Southern District of New York, Case No. 08 CV 1918) make substantially the same allegations as the Reimer action. In addition, at least seven shareholder derivative actions have been filed in New York federal court and in Delaware and New York state courts. The first shareholder derivative action, captioned Rubery v. Callen, et al. (filed on or about January 23, 2008 in the United States District Court for the Southern District of New York, case No. 08 CV 854), names as defendants certain present and former officers and directors of Ambac and names Ambac as a nominal defendant. This suit asserts violation of state and federal law, including breaches of fiduciary duties, waste of corporate assets, unjust enrichment and violations of the federal securities laws, for conduct occurring between October 2005 and the present regarding, among other things, our guarantees of CDO and MBS transactions and defendants’ alleged insider trading on non-public information. Ambac has also received various regulatory inquiries and requests for information. For example, recently we received a subpoena duces tecum and interrogatories from the Securities Division of the Office of the Secretary of the Commonwealth of Massachusetts, dated January 18, 2008, that seeks certain information and documents concerning “Massachusetts Public Issuer Bonds.” See Item 3, “Legal Proceedings” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement, for additional information.

It is not possible to predict whether additional suits will be filed or whether additional inquiries or requests for information will be made, and it is also not possible to predict the outcome of litigation, inquiries or requests for information. It is possible that there could be unfavorable outcomes in these or other proceedings. Management is unable to make a meaningful estimate of the amount or range of loss that could result from unfavorable outcomes but, under some circumstances, adverse results in legal proceedings could be material to our company’s business, operations, financial position, profitability or cash flows.

We likely will experience an ownership change under Section 382 of the Internal Revenue Code.

In connection with the Common Stock Offering, the Equity Units Offering and/or other transactions in our shares from time to time, we likely will experience an “ownership change” within the meaning of Section 382 of the Internal Revenue Code. In general terms, an ownership change would result from transactions increasing the aggregate ownership of certain stockholders in our stock by more than 50 percentage points over a testing period (generally three years). If an ownership change were to occur, our ability to use certain tax attributes, including certain built-in losses, credits, deductions or tax basis and/or our ability to continue to reflect the associated tax benefits as assets on our balance sheet, may be limited. We have concluded that these limitations are unlikely to have any material tax or accounting consequences. However, this conclusion is based on a variety of assumptions, including our estimates regarding the amounts and timing of certain deductions and future earnings, any of which could be incorrect. Accordingly, there can be no assurance that these limitations would not have an adverse effect on our results of operations or that such adverse effects would not be material.

Failure of our shareholders to approve the issuance of common stock underlying the purchase contracts that form a part of the Equity Units within 120 days from the issuance of the Equity Units could materially adversely affect the value of your investment in the Company.

At the completion of the offering of the Equity Units, the Company may not have a sufficient number of shares of authorized and unissued common stock to settle all purchase contracts in full. Until such time as the Company has a sufficient number of authorized and unissued shares of common stock on reserve for settlement of all outstanding Equity Units in all circumstances, the holder of an Equity Unit will receive shares of Series A Preferred Stock of the Company upon settlement of a purchase contract in lieu of common stock.

 

S-20


Table of Contents

In the event that the Company does not have a sufficient number of authorized and unissued shares of common stock on reserve, then, beginning 120 days after issuance of the Equity Units until such time as the Company has such sufficient number of authorized and unissued shares of common stock, a quarterly contract adjustment fee that holders of purchase contracts receive will increase from       % to       % and holders of shares of our Series A Preferred Stock (if any such shares are outstanding) will be paid a cash dividend per quarter equal to $             (which is equal to 2.5% (or 10% on an annualized basis) multiplied by the closing sale price of our common stock on the date of this prospectus supplement multiplied by 100. Because the contract adjustment payment and/or dividend on our Series A Preferred Stock are payable in cash, your investment could be materially decreased as a result of each payment and/or dividend so long as the Company does not have a sufficient number of authorized and unissued shares of common stock on reserve.

See “Equity Units Offering” for a description of the terms of the Equity Units.

Investors may become “controllers” of Ambac Financial Group, Inc. for the purposes of UK law and may require prior approval of UK’s Financial Services Authority

As a result of Ambac Financial Group, Inc. being the holding company of Ambac Assurance UK Limited and Ambac Credit Products Limited the prior consent of the UK’s Financial Services Authority (FSA) will be required for any individual, group or institution who proposes to take a step that would result in his becoming Controller of or increasing his kind of control over Ambac Assurance UK Limited and Ambac Credit Products Limited.

Broadly, in respect of the FSA’s consent, where an individual person or body corporate, inter alia:

 

  (a)   holds 10 per cent. or more of the shares in a parent undertaking (“P”) of a company undertaking a regulated activity (“A”); or

 

  (b)   is able to exercise significant influence over the management of P through his shareholding in P; or

 

  (c)   is able to exercise significant influence over the management of P through his voting power in P; or

 

  (d)   is entitled to exercise or control the exercise of 10 per cent. or more of the voting power in P, then such person will be a Controller of A, in this case A being Ambac Assurance UK Limited and Ambac Credit Products Limited. Any proposed changes in either existing Controllers or the appointment of new Controllers must first be approved by the FSA.

Any such acquisition which occurs without first obtaining this consent could lead to criminal sanctions.

Section 189 of the Financial Services and Markets Act 2000 confers powers on the FSA to impose one or more of the following restrictions on a proposed Controller if such approval is not given:

 

  (a)   the transfer of existing shares or the right to be issued new or further shares is void;

 

  (b)   no further voting rights are exercisable in respect of the shares acquired without approval; no further shares are to be issued in respect of the shares accepted without approval; and

 

  (c)   except in a liquidation, no payment is to be made of any sum due from the body corporate on the shares acquired, whether in respect of capital or otherwise.

The court also has the power to make such order relating to the sale or transfer of the shares as it thinks fit on the application of the FSA.

A person who is already an approved controller by virtue of holding 10 per cent. or more of the shares in the Company or being entitled to exercise or control the exercise of 10 per cent. or more of the voting power in the Company will nevertheless require the prior approval of the FSA if it wishes to increase its level of control beyond certain specified percentages. These are 20 per cent., 33 per cent. and 50 per cent.

 

S-21


Table of Contents

 

Among the bonds we insure are those issued by sovereign and sub-sovereign entities, and we include statistics concerning those bonds in our Annual Report on Form 10-K for the year ended December 31, 2007, which is attached to this prospectus supplement. We note that we include in the “Sovereign/Sub Sovereign” category bonds not backed by the full faith and credit of a sovereign or sub-sovereign entity, which bonds are generally in the nature of privatizations of essential infrastructure by sovereigns and sub-sovereigns.

 


Table of Contents

USE OF PROCEEDS

We expect to receive net proceeds from this offering, after deducting underwriting discounts and commissions and other offering expenses payable by us, of approximately $            . We intend to contribute the net proceeds from this offering, as well as the approximately $              of net proceeds (after deducting underwriting discounts and commissions and other offering expenses payable by us) from our concurrent offering of Equity Units, to Ambac Assurance in order to increase its capital position, less approximately $100 million, which we intend to retain at Ambac Financial Group, Inc. to provide incremental holding company liquidity to pay principal and interest on its indebtedness, to pay its operating and other expenses and to pay dividends on its capital stock.

 

S-22


Table of Contents

CAPITALIZATION

The following table sets forth our cash and cash equivalents capitalization as of December 31, 2007. Each is presented:

 

   

on an actual basis; and

 

   

as adjusted to reflect the sale of             shares in this offering and the sale of             Equity Units in a concurrent offering and our application of the proceeds of both offerings. See “Use of Proceeds.”

You should read the information in this table together with our consolidated financial statements and the related notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement.

 

     At December 31, 2007
     Actual    As Adjusted
    

(unaudited)

(in thousands)

Cash and Cash Equivalents

   $ 123,933    $  
             

Long-term debt:

     

9 3/8% Debentures due 2011

     142,347      142,347

7 1/2% Debentures due 2023

     74,682      74,682

5.95% Debentures due 2103

     200,000      200,000

5.875% Debentures due 2103

     175,000      175,000

5.95% Debentures due 2035

     399,844      399,844

% Senior Notes due 2021(1)

     —     
             

Total senior long-term debt

     991,873   

Directly-Issued Subordinated Capital Securities due 2037

     397,421      397,421
             

Total long-term debt(2)

     1,389,294   
             

Stockholders’ equity

     2,279,893   
             

Total capitalization

   $ 3,669,187    $  
             

 

(1)   The     % Senior Notes due 2021 are a component of the Equity Units being concurrently offered pursuant to a separate prospectus supplement. See “Equity Units Offering” for a discussion of the terms of the offering of the Equity Units. As adjusted amount will be $             million if the underwriters exercise their over-allotment option in full.
(2)   Total long-term debt does not include $280,651 of variable interest entity notes, which are required to be consolidated pursuant to FIN 46.

 

S-23


Table of Contents

EQUITY UNITS OFFERING

By means of a separate prospectus supplement, we are concurrently offering up to             Equity Units. The underwriters of that offering have an option to purchase a maximum of              additional Equity Units from us to cover over-allotments. Each Equity Unit will have a stated amount of $50 and will consist of a purchase contract and a 1/20, or 5%, undivided beneficial ownership interest in a $1,000 principal amount senior note initially due February 15, 2021. The purchase contract obligates the holder of an Equity Unit to purchase, and obligates us to sell, on May 17, 2011, a number of newly issued shares of our common stock or, in the circumstances described below, shares of our Series A Participating Preferred Stock, which we refer to as Series A Preferred Stock. Under certain circumstances, each holder may elect to settle a purchase contract prior to May 17, 2011.

Each holder of an Equity Unit will be entitled to receive quarterly cash distributions consisting of interest payments at the rate of         % per annum on the holder’s undivided beneficial ownership interest in the senior notes, and quarterly contract adjustment payments payable by us at the rate of         % per annum on the stated amount of $50 per Equity Unit until the earliest of May 17, 2011, the termination of the purchase contracts, an early settlement, including upon cash merger of the Company, (in each case as described in the prospectus supplement in the concurrent Equity Units Offering) and the most recent quarterly payment date on or before any other early settlement of the related purchase contracts.

Attempts will be made to remarket the senior notes beginning on February 4, 2011. To facilitate such remarketing, a remarketing agent, in consultation with the Company, may elect to modify the interest rate on the senior notes. In connection with any remarketing, we, in consultation with the remarketing agent, may elect to modify the maturity date or redemption provisions of the senior notes. If the senior notes are successfully remarketed, the proceeds from such remarketing will be invested in a portfolio of U.S. Treasury securities and ultimately applied to satisfy the holders’ obligations under the purchase contracts unless any holders elect to settle the purchase contract with cash.

At the completion of the offering of Equity Units, the Company may not have a sufficient number of shares of authorized and unissued common stock to settle all purchase contracts in full. The Company has agreed to use commercially reasonable efforts to have a sufficient number of authorized and unissued shares of common stock in reserve and registered in a registration statement under the Securities Act for the settlement in all circumstances of all outstanding purchase contracts and the automatic conversion, as described below, of all outstanding shares of our Series A Preferred Stock into shares of common stock (we refer to this as the “Authorized Share Condition”).

Until such time as the Company has satisfied the Authorized Share Condition, the holder of an Equity Unit will receive upon settlement of a purchase contract, in lieu of the number of shares of common stock that the holder would otherwise receive, a number of shares of our mandatory convertible Series A Preferred Stock equal to the number of shares of common stock that would otherwise be received multiplied by 1/100. If the Company has not satisfied the Authorized Share Condition within 120 days after the date of the issuance of the Equity Units, holders of outstanding shares of Series A Preferred Stock, in addition to the dividends payable on our common stock, will be paid a cash dividend per quarter equal to $            (which is equal to 2.5% (or 10% on an annualized basis) multiplied by the price at which we offered our common stock in the Common Stock Offering multiplied by 100.

Dividends on the Series A Preferred Stock are cumulative and will be payable when, as and if declared by our board of directors.

In addition, if the Authorized Share Condition has not been satisfied by the 120th day following the issuance of the Equity Units, the contract adjustment payments will increase from         % per annum to         % per annum on the stated amount of $50 per Corporate Unit from such date to, but excluding, the date on which the Authorized Share Condition is satisfied, at which time such contract adjustment payments shall return to         % per annum.

 

S-24


Table of Contents

Once the Company has satisfied the Authorized Share Condition, all issued and outstanding shares of our Series A Preferred Stock shall automatically convert into shares of common stock in accordance with the terms of our Series A Preferred Stock and all accrued and unpaid dividends shall be paid to such holders in connection with such conversion.

We have agreed that at the time of settlement of the purchase contracts, we will use the proceeds therefrom to repay $142.5 million of our debt maturing on August 1, 2011, to the extent that the cash proceeds of such settlement are sufficient for such repayment, and that the remaining proceeds will be used for general corporate purposes including the opportunistic repurchase of outstanding debt. We have agreed that proceeds from the settlement of the purchase contracts will not be used to repurchase common stock.

The Equity Units Offering is contingent upon the completion of the Common Stock Offering, but the Common Stock Offering is not contingent upon the completion of the Equity Units Offering.

 

S-25


Table of Contents

PRICE RANGE OF COMMON STOCK AND DIVIDENDS

Our common stock is listed on the New York Stock Exchange under the symbol “ABK.” The closing price of our common stock on the New York Stock Exchange on March 4, 2008 was $10.72 per share. The table below sets forth, for the quarters indicated, the high and low sales prices per share of our common stock and the amount of cash dividends declared per common share.

 

     High    Low    Dividends

2008:

        

First Quarter (Through March 4, 2008)

   $ 26.79    $ 4.50    $ 0.07

2007:

        

Fourth Quarter

   $ 73.20    $ 20.55    $ 0.210

Third Quarter

   $ 88.41    $ 53.10    $ 0.210

Second Quarter

   $ 96.10    $ 84.02    $ 0.180

First Quarter

   $ 91.83    $ 83.48    $ 0.180

2006:

        

Fourth Quarter

   $ 90.75    $ 81.56    $ 0.180

Third Quarter

   $ 87.50    $ 80.64    $ 0.180

Second Quarter

   $ 85.00    $ 76.79    $ 0.150

First Quarter

   $ 82.00    $ 73.74    $ 0.150

In connection with our efforts to raise capital and maintain triple-A ratings, we have reduced our quarterly dividend payable on our common shares to $0.01 per share.

 

S-26


Table of Contents

DISCUSSION OF CERTAIN PORTFOLIO RISKS

Our insured portfolio is subject to a variety of factors that could adversely affect our business results and prospects. Risk factors that could cause actual results to deviate from expected results in our various business lines include, but are not limited to:

 

   

changes in general economic conditions,

 

   

catastrophic events (natural disasters or terrorist acts),

 

   

downturns in the U.S. housing market or commercial real estate market,

 

   

changes in interest rate level and widening of credit spreads,

 

   

rising energy, fuel and utility costs,

 

   

corporate default rates and correlated loss given default,

 

   

dislocation and lack of liquidity in credit and financial markets, and

 

   

legislative and regulatory developments,

as well as other factors listed under “Forward-Looking Statements” and “Risk Factors.” Different segments of our portfolio, and different business lines within these segments, are affected by differing risk factors and to differing degrees.

Recently, our insured portfolio has been adversely affected by credit deterioration related to residential mortgage markets in the United States that are experiencing financial stress. For the year ended December 31, 2007, Ambac reported a total of $6.0 billion of mark-to-market losses on credit derivative exposures. See “Mark-to-Market Losses and Credit Impairments with respect to Credit Derivatives” below for additional information. Of the $6.0 billion, we estimate credit impairment of approximately $1.1 billion related to certain CDO of ABS and CDO-squared transactions that have recently been internally downgraded to below investment grade. In addition, in 2007, we increased our loss reserves relating to RMBS by $291 million. U.S. GAAP requires us to account for our financial guarantee contracts based on the terms of the contract. Generally, insurance contracts (including, without limitation, the financial guarantee insurance that we execute with respect to our RMBS portfolio) are not marked to market and loss reserves reflect management’s estimate of probable and estimable losses due to credit deterioration of insured credits. Ambac’s estimates of credit impairment and estimates of loss reserves are only established when management has observed significant credit deterioration, in most cases, when the underlying credit is considered below investment grade. We do not record loss reserves for performing credits. Furthermore, the objective of establishing loss reserves and impairment estimates is not to reflect the worst possible outcome. As such, there can be no assurance that the actual loss will not exceed our estimates. See “Third-Party Estimates of Losses and Credit Impairments.” The following discussion provides further information about our calculation of loss reserves, credit impairment estimates and mark-to-market valuations of our credit derivatives and includes a discussion of some of the relevant risk sensitivities. We have also included a discussion of potential increased capital requirements of the rating agencies.

We are subject to credit risk throughout our business. In particular, we are exposed to the risk that issuers whose debt we have insured (or with respect to which we have written credit derivatives) may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure, fraud or other reasons. Increased levels of credit risks could cause:

 

   

increased claims payments and loss reserves,

 

   

mark-to-market losses and credit impairments with respect to credit derivatives in our financial guarantee business, and

 

   

the requirement that we hold additional rating agency capital against insured exposures that have been downgraded by those agencies.

 

S-27


Table of Contents

Increased Claim Payments and Loss Reserves

This discussion of loss reserves for financial guarantee insurance relates only to Ambac’s non-derivative insurance business. U.S. GAAP requires us to establish loss reserves on our financial guaranty insurance policies (including without limitation the financial guaranty insurance that we execute with respect to our RMBS portfolio) only for probable and estimable losses. See “Critical Accounting Policies and Estimates—Financial Guarantee Insurance Losses and Loss Expenses” in our Annual Report on Form 10-K for the year ended December 31, 2007 attached to this prospectus supplement for further detail on case basis and active credit reserves.

The primary assumptions impacting the estimate of loss reserves are the probability of default and severity of loss given a default. When credits are in default or have specific attributes that warrant an adjustment, we typically employ a best judgmental estimate of the loss based upon transaction-specific elements rather than a statistical loss estimate (derived from the product of actuarial estimates of probability of default and loss given default) as we believe we have deal-specific knowledge as to the ultimate outcome of these credits due to our surveillance and remediation activity.

For the active credit reserve component of our total reserves, as the probability of default for an individual credit and/or its estimated loss given a default increases, our total reserve for that insured obligation will also increase. Political, economic, credit or other unforeseen events could have an adverse impact on default probabilities and loss severities. A downgrade by Ambac of the underlying ratings of an adversely classified credit, particularly a credit with a large net par balance, could have a significant impact on our reserves.

For example, we have insured the Las Vegas, NV Monorail project and have established an active credit reserve based on an actuarial estimate of loss. Given the large net par balance for this transaction, downgrades of Ambac’s rating of the underlying credit rating could have a material adverse effect on our reserves. Furthermore, external influences beyond our control may have significant favorable or unfavorable effects on our reserves.

Case basis credit reserves for public finance and other non-collateral dependent transactions are sensitive solely to severity assumptions because the underlying financial obligation has already defaulted (i.e. 100% probability of default). Case basis credit reserves for collateral-dependent transactions (such as mortgage-backed security transactions) are sensitive to both severity assumptions as well as probability of default, as the probability of default will vary based upon the performance of the non-defaulted underlying collateral.

Adjustments to the probability of default or severity assumptions may affect our financial results over various periods. Loss reserve volatility will be correlated with the credit performance of our insured portfolio including the number, size, asset class and quality of credits included on our adversely classified list. The number and severity of adversely classified credits depend to a large extent on transaction-specific attributes, but will generally increase during periods of economic stress and decline during periods of economic stability. Due to the small number of credits and significant size of certain individual adversely classified credits, modest changes in Ambac’s underlying ratings or classifications may have a significant impact on any quarter’s provision for losses and loss expenses.

The table below indicates the number of credits and net par outstanding for case reserves and active credit reserves on non-investment grade credits at December 31, 2007:

 

$ in millions    Number of
credits
   Net par
outstanding
   Net Loss
Reserves(1)

Active credit reserves

   45    $ 6,513    $ 363.4

Case reserves

   13    $ 1,359    $ 109.8
                  

Total

   58    $ 7,872    $ 473.2
                  

 

(1)   Net of reinsurance recoverable on unpaid losses of $11.1 million.

 

S-28


Table of Contents

We have exposure to various bond types issued in the debt capital markets. Our experience has shown that for the majority of bond types, we have not experienced claims and therefore we have had no basis for altering our estimates of loss severity. However, for certain bond types our recent loss experience has caused us to believe that there are factors that may lead to revisions of our original estimates of loss severity. We have observed that, with respect to four bond types in particular, it is possible that a material change in actual loss severities and defaults could occur over time. These four bond types are healthcare institutions, aircraft lease securitizations known as Enhanced Equipment Trust Certificates (to which we do not currently have any exposure in our classified credit portfolio), mortgage backed and home equity securitizations, and CDOs. These four bond types represent 53% of our ever-to-date claim payments.

Generally, severity assumptions are established within our active credit reserve for entire asset classes and therefore represent an average severity of loss given a default. However, it is our experience that ultimate severity outcomes often vary from averages. Therefore, we have not provided reasonably possible negative scenarios for the severity assumption.

Healthcare Institutions and Transportation

The table below presents our estimates of the impact on the December 31, 2007 consolidated loss reserve from increases in the probability of default estimate that would arise from a one full letter downgrade for each credit (including both investment grade and non-investment grade) of the following bond types that were within the adversely classified credit listing as of December 31, 2007.

 

$ in millions

Category

   Net par
outstanding
   Loss
Reserves at
12/31/07
   Increase in
Reserve
Estimate

Health care

   $ 456    $ 30.8    $ 39.6

Transportation

   $ 867    $ 77.0    $ 77.3

Mortgage-Backed and Home Equity Securitizations

The table below presents the number of credits, net par outstanding and total loss reserves for RMBS exposures that were within the adversely classified credit listing as of December 31, 2007:

 

$ in millions    Number of
credits
   Net par
outstanding
   Net Loss
Reserves
 

Second lien

   12    $ 4,164    $ 266  

First lien - subprime

   11      699      10  

Other

   5      22      26 (1)
                    

Totals

   28    $ 4,885    $ 302  
                    

 

(1)   Includes allowance for reinsurance recoverables.

Continued increases in RMBS defaults as a result of fraud, foreclosures, increases in interest rates, unemployment and/or personal bankruptcies could adversely impact the probability of default and severity of loss for our transactions. The loss experience in the RMBS insured portfolio in 2007 occurred predominantly in transactions composed of HELOCs and closed end second mortgage loans that were securitized in 2006 and 2007. The underlying loans in these vintages are experiencing near-record volumes of delinquencies and losses, due to factors such as weak mortgage industry underwriting standards, declining home values, abrupt slowdowns in voluntary prepayments due to a decreased availability of mortgage credit, and potential misrepresentations and/or fraud, among other factors.

Our loss estimates for the portfolio are primarily based upon the assumption that these factors are contributing to significant collateral delinquencies and early payment defaults that will reach peak loss levels

 

S-29


Table of Contents

between months 21 and 29 following transaction close and will then rapidly reduce to substantially lower levels through a period extending to months 50 and 60, after which relatively smaller delinquency and loss rates occur. However, it is possible that our losses in these securities could be substantially higher as a result of continued illiquidity of the mortgage market, continued deterioration in housing prices, and/or the effects of a weakened economy marked by growing unemployment and wage pressures. In other words, we believe that it is possible that the actual loss pattern for these transactions could be more severe and prolonged than we currently assume. If we were instead to assume that delinquency and loss rates peak around the same time as our prior assumption, but that the reduction of these rates occurs over a more prolonged time period extending beyond month 120 and continues at relatively higher rates throughout the life of our portfolio, our net loss reserve would increase from $302 million to approximately $750 million of exposures that were within the adversely classified credit listing as of December 31, 2007.

Collateralized Debt Obligations

The majority of our CDO portfolio (approximately 85% at December 31, 2007) was executed in derivative form and accordingly must be recorded on our balance sheet at fair value. Please refer to “Mark-to-Market Losses with Respect to Credit Derivatives” below for further discussion

Mark-to-Market Losses and Credit Impairments with Respect to Credit Derivatives

RMBS and CDOs which we have underwritten in the form of Credit Default Swaps (CDS) are subject to FAS 133. FAS 133 requires that credit derivative transactions be recorded at fair value, or “mark-to-market,” in the financial statements. The CDS contracts we execute are a modified version of the standard CDS contracts executed by other financial institutions such as investment banks and broker dealers. These modifications include a provision to “pay-as-you-go” which provides that Ambac pays interest shortfalls on the reference obligation as they are incurred on each scheduled payment date, but only pays principal shortfalls upon the earlier of (i) the date on which the assets designated to fund the referenced obligation have been liquidated and (ii) the legal final maturity date of the referenced obligation. In addition, our CDS contracts do not include any ratings based collateral triggers or otherwise require Ambac to post collateral regardless of Ambac’s ratings or the mark-to-market exposure to Ambac.

Quoted market prices represent prices for particular instruments and include credit and market liquidity components. While quoted market prices may be available for the underlying reference securities, quoted market prices for the CDS contracts we execute are not readily observable in the market. Prospective investors should note that we establish “mark-to-market” (i.e., fair value per FAS 133) for our CDS contracts using valuation models that produce estimates that generally vary from the liquidation value of the underlying reference securities using quoted market prices because we do not own the underlying obligation and are not subject to the risks therein. However, as the credit quality of our CDS portfolio deteriorates, our mark-to-market estimates will approach the fair value of the underlying reference obligations; upon default, the financial guarantee CDS price would equal the value of the underlying reference security. If we used the liquidation value of the underlying reference security as the fair value of our CDS contract, the resulting valuation would have a materially adverse affect on our financial statements. For further discussion, see “Critical Accounting Policies and Estimates— Valuation of Financial Instruments” contained in our Annual Report on Form 10-K for the year ended December 31, 2007 attached to this prospectus supplement.

Ambac’s RMBS exposure embedded in CDOs relates primarily to the asset class commonly referred to as CDO of asset backed securities or CDO of ABS. Ambac participated in both the “High-grade CDO of ABS” and the “Mezzanine CDO of ABS” asset classes. Our CDOs of ABS transactions where the underlying securities are RMBS are subject to various risks, including those described under “Risk Factors—We are subject to credit risks related to RMBS and CDOs of ABS.” For further discussion please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2007 attached to this prospectus supplement.

 

S-30


Table of Contents

Fair value of Ambac’s financial guarantee CDS transactions represents the net present value of the difference between the fees Ambac originally charged for the credit protection and our estimate of the fees that a comparable financial guarantor may charge for the same protections at the balance sheet date. Key variables used in our valuation of credit derivatives on CDOs include the balance of unpaid notional amounts, expected term, fair values of the underlying reference obligations, reference obligation credit ratings, assumptions about current financial guarantee CDS fee levels relative to reference obligation spreads and other factors. Due to the significance of unobservable inputs required in valuing our financial guarantee CDS contracts, they are considered to be Level 3 under FAS 157 fair value hierarchy. See Note 17 in our 2007 audited financial statements in the attached Annual Report on Form 10-K for the year ended December 31, 2007. Notional balances, expected remaining term and reference obligation credit ratings are monitored and determined by Ambac’s surveillance group. Fair values of the underlying reference obligations are obtained from broker quotes when available, or are derived from other market indications such as new issuance spreads and quoted values for similar transactions. Ambac’s CDS fair value calculations are adjusted for increases in expected loss on the reference obligations and observable changes in financial guarantee market pricing. If no adjustment is considered necessary Ambac maintains the same percentage of the spread demanded in the market for the reference obligation as existed at the inception of the CDS. Therefore, absent changes in expected loss on the reference obligations or financial guarantee CDS market pricing, the financial guarantee CDS fees used for a particular contract in Ambac’s fair value calculations represent a consistent percentage, period to period, of the spread (over LIBOR) determinable from the reference obligation value at the balance sheet date. This results in a CDS fair value balance that fluctuates in proportion with the reference obligation value.

The following table summarizes the net par exposure outstanding and net derivative asset (liability) balance related to credit derivatives and total return swaps as of December 31, 2007 by asset type ($ in millions):

 

     CDO of
ABS
    CDO of
CDO
    CLO     Other(2)     Total  

Net par outstanding(1)

   $ 26,675     $ 2,472     $ 20,818     $ 16,284     $ 66,249  

Net asset (liability) fair value

     (3,778 )     (1,871 )     (222 )     (147 )     (6,018 )

 

(1)   Par amounts do not include outstanding commitments to provide guarantees. Certain financial guarantee commitments relate to potential increases in funding levels for existing credit derivative exposures or otherwise require fair value accounting. The amount of such outstanding commitments was $4,749 million at December 31, 2007.
(2)   Includes total return swaps with a total notional value of $535 million as of December 31, 2007.

The following table summarizes the estimated change in fair values on the net balance of Ambac’s net structured credit derivative and total return swap positions assuming immediate parallel shifts in spreads at December 31, 2007 ($ in millions):

 

     Estimated Unrealized Gain / (Loss)        

Change in Underlying Spreads

   CDO of
ABS
    CDO of
CDO
    CLO     Other(1)     Total     Total
Estimated
Unrealized
Gain/
(Loss)
 

500 basis point widening

   $ (2,490 )   $ (510 )   $ (1,686 )   $ (1,324 )   $ (6,010 )   $ (12,028 )

250 basis point widening

     (1,246 )     (255 )     (843 )     (663 )     (3,007 )     (9,025 )

50 basis point widening

     (249 )     (51 )     (168 )     (132 )     (600 )     (6,618 )

Base scenario

     —         —         —         —         —         (6,018 )

50 basis point narrowing

     245       51       169       106       571       (5,447 )

250 basis point narrowing

     1,197       255       291       191       1,934       (4,084 )

500 basis point narrowing

     2,345       510       294       193       3,342       (2,675 )

 

(1)   Includes total return swaps.

 

S-31


Table of Contents

When reference obligations experience credit deterioration, there is an increase in the probability of default on the obligation and therefore an increase in expected loss. The effects of credit deterioration on financial guarantee CDS fees are not readily observable in the market. Ambac reflects the effects of changes in expected loss on the fair value of its CDS contracts by increasing the percentage of the reference obligation spread which would be captured as a CDS fee at the valuation date, resulting in a higher mark-to-market loss on our CDS relative to any price decline on the reference obligation. The fundamental assumption is that financial guarantee CDS fees will increase relative to reference obligation spreads as the underlying credit quality of the reference obligation deteriorates and approaches payment default. Upon default (“D” rating), the financial guarantee CDS fee would reflect 100% of the reference obligation spread. In 2007, such adjustments were made on CDO of ABS transactions containing over 25% MBS exposure which have suffered credit downgrades. For Ambac’s four CDO of ABS transactions that are rated below investment grade (three CDO squareds and one CDO of Mezzanine ABS), the average spread capture percentage is approximately 89%. Other asset types within the CDS portfolio have not experienced significant downgrades as of December 31, 2007.

The following table summarizes the estimated impact of immediate changes in Ambac’s internal credit rating on the fair value of Ambac’s credit derivative liability balance related to CDO of ABS transactions with >25% RMBS. These scenarios assume that all other variables included in the determination of fair value of these credit derivatives at December 31, 2007 remain unchanged.

 

($ in millions):

Change in Ambac Internal Credit Rating

   Estimated
Unrealized
Gain /
(Loss)
    Estimated Net
Fair Value
 

Four letter upgrade

   $ 487     ($ 5,162 )

Three letter upgrade

     471       (5,178 )

Two letter upgrade

     370       (5,279 )

One letter upgrade

     230       (5,419 )

Base scenario

     —         (5,649 )

One letter downgrade

     (335 )     (5,984 )

Two letter downgrade

     (978 )     (6,627 )

Three letter downgrade

     (2,002 )     (7,651 )

Four letter downgrade

     (3,255 )     (8,904 )

RMBS and (inner) CDO rating downgrades impact ABS CDOs negatively in two distinct ways. First, rating declines in ABS CDO collateral (i.e., RMBS and CDOs) imply direct increases in the default probabilities of that collateral and, therefore, increased expected losses of each CDO tranche. Second, as they relate to the CDO within Ambac’s high-grade ABS CDOs, ratings declines in ABS CDO collateral can trigger structural mechanisms that alter tranche cash flows in a manner wholly independent of the ultimate credit performance of that collateral. Generally these mechanisms protect the senior-most CDO tranches in the event of ratings downgrades at the expense of the more junior tranches.

Requirement by rating agencies to hold additional capital

Changes in the ratings of the credit risks in our insured portfolio could require us to hold more capital against these credit risks. In particular, ratings downgrades by a rating agency on our insured portfolio increase the amount of capital necessary to satisfy such rating agency’s capital requirements, the amount of which varies by bond type and the extent of the downgrade. For example, Ambac estimates that the capital required to support its ABS portfolio using Moody’s portfolio risk model would increase by 59% in the event the entire ABS portfolio were downgraded one notch, 99% if downgraded two notches or 153% if downgraded three notches.

 

S-32


Table of Contents

Rating Agency Perspective on Stress Testing Ambac’s Capital Adequacy

To provide prospective investors with additional perspective concerning potential losses and risks and uncertainties of certain portions of our financial guarantee business, set forth below is an excerpt from a report published by Standard & Poor’s (“S&P”) and dated February 25, 2008. Investors should be aware that this report may not reflect the current views of S&P. Investors should consult announcements by the rating agencies and the websites of the rating agencies for current publicly available information. See “Recent Developments—Rating Agencies” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement. This excerpt is reprinted here with the permission of S&P; however, prospective investors should be aware that its report was prepared independently by S&P, and Ambac and the underwriters assume no responsibility for its contents or conclusions. The losses estimated in this report are credit loss estimates and do not represent mark-to-market values. Prospective investors should also be aware that if some of the stress scenarios described below were to occur, there is no assurance that we would maintain our triple-A financial strength ratings from S&P, or from Moody’s; we can also provide no assurance regarding what level our financial strength would be if a downgrade were to occur. S&P’s results are not promulgated under U.S. GAAP and accordingly should not be compared to our financial statements with regard to the market on credit derivatives or loss reserves for non-derivative insurance financial guarantees.

S&P tested the capital adequacy of Ambac against a scenario that applies stressful default assumptions to various RMBS-related transactions that Ambac has insured. (For a full report of this analysis, refer to “Detailed Results of Subprime Stress Test of Financial Guarantors” published on February 25, 2008.) The insured direct RMBS transactions (direct RMBS) and tranches of uninsured RMBS transactions (tranched RMBS) are components of the collateral backing insured CDOs. S&P based the default rates for these transactions on stressful cumulative net loss assumptions that varied by asset type and vintage and included the Alt-A, subprime, closed-end second, home equity line of credit (HELOC), and net interest margin (NIM) asset types with 2005, 2006, and 2007 vintages in this analysis. Table 1 shows the cumulative net loss assumptions for each of the asset classes by vintage.

To stress the direct RMBS component of Ambac’s total exposure, S&P developed rating-sensitive loss assumptions for individual insured transactions in each asset class. S&P also converted the various asset-type loss assumptions to probability distributions of outcomes using their internal data of projected losses for individual transactions. Each of the theoretic outcomes was compared with typical credit enhancement levels for such transactions to determine if the transactions defaulted or not, and if so, what the losses would be. Factoring in the probability of each possible outcome produced an analysis that defined the expected losses at each rating level for transactions in the various asset classes and vintages. Table 2 shows the results of this analysis.

S&P computed the expected loss on each transaction based on the original par value and original rating of the transaction. Next, S&P adjusted the accumulated results to reflect the reality that Ambac’s underwriting and risk remediation processes result in better overall loss rates. S&P effected this adjustment by reducing expected losses by a modest amount. Finally, S&P converted the calculated results to a present value by discounting the losses at 5% per year over a five-year period, assuming an equal payout in each period and adjusting for taxes. Table 6 shows the results of this analysis.

For CDOs, S&P computed rating-sensitive tranche loss assumptions using the same methodology described for computing rating-sensitive loss assumptions on direct RMBS transactions. To reflect the comparatively poorer performance of CDOs versus RMBS transactions, S&P increased the loss assumptions in table 1 (except for the 2006 and 2007 Alt-A asset classes discussed above) by 10%. (Table 3 shows the results of this analysis.) For each insured CDO, S&P computed incremental collateral pool losses on all the asset types with 2005-2007 vintages based on the same methodology as described for computing losses on RMBS transactions. In this case, however, there was no adjustment for better underwriting and the present value methodology was changed to reflect different payment patterns. S&P removed the better underwriting adjustment since the collateral of the wrapped CDOs is not insured, and per S&P, does not benefit from Ambac’s underwriting and risk remediation expertise. S&P changed the period for the present value adjustment to 10 years, reflecting the structural features of the CDOs, which often require interest only until the final maturity.

 

S-33


Table of Contents

For the portion of the CDO collateral that was made up of tranches of other ABS CDOs, S&P determined incremental loss assumptions based on the typical asset composition of such CDOs. S&P added additional capital charges to ABS CDOs that are likely to be subject to the negative effects of event-of-default triggers. (Table 4 shows these loss assumptions.) S&P handled possible losses on CDO squared transactions on a case-by-case basis. Incremental losses were then aggregated to determine the collateral pool impairment.

S&P then compared the collateral impairment to the subordination supporting the tranche that the bond insurer had insured. In the vast majority of cases, Ambac has insured a “super senior” tranche, meaning that the subordination supporting Ambac’s insured tranches is a least 1.3x the level required to achieve a ‘AAA’ rating. The “subordination impairment ratio” (the ratio of collateral impairment divided by available subordination) shows how much of the available subordination would be lost to theoretic incremental losses.

Subordination impairment ratios above 1.0 signify that theoretic incremental losses would exceed the available subordination. Ratios below 1.0 signify that theoretic incremental losses would be less than the available subordination in the CDO. In this case, Ambac would not incur a loss. Four categories of CDO impairment ratios under 1.0 were defined and incremental capital charges were assigned. (See table 5 for the incremental capital charges assigned and table 7 for the results of this analysis.) The theoretic capital charges varied depending on whether the CDO was “high grade” or “mezzanine.” A high-grade CDO has collateral originally rated in the ‘A’, ‘AA’, or ‘AAA’ rating categories. A mezzanine CDO has collateral originally rated largely in the ‘BBB’ category.

Table 1

S&P Asset Class Cumulative Net Loss Assumptions (%)

 

Vintage

   Alt-A    Subprime    Closed-end
second
   HELOC    NIM

2005

   2.75    8.50    17.25    10.35    8.50

2006

   5.50    18.80    40.00    15.75    18.80

2007

   9.00    17.40    40.00    13.00    17.40

Table 2

S&P Direct RMBS Transaction Loss Assumptions (%)

 

Vintage/ Original Rating

   Alt-A    Subprime    Closed-end
second
   HELOC    NIM

2005

              

AAA

   0.00    0.00    0.06    0.04    0.00

AA

   0.05    0.13    1.49    1.13    0.13

A

   0.38    0.80    3.75    2.98    0.80

BBB

   0.96    2.19    6.58    5.03    2.19

BB and lower

   N/A    N/A    N/A    N/A    20.00

2006

              

AAA

   0.03    0.59    17.40    0.69    0.59

AA

   1.24    5.34    26.12    4.78    5.34

A

   2.47    8.86    29.91    7.91    8.86

BBB

   3.41    11.66    32.82    10.40    11.66

BB and lower

   N/A    N/A    N/A    N/A    20.00

2007

              

AAA

   1.78    0.08    16.18    0.36    0.08

AA

   4.80    2.45    24.95    3.34    2.45

A

   6.10    5.45    28.91    5.92    5.45

BBB

   7.01    8.56    32.05    8.07    8.56

BB and lower

   N/A    N/A    N/A    N/A    20.00

N/A-not applicable.

 

S-34


Table of Contents

Table 3

S&P Tranched RMBS Tranche Loss Assumptions (%)

 

Vintage/Original Rating

   Alt-A    Subprime    Closed-end
second
   HELOC

2005

           

AAA

   0.00    0.00    0.23    0.13

AA

   3.03    2.50    15.29    18.29

A

   31.60    22.22    45.47    57.71

BBB

   66.23    45.86    64.99    74.49

BB and lower

   90.51    60.34    75.00    76.10

2006

           

AAA

   0.03    1.38    22.58    1.38

AA

   29.41    50.22    86.11    56.32

A

   77.53    82.25    96.01    86.24

BBB

   90.91    88.70    96.57    93.91

BB and lower

   96.64    92.19    97.41    96.86

2007

           

AAA

   1.78    0.25    21.47    0.85

AA

   79.42    27.82    84.86    49.55

A

   94.08    68.09    94.49    84.35

BBB

   96.76    79.70    95.91    92.43

BB and lower

   98.52    85.72    96.92    96.34

NIM transactions were not tranched.

Table 4

S&P ABS CDO Collateral Loss Assumptions (%)

 

Wrapped CDO

Type/Year of

Origination

  

No event-of-default risk

  

Event-of-default risk

High-grade CDO

     

2005

   30.25    40.25

2006

   59.40    69.40

2007

   56.10    66.10

Mezzanine CDO

     

2005

   72.60    77.60

2006

   82.50    87.50

2007

   89.10    94.10

These loss assumptions apply to ABS CDO collateral within wrapped CDOs.

 

S-35


Table of Contents

Table 5

S&P Incremental Losses/Capital Charges on CDOs (%)

 

Impairment ratio

 

High-grade CDOs

 

Mezzanine CDOs

> 1.00

  Greater of calculated loss or 10.0   Greater of calculated loss or 20.0

> 0.75 < 1.00

  4.0   13.6

> 0.50 < 0.75

  2.2   7.0

> 0.25 < 0.50

  0.6   2.0

> 0.00 < 0.25

  0.4   1.4

Capital charges applied to notional value of insured CDOs.

Table 6

S&P RMBS Exposure Information and Stress Test Results

 

     (Mil. $)

Original net par written

  

CES

   15,017.5

HELOCs

   34,521.9

NIMs

   346.1

Alt-A

   15,076.8

Subprime

   48,754.7

Total

   113,717.1

Current par outstanding at Sept. 30, 2007

  

CES

   5,653.6

HELOCs

   12,483.3

NIMs

   27.5

Alt-A

   7,789.5

Subprime

   8,774.1

Total

   34,728.0

Vintage based on original par written

  

2004 and prior

   66.9

2005

   11.3

2006

   12.3

2007

   9.5

Rating distribution based on original par written

  

AAA

   10.2

AA

   5.2

A

   37.8

BBB

   46.7

BB and lower

   0.2

Total projected losses by asset class

  

CES

   1,580.4

HELOCs

   1,013.2

NIMs

   7.0

Alt-A

   67.9

Subprime

   215.7

Total

   2,884.2

Present value of losses

   2,497.5

After-tax net RMBS losses

   1,623.4

 

N/A-not   applicable.

 

S-36


Table of Contents

Table 7

 

S&P CDO Exposure Information And Stress Test Results

     (Mil. $)

CDO net par insured with RMBS exposure as of Sept. 30, 2007

  

High-grade CDOs

   28,683.9

Mezzanine CDOs

   510.0

Secondary market

   N/A

Total

   29,193.9

CDO net par by impairment ratio

  

Impairment ratios > 1.0

   19,159.3

Impairment ratios > 0.75 < 1.0

   1,933.0

Impairment ratios > 0.50 < 0.75

   2,792.3

Impairment ratios > 0.25 < 0.50

   5,309.3

Impairment ratios > 0.0 < 0.25

   0.0

Secondary market

   N/A

Total

   29,193.9

Theoretic loss and incremental capital charges

  

Impairment ratios > 1.0

   4,434.6

Impairment ratios > 0.75 < 1.0

   77.3

Impairment ratios > 0.50 < 0.75

   61.4

Impairment ratios > 0.25 < 0.50

   31.9

Impairment ratios > 0.0 < 0.25

   0.0

Secondary market

   N/A

Total

   4,605.2

Present value of losses

   3,684.2

After-tax net CDO losses

   2,394.7

Third-Party Estimates of Losses and Credit Impairments

Various third-party securities analysts and other market participants have made estimates of our loss and credit impairment amounts under various scenarios. In light of various factors, including, without limitation, the volatility in the capital markets, the limited liquidity for certain classes of securities and the various assumptions about the future that are inherent in making such estimates, including estimates regarding the performance of RMBS and the housing market more generally, these third-party estimates vary widely. We have been informed by certain of the underwriters in this offering and the concurrent Equity Units Offering that their estimates of our losses and mark-to market-losses, which include estimates of our credit impairment, materially exceed the corresponding amounts shown in the stress cases of S&P discussed below in “Discussion of Certain Portfolio Risks—Rating Agency Perspective on Stress Testing Ambac’s Capital Adequacy,” and, in some cases, materially exceed the sum of the mark-to-market losses we have reported plus the amount of our loss reserve estimates. In the event that our ultimate losses and credit impairments approach some of these third-party estimates, such losses and credit impairments would have a materially adverse effect on our performance and financial position. In addition, we can provide no assurance that we would be able to maintain our triple-A ratings from Moody’s and S&P or our double-A from Fitch if our losses and credit impairments approached or exceeded these third-party estimates, even if such actual losses and credit impairments were less than the stress losses currently modeled by those rating agencies; we can also provide no assurance regarding at what level our financial strength would be if such a downgrade were to occur.

 

S-37


Table of Contents

CERTAIN UNITED STATES FEDERAL INCOME TAX CONSEQUENCES TO NON-U.S. HOLDERS

The following discussion summarizes certain United States federal income tax consequences relevant to the acquisition, ownership and disposition of our common stock, and does not purport to be a complete analysis of all potential tax consequences. This discussion applies only to Non-U.S. Holders (as defined below) of our common stock. The discussion is based upon the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), existing and proposed United States Treasury regulations promulgated thereunder and administrative and judicial interpretations thereof, all as of the date hereof, all of which are subject to change, possibly with retroactive effect. This discussion is limited to investors that hold our common stock as capital assets within the meaning of Section 1221 of the Code (generally, property held for investment). Furthermore, this discussion does not address all aspects of United States federal income taxation that may be applicable to investors in light of their particular circumstances, or to investors subject to special treatment under United States federal income tax law, such as financial institutions, insurance companies, tax-exempt organizations, holders who acquire our common stock pursuant to the exercise of employee stock options or otherwise as compensation, holders liable for the alternative minimum tax, entities or arrangements that are treated as partnerships for United States federal income tax purposes, dealers in securities or currencies, traders in securities that elect mark-to-market treatment, common trust funds, U.S. expatriates, persons deemed to sell our common stock under the constructive sale provisions of the Code and persons that hold our common stock as part of a straddle, hedge, conversion transaction or other integrated investment. Furthermore, this discussion does not address United States federal tax laws other than those pertaining to the United States federal income and withholding tax, nor does it address any aspects of United States federal estate or gift tax consequences or any state, local or foreign tax consequences. Each prospective investor is advised to consult a tax advisor regarding the United States federal, state, local or foreign income, estate or other tax consequences of the acquisition, ownership and disposition of our common stock.

For the purpose of this summary, the term “Non-U.S. Holder” means a beneficial owner of our common stock that is not, for United States federal income tax purposes, (i) an individual who is a citizen or resident of the United States, (ii) a corporation or other entity subject to tax as a corporation for such purposes that is created or organized under the laws of the United States, any state thereof or the District of Columbia, (iii) an estate the income of which is subject to United States federal income taxation regardless of its source, or (iv) a trust (A) if a court within the United States is able to exercise primary supervision over its administration and one or more U.S. persons have the authority to control all of its substantial decisions or (B) that has made a valid election to be treated as a U.S. person for such purposes.

If a partnership (including any entity or arrangement treated as a partnership for United States federal income tax purposes) owns our common stock, the tax treatment of a person treated as a partner in the partnership generally will depend upon the status of the partner and the activities of the partnership. Persons that for United Stated federal income tax purposes are treated as a partner in a partnership that owns our common stock should consult their tax advisors as to the particular United States federal income, estate and other tax consequences applicable to them.

THIS SUMMARY IS FOR GENERAL INFORMATION ONLY AND IS NOT INTENDED TO CONSTITUTE A COMPLETE DESCRIPTION OF ALL TAX CONSEQUENCES RELATING TO THE OWNERSHIP AND DISPOSITION OF OUR COMMON STOCK. HOLDERS OF OUR COMMON STOCK SHOULD CONSULT WITH THEIR TAX ADVISORS REGARDING THE TAX CONSEQUENCES TO THEM (INCLUDING THE APPLICATION AND EFFECT OF ANY STATE, LOCAL, FOREIGN INCOME AND OTHER TAX LAWS) OF THE OWNERSHIP AND DISPOSITION OF OUR COMMON STOCK

Dividends

Dividends paid to a Non-U.S. Holder generally will be subject to withholding of United States federal income tax at a 30% rate (or such lower rate as may be specified by an applicable income tax treaty) unless the

 

S-38


Table of Contents

dividends are effectively connected with a trade or business carried on by the Non-U.S. Holder within the United States and, if required by an applicable income tax treaty, are attributable to a permanent establishment of the Non-U.S. Holder within the United States. Non-U.S. Holders should consult their tax advisors regarding their entitlement to benefits under an applicable income tax treaty and the manner of claiming the benefits of such treaty. A Non-U.S. Holder that is eligible for a reduced rate of withholding tax under an income tax treaty may obtain a refund or credit of any excess amounts withheld by filing an appropriate claim for refund with the Internal Revenue Service.

Dividends that are effectively connected with a Non-U.S. Holder’s conduct of a trade or business in the United States and, if required by an applicable income tax treaty, that are attributable to a Non-U.S. Holder’s permanent establishment in the United States, generally are not subject to the withholding tax described above but instead are subject to United States federal income tax on a net income basis at applicable graduated United States federal income tax rates. A Non-U.S. Holder must satisfy certain certification requirements, including the furnishing of an Internal Revenue Service Form W-8ECI (or any successor form), for its effectively connected dividends to be exempt from the withholding tax described above. Dividends received by a foreign corporation that are effectively connected with its conduct of a trade or business in the United States may be subject to an additional branch profits tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. Under applicable United States Treasury regulations, a Non-U.S. Holder (including, in the case of certain Non-U.S. Holders that are entities, the owner or owners of these entities) is required to satisfy certain certification requirements in order to claim a reduced rate of withholding pursuant to an applicable income tax treaty.

Gain on Disposition of Common Stock

A Non-U.S. Holder generally will not be subject to United States federal income tax on gain recognized on a disposition of our common stock unless:

 

   

the Non-U.S. Holder is an individual, is present in the United States for 183 days or more during the taxable year of the disposition and meets certain other conditions;

 

   

the gain is effectively connected with the Non-U.S. Holder’s conduct of a trade or business in the United States and, if required by an applicable income tax treaty, the gain is attributable to a Non-U.S. Holder’s permanent establishment in the United States; or

 

   

we are or have been a “United States real property holding corporation” (a “USRPHC”) for United States federal income tax purposes at any time within the shorter of the five-year period ending on the date of disposition or the period that the Non-U.S. Holder held our common stock. We do not believe that we have been, currently are, or will become, a USRPHC.

Individual Non-U.S. Holders who are subject to United States federal income tax because the Non-U.S. Holders were present in the United States for 183 days or more during the year of disposition are taxed on their gains (including gains from the sale of our common stock and net of applicable U.S. losses from sales or exchanges of other capital assets recognized during the year) at a flat rate of 30% or such lower rate as may be specified by an applicable income tax treaty. Other Non-U.S. Holders subject to United States federal income tax with respect to gain recognized on the disposition of our common stock generally will be taxed on any such gain on a net income basis at applicable graduated United States federal income tax rates and, in the case of foreign corporations, the branch profits tax discussed above also may apply.

Information Reporting and Backup Withholding

In general, backup withholding will apply to dividends on our common stock paid to a Non-U.S. Holder, unless such Non-U.S. Holder has provided the required certification that it is a Non-U.S. Holder, and the payor does not have actual knowledge (or reason to know) that the Non-U.S. Holder is a U.S. person or otherwise establishes an exemption. Dividends paid to a Non-U.S. Holder of our common stock generally will be exempt

 

S-39


Table of Contents

from backup withholding if the Non-U.S. Holder provides a properly executed Internal Revenue Service Form W-8BEN or otherwise establishes an exemption. Generally, information will be reported to the Internal Revenue Service regarding the amount of dividends paid, the name and address of the recipient and the amount, if any, of tax withheld. These information reporting requirements apply even if no tax was required to be withheld and regardless of whether withholding was reduced or eliminated by an applicable tax treaty. A similar report is sent to the recipient of the dividend. Copies of this information may also be made available under the provisions of a specific treaty or agreement with the tax authorities in the country in which the Non-U.S. Holder resides or is established.

In general, backup withholding and information reporting will apply to the payment of proceeds from the disposition of our common stock by a Non-U.S. Holder through a U.S. office of a broker unless such Non-U.S. Holder has provided the required certification that it is a Non-U.S. Holder, and the payor does not have actual knowledge (or reason to know) that the holder is a U.S. person or otherwise establishes an exemption. In general, backup withholding and information reporting will not apply to the payment of proceeds from the disposition of our common stock by a Non-U.S. Holder through the non-U.S. office of a broker, except as noted below. In the case of proceeds from a disposition of our common stock by a Non-U.S. Holder effected at a non-U.S. office of a broker that is:

 

   

a U.S. person;

 

   

a “controlled foreign corporation” for United States federal income tax purposes;

 

   

a foreign person 50% or more of whose gross income from certain periods is effectively connected with a U.S. trade or business; or

 

   

a foreign partnership if at any time during its tax year (a) one or more of its partners are U.S. persons who, in the aggregate, hold more than 50% of the income or capital interests of the partnership or (b) the foreign partnership is engaged in a U.S. trade or business;

information reporting will apply unless the broker has documentary evidence in its files that the owner is a Non-U.S. Holder and certain other conditions are satisfied, or the beneficial owner otherwise establishes an exemption (and the broker has no knowledge or reason to know to the contrary). Backup withholding will apply if the sale is subject to information reporting and the broker has actual knowledge that the Non-U.S. holder is a U.S. person.

Backup withholding is not an additional tax. Any amounts that are withheld under the backup withholding rules from a payment to a Non-U.S. Holder will be credited or refunded against the Non-U.S. Holder’s United States federal income tax liability, if any, provided that certain required information is timely furnished to the Internal Revenue Service.

Non-U.S. Holders should consult their tax advisors regarding the application of the information reporting and backup withholding rules to them.

 

S-40


Table of Contents

UNDERWRITING

Under the terms and subject to the conditions contained in an underwriting agreement dated                     , 2008, each of the underwriters named below, for whom Credit Suisse Securities (USA) LLC, Citigroup Global Markets Inc., Banc of America Securities LLC and UBS Securities, LLC are acting as representatives, have severally agreed to purchase, and we have agreed to sell to them, the following respective number of shares of common stock:

 

Name

   Number of
Shares

Credit Suisse Securities (USA) LLC

  

Citigroup Global Markets Inc.

  

Banc of America Securities LLC

  

UBS Securities LLC

  

BNY Capital Markets, Inc.

  

Keefe, Bruyette & Woods, Inc.

  

KeyBanc Capital Markets Inc.

  

Total

  
    

The underwriters are offering the shares subject to their acceptance of the shares from us and subject to prior sale. The underwriting agreement provides that the obligations of the several underwriters to pay for and accept delivery of the shares offered by this prospectus supplement are subject to the approval of certain legal matters by their counsel and to certain other conditions. The underwriting agreement also provides that the underwriters are obligated to purchase all of the shares of common stock in the offering if any are purchased, other than those shares covered by the over-allotment option described below. The underwriting agreement further provides that if an underwriter defaults, the purchase commitments of non-defaulting underwriters may be increased or the offering may be terminated.

Over-allotment Option

We have granted to the underwriters a 30-day option to purchase on a pro rata basis up to              additional shares at the initial offering price listed on the cover page of this prospectus supplement less underwriting discounts and commissions. The option may be exercised only to cover any over-allotments of common stock.

Reserved Shares

At our request, the underwriters have reserved up to     % of the shares of common stock for sale at the public offering price to persons who are directors, officers or managing directors of the Company. In addition, the underwriters in the concurrent Equity Unit Offering have reserved up to     % of the Equity Units for sale at the public offering price to persons who are directors, officers or managing directors of the Company.

The number of shares of common stock available for sale to the general public will be reduced by the number of directed shares purchased by participants in the program. Any directed shares not purchased will be offered by the underwriters to the general public on the same basis as all other shares of common stock offered. We have agreed to indemnify the underwriters against certain liabilities and expenses, including liabilities under the Securities Act, in connection with the sales of the directed shares.

Commissions and Expenses

The underwriters propose to offer the shares of common stock initially at the public offering price on the cover page of this prospectus supplement and to the selling group members at that price less a selling concession not in excess of $             per share. After the initial offering, the underwriters may change the public offering price and concession and discount to broker/dealers.

 

S-41


Table of Contents

The following table summarizes the compensation and estimated expenses we will pay:

 

     Per Share    Total
     Without
Over-allotment
   With
Over-allotment
   Without
Over-allotment
   With
Over-allotment

Underwriting Discounts and Commissions paid by us(1)

   $                 $                 $                 $             

Expenses payable by us

   $                 $                 $                 $             

 

(1)   Included in the calculation of “Underwriting Discounts and Commissions paid by us” is a structuring fee paid to Credit Suisse Securities USA LLC of 1% of gross proceeds raised in any capital raising transaction by us. For a further discussion of this fee, please see “—Other Relationships” below.

Lock-Up Agreements

We have agreed that we will not, directly or indirectly, take any of the following actions with respect to our shares of common stock or any securities convertible into or exchangeable or exercisable for any such securities: (i) offer, sell, issue, contract to sell, pledge or otherwise dispose of any such securities, (ii) offer, sell, issue, contract to sell, contract to purchase or grant any option, right or warrant to purchase any such securities, (iii) enter into any swap, hedge or any other agreement that transfers, in whole or in part, the economic consequences of ownership of any such securities, (iv) establish or increase a put equivalent position or liquidate or decrease a call equivalent position in any such securities within the meaning of Section 16 of the Exchange Act, or (v) file with the SEC a registration statement under the Securities Act of 1933, as amended (the “Securities Act”), relating to any such securities, or publicly disclose the intention to take any such action, in each case, without the prior written consent of Credit Suisse Securities (USA) LLC and Citigroup Global Markets Inc., for a period of 90 days after the date of this prospectus supplement, except issuances pursuant to the conversion or exchange of convertible or exchangeable securities or the exercise of warrants or options outstanding on the date hereof, or grants of employee stock options pursuant to the terms of plans in effect on the date hereof (or, solely in the case of the Ambac 1997 Equity Plan and the Ambac 1997 Non-Employee Directors’ Equity Plan, as amended to reflect an aggregate increase in the number of shares authorized under those plans by up to 6.5 million shares), or issuances of such securities pursuant to the exercise of such options, or the issuance of the shares of common stock being offered hereby or the issuance of the Equity Units (including the related purchase contracts and senior notes) in the concurrent Equity Units Offering.

Our executive officers and directors and certain employees have agreed that they will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, any shares of our common stock or securities convertible into or exchangeable or exercisable for any shares of our common stock, enter into a transaction that would have the same effect, or enter into any swap, hedge or other arrangement that transfers, in whole or in part, any of the economic consequences of ownership of shares of our common stock, whether any of these transactions are to be settled by delivery of shares of our common stock or other securities, in cash or otherwise, or publicly disclose the intention to make any offer, sale, pledge or disposition, or to enter into any transaction, swap, hedge or other arrangement, and will not make any demand for or exercise any right with respect to the registration of any shares of our common stock or any security convertible into or exchangeable or exercisable for such shares of common stock without, in each case, the prior written consent of Credit Suisse Securities (USA) LLC and Citigroup Global Markets Inc. for a period of 90 days after the date of this prospectus supplement, except transfers of shares of common stock received upon exercise of options granted to such employee executive officer or director, transfers to family members or trusts in which the transferee agrees to be bound in writing by these same obligations and which transfer, in each case, requires no filing with the SEC in connection therewith and except for the withholding of shares of common stock to pay taxes upon settlement of restricted stock units granted to such employee and executive officer pursuant to the terms of plans in effect of the date hereof.

 

S-42


Table of Contents

Indemnification

We have agreed to indemnify the underwriters against liabilities under the Securities Act, or contribute to payments that the underwriters may be required to make in that respect.

Listing

Our shares of common stock trade on the New York Stock Exchange under the symbol “ABK”. We have applied for listing of the additional shares of common stock being offered hereby on The New York Stock Exchange, under such symbol.

Stabilization, Short Positions and Penalty Bids

In connection with the offering, the underwriters may engage in stabilizing transactions, over-allotment transactions, syndicate covering transactions and penalty bids.

 

   

Stabilizing transactions permit bids to purchase the underlying security so long as the stabilizing bids do not exceed a specified maximum.

 

   

Over-allotment involves sales by the underwriters of shares in excess of the number of shares the underwriters are obligated to purchase, which creates a syndicate short position. The short position may be either a covered short position or a naked short position. In a covered short position, the number of shares over-allotted by the underwriters is not greater than the number of shares that they may purchase in the over-allotment option. In a naked short position, the number of shares involved is greater than the number of shares in the over-allotment option. The underwriters may close out any covered short position by either exercising their over-allotment option and/or purchasing shares in the open market.

 

   

Syndicate covering transactions involve purchases of the common stock in the open market after the distribution has been completed in order to cover syndicate short positions. In determining the source of shares to close out the short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. If the underwriters sell more shares than could be covered by the over-allotment option, a naked short position, the position can only be closed out by buying shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there could be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase in the offering.

 

   

Penalty bids permit the representatives to reclaim a selling concession from a syndicate member when the common stock originally sold by the syndicate member is purchased in a stabilizing or syndicate covering transaction to cover syndicate short positions.

These stabilizing transactions, syndicate covering transactions and penalty bids may have the effect of raising or maintaining the market price of our common stock or preventing or retarding a decline in the market price of the common stock. As a result, the price of our common stock may be higher than the price that might otherwise exist in the open market. These transactions may be effected on The New York Stock Exchange or otherwise and, if commenced, may be discontinued at any time.

Neither we nor the underwriters make any representation or prediction as to the direction or magnitude of any effect that the transactions described above may have on the price of the common stock. In addition, neither we nor the underwriters make any representation that the underwriters will engage in these stabilizing transactions or that any transaction, once commenced, will not be discontinued without notice.

Electronic Distribution

A prospectus supplement in electronic format may be made available on Internet sites or through other online services maintained by one or more of the underwriters and/or selling group members participating in this offering, or by their affiliates. In those cases, prospective investors may view the prospectus supplement online

 

S-43


Table of Contents

and, depending upon the particular underwriter or selling group member, prospective investors may be allowed to place orders online. The underwriters may agree with us to allocate a specific number of shares for sale to online brokerage account holders. Any such allocation for online distributions will be made by the representatives on the same basis as other allocations. In addition, one or more of the underwriters participating in this offering may distribute prospectuses electronically.

Other than the prospectus supplement in electronic format, information on the underwriters or selling group member’s website and any information contained in any other website maintained by an underwriter or selling group member is not part of this prospectus supplement, the accompanying prospectus or the registration statement of which this prospectus supplement and accompanying prospectus form a part, has not been approved and/or endorsed by us or any underwriter or selling group member in its capacity as underwriter or selling group member and should not be relied on by investors.

Other Relationships

The underwriters and their affiliates have from time to time provided, and expect to provide in the future, investment banking, commercial banking and other financial services to us and our affiliates, for which they have received and may continue to receive customary fees and commissions. Several of the underwriters and their affiliates have utilized products and services provided by us and our affiliates, including certain of our financial guarantee and credit derivative products in transactions underwritten by such parties, and certain of the underwriters and their affiliates are the beneficiaries of the products and services provided by us and our affiliates, including by being a holder of one of our financial guarantee policies or a counterparty to one of our credit derivatives. As beneficiaries of our products and services, these underwriters have an interest in our being successful in our efforts to raise capital and maintain our triple-A ratings from Moody’s and S&P. For example, certain of the underwriters are counterparties to a significant portion of our CDO of ABS credit default swaps that have greater than 25% RMBS Exposure. For a discussion of these products see “Residential Mortgage-Backed Securities Exposure” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which is attached to this prospectus supplement. In addition, certain of the underwriters on various occasions have disclosed information regarding the extent of their commercial relationships with us and our competitors, including in filings made with the SEC. In addition, certain underwriters have exposure to deteriorations in our credit through holding our securities, holding derivatives for which our securities are the reference security, or otherwise, and as part of trading strategies and/or credit risk management have entered into CDS based upon our credit.

Credit Suisse Securities (USA) LLC, one of the joint book running managers for this offering, has executed an engagement letter with us pursuant to which it has, among other things, agreed to review and analyze our strategic plans and our financing and other business alternatives, and identify and structure potential capital raising transactions. In connection with the engagement, we have paid Credit Suisse Securities (USA) LLC a financial advisory fee of $5 million for their services. Additionally, upon completion of any equity or debt raising transaction, we have agreed to pay Credit Suisse a structuring fee equal to 1% of the gross proceeds raised by us in any such transactions; the $5 million fee will be creditable against any such fee. We have also agreed to indemnify Credit Suisse Securities (USA) LLC for any losses, claims, damages or liabilities suffered by Credit Suisse Securities (USA) LLC arising from the engagement other than to the extent such losses are determined to be caused by the bad faith or gross negligence of Credit Suisse Securities (USA) LLC.

Credit Suisse Securities (USA) LLC together with Citigroup Global Markets Inc., Banc of America Securities LLC and UBS Securities LLC, the joint book running managers and underwriters for this offering, are also acting as joint book running managers and underwriters in the concurrent Equity Units Offering for which they will receive customary underwriting commissions. Keefe, Bruyette & Woods, Inc. is a co-managing underwriter in this offering and the concurrent Equity Units Offering and will receive customary underwriting commissions in each role. BNY Capital Markets, Inc., an affiliate of The Bank of New York, is one of the co-managing underwriters in this offering. The Bank of New York is also acting as purchase contract agent, collateral agent, trustee and securities intermediary in connection with the concurrent Equity Units Offering.

 

S-44


Table of Contents

Ambac and its subsidiary Ambac Assurance Corporation have entered into a $400 million revolving credit facility with some of the affiliates of some of the underwriters. Citibank, N.A. serves as administrative agent and lender, and Citigroup Global Markets Inc. serves as sole lead arranger and sole book runner under the revolving credit facility and, in connection with the offering, has entered into an amendment to the credit facility for which it received a fee under the credit facility. These companies also receive standard fees for their services. In addition, affiliates of BNY Capital Markets and KeyBanc Capital Markets Inc., each of whom are acting as co-managing underwriters in this offering, serve as lenders under the revolving credit facility.

In addition, commencing in January 2008, a number of financial institutions and other market participants, consisting in significant part of insured counterparties to our CDOs of ABS, contemplated various transactions with the objective of enhancing our ability to maintain our credit ratings. An affiliate of Citigroup Global Markets Inc., one of the co-book running managers of this offering and the Equity Units Offering, was a principal participant in these matters. Certain other underwriters of this offering and the Equity Units Offering also were participants in these matters. As counterparties to our insured swaps, beneficiaries of our other products and services and holders of our securities and derivatives on our securities, the financial institutions, including those whose affiliates are underwriters in this transaction, have an interest in our being successful in our efforts to raise capital in this offering and the concurrent Equity United Offering and our maintaining our triple-A ratings.

European Economic Area

In relation to each Member State of the European Economic Area which has implemented the Prospectus Directive (each, a Relevant Member State), each underwriter has represented and agreed that with effect from and including the date on which the Prospectus Directive is implemented in that Relevant Member State (the Relevant Implementation Date) it has not made and will not make an offer of shares to the public in that Relevant Member State prior to the publication of a prospectus in relation to the shares which has been approved by the competent authority in that Relevant Member State or, where appropriate, approved in another Relevant Member State and notified to the competent authority in that Relevant Member State, all in accordance with the Prospectus Directive, except that it may, with effect from and including the Relevant Implementation Date, make an offer of shares to the public in that Relevant Member State at any time:

 

  (a)   to legal entities which are authorised or regulated to operate in the financial markets or, if not so authorised or regulated, whose corporate purpose is solely to invest in securities;

 

  (b)   to any legal entity which has two or more of (1) an average of at least 250 employees during the last financial year; (2) a total balance sheet of more than €43,000,000; and (3) an annual net turnover of more than €50,000,000, as shown in its last annual or consolidated accounts;

 

  (c)   to fewer than 100 natural or legal persons (other than qualified investors as defined in the Prospectus Directive) subject to obtaining the prior consent of the representatives for any such offer; or

 

  (d)   in any other circumstances which do not require the publication by the Issuer of a prospectus pursuant to Article 3 of the Prospectus Directive.

For the purposes of this provision, the expression an “offer of shares to the public” in relation to any shares in any Relevant Member State means the communication in any form and by any means of sufficient information on the terms of the offer and the shares to be offered so as to enable an investor to decide to purchase or subscribe the shares, as the same may be varied in that Relevant Member State by any measure implementing the Prospectus Directive in that Relevant Member State and the expression Prospectus Directive means Directive 2003/71/EC and includes any relevant implementing measure in each Relevant Member State.

United Kingdom

Each underwriter has severally represented and agreed that:

 

   

it has only communicated or caused to be communicated and will only communicate or cause to be communicated an invitation or inducement to engage in investment activity (within the meaning of

 

S-45


Table of Contents
 

Section 21 of the Financial Services and Markets Act 2000 (“FSMA”)) received by it in connection with the issue or sale of the shares in circumstances in which Section 21(1) of the FSMA does not apply to the Company; and

 

   

it has complied and will comply with all applicable provisions of the FSMA with respect to anything done by it in relation to the shares in, from or otherwise involving the United Kingdom.

Notice to Residents of Hong Kong

The underwriters and each of their affiliates have not (i) offered or sold, and will not offer or sell, in Hong Kong, by means of any document, our shares of common stock other than (a) to “professional investors” as defined in the Securities and Futures Ordinance (Cap.571) of Hong Kong and any rules made under that Ordinance or (b) in other circumstances which do not result in the document being a “prospectus” as defined in the Companies Ordinance (Cap. 32 of Hong Kong) or which do not constitute an offer to the public within the meaning of that Ordinance or (ii) issued or had in its possession for the purposes of issue, and will not issue or have in its possession for the purposes of issue, whether in Hong Kong or elsewhere any advertisement, invitation or document relating to our shares of common stock which is directed at, or the contents of which are likely to be accessed or read by, the public in Hong Kong (except if permitted to do so under the securities laws of Hong Kong) other than with respect to our securities which are or are intended to be disposed of only to persons outside Hong Kong or only to “professional investors” as defined in the Securities and Futures Ordinance and any rules made under that Ordinance. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice.

Notice to Residents of Singapore

This prospectus supplement or any other offering material relating to our shares of common stock has not been and will not be registered as a prospectus with the Monetary Authority of Singapore, and the shares of common stock will be offered in Singapore pursuant to exemptions under Section 274 and Section 275 of the Securities and Futures Act, Chapter 289 of Singapore (the “ Securities and Futures Act”). Accordingly our shares of common stock may not be offered or sold, or be the subject of an invitation for subscription or purchase, nor may this prospectus supplement or any other offering material relating to our shares of common stock be circulated or distributed, whether directly or indirectly, to the public or any member of the public in Singapore other than (a) to an institutional investor or other person specified in Section 274 of the Securities and Futures Act, (b) to a sophisticated investor, and in accordance with the conditions specified in Section 275 of the Securities and Futures Act or (c) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the Securities and Futures Act.

Notice to Residents of the United Arab Emirates

This prospectus supplement is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The shares of common stock have not been and will not be registered under Federal Law No. 4 of 2000 Concerning the Emirates Securities and Commodities Authority and the Emirates Security and Commodity Exchange, or with the UAE Central Bank, the Dubai Financial Market, the Abu Dhabi Securities market or with any other UAE exchange. The offering, the shares of our common stock and interests therein have not been approved or licensed by the UAE Central Bank or any other relevant licensing authorities in the UAE, and do not constitute a public offer of securities in the UAE in accordance with the Commercial Companies Law, Federal Law No. 8 of 1984 (as amended) or otherwise. In relation to its use in the UAE, this prospectus supplement is strictly private and confidential and is being distributed to a limited number of investors and must not be provided to any person other than the original recipient, and may not be reproduced or used for any other purpose. The interests in the shares of common stock may not be offered or sold directly or indirectly to the public in the UAE.

 

S-46


Table of Contents

WHERE YOU CAN FIND MORE INFORMATION

We file reports, proxy statements, and other information with the SEC. These reports, proxy statements, and other information can be read and copied at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. The SEC maintains an internet site at http://www.sec.gov that contains reports, proxy and information statements and other information regarding companies that file electronically with the SEC, including Ambac. These reports, proxy statements and other information can also be read at the offices of the NYSE, 20 Broad Street, New York, New York 10005 or on our internet site at www.ambac.com. Information on our website is not incorporated into this prospectus supplement or our other SEC filings and is not a part of this prospectus supplement or those filings.

This prospectus supplement is part of a registration statement filed by us with the SEC. The full registration statement can be obtained from the SEC as indicated above, or from us.

The SEC allows us to “incorporate by reference” the information we file with the SEC. This permits us to disclose important information to you by referencing these filed documents. Any information referenced this way is considered part of this prospectus supplement, and any information filed with the SEC subsequent to this prospectus supplement and prior to the termination of the particular offering referred to in this prospectus supplement will automatically be deemed to update and supersede this information. We incorporate by reference the following documents which have been filed with the SEC:

 

   

Annual Report on Form 10-K for the fiscal year ended December 31, 2007 (filed on February 29, 2008); and

 

   

Current Reports on Form 8-K filed on January 18, 2008, January 22, 2008, January 23, 2008, January 25, 2008, February 1, 2008 and February 13, 2008, in each case excluding any portions of such Current Reports on Form 8-K which are specifically or deemed to be furnished to the SEC.

We incorporate by reference the documents listed above and any future filings made with the SEC prior to the termination of the particular offering referred to in this prospectus supplement in accordance with Sections 13(a), 13(c), 14 or 15(d) of the Exchange Act, with the exception of any documents deemed not to be filed.

We will provide without charge upon written or oral request, a copy of any or all of the documents which are incorporated by reference in this prospectus supplement, other than exhibits which are specifically incorporated by reference into those documents. Requests should be directed to Vandana Sharma, First Vice President, Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004 (telephone number (212) 208-3333 or at vsharma@ambac.com).

LEGAL OPINIONS

Anne Gill Kelly, Esq., Managing Director, Secretary and Assistant General Counsel of Ambac, One State Street Plaza, New York, New York 10004, will issue an opinion about the legality of the shares offered hereby. Anne Gill Kelly, Esq. beneficially owns, or has the right to acquire under Ambac’s employee benefit plans, an aggregate of less than 1% of our common stock. Additionally, certain legal matters relating to the shares offered hereby will be passed upon for us by Wachtell, Lipton, Rosen & Katz, New York, New York 10019, and for the underwriters by Sidley Austin LLP, New York, New York and Sullivan & Cromwell LLP, New York, New York. Sidley Austin LLP has in the past represented certain of our affiliates, and has also represented issuers and/or underwriters in transactions insured by our affiliates or for which our affiliates issued credit derivatives.

 

S-47


Table of Contents

EXPERTS

The consolidated financial statements and related financial statement schedules of Ambac as of December 31, 2007 and 2006, and for each of the years in the three-year period ended December 31, 2007, have been included in this preliminary prospectus supplement (and incorporated by reference in the registration statement of which it forms a part), in reliance upon the reports of KPMG LLP, independent registered public accounting firm, appearing elsewhere herein, and upon the authority of said firm as experts in accounting and auditing. The reports of KPMG LLP on such consolidated financial statements and related financial statement schedules refer to changes in Ambac’s method of accounting for variable interest entities and stock-based compensation in 2006.

 

S-48


Table of Contents

PROSPECTUS

LOGO

Ambac Financial Group, Inc.

Ambac Financial Group, Inc. may sell from time to time

Common Stock

Preferred Stock

Depositary Shares

Senior Debt Securities

Junior Subordinated Debt Securities

Warrants

Stock Purchase Contracts

Stock Purchase Units

 

 

This prospectus describes some of the general terms that may apply to these securities. The specific terms of the common stock, preferred stock, depositary shares, senior debt securities, junior subordinated debt securities, warrants to purchase our capital stock or debt securities, stock purchase contracts and stock purchase units then being offered will be described in supplements to this prospectus. The prospectus supplements may also add, update or change information contained in this prospectus. You should read this prospectus and the applicable prospectus supplement carefully before you make your investment decision.

We may offer and sell these securities through one or more underwriters, dealers and agents, underwriting syndicates managed or co-managed by one or more underwriters, or directly to purchasers, on a continuous or delayed basis.

This prospectus may not be used to sell securities unless accompanied by a prospectus supplement.

The prospectus supplement for each offering of securities will describe in detail the plan of distribution for that offering. Our common stock is listed on the New York Stock Exchange under the trading symbol “ABK”. Each prospectus supplement will indicate if the securities offered thereby will be listed on any securities exchange.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus or the accompanying prospectus supplement is truthful or complete. Any representation to the contrary is a criminal offense.

The date of this prospectus is January 16, 2008.


Table of Contents

TABLE OF CONTENTS

 

ABOUT THIS PROSPECTUS

   1

AMBAC FINANCIAL GROUP, INC.

   1

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

   3

USE OF PROCEEDS

   4

RATIO OF EARNINGS TO FIXED CHARGES

   5

DESCRIPTION OF SECURITIES

   6

Description of Capital Stock

   6

Description of Depositary Shares

   8

Description of Debt Securities

   11

Description of Warrants

   21

Description of Stock Purchase Contracts and Stock Purchase Units

   22

WHERE YOU CAN FIND MORE INFORMATION

   23

LEGAL OPINIONS

   24

EXPERTS

   25

 

i


Table of Contents

ABOUT THIS PROSPECTUS

This prospectus is part of a registration statement that we filed with the SEC using a “shelf” registration process. Under this shelf process, we may, from time to time, sell any combination of the securities described in this prospectus in one or more offerings. This prospectus provides you with a general description of the securities we may offer. Each time we sell securities, we will provide a prospectus supplement that will contain specific information about the terms of that offering. The prospectus supplement may also add, update or change information contained in this prospectus. You should read both this prospectus and any prospectus supplement together with additional information described under the heading “Where You Can Find More Information.” Unless otherwise stated or the context otherwise requires, references in this prospectus to “Ambac”, “we”, “our” or “us” refer to Ambac Financial Group, Inc., and its direct and indirect subsidiaries.

AMBAC FINANCIAL GROUP, INC.

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 was incorporated on April 29, 1991. Ambac’s activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services. Ambac provides financial guarantees for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation, or Ambac Assurance. Ambac Assurance is the successor to the founding financial guarantee insurance company, which wrote the first bond insurance policy in 1971. Through its financial services subsidiaries, Ambac provides financial and investment products including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to its clients of the financial guarantee business.

Ambac Assurance has earned triple-A financial strength ratings, the highest ratings available from Moody’s Investors Service, Inc., or Moody’s, in 1987, Standard & Poor’s Ratings Services, or S&P, in 1979 and Fitch, Inc., or Fitch, in 1994. Ambac Assurance’s ratings have been periodically affirmed by each of these rating agencies. Moody’s rating was last reaffirmed in December 2007. S&P’s rating was last reaffirmed in December 2007; however, its outlook was changed from stable to negative. Fitch’s rating was changed from stable to rating watch negative in December 2007. These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement and any reduction in these ratings could have a material adverse affect on Ambac Assurance’s ability to compete in the financial guarantee business. See “Business—Rating Agencies” and “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, which is incorporated by reference in this prospectus, for further information.

Ambac Assurance provides its financial guarantees for a variety of products, including:

 

   

public finance securities, which include bonds issued by state and local municipalities such as cities, counties, towns and villages, as well as water districts, sewer districts, higher educational institutions, hospitals, transportation authorities, housing authorities and other similar agencies;

 

   

securities issued in connection with privatizations of essential infrastructures by sovereign entities and sub-sovereigns where the insured debt is backed by payments made by private companies which own concessions to build, maintain and operate roads, hospitals, schools and other essential infrastructure;

 

   

mortgage-backed securities, which are bonds and notes where investors receive payments out of the interest and principal on the underlying mortgages that back the securities;

 

   

asset-backed securities, which are bonds and notes where investors receive payments out of cash flows from the underlying accounts receivable, loans, corporate debt or sovereign debt that back the securities; and

 

   

structured credit derivatives, which are privately negotiated contracts that provide an investor with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation.

 

1


Table of Contents

Ambac Assurance and its subsidiary Ambac Assurance UK Limited, which serve the global capital markets, are primarily engaged in guaranteeing public finance securities, mortgage-backed securities, asset-backed securities and other structured finance obligations. Global capital markets include the U.S. financial markets and international markets such as the United Kingdom, Italian, Japanese and Australian financial markets.

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, which is the entity responsible for making payments. In the case of default on a guaranteed obligation, payments under the financial guarantee policy generally may not be accelerated by the policyholder without Ambac Assurance’s consent. As of December 31, 2006 and September 30, 2007, Ambac Assurance’s net financial guarantee in force, after giving effect for reinsurance, was $802.7 billion and $892.0 billion, respectively.

Ambac Credit Products, LLC, a wholly owned subsidiary of Ambac Assurance, primarily provides credit protection in the global markets in the form of structured credit derivatives. Structured credit derivatives are privately negotiated contracts that require Ambac Credit to make payments upon the occurrence of certain defined credit events relating to an underlying obligation. Structured credit derivatives issued by Ambac Credit are guaranteed by Ambac Assurance. Ambac Credit generally enters into structured credit derivative contracts in which its exposure is to highly rated risks.

Ambac provides financial services and investment products principally to its financial guarantee clients which include municipalities and their authorities, school districts, health care organizations and asset-backed issuers.

Through its financial services subsidiaries, Ambac provides financial and investment products that include:

 

   

investment agreements, which are contracts between Ambac and a client that provide for the guaranteed return of principal invested and for the payment of interest at a guaranteed rate;

 

   

interest rate swaps, currency swaps and total return swaps; and

 

   

funding conduits, which are special purpose companies that help clients raise funds by issuing notes for the purpose of acquiring financial assets such as trade receivables.

We conduct our investment agreement business through our subsidiary, Ambac Capital Funding, Inc., or Ambac Capital. Ambac Capital provides investment agreements primarily to municipalities and their authorities, mortgage-backed security issuers, asset-backed security issuers and international issuers. The investment agreements written by Ambac Capital are guaranteed by Ambac Assurance. Investment agreements are primarily used by issuers to invest bond proceeds until the proceeds can be used for their intended purpose.

Ambac provides interest rate and currency swaps through its subsidiary, Ambac Financial Services, L.L.C. and total return swaps through its subsidiary Ambac Capital Services, L.L.C., primarily to states, municipalities and their authorities, issuers of asset-backed securities, investment banks and other entities in connection with their financings. The swaps provided by Ambac Financial Services and Ambac Capital Services are guaranteed by Ambac Assurance and provide a financing alternative that is intended to reduce an issuer’s overall borrowing costs and/or help manage their risk.

As a holding company, Ambac Financial Group, Inc. is largely dependent on dividends from Ambac Assurance to pay dividends on its capital stock, to pay principal of 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.

Our principal executive offices are located at One State Street Plaza, New York, New York 10004 and our telephone number is (212) 668-0340.

 

2


Table of Contents

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus and accompanying prospectus supplement may contain or incorporate by reference information that includes or is based upon forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts but instead represent management’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future plans or objectives and results.

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’s actual results may vary materially, and there are no guarantees about the performance of our securities. Among factors that could cause actual results to differ materially are:

 

   

changes in the economic, credit or interest rate environment in the United States and abroad;

 

   

the level of activity within the national and worldwide debt markets;

 

   

competitive conditions and pricing levels;

 

   

legislative and regulatory developments;

 

   

changes in tax laws;

 

   

the policies and actions of the United States and other governments;

 

   

changes in capital requirement or other criteria of rating agencies;

 

   

changes in accounting principles or practices that may impact Ambac’s reported financial results;

 

   

the amount of reserves established for losses and loss expenses;

 

   

default of one or more of Ambac’s reinsurers;

 

   

market spreads and pricing on insured pooled debt obligations and other derivative products insured or issued by Ambac;

 

   

prepayment speeds on insured asset-backed securities and other factors that may influence the amount of installment premiums paid to Ambac; and

 

   

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 our reports to the SEC.

 

3


Table of Contents

USE OF PROCEEDS

Unless otherwise indicated in the applicable prospectus supplement, we intend to use the proceeds of any securities sold for general corporate purposes.

 

4


Table of Contents

RATIO OF EARNINGS TO FIXED CHARGES

The following table contains our ratio of earnings to fixed charges for each of the periods indicated:

 

     Years Ended December 31,    Nine Months Ended
     2006    2005    2004    2003    2002    September 30,
2007
   September 30,
2006

Ratio of earnings to fixed charges

   16.4x    18.3x    18.1x    16.0x    13.3x    1.4x    16.2x

We computed the ratio of earnings to fixed charges by dividing earnings before income taxes and extraordinary items plus fixed charges by the fixed charges. For the purpose of this ratio, fixed charges consist of interest expense incurred, capitalized interest, amortization of debt expense and one-third of rental payments under operating leases, an amount deemed representative of the appropriate interest factor. Since we did not have any preferred stock outstanding during the periods indicated above, our ratio of earnings to combined fixed charges and preference dividends for each relevant period will be the same as our ratio of earnings to fixed charges.

The decline in the ratio of earnings to fixed charges from September 30, 2006 to September 30, 2007 was primarily a result of the impact on earnings of net mark-to-market losses on credit and total return derivatives of $816.0 million during the 9-month period ended September 30, 2007 versus net mark-to-market gains of $16.4 million during the 9-month period ended September 30, 2006.

 

5


Table of Contents

DESCRIPTION OF SECURITIES

This prospectus contains a summary of the capital stock (including common stock and preferred stock), depositary shares, debt securities (including senior debt securities and junior subordinated debt securities), warrants to purchase our capital stock or debt securities, stock purchase contracts and stock purchase units that we may sell. These summaries are not meant to be a complete description of each security. However, this prospectus, together with the applicable accompanying prospectus supplement, contain all the material terms of the securities being offered.

Description of Capital Stock

Our authorized capital stock consists of 350,000,000 shares of common stock, par value $0.01 per share, and 4,000,000 shares of preferred stock, par value $0.01 per share. No shares of preferred stock were issued or outstanding as of January 16, 2008.

Common Stock

Voting rights. Each holder of common stock is entitled to one vote for each share held on all matters to be voted upon by stockholders.

Dividends. The holders of common stock, after any preferences of holders of any preferred stock, are entitled to receive dividends as determined by the board of directors.

Liquidation and dissolution. If we liquidate or dissolve, the holders of the common stock will be entitled to share in our assets available for distribution to common stockholders in proportion to the amount of common stock they own. The amount available for common stockholders is calculated after payment of liabilities. Holders of any preferred stock will receive a preferential share of our assets before the holders of the common stock receive any assets.

Other rights. Holders of the common stock have no right to:

 

   

convert or exchange the stock into any other security;

 

   

have the stock redeemed; or

 

   

purchase additional stock or to maintain their proportionate ownership interest.

The common stock does not have cumulative voting rights. Holders of shares of our common stock are not required to make additional capital contributions.

Our common stock is listed and traded on the New York Stock Exchange under the symbol “ABK.”

Transfer Agent and Registrar

The Bank of New York Mellon is the transfer agent and registrar for the common stock.

Removal of Directors by Stockholders

Delaware law provides that members of a board of directors may be removed, with or without cause, by a majority of the outstanding shares entitled to vote on the election of the directors.

Stockholder Nomination of Directors

Our by-laws provide that a stockholder must notify us in writing of any stockholder nomination of a director at least sixty, but not more than ninety, days prior to the date of the meeting for the election of directors. Except that if we give less than seventy days notice or prior public disclosure of the date for the meeting, then notice by a stockholder is timely if received by us no later than the close of business on the tenth day after which such notice was mailed or such public disclosure was made.

 

6


Table of Contents

10% Stockholder Provision

Our subsidiary, Ambac Assurance, is a Wisconsin corporation and subject to the insurance and regulatory laws of the State of Wisconsin. Under Wisconsin insurance holding company laws, any acquisition of control of Ambac requires the prior approval of the Office of the Commissioner of Insurance of the State of Wisconsin. As a result, section 4.5 of our amended and restated certificate of incorporation provides that no stockholder may cast votes with respect to 10% or more of our voting stock, regardless of the actual number of shares of voting stock beneficially held by the stockholder. In addition, any voting stock held by a stockholder in excess of 10% will not count in the calculation of or toward a quorum at any meeting of stockholders. These voting restrictions will not apply to any stockholder whose acquisition or ownership of 10% or more of our voting stock has been approved by the Office of the Commissioner of Insurance of the State of Wisconsin.

Delaware Business Combination Statute

Section 203 of the Delaware General Corporation Law (“DGCL”) is applicable to us. Section 203 of the DGCL restricts some types of transactions and business combinations between a corporation and a 15% stockholder. A 15% stockholder is generally considered by Section 203 to be a person owning 15% or more of the corporation’s outstanding voting stock. Section 203 refers to a 15% stockholder as an “interested stockholder.” Section 203 restricts these transactions for a period of three years from the date the stockholder acquired 15% or more of our outstanding voting stock. With some exceptions, unless the transaction is approved by the board of directors and the holders of at least two-thirds of the outstanding voting stock of the corporation, Section 203 prohibits significant business transactions such as:

 

   

a merger with, disposition of significant assets to, or receipt of disproportionate financial benefits by, the 15% stockholder, or

 

   

any other transaction that would increase the 15% stockholder’s proportionate ownership of any class or series of our capital stock.

The shares held by the 15% stockholder are not counted as outstanding when calculating the two-thirds of the outstanding voting stock needed for approval.

The prohibition against these transactions does not apply if:

 

   

prior to the time that any stockholder became a 15% stockholder, the board of directors approved either the business combination or the transaction in which such stockholder acquired 15% or more of our outstanding voting stock, or

 

   

the 15% stockholder owns at least 85% of the outstanding voting stock of the corporation as a result of the transaction in which such stockholder acquired 15% or more of our outstanding voting stock. Shares held by persons who are both directors and officers or by some types of employee stock plans are not counted as outstanding when making this calculation.

Preferred Stock

General. We are authorized to issue 4,000,000 shares of preferred stock. No shares of preferred stock are currently issued or outstanding. Our board of directors may, without stockholder approval, issue shares of preferred stock. The board can issue more than one series of preferred stock. The board has the right to fix the number of shares, dividend rights, conversion rights, voting rights, redemption rights, liquidation preferences and any other rights, preferences, privileges and restrictions applicable to the preferred stock it decides to issue.

Voting rights. The DGCL provides that the holders of preferred stock will have the right to vote separately as a class on any proposal involving fundamental changes in the rights of holders of such preferred stock.

Conversion or exchange. The prospectus supplement will describe the terms, if any, on which the preferred stock may be convertible into or exchangeable for our debt securities, common stock, warrants or other preferred stock. These terms will include provisions as to whether conversion or exchange is mandatory, at the option of the holder or at our option. These provisions may allow or require the number of our shares of common stock or other securities to be received by the holders of preferred stock to be adjusted.

 

7


Table of Contents

Description of Depositary Shares

General

We may elect to offer fractional shares of preferred stock rather than full shares of preferred stock. In that event, we will issue receipts for depositary shares, and each of these depositary shares will represent a fraction (to be set forth in the applicable prospectus supplement) of a share of a particular series of preferred stock.

The shares of any series of preferred stock underlying the depositary shares will be deposited under a deposit agreement between us and a bank or trust company selected by us. The depositary will have its principal office in the United States and a combined capital and surplus of at least $50,000,000.

Subject to the terms of the deposit agreement, each owner of a depositary share will be entitled, in proportion to the applicable fraction of a share of preferred stock underlying the depositary share, to all the rights and preferences of the preferred stock underlying that depositary share. Those rights may include dividend, voting, redemption, conversion and liquidation rights.

The depositary shares will be evidenced by depositary receipts issued under a deposit agreement. Depositary receipts will be distributed to those persons purchasing the fractional shares of preferred stock underlying the depositary shares, in accordance with the terms of the offering. The following description of the material terms of the deposit agreement, the depositary shares and the depositary receipts is only a summary, and you should refer to the forms of the deposit agreement and depositary receipts that will be filed with the SEC in connection with the offering of the specific depositary shares for more complete information.

Pending the preparation of definitive engraved depositary receipts, the depositary may, upon our written order, issue temporary depositary receipts substantially identical to the definitive depositary receipts but not in definitive form. These temporary depositary receipts entitle their holders to all the rights of definitive depositary receipts. Temporary depositary receipts will then be exchangeable for definitive depositary receipts at our expense.

Dividends and Other Distributions

The depositary will distribute all cash dividends or other cash distributions received with respect to the underlying stock to the record holders of depositary shares in proportion to the number of depositary shares owned by those holders.

If there is a distribution other than in cash, the depositary will distribute property received by it to the record holders of depositary shares that are entitled to receive the distribution, unless the depositary determines that it is not feasible to make the distribution. If this occurs, the depositary may, with our approval, sell the property and distribute the net proceeds from the sale to the applicable holders.

Withdrawal of Underlying Preferred Stock

Unless we say otherwise in a prospectus supplement, holders may surrender depositary receipts at the principal office of the depositary and, upon payment of any unpaid amount due to the depositary, be entitled to receive the number of whole shares of underlying preferred stock and all money and other property represented by the related depositary shares. We will not issue any partial shares of preferred stock. If the holder delivers depositary receipts evidencing a number of depositary shares that represent more than a whole number of shares of preferred stock, the depositary will issue a new depositary receipt evidencing the excess number of depositary shares to that holder.

Redemption of Depositary Shares

If a series of preferred stock represented by depositary shares is subject to redemption, the depositary shares will be redeemed from the proceeds received by the depositary resulting from the redemption, in whole or in part,

 

8


Table of Contents

of that series of underlying stock held by the depositary. The redemption price per depositary share will be equal to the applicable fraction of the redemption price per share payable with respect to that series of underlying stock. Whenever we redeem shares of underlying stock that are held by the depositary, the depositary will redeem, as of the same redemption date, the number of depositary shares representing the shares of underlying stock so redeemed. If fewer than all the depositary shares are to be redeemed, the depositary shares to be redeemed will be selected by lot or proportionately or by other equitable method, as may be determined by the depositary.

Voting

Upon receipt of notice of any meeting at which the holders of the underlying stock are entitled to vote, the depositary will mail the information contained in the notice to the record holders of the depositary shares underlying the preferred stock. Each record holder of the depositary shares on the record date (which will be the same date as the record date for the underlying stock) will be entitled to instruct the depositary as to the exercise of the voting rights pertaining to the amount of the underlying stock represented by that holder’s depositary shares. The depositary will then try, as far as practicable, to vote the number of shares of preferred stock underlying those depositary shares in accordance with those instructions, and we will agree to take all reasonable actions which may be deemed necessary by the depositary to enable the depositary to do so. The depositary will not vote the underlying shares to the extent it does not receive specific instructions with respect to the depositary shares representing the preferred stock.

Conversion or Exchange of Preferred Stock

If the deposited preferred stock is convertible into or exchangeable for other securities, the following will apply. The depositary shares, as such, will not be convertible into or exchangeable for such other securities. Rather, any holder of the depositary shares may surrender the related depositary receipts, together with any amounts payable by the holder in connection with the conversion or the exchange, to the depositary with written instructions to cause conversion or exchange of the preferred stock represented by the depositary shares into or for such other securities. If only some of the depositary shares are to be converted or exchanged, a new depositary receipt or receipts will be issued for any depositary shares not to be converted or exchanged.

Amendment and Termination of the Deposit Agreement

The form of depositary receipt evidencing the depositary shares and any provision of the deposit agreement may at any time be amended by agreement between us and the depositary. However, any amendment which materially and adversely alters the rights of the holders of depositary shares will not be effective unless the amendment has been approved by the holders of at least a majority of the depositary shares then outstanding. The deposit agreement may be terminated by us upon not less than 60 days’ notice whereupon the depositary shall deliver or make available to each holder of depositary shares, upon surrender of the depositary receipts held by such holder, the number of whole or fractional shares of preferred stock represented by such receipts. The deposit agreement will automatically terminate if (a) all outstanding depositary shares have been redeemed or converted into or exchanged for any other securities into or for which the underlying preferred stock are convertible or exchangeable or (b) there has been a final distribution of the underlying stock in connection with our liquidation, dissolution or winding up and the underlying stock has been distributed to the holders of depositary receipts.

Charges of Depositary

We will pay all transfer and other taxes and governmental charges arising solely from the existence of the depositary arrangements. We will also pay charges of the depositary in connection with its duties in accordance with the deposit agreement. Holders of depositary receipts will pay transfer and other taxes and governmental and other charges, including a fee for any permitted withdrawal of shares of underlying stock upon surrender of depositary receipts, as are expressly provided in the deposit agreement to be for their accounts.

 

9


Table of Contents

Reports

The depositary will forward to holders of depositary receipts all reports and communications from us that we deliver to the depositary and that we are required to furnish to the holders of the underlying stock.

Limitation on Liability

Neither we nor the depositary will be liable if either of us is prevented or delayed by law or any circumstance beyond our control in performing our respective obligations under the deposit agreement. Our obligations and those of the depositary will be limited to performance in good faith of our respective duties under the deposit agreement. Neither we nor the depositary will be obligated to prosecute or defend any legal proceeding in respect of any depositary shares or underlying stock unless satisfactory indemnity is furnished. We and the depositary may rely upon written advice of counsel or accountants, or upon information provided by persons presenting underlying stock for deposit, holders of depositary receipts or other persons believed to be competent and on documents believed to be genuine.

In the event the depositary receives conflicting claims, requests or instructions from any holders of depositary shares, on the one hand, and us, on the other, the depositary will act on our claims, requests or instructions.

Resignation and Removal of Depositary

The depositary may resign at any time by delivering notice to us of its election to resign. We may remove the depositary at any time. Any resignation or removal will take effect upon the appointment of a successor depositary and its acceptance of the appointment. The successor depositary must be appointed within 60 days after delivery of the notice of resignation or removal and must be a bank or trust company having its principal office in the United States and having a combined capital and surplus of at least $50,000,000.

 

10


Table of Contents

Description of Debt Securities

The debt securities covered by this prospectus will be our direct unsecured obligations. The debt securities will be either senior debt securities that rank on an equal basis with all our other unsecured and unsubordinated debt, or they will be junior subordinated debt securities that will rank junior to all of our senior unsecured debt including any senior subordinated debt.

The following description briefly sets forth certain general terms and provisions of the debt securities. The prospectus supplement for a particular series of debt securities will describe the particular terms of the debt securities we offer and the extent to which these general provisions may apply to that particular series of debt securities.

Our senior debt securities have been or will be issued under a senior debt indenture, dated as of February 15, 2006, by and among us and Bank of New York Mellon, as trustee, as supplemented by an officers’ certificate issued pursuant thereto or a supplemental indenture entered into by us and the trustee pursuant thereto. Our junior subordinated debt securities have been or will be issued under a junior subordinated debt indenture, dated as of February 12, 2007, as supplemented by an officers’ certificate issued pursuant thereto or a supplemental indenture entered into by us and the trustee pursuant thereto. Forms of the senior debt indenture and the junior subordinated debt indenture have been filed with the SEC and are incorporated by reference as Exhibits 4.1 and 4.4, respectively, to the registration statement on Form S-3 under the Securities Act of 1933, of which this prospectus forms a part. The senior debt indenture and the junior subordinated debt indenture are sometimes referred to in this prospectus individually as an “indenture” and collectively as the “indentures.”

We have summarized all material provisions of the indentures below. You should read the indentures for further information. If we make no distinction in the following summaries between the senior debt securities and the junior subordinated debt securities or between the indentures, such summaries refer to any debt securities and either indenture.

General

The indentures allow us to issue either senior or junior subordinated debt securities from time to time under the applicable indenture without limitation as to amount. We may issue the debt securities in one or more series with the same or different terms.

Because we are a holding company, our rights and the rights of our creditors, including the holders of debt securities, to participate in the assets of any subsidiary upon its liquidation or recapitalization will be subject to the prior claims of the subsidiary’s creditors, except to the extent that we may ourself be a creditor with recognized claims against the subsidiary.

We may sell debt securities at a substantial discount below their stated principal amount that bear no interest or below market rates of interest. The applicable prospectus supplement will describe the material federal income tax consequences and special investment considerations applicable to any such series of debt securities.

Provisions Generally Applicable to Both Senior and Junior Subordinated Debt Securities

Unless otherwise indicated, the following terms apply to both the senior debt securities and the junior subordinated debt securities and to both of the indentures.

Terms Specified in the Prospectus Supplement

A prospectus supplement relating to any series of debt securities being offered will include specific terms relating to the offering.

 

11


Table of Contents

With respect to either indenture, the prospectus supplement will include some or all of the following for a particular series of debt securities:

 

   

the title of debt securities;

 

   

any limit on the aggregate principal amount of the debt securities;

 

   

the price or prices at which we will sell the debt securities;

 

   

the maturity date or dates of the debt securities;

 

   

the per annum interest rate or rates, if any, on the series and the date or dates from which any such interest will accrue;

 

   

whether the amount of payments of principal of and premium, if any, or interest on the debt securities may be determined with reference to any index, formula or other method, such as one or more currencies, commodities, equity indices or other indices, and the manner of determining the amount of such payments;

 

   

the dates or dates, or the method by which such date or dates will be determined or, in the case of the junior subordinated indenture, extended, on which we will pay interest on the debt securities and the regular record date for determining who is entitled to the interest payable on any interest payment date;

 

   

the place or places where the principal of and premium, if any, and interest on the debt securities will be payable;

 

   

if we possess the option to do so, the periods within which and the prices at which we may redeem the debt securities, in whole or in part, pursuant to optional redemption provisions, and the other terms and conditions of any such provisions;

 

   

our obligation, if any, to redeem, repay or purchase debt securities by making periodic payments to a sinking fund or through an analogous provision or at the option of holders of the debt securities, and the period or periods within which and the price or prices at which we will redeem, repay or purchase the debt securities, in whole or in part, pursuant to such obligation, and the other terms and conditions of such obligation;

 

   

the denominations in which the debt securities will be issued, if other than $1,000 and integral multiples of $1,000;

 

   

the portion or methods of determining the portion of the principal amount of the debt securities which we must pay upon the acceleration of the maturity of the debt securities in connection with an Event of Default, as described below, if other than the full principal amount;

 

   

the currency, currencies or currency unit in which we will pay the principal of and premium, if any or interest, if any, on the debt securities, if not United States dollars;

 

   

provisions, if any, granting special rights to holders of the debt securities upon the occurrence of specified events;

 

   

any deletions from, modifications of or additions to the Events of Default or our covenants with respect to the applicable series of debt securities, and whether or not such Events of Default or covenants are consistent with those contained in the applicable indenture;

 

   

the application, if any, of the terms of the applicable indenture relating to defeasance and covenant defeasance, which terms are described below, to the debt securities;

 

   

whether any of the debt securities will be issued in global form and, if so, the terms and conditions upon which global debt securities may be exchanged for certificated debt securities;

 

   

the depositary for global or certificated debt securities;

 

   

any trustees, authenticating or paying agents, transfer agents or registrars or other agents with respect to the debt securities;

 

12


Table of Contents
   

whether and under what circumstances we may from time to time, without the consent of holders of debt securities, issue additional debt securities, having the same ranking and the same interest rate, maturity and other terms as the debt securities being offered, except for the issue price and issue date and, in some cases, the first interest payment date, whereby such additional securities will, together with the then outstanding debt securities, constitute a single class of debt securities under the applicable indenture, and will vote together on matters under the applicable indenture; and

 

   

any other terms of the debt securities consistent with the provisions of the applicable indenture.

With respect to the junior subordinated indenture, the prospectus supplement may also include some or all of the following for a particular series of debt securities:

 

   

our right, if any, and/or obligation, if any, at any time and/or from time to time, during the term of the junior subordinated debt securities of any series, to defer payments of interest on the junior subordinated debt securities of such series and the terms and conditions of such right and/or obligation, if applicable; and

 

   

our right, if any, and/or obligation, if any, to satisfy our obligation to pay interest then outstanding on and/or principal of the junior subordinated debt securities of a series by selling our common stock, warrants on common stock, securities mandatorily convertible into common stock or non-cumulative perpetual preferred stock or other qualifying securities specified in connection with establishment of the junior subordinated debt securities of such series to third parties that are not our subsidiaries (i.e., a “share settlement mechanism”), the proceeds of which shall be paid to the holders of the junior subordinated debt securities, in satisfaction of interest or principal, as applicable, then due on such junior subordinated debt securities and the terms and conditions of such right and/or obligation, if applicable.

Consolidation, Merger, Sale of Assets and Other Transactions

Under each of the indentures, so long as any debt securities are outstanding, we may not consolidate or merge with another corporation or convey, transfer or lease its properties or assets as an entirety or substantially as an entirety to another person, unless:

 

   

the successor or purchaser is a corporation organized under the laws of the United States, any state within the United States or the District of Columbia;

 

   

the successor or purchaser expressly assumes our obligations under the applicable indenture and the applicable debt securities; and

 

   

immediately after the transaction, no Event of Default, and no event which, if notice was given and/or a certain period of time passed, would become an Event of Default, shall exist.

Except as described above, neither of the indentures nor the applicable debt securities contain change of control or similar provisions intended to protect you by requiring us to repurchase or redeem the debt securities if we become involved in a merger or other significant corporate event. In addition, except as described above, no indenture provisions prohibit us from entering into a merger or a significant corporate event.

Events of Default

Unless we tell you otherwise in an accompanying prospectus supplement, the following shall constitute “Events of Default” under each of the indentures with respect to each series of the applicable debt securities:

 

   

our failure for 30 days to pay any interest on any debt security of such series when due;

 

   

our failure to pay principal or premium, if any, on any debt security of such series at maturity;

 

   

our failure to pay any sinking fund installment on any debt security of such series when due;

 

13


Table of Contents
   

our failure to perform any of our covenants with respect to such debt securities for 60 days after we receive notice of such failure;

 

   

certain events of bankruptcy, insolvency or reorganization of Ambac, Ambac Assurance or any successor to the business of Ambac Assurance which is also a subsidiary of Ambac; and

 

   

any other event of default established for the debt securities of such series.

We are required to file with the trustee each year a written statement as to our compliance with certain of our obligations under each of the indentures.

Remedies

Under each of the indentures, if an Event of Default resulting from the failure to pay interest or principal or premium, if any, on the debt securities of any series exists, either the trustee or the holders of 25% in aggregate principal amount of outstanding debt securities of such series may declare the principal of all the outstanding debt securities of that series and all accrued interest on the applicable debt securities immediately due.

If one of the other Events of Default exists, either the trustee or the holders of 25% in aggregate principal amount of the outstanding debt securities of all existing series, voting together as one class, may declare the principal of all the outstanding debt securities of all series and all accrued interest on the applicable debt securities immediately due.

Under certain conditions, these declarations may be annulled and defaults which have been cured may be waived by the holders of a majority in aggregate principal amount of the outstanding debt securities of the affected series, voting separately, or of all series of the applicable debt securities, voting together as one class, whichever was required to make the declaration in the first place.

Before the principal of the debt securities of any series is declared immediately due as described above, the holders of a majority in aggregate principal amount of the outstanding debt securities of the affected series, voting separately, or of all series, voting together as one class, depending on the nature of the Event of Default, may waive any Event of Default other than an Event of Default:

 

   

resulting from a failure to pay principal of and premium, if any, or interest on any of the debt securities or

 

   

in respect of a provision of the applicable indenture which cannot be modified without the consent of the holder of each debt security affected by the modification.

If an Event of Default occurs, the holders of a majority in aggregate principal amount of the outstanding debt securities of the affected series, voting separately, or of all series of the applicable debt securities, voting together as one class, depending on the nature of the proceeding, may direct the time, method and place of conducting any proceeding for any remedy available to the trustee, or exercising any trust or power conferred on the trustee. However, unless the applicable indenture requires otherwise, the trustee is not under any obligation to exercise any of its rights or powers under the applicable indenture at the request or direction of holders of applicable debt securities unless such holders offer indemnity reasonably satisfactory to the trustee.

Defeasance and Covenant Defeasance

We may, at our option, irrevocably deposit with the trustee money and/or United States government obligations in an amount that would be sufficient to pay the principal of and premium, if any, and interest on the debt securities of a series when each payment becomes due. If we do so, we may then elect to take advantage of the concept of defeasance, which allows us to be discharged from our obligations on the debt securities of such series, other than certain continuing obligations specified in each indenture relating to:

 

   

the transfer of debt securities;

 

14


Table of Contents
   

the replacement of temporary or mutilated, lost or stolen debt securities; and

 

   

the place we maintain for payments of the debt securities.

Alternately, we may elect to take advantage of the concept of covenant defeasance, which allows us to be discharged from our obligations with respect to the debt securities of such series under certain covenants.

Notwithstanding the deposit of funds and/or United States government obligations described above, in order to effect defeasance or covenant defeasance, each indenture requires us to deliver to the trustee an opinion of counsel that the contemplated defeasance or covenant defeasance will not cause the holders of debt securities of the relevant series to recognize income, gain or loss for federal income tax purposes.

Modification and Waiver

Under each of the indentures, Ambac and the trustee may modify the applicable indenture or any supplemental indenture in a manner that affects the interests or rights of the holders of debt securities with the consent of the holders of at least a majority in principal amount of the outstanding debt securities of all affected series, voting together as one class. However, no modification may, without the consent of the holder of each outstanding debt security affected by the modification, among other things:

 

   

a change in the stated maturity of the principal of, or any installment of interest, if any, on any debt securities;

 

   

reduce the principal of or any premium on any debt securities or reduce the rate of interest on any debt security;

 

   

reduce the amount of principal of any original issue discount securities that would be due and payable upon an acceleration of the maturity of the debt security;

 

   

adversely affect any right of repayment at the option of any holder;

 

   

change any currency in which the principal of, premium on or interest on any debt securities are payable;

 

   

impair the holder’s right to institute suit to enforce the payment of any debt securities on or after their stated maturity or, in the case of redemption, on or after the redemption date; or

 

   

reduce the percentage of debt securities of any series issued whose holders must consent to, or modify any provisions of the applicable indenture relating to, any supplemental indenture or any waiver of compliance with specific provisions of the indenture or specified defaults under the indenture and their consequences, except to increase any such percentage or to provide that certain other provisions of the indenture cannot be modified or waive without the consent of holders affected thereby.

Each of the indentures also contain provisions permitting us and the trustee, without the consent of the holders of any debt securities issued thereunder, to modify or amend the indenture, among other things:

 

   

to evidence the succession of another corporation to us and the assumption of our covenants contained in the applicable indenture and the debt securities;

 

   

to add to our covenants for the benefit of the holders of all or any series of debt securities or to surrender any right or power conferred upon us;

 

   

to add any additional events of default with respect to all or any series of debt securities;

 

   

to add to or change any provisions of the indenture to facilitate the issuance of bearer securities;

 

   

to add, change or eliminate any of the provisions of this indenture with respect to all or any series of debt securities;

 

   

to secure the debt securities in accordance with the indenture;

 

   

to establish the form or terms of debt securities of any series permitted under the indenture;

 

15


Table of Contents
   

to allow for the issuance of additional debt securities of any series;

 

   

to evidence and provide for the acceptance of appointment by a successor trustee and to add or change any provisions of the indenture as shall be necessary to facilitate the administration of the trusts under the indenture;

 

   

to cure any ambiguity or correct or supplement any provision in the indenture which may be inconsistent with other provisions in the indenture, or to make any other provisions with respect to matters or questions arising under the indenture which will not adversely affect the interests in any material respect of the holders of the debt securities of any series then outstanding; or

 

   

to make any changes to the indenture in order to conform the indenture to the final prospectus provided to investors in connection with the initial offering of the debt securities.

In addition, under the junior subordinated indenture, the following modifications and amendments will not be effective against any holder without its consent:

 

   

a change in the manner of calculating payments due on the junior subordinated debt securities of any series in a manner adverse to holders of such junior subordinated debt securities;

 

   

a change in the place of payment for any payment on the junior subordinated debt securities of any series that is adverse to holders of such junior subordinated debt securities or a change in the currency in which any payment on such junior subordinated debt securities is payable; and

 

   

a change in the subordination of the junior subordinated debt securities of any series in a manner adverse to holders of such junior subordinated debt securities.

Each of the indentures permits the holders of a majority in aggregate principal amount of the outstanding debt securities of all series, voting together as one class, to waive our compliance with certain covenants contained in the applicable indenture.

Payment and Paying Agents

We will make payment of principal of and premium, if any, and interest on debt securities at the place we designate. We may, at our option, make payments of interest by check mailed to the address of the person entitled to receive such interest payment according to the register for the debt securities or by transfer to an account of such person. Interest payments will be made to the person in whose name a debt security is registered as of a certain number of days prior to the relevant payment date. Although we may designate additional paying agents or remove paying agents, we will at all times maintain a paying agent in each place we designate for payment.

If the debt securities are represented by global certificates, payments will be made to The Depository Trust Company.

Denominations, Registrations and Transfer

Unless we tell you otherwise in an accompanying prospectus supplement, debt securities will be represented by one or more global certificates registered in the name of a nominee for The Depository Trust Company. In such case, each owner’s beneficial interest in the global securities will be shown on the records of DTC and transfers of beneficial interests will only be effected through DTC’s records.

Beneficial interests in a global security may only be exchanged for certificated securities registered in the particular owner’s name if:

 

   

DTC notifies us that it is unwilling or unable to continue serving as the depositary for the relevant global securities or DTC ceases to maintain certain qualifications under the Securities Exchange Act of 1934, as amended, and no successor depositary has been appointed for 90 days;

 

16


Table of Contents
   

we determine, in our sole discretion, that the global security shall be exchangeable; or

 

   

an Event of Default has occurred and is continuing.

If debt securities are issued in certificated form, they will only be issued in the minimum denomination specified in the accompanying prospectus supplement and integral multiples of such denomination. Transfers and exchanges of such debt securities will only be permitted in such minimum denomination. Transfers of debt securities in certificated form may be registered at the trustee’s corporate office or at the offices of any paying agent or trustee appointed by Ambac under the applicable indenture. Exchanges of debt securities for an equal aggregate principal amount of debt securities in different denominations may also be made at such locations.

Governing Law

Each of the indentures and the applicable debt securities will be governed by the laws of New York.

Our Relationship with the Trustee

The Trust Indenture Act of 1939 contains limitations on the rights of a trustee, should it become a creditor of Ambac, to obtain payment of claims in certain cases or to realize on certain property received by it in respect of those claims, as security or otherwise. Bank of New York Mellon, as trustee, is permitted to engage in other transactions with Ambac and its subsidiaries from time to time, provided that if Bank of New York Mellon acquires any conflicting interest it must eliminate the conflict upon the occurrence of an event of default under the relevant indenture, or else resign.

The trustee under the indentures, Bank of New York Mellon, occasionally acts as trustee in connection with obligations insured by Ambac and its subsidiaries. Bank of New York Mellon is also acting as a trustee in connection with certain debt obligations that were previously issued by us and as a creditor under the $400 million revolving credit facility entered into by Ambac and its subsidiary Ambac Assurance Corporation. In addition, we have various business dealings with affiliates of the trustee.

Conversion or Exchange Rights

The prospectus supplement will describe the terms, if any, on which a series of debt securities may be convertible into or exchangeable for our preferred stock, common stock, warrants or other debt securities. These terms will include provisions as to whether conversion or exchange is mandatory, at the option of the holder or at our option. These provisions may allow or require the number of our shares of common stock, shares of preferred stock, warrants or other debt securities to be received by the holders of such series of debt securities to be adjusted.

Provisions Applicable Solely to Senior Debt Securities

Unless we tell you otherwise in an accompanying prospectus supplement, the following restrictive covenants shall apply with respect to each series of our senior debt securities:

Limitation on Liens. So long as any senior debt securities are outstanding, neither Ambac nor any of its subsidiaries will create, incur or guarantee any debt which is secured by any mortgage, pledge, lien, security interest or other encumbrance on any capital stock of Ambac Assurance, any successor to the business of Ambac Assurance which is also a subsidiary of Ambac or any corporation, other than Ambac, having direct or indirect control of Ambac Assurance or any such successor. However, this restriction will not apply if the senior debt securities then outstanding are secured at least equally and ratably with the otherwise prohibited secured debt so long as it is outstanding.

 

17


Table of Contents

Limitations on Dispositions of Stock of Certain Subsidiaries. So long as any debt securities are outstanding and subject to the provisions of the senior indenture regarding mergers, consolidations and sales of assets, neither Ambac nor any of its subsidiaries will sell or otherwise dispose of any shares of capital stock of Ambac Assurance, any successor to the business of Ambac Assurance which is also a subsidiary of Ambac or any corporation, other than Ambac, having direct or indirect control of Ambac Assurance or any such successor, except for:

 

   

a sale or other disposition of any of such stock to a wholly-owned subsidiary of Ambac or of such subsidiary;

 

   

a sale or other disposition of all of such stock for at least fair value, as determined by Ambac’s board of directors acting in good faith, or

 

   

a sale or other disposition of any of such stock for at least fair value, as determined by Ambac’s board of directors acting in good faith, if, after such transaction, Ambac and its subsidiaries would own more than 80% of the issued and outstanding voting stock of Ambac Assurance or any such successor.

Provisions Applicable Solely to Junior Subordinated Debt Securities

General

Our junior subordinated debt securities will be issued under the junior subordinated indenture. Holders of junior subordinated debt securities should recognize that contractual provisions in the junior subordinated debt indenture may prohibit us from making payments on these securities. The junior subordinated debt securities will rank on an equal basis with certain of our other junior subordinated debt that may be outstanding from time to time and will rank junior to all of our senior indebtedness, as defined below, including any senior debt securities that may be outstanding from time to time.

If we issue junior subordinated debt securities, the aggregate principal amount of senior indebtedness outstanding as of a recent date will be set forth in the applicable prospectus supplement. Neither the senior nor the junior subordinated debt indenture restricts the amount of senior indebtedness that we may incur.

Subordination

The payment of the principal of, and premium, if any, and interest on the junior subordinated debt securities is expressly subordinated, to the extent and in the manner set forth in the junior subordinated indenture, in right of payment to the prior payment in full of all of our senior indebtedness.

Subject to the qualifications described below, the term “senior indebtedness” is defined in the junior subordinated indenture to include principal of, and interest and premium (if any) on, the following:

 

   

all indebtedness of Ambac (other than indebtedness issued pursuant to the junior subordinated indenture), whether outstanding on the date of the issuance of the junior subordinated debt securities of any series or thereafter created, incurred or assumed, which is for money borrowed, or which is evidenced by a note, bond, indenture or similar instrument;

 

   

all obligations of Ambac under leases required or permitted to be capitalized under generally accepted accounting principles;

 

   

all of Ambac’s reimbursement obligations with respect to any letter of credit, banker’s acceptance, security purchase facility or similar credit transactions;

 

   

all obligations of the types referred to in the preceding bullet points of another person, the payment of which Ambac is responsible or liable as guarantor or otherwise;

 

   

any agreements or obligations to pay deferred purchase price or conditional sales agreements other than in the ordinary course of business;

 

18


Table of Contents
   

all obligations of the types referred to in the preceding bullet points of another person secured by any lien on any property or assets of Ambac (whether or not that obligation has been assumed by Ambac); and

 

   

amendments, modifications, renewals, extensions, deferrals and refundings of any of the above types of indebtedness.

The junior subordinated debt securities will rank senior to all of our equity securities, including any preferred stock we may issue in the future.

The senior indebtedness will continue to be senior indebtedness and entitled to the benefits of the subordination provisions irrespective of any amendment, modification or waiver of any term of the senior indebtedness or extension or renewal of the senior indebtedness. Notwithstanding anything to the contrary in the foregoing, senior indebtedness will not include (1) indebtedness incurred for the purchase of goods, materials or property, or for services obtained in the ordinary course of business or for other liabilities arising in the ordinary course of business and (2) any indebtedness which by its terms is expressly made equal in rank and payment with or subordinated to the junior subordinated debt securities of any series.

The junior subordinated indenture provides that, unless all principal of, and any premium or interest on, the senior indebtedness has been paid in full, or provision has been made to make these payments in full, no payment or other distribution may be made with respect to the junior subordinated indebtedness in the following circumstances.

 

   

any insolvency, bankruptcy, receivership, liquidation, reorganization, readjustment, composition or other similar proceeding relating to Ambac, its creditors or its property;

 

   

any proceeding for the liquidation, dissolution or other winding-up of Ambac, voluntary or involuntary, whether or not involving insolvency or bankruptcy proceedings;

 

   

any assignment by Ambac for the benefit of creditors;

 

   

any other marshaling of the assets of Ambac;

 

   

a default in the payment of principal, premium, if any, sinking fund or interest with respect to any of our senior indebtedness, whether at maturity or at a date fixed for prepayment or declaration or otherwise; or

 

   

an event of default occurs with respect to any senior indebtedness permitting the holders to accelerate the maturity and written notice of such event of default, requesting that payments on the junior subordinated debt securities cease, is given to Ambac by the holders of senior indebtedness unless and until such default in payment or event of default has been cured or waived or ceases to exist.

A merger, consolidation or conveyance of all or substantially all of our assets on the terms and conditions provided in the junior subordinated indenture will not be deemed a liquidation, dissolution or winding-up for the purposes of these subordination provisions.

Notwithstanding the foregoing subordination provisions, we may make payments or distributions on the junior subordinated debt securities of any series so long as:

 

   

the payments or distributions consist of securities issued by us or another company in connection with a plan of reorganization or readjustment; and

 

   

payment on those securities is subordinate to outstanding senior debt and any securities issued with respect to senior debt under such plan of reorganization or readjustment at least to the same extent provided in the subordination provisions of such junior subordinated debt securities.

If the holders of junior subordinated securities receive any payment or distribution of our assets not permitted by the subordination provisions, the holders of junior subordinated debt securities will have to repay that amount to the holders of the senior debt securities or to the trustee.

 

19


Table of Contents

Subrogation

After the payment in full of all senior indebtedness, the holders of the junior subordinated debt securities will be subrogated to the rights of the holders of senior indebtedness to receive payments or distributions of our assets or securities applicable to the senior indebtedness until the junior subordinated debt securities are paid in full. Under these subrogation provisions, no payments or distributions to the holders of senior indebtedness which otherwise would have been payable or distributable to holders of the junior subordinated debt securities will be deemed to be a payment by us to holders of or on the account of the senior indebtedness. These provisions of the junior subordinated indenture are intended solely for the purpose of defining the relative rights of the holders of the junior subordinated debt securities and the holders of the senior debt securities. Nothing contained in the junior subordinated indenture is intended to impair our absolute obligation to pay the principal of and premium and interest on the junior subordinated debt securities in accordance with their terms or to affect the relative rights of the holders of the junior subordinated debt securities and our creditors other than the holders of the senior indebtedness. These subrogation provisions of the junior subordinated indenture will not prevent the holder of any junior subordinated debt security from exercising all remedies otherwise permitted by applicable law upon default of that security, subject to the rights of subordination described above.

 

20


Table of Contents

Description of Warrants

We may issue warrants to purchase our debt securities, preferred stock or common stock. Each warrant will entitle the holder of warrants to purchase for cash the amount of debt securities, preferred stock or common stock at the exercise price stated or determinable in the prospectus supplement for the warrants. We may issue warrants independently or together with any offered securities. The warrants may be attached to or separate from those offered securities. We will issue the warrants under warrant agreements to be entered into between us and a bank or trust company, as warrant agent, all as described in the applicable prospectus supplement. The warrant agent will act solely as our agent in connection with the warrants and will not assume any obligation or relationship of agency or trust for or with any holders or beneficial owners of warrants.

The prospectus supplement relating to any warrants that we may offer will contain the specific terms of the warrants. These terms may include the following:

 

   

the title of the warrants;

 

   

the price or prices at which the warrants will be issued;

 

   

the designation, amount and terms of the securities for which the warrants are exercisable;

 

   

the designation and terms of our debt securities, preferred stock or common stock, if any, with which the warrants are to be issued and the number of warrants issued with each such debt security, preferred stock or common stock;

 

   

the aggregate number of warrants;

 

   

any provisions for adjustment of the number or amount of securities receivable upon exercise of the warrants or the exercise price of the warrants;

 

   

the price or prices at which the securities purchasable upon exercise of the warrants may be purchased;

 

   

the date on and after which the warrants and the securities purchasable upon exercise of the warrants will be separately transferable, if applicable;

 

   

a discussion of any material U.S. federal income tax considerations applicable to the exercise of the warrants;

 

   

the date on which the right to exercise the warrants will commence, and the date on which the right will expire;

 

   

the maximum or minimum number of warrants that may be exercised at any time;

 

   

information with respect to book-entry procedures, if any; and

 

   

any other terms of the warrants, including terms, procedures and limitations relating to the exchange and exercise of the warrants.

 

21


Table of Contents

Description of Stock Purchase Contracts and Stock Purchase Units

The following is a general description of the terms of the stock purchase contracts and stock purchase units we may issue from time to time.

The applicable prospectus supplement will describe the terms of any stock purchase contracts or stock purchase units and, if applicable, prepaid stock purchase contracts. The description in the prospectus supplement will be qualified in its entirety by reference to (1) the stock purchase contracts, (2) the collateral arrangements and depositary arrangements, if applicable, relating to such stock purchase contracts or stock purchase units and (3) if applicable, the prepaid stock purchase contracts and the document pursuant to which such prepaid stock purchase contracts will be issued.

Stock Purchase Contracts

We may issue stock purchase contracts, including contracts obligating holders to purchase from us, and obligating us to sell to holders, a fixed or varying number of common stock, preferred stock or depositary shares at a future date or dates. The consideration per share of common stock, preferred stock or depositary shares may be fixed at the time that the stock purchase contracts are issued or may be determined by reference to a specific formula set forth in the stock purchase contracts. Any stock purchase contract may include anti-dilution provisions to adjust the number of shares issuable pursuant to such stock purchase contract upon the occurrence of certain events.

Stock Purchase Units

The stock purchase contracts may be issued separately or as a part of units (“stock purchase units”), consisting of a stock purchase contract and debt securities, preferred securities or debt or equity obligations of third parties, including U.S. Treasury securities, in each case securing holders’ obligations to purchase common stock, preferred stock or depositary shares under the stock purchase contracts. The stock purchase contracts may require us to make periodic payments to holders of the stock purchase units, or vice versa, and such payments may be unsecured or prefunded and may be paid on a current or on a deferred basis. The stock purchase contracts may require holders to secure their obligations thereunder in a specified manner and in certain circumstances we may deliver newly issued prepaid stock purchase contracts upon release to a holder of any collateral securing such holder’s obligations under the original stock purchase contract. Any one or more of the above securities, common stock or the stock purchase contracts or other collateral may be pledged as security for the holders’ obligations to purchase or sell, as the case may be, the common stock, preferred stock or depositary shares under the stock purchase contracts. The stock purchase contracts may also allow the holders, under certain circumstances, to obtain the release of the security for their obligations under such contracts by depositing with the collateral agent as substitute collateral U.S. Treasury securities with a principal amount at maturity equal to the collateral so released or the maximum number of shares deliverable by such holders under stock purchase contracts requiring the holders to sell common stock, preferred stock or depositary shares to us.

 

22


Table of Contents

WHERE YOU CAN FIND MORE INFORMATION

We file reports, proxy statements, and other information with the SEC. These reports, proxy statements, and other information can be read and copied at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. The SEC maintains an internet site at http://www.sec.gov that contains reports, proxy and information statements and other information regarding companies that file electronically with the SEC, including Ambac. These reports, proxy statements and other information can also be read at the offices of the NYSE, 20 Broad Street, New York, New York 10005 or on our internet site at www.ambac.com. Information on our website is not incorporated into this prospectus or our other SEC filings and is not a part of this prospectus or those filings.

This prospectus is part of a registration statement filed by us with the SEC. The full registration statement can be obtained from the SEC as indicated above, or from us.

The SEC allows us to “incorporate by reference” the information we file with the SEC. This permits us to disclose important information to you by referencing these filed documents. Any information referenced this way is considered part of this prospectus, and any information filed with the SEC subsequent to this prospectus and prior to the termination of the particular offering referred to in such prospectus supplement will automatically be deemed to update and supersede this information. We incorporate by reference the following documents which have been filed with the SEC:

 

   

Annual Report on Form 10-K for the fiscal year ended December 31, 2006 (filed on March 1, 2007);

 

   

Quarterly Reports on Form 10-Q for the quarters ended March 31, 2007 (filed on May 10, 2007), June 30, 2007 (filed on August 9, 2007) and September 30, 2007 (filed on November 9, 2007);

 

   

Current Reports on Form 8-K filed on January 31, 2007, February 2, 2007, February 12, 2007, April 25, 2007, July 25, 2007, August 3, 2007, October 11, 2007, October 24, 2007, October 30, 2007, November 7, 2007, November 13, 2007, December 14, 2007 (two Current Reports on Form 8-K); December 21, 2007; December 27, 2007 and January 16, 2008, in each case excluding any portions of such Current Reports on Form 8-K which are specifically or deemed to be furnished to the SEC;

 

   

portions of our Definitive Proxy Statement on Schedule 14A filed on March 30, 2006 that are incorporated by reference into Part III of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006; and

 

   

Registration Statements on Form 8-A dated June 12, 1991 and February 28, 1996.

We incorporate by reference the documents listed above and any future filings made with the SEC in accordance with Sections 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934, with the exception of any documents deemed not to be filed and any documents filed pursuant to Item 402(a)(8) of Regulation S-K under the Securities Act.

We will provide without charge upon written or oral request, a copy of any or all of the documents which are incorporated by reference in this prospectus, other than exhibits which are specifically incorporated by reference into those documents. Requests should be directed to Peter R. Poillon, Managing Director, Investor Relations, Ambac Financial Group, Inc., One State Street Plaza, New York, New York 10004 (telephone number (212) 208-3333 or at ppoillon@ambac.com).

 

23


Table of Contents

LEGAL OPINIONS

Anne Gill Kelly, Esq., Managing Director, Corporate Secretary and Assistant General Counsel of Ambac, One State Street Plaza, New York, New York 10004, and/or Skadden, Arps, Slate, Meagher & Flom LLP, New York, New York 10036 will act as our legal counsel. Anne Gill Kelly, Esq. will pass upon the legality of the securities registered hereby. Anne Gill Kelly, Esq. beneficially owns, or has the right to acquire under Ambac’s employee benefit plans, an aggregate of less than 1% of Ambac’s common stock.

 

24


Table of Contents

EXPERTS

Ambac’s consolidated financial statements and related financial statement schedules as of December 31, 2006 and 2005 and for each of the years in the three-year period ended December 31, 2006 and management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2006, have been incorporated by reference in this prospectus (and the registration statement of which it forms a part) in reliance upon the reports of KPMG LLP, independent registered public accounting firm, thereon, which reports are also incorporated by reference in this prospectus (and the registration statement of which it forms a part), and upon the authority of said firm as experts in accounting and auditing. The report of KPMG LLP on such consolidated financial statements and related financial statement schedules refers to changes in Ambac’s method of accounting for variable interest entities and stock-based compensation in 2006.

 

25


Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

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

For the fiscal year ended December 31, 2007

 

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

For the transition period from              to             

Commission file number 1-10777

 

 

Ambac Financial Group, Inc.

(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   New York Stock Exchange, Inc.
                5.875% Debentures, Due March 24, 2103   New York Stock Exchange, Inc.
                5.95% Debentures, Due February 28, 2103   New York Stock Exchange, Inc.

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

 

 

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

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

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

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

Large Accelerated Filer  x        Accelerated filer  ¨        Non-accelerated filer  ¨

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

The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2007 was $8,847,312,379 (based upon the closing price of the Registrant’s shares of the New York Stock Exchange on that date, which was $87.19). 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 February 20, 2008, 101,633,722 shares of Common Stock, par value $0.01 per share, (net of 7,559,374 treasury shares) were outstanding.

Documents Incorporated By Reference

Portions of Ambac Financial Group, Inc.’s Proxy Statement for its 2008 Annual Meeting of Stockholders scheduled to be held on May 15, 2008 are incorporated by reference into the Annual Report on Form 10-K in response to Part III, Items 10, 11, 12 and 14.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page
  

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

   1
PART I      
Item 1.   

Business

   3
  

Introduction

   3
  

Business Segments

   5
  

Employees

   32
  

Corporate Governance

   32
Item 1A.   

Risk Factors

   32
Item 1B.   

Unresolved Staff Comments

   42
Item 2.   

Properties

   43
Item 3.   

Legal Proceedings

   43
Item 4.   

Submission of Matters to a Vote of Security Holders

   44
PART II      
Item 5.   

Market for Registrant’s Common Equity and Related Stockholder Matters

   45
Item 6.   

Selected Financial Data

   46
Item 7.   

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

   47
Item 7A.   

Quantitative and Qualitative Disclosures About Market Risk

   90
Item 8.   

Financial Statements and Supplementary Data

   96
Item 9.   

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   153
Item 9A.   

Controls and Procedures

   153
Item 9B.   

Other Information

   153
PART III      
Item 10.   

Directors and Executive Officers of the Registrant

   154
Item 11.   

Executive Compensation

   154
Item 12.   

Security Ownership of Certain Beneficial Owners and Management

   154
Item 13.   

Certain Relationships and Related Transactions

   154
Item 14.   

Principal Accountant Fees and Services

   154
PART IV      
Item 15.   

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

   154
SIGNATURES    160
FINANCIAL STATEMENT SCHEDULES    S-2


Table of Contents

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

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

Any or all of management’s forward-looking statements here or in other publications may turn out to be wrong and are based on Ambac’s management current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) changes in the economic, credit, foreign currency or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide credit markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) changes in our business plan, including our decision to discontinue writing new business in the financial services area, to significantly reduce new underwriting of structured finance business and to discontinue all new underwritings of structured finance business for six months, (7) the policies and actions of the United States and other governments; (8) changes in capital requirements whether resulting from downgrades in our insured portfolio or changes in rating agencies’ rating criteria or other reasons; (9) changes in Ambac’s and/or Ambac Assurance’s credit or financial strength ratings; (10) changes in accounting principles or practices relating to the financial guarantee industry or that may impact Ambac’s reported financial results; (11) inadequacy of reserves established for losses and loss expenses; (12) default by one or more of Ambac Assurance’s portfolio investments, insured issuers, counterparties or reinsurers; (13) credit risk throughout our business, including large single exposures to reinsurers; (14) market spreads and pricing on insured collateralized debt obligations (“CDOs”) and other derivative products insured or issued by Ambac; (15) credit risk related to residential mortgage securities and CDOs; (16) the risk that holders of debt securities or counterparties on credit default swaps or other similar agreements, seek to declare events of default or seek judicial relief or bring claims alleging violation or breach of covenants by Ambac or one of its subsidiaries; (17) the risk that our underwriting and risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss as a result of unforeseen risks; (18) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting, or FAS 133, to the portion of our credit enhancement business which is executed in credit derivative form; (19) operational risks, including with respect to internal processes, risk models, systems and employees; (20) the risk of decline in market position; (21) the risk that market risks impact assets in our investment portfolio; (22) the risk of credit and liquidity risk due to unscheduled and unanticipated withdrawals on Investment Agreements; (23) prepayment speeds on insured asset-backed securities; (24) factors that may influence the amount of installment premiums paid to Ambac; (25) the risk that we may be required to raise additional capital, which could have a dilutive effect on our outstanding equity capital and/or future earnings; (26) ability or inability to raise additional capital, including the risks that regulatory or other approvals for any plan to raise capital are not obtained, or that various conditions to such a plan, either imposed by third parties or imposed by Ambac or its Board of Directors, are not satisfied and thus potentially necessary capital raising transactions do not occur, or the risk that for other reasons the Company cannot accomplish any potentially necessary capital raising transactions; (27) the risk that Ambac’s holding company structure and certain regulatory and other constraints, including adverse business performance,

 

1


Table of Contents

affect Ambac’s ability to pay dividends and make other payments; (28) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on our business, operations, financial position, profitability or cash flows; (29) other factors described in the Risk Factors section in Part I, 1A of this Annual Report on Form 10-K and also disclosed from time to time by Ambac in its subsequent reports on Form 10-Q and Form 8-K, which are or will be available on the Ambac website at www.ambac.com and at the SEC’s website, www.sec.gov; and (30) other risks and uncertainties that have not been identified at this time. Readers are cautioned that forward-looking statements speak only as of the date they are made and that Ambac does not undertake to update forward-looking statements to reflect circumstances or events that arise after the date the statements are made. You are therefore advised to consult any further disclosures we make on related subjects in Ambac’s reports to the SEC.

 

2


Table of Contents

Part I

 

Item 1. Business.

INTRODUCTION

Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products (including credit derivatives) and provides other financial services to clients in both the public and private sectors around the world. Ambac was incorporated on April 29, 1991. Ambac’s activities are divided into two business segments: (i) Financial Guarantee and (ii) Financial Services. Ambac provides financial guarantee insurance for public and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation. Ambac Assurance is the successor to the founding financial guarantee insurance company, which wrote the first bond insurance policy in 1971. As an alternative to financial guarantee insurance credit protection is provided by Ambac Credit Products, a subsidiary of Ambac Assurance, in credit derivative format. Through its financial services subsidiaries, Ambac has provided financial and investment products including investment agreements, funding conduits, interest rate, currency and total return swaps, principally to its clients of the financial guarantee business. Please see “Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion.

As a holding company, Ambac is largely dependent on dividends from Ambac Assurance to pay dividends on its common stock, to pay principal and interest on its indebtedness and to pay its operating expenses. Dividends from Ambac Assurance are subject to certain insurance regulatory restrictions. See “Insurance Regulatory Matters—Wisconsin Dividend Restrictions” section and “Management’s Discussion and Analysis—Liquidity and Capital Resources” located in Part II, Item 7 for further information.

Ambac’s internet address is www.ambac.com. We make available free of charge, or through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934.

Recent Developments:

Currently, Ambac Assurance has triple-A financial strength ratings from Moody’s Investors Services, Inc. (“Moody’s”) and Standard and Poor’s Rating Services (“S&P”), and a double-A rating from Fitch Inc. (“Fitch”) (downgraded from triple-A on January 18, 2008). These ratings are an essential part of Ambac Assurance’s ability to provide credit enhancement and are essential to Ambac Assurance’s ability to compete in the financial guarantee business. See “Rating Agencies” section below for further information. Considering the high levels of delinquencies and defaults within residential mortgage loans, each of these rating agencies began a review of the capital adequacy of the financial guarantee industry in the fall of 2007. In late December 2007, following the rating agency reviews, Ambac Assurance’s triple-A rating was affirmed by both S&P (with “negative outlook”) and Moody’s; however, Fitch placed Ambac’s triple-A rating on “rating watch negative” and stated that Ambac Assurance had a modeled $1 billion capital shortfall. On January 16, 2008, Moody’s put Ambac Assurance’s triple-A rating on review for possible downgrade. On January 18, 2008, S&P placed Ambac Assurance’s triple-A financial strength rating on Credit Watch Negative. On January 18, 2008, Fitch downgraded Ambac Assurance’s insurance financial strength rating to double-A (“ratings watch negative”). On February 25, 2008, S&P reaffirmed Ambac Assurance’s triple A rating, but kept it on Credit Watch Negative. On February 29, 2008, Moody’s publicly announced that it is continuing a review for possible downgrade that was initiated on January 16. 2008. Based on an updated assessment of Ambac Assurance’s mortgage risk, Moody’s believes that Ambac Assurance’s capital exceeds the minimum Aaa standard but falls below the Aaa target level. Moody’s further stated that Ambac is actively pursuing capital strengthening activities that, if successful, are expected to result in Ambac Assurance meeting Moody’s current estimate of the Aaa target level. There have been a number of recent developments with respect to ratings actions by the rating agencies. In light of the ongoing nature of ratings actions or announcements by the rating agencies, one should consult announcements by the rating agencies, the

 

3


Table of Contents

websites of the rating agencies and Ambac’s website for the then current publicly available information. These ratings actions have had a significant impact on Ambac Assurance’s ability to compete in the financial guarantee business. Please refer to Part I, Item 1 “Business—Business Segments—Financial Guarantee” below for further discussion as to its impact on the U.S. public finance and asset-backed and international markets.

Currently, Ambac Financial Group’s long-term senior unsecured debt is rated “AA” by S&P (negative outlook), “Aa2” by Moody’s (review for possible downgrade) and A by Fitch (Rating Watch Negative).

As a result of the rating agency actions described above, as well as significant disruption in the capital markets and investor concern with respect to our financial position, we have been able to write only a limited amount of new financial guarantee business since November 2007.

In recent months, we have undertaken a review of all our business units. In conducting this review, we considered the risk exposure within each business (including our view of the probability of default, the potential loss given default and the relevant correlations), the risk adjusted returns over the course of an economic cycle and Ambac’s franchise value and competitive advantages.

As a result of this review, in connection with our efforts to raise capital and maintain our triple-A ratings, we expect to:

 

   

Emphasize our public finance business (including municipal finance, healthcare and global utilities) and refocus our structured finance business (including emphasizing segments of the global infrastructure market, student loans, leasing & asset finance and structured insurance). Many of the above businesses will be subject to revised underwriting and risk management guidelines;

 

   

Suspend underwriting all structured finance businesses (domestic and international), for six months in order to accumulate capital;

 

   

Discontinue underwriting certain structured finance businesses (domestic and international), including collateralized debt obligations and collateralized loan obligations, mortgage-backed securities, whole business securitizations, auto and credit cards and emerging market transactions;

 

   

Discontinue the execution of credit enhancement transactions in credit default swap format;

 

   

Discontinue writing new Financial Services business; and

 

   

Focus on reducing single risk concentrations across our portfolio.

We also will reduce the quarterly dividend payable on our common shares to $.01 per share.

Notwithstanding these actions, management remains confident that its claim paying ability is adequate to support policyholder liabilities.

In addition, Ambac is in the process of evaluating several options related to its capitalization which are focused on maintaining Ambac Assurance’s triple-A financial strength rating from the major rating agencies. These options may include a plan to raise additional capital. In the event that we do not maintain our triple-A ratings, we believe that we can execute a significantly reduced business plan and operate with double-A ratings that will include Structured Finance, International and reinsurance across a variety of bond types. In that circumstance, we expect to accumulate capital and position ourselves to regain our triple-A ratings. Ambac will continue to work closely with the regulators and the rating agencies to design and implement a strategy to address the credit issues within its portfolio and to preserve and grow the business franchise.

 

4


Table of Contents

BUSINESS SEGMENTS

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

Financial Guarantee

The financial guarantee segment includes financial guarantee insurance and other credit enhancement products, such as credit derivatives. Financial guarantee insurance provides an unconditional and irrevocable guarantee that protects the holder of a fixed income obligation against non-payment of principal and interest when due. Essentially, Ambac Assurance or Ambac Assurance UK makes payments if the obligor responsible for making payments fails to do so. Ambac Assurance and its subsidiaries serve the global capital markets by providing financial guarantee insurance for public finance and structured finance obligations. Total net premiums earned and other credit enhancement fees from external customers, by geographic location of risk is discussed in Part II, Item 8 under Note 19 of Notes to Consolidated Financial Statements. Both issuers and investors benefit from financial guarantee insurance. Issuers typically benefit when the insurance has the effect of lowering their cost of borrowing because the insurance premium is less than the value of the spread between the yield on the insured obligation (carrying the credit rating of Ambac Assurance) and the yield of the uninsured obligation. Financial guarantee insurance also typically increases the marketability of obligations issued by infrequent or unknown issuers or in connection with complex financings. Investors generally benefit from increased liquidity in the secondary market, reduced exposure to price volatility caused by changes in the credit quality of the underlying obligor, monitoring and remediation by Ambac on insured transactions and added protection against a potential loss in the event that the obligor defaults on its obligation. As a result of the actions by the rating agencies in the fourth quarter of 2007 and the beginning of 2008, obligations guaranteed by Ambac Assurance and other financial guarantors have experienced significantly greater price volatility and reduced liquidity, thereby reducing some of the benefit noted above.

In certain floating rate insured transactions, the issuer of insured securities is party to an interest rate swap that hedges their risk to interest rates effectively creating a synthetic fixed rate obligation. In such transactions, Ambac Assurance has, from time-to-time, insured the issuer’s obligations under both the insured securities and the derivative contract.

As an alternative to financial guarantee insurance, credit protection relating to a particular pool of assets, security or issuer can be provided through a credit derivative. Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance, provides credit protection in the global markets in credit derivative form. These credit derivatives, which are privately negotiated contracts, provide the counterparty with credit protection against the occurrence of a specific event such as a payment default or bankruptcy relating to an underlying obligation. Upon a credit event, Ambac Credit Products is generally required to make payments equal to the difference between the scheduled debt service payment and the actual payment made by the issuer. In a small number of transactions, Ambac Credit Products is required to (i) make a payment equal to the difference between the par value and market value of the underlying obligation or (ii) purchase the underlying obligation at its par value and a loss is realized for the difference between the par and market value of the underlying obligation. Substantially all of Ambac Credit Product’s credit derivative contracts relate to structured finance transactions. Credit derivatives issued by Ambac Credit Products are insured by Ambac Assurance. See “Quantitative and Qualitative Disclosures About Market Risk” located in Part II, Item 7A for further information about credit derivatives.

Ambac Assurance and its subsidiaries also guarantee or provide credit protection on obligations already carrying insurance from other financial guarantors, with Ambac Assurance obligated to pay only upon a default by both the underlying obligor and the original financial guarantor. At December 31, 2007, Ambac provided credit protection for $1.7 billion outstanding par on these obligations, primarily through the issuance of credit derivatives. The weighted-average rating of these underlying obligations, excluding the guarantee from other financial guarantors, was BBB+ at December 31, 2007.

 

5


Table of Contents

In addition to the guarantees on fixed income obligations described above, Ambac Assurance, from time to time, enters into transactions that expose the company to risks which may not be correlated to credit risk, for example, market risk, weather-related or other disasters, mortality or other property and casualty type risk characteristics. Ambac underwrites such risks so that a substantial level of first loss protection would have to be exhausted before Ambac would become liable in respect of such risks. Additionally, Ambac underwrites such business primarily in relation to broad indices and reference pools which embody diverse risk characteristics.

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 derives financial guarantee revenues from: (i) premiums earned from insurance contracts; (ii) net investment income; (iii) revenue from credit derivative transactions; (iv) net realized gains and losses from sales of investment securities; and (v) certain structuring and other fees. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 and Note 19 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

Pricing:

Ambac Assurance determines premium rates on the basis of the type of transaction and its assessment of the risk it is guaranteeing. Factors considered in pricing include underlying credit ratings, 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 issue is considered in the pricing process as well as the cost and the projected return to Ambac Assurance.

Prior to the rating agency actions on Ambac Assurance and other financial guarantors, the business environment was extremely competitive stemming from bank funding, the uninsured market, senior/subordinate securitizations, other providers of credit derivatives and other triple-A rated financial guarantors. This increased competition had an adverse impact on pricing. In the fall of 2007, each of the major rating agencies (S&P, Moody’s and Fitch) began a review of the capital adequacy of the financial guarantee industry. As a result of their reviews, the major rating agencies have recently (i) changed their rating outlook for certain financial guarantors to “negative”, (ii) placed certain financial guarantee insurers on review for a possible downgrade, and (iii) downgraded certain financial guarantee insurers. Certain financial guarantors had their current ratings affirmed as “stable”. Distress in the current credit environment has produced credit spread widening. However, due to the uncertainty of Ambac’s ratings as indicated above, Ambac’s business has been limited and we have not been able to benefit from the pricing environment. As a result of these actions and the uncertainty regarding future actions to be taken by the rating agencies, Ambac Assurance has been placed at a competitive disadvantage in all three of the financial guarantee markets: public finance, structured finance and international finance. See “Competition” section below for further information.

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.

U.S. Public Finance Market

The U.S. public finance market includes all U.S. municipal issuance including general obligations, lease and tax-backed obligations, health care, housing, public utilities, transportation and higher education, as well as certain infrastructure privatization transactions, such as toll road and bridge financings, public transportation financings, stadium financings, military housing and student housing. Public finance obligations are generally supported by either the taxing authority of the issuer or the issuer’s or underlying obligor’s ability to collect fees or assessments for certain projects or public services. Although Ambac Assurance guarantees the full range of

 

6


Table of Contents

public finance obligations, Ambac Assurance concentrates on those projects 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, is being paid from a variety of revenue sources, including revenues derived from the project itself. Examples of these transactions include toll road financings, stadium financings, student housing and military housing. 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. 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.

U.S. Public Finance Long-Term Market

 

($ in Billions)

   New
Money
   Refundings    Total
Volume
   Refundings as
Percentage

of Total Volume
   Insured
Volume
   Insured Bonds
as Percentage
of Total Volume

1998

   204.7    82.0    286.7    28.6    145.5    50.7

1999

   189.3    38.3    227.6    16.8    105.6    46.4

2000

   181.3    19.5    200.8    9.7    79.3    39.5

2001

   223.5    64.7    288.2    22.4    134.4    46.6

2002

   266.7    92.1    358.8    25.7    178.9    49.9

2003

   288.7    95.0    383.7    24.8    190.7    49.7

2004

   271.7    88.4    360.1    24.5    192.7    53.5

2005

   277.6    130.7    408.3    32.0    233.0    57.1

2006

   309.5    79.1    388.6    20.3    184.8    47.5

2007

   351.4    76.2    427.6    17.8    201.0    47.0

Source: Amounts are reported by The Bond Buyer. Amounts represent gross par amounts issued or insured, respectively, during such year.

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. Volume since 2002 has exceeded historical levels as a result of the low interest rate environment and considerable infrastructure finance needs. Insured volume as a percentage of total volume (“insured penetration”) during 2004 through 2005 increased, largely the result of budget deficits experienced by municipalities and the corresponding flight to quality by investors. Beginning December 2007, insured penetration was reduced significantly as a result of the uncertainty regarding the financial stability of the financial guarantors, including Ambac Assurance. This has also caused a reduction in new issuances as certain municipalities either (i) delayed issuance, or (ii) were unable to find purchasers for their obligations, given that their issuance was not going to be insured by a financial guarantor.

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 insurance. 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.

 

7


Table of Contents

Ambac Assurance also provides financial guarantees on public finance bonds outstanding in the secondary market that are typically purchased by an institution to hedge or facilitate the sale of bonds in its portfolio or inventory. Historically, the financial guarantee 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. Ambac’s ability to underwrite insurance policies in the secondary market has also been adversely impacted by the actions of the rating agencies. 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. For secondary market transactions, Ambac is generally not afforded the same level of control over credit remediation as a new issue insurance policy.

Ambac Assurance guaranteed gross par of $52.3 billion, $43.1 billion and $53.8 billion in 2007, 2006 and 2005, respectively, in the U.S. public finance market. Public Finance new business guaranteed represented 41%, 35% and 43% of total gross par guaranteed for 2007, 2006 and 2005, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 for further information.

The table below shows our ten largest Public Finance exposures, by repayment source, as a percentage of total Financial Guarantee net par outstanding at December 31, 2007:

 

(Dollars in Millions)

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

California State—GO

   A+    $ 3,109    0.6 %

New Jersey Transportation Trust Fund Authority—Transportation System

   A+      2,162    0.4 %

Washington State—GO

   AA      1,879    0.4 %

Bay Area Toll Authority, CA Toll Bridge Revenue

   AA-      1,838    0.4 %

MTA, NY, Transportation Revenue (Farebox)

   A      1,724    0.3 %

California Department of Water Resources, Power Supply

   A      1,694    0.3 %

NYS Thruway Authority, Highway & Bridge Revenue

   AA-      1,488    0.3 %

New Jersey Economic Development Authority—School Facilities Construction

   A+      1,440    0.3 %

New Jersey Turnpike Authority Revenue

   A      1,374    0.3 %

Massachusetts Commonwealth—GO

   AA      1,327    0.3 %
                

Total

      $ 18,035    3.4 %
                

 

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

U.S. Structured Finance Market

As described above in part I, Item 1, “Introduction”, as part of its plan to raise additional capital and maintain triple-A ratings, Ambac has reduced or expects to suspend, discontinue or limit, its participation in various parts of the structured finance sector in 2008; our review of our activities in this sector is ongoing. In addition, we have been able to write only a limited amount of new financial guarantee business since November 2007. Following is a description of our participation in the structured finance sector to date.

 

8


Table of Contents

Financial guarantees of securities in the U.S. structured finance 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 cash flow generating assets. This pool of assets has an identifiable cash flow or market value and is generally held by a special purpose entity. Structured finance 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 includes the securitization of a variety of asset types such as mortgage loans, home equity loans, auto loans, student loans, credit card debt, leases, operating assets and CDOs where the majority of the underlying collateral risks are situated in the United States. Additionally, Ambac’s Structured finance business encompasses both secured and unsecured debt issued by investor-owned utilities. Included within the operating asset sector are securitizations of aircraft, rental car, shipping container and rail cars fleets, as well as film rights, franchise fees, pharmaceutical royalties, and intellectual property. Included within CDOs are transactions that contain significant risks to the Residential Mortgage-Backed Securities (“RMBS”) market, including subprime borrowers. Please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Residential Mortgage-Backed Securities Exposures” for further discussion.

Structured Finance includes credit enhancement for asset-backed commercial paper conduits (“conduits”). Conduits are used by issuers to efficiently fund assets in the commercial paper market. Typically sponsored by financial institutions, the conduits usually 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.

Structured Finance also includes the credit enhancement of CDOs. These transactions involve the securitization of a portfolio of corporate bonds, corporate loan obligations and/or asset-backed securities, including exposure to subprime residential mortgages (the “Securitized Assets”). The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms; however, the most common are over-collateralization, first loss and excess spread. In the case of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac), the structure allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations that have been guaranteed by Ambac. In the case of first loss, the financial guarantee only covers a senior layer of debt. A subordinated layer of debt is either retained by the seller or sold off in the form of equity and mezzanine debt to other investors; these subordinated layers absorb losses before the senior layer experiences any loss. In the case of excess spread, the Securitized Assets generate cash flow in the form of interest that is in excess of the interest payments on the related debt. Ambac has participated in CDO transactions whereby the underlying collateral contains other CDO assets (commonly referred to as CDO squared) or mezzanine tranches of RMBS securities. As a result of these underlying securities forming the collateral pool, the senior debt holders or guarantor is not afforded the same control rights or structural protection that is present in Ambac’s remaining guaranteed portfolio of CDOs. Currently, Ambac has $2.9 billion of risk to these transactions.

Unlike the public finance market in which a substantial portion of the deals are bid competitively by the financial guarantors, the U.S. structured finance market is often a negotiated one. The financial guarantor will work directly with the investment bank or client to create an acceptable structure once having been awarded the business. Ambac participates in these markets through the issuance of financial guarantee insurance policies and credit default swaps.

 

9


Table of Contents

The U.S. structured finance market in which Ambac provides financial guarantees is broad and varied, comprising public issues, private placements and bank loans. The increasing array of classes of assets securitized or guaranteed, and the ongoing rapid changes to the market, makes estimating the aggregate size of the market that we participate in difficult. Similar to the U.S. public finance market, the U.S. structured finance market has been adversely impacted by the rating agency actions including those with respect to Ambac Assurance, other financial guarantors as well as CDO and MBS securities.

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

Ambac Assurance guaranteed gross par of $53.6 billion, $62.4 billion and $58.8 billion in 2007, 2006 and 2005, respectively, in the U.S. structured finance market. U.S. Structured Finance new business guaranteed represents 43%, 50% and 47% of total gross par guaranteed for 2007, 2006 and 2005, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 for further discussion.

The table below shows our ten largest Structured Finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2007:

 

($ in Millions)

   Ambac
Rating(1)
   Net Par
Outstanding(2)
   % of Total
Net Par
Outstanding
 

CDO of ABS < 25% MBS

   AAA    $ 2,700    0.5 %

Private Commercial Asset-Backed Transaction

   BBB+      2,425    0.5 %

Kleros Preferred Funding VI, Ltd

   A      2,397    0.5 %

Iowa Student Loan Liquidity Corporation Revenue Bonds

   A      2,168    0.4 %

Ridgeway Court Funding II, Ltd

   AA-      1,942    0.4 %

Diversey Harbor ABS CDO, Ltd

   AA-      1,868    0.3 %

Wachovia Asset Securitization Issuance II, LLC 2007-HE2

   BBB+      1,827    0.3 %

Vermont Student Assistance Corporation Revenue Bonds

   A      1,779    0.3 %

Belle Haven ABS CDO 2006-1, Ltd

   A      1,667    0.3 %
                

Total

      $ 18,773    3.6 %
                

 

(1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac credit ratings are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.
(2) Ambac also has an outstanding commitment to provide a $2,934 financial guarantee on a pool of ABS CDO securities. Ambac has rated this exposure BBB+. For additional discussion, see “Residential Mortgage-backed Securities Exposure” within Part II, Item 7.

International Finance Market

As described above in part I, Item 1, “Introduction,” as part of its plan to raise additional capital and maintain triple-A ratings, Ambac has reduced, or expects to suspend, discontinue or limit, its participation in various parts of the structured finance sector in international markets in 2008; our review of our activities in this sector is ongoing. Following is a description of our participation in the structured finance sector in international markets to date.

 

10


Table of Contents

Outside of the United States, structured finance issuers, utilities, sub-sovereigns, banks and investors have used financial guarantee products, particularly in markets throughout Western Europe. 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 sponsors to secure long term financing and investors in such projects to seek the security of financial guarantee products. These privatization efforts are currently being initiated in most other European countries and Australia as well.

While the principles of securitization have been increasingly applied in overseas markets, development in particular countries has varied as a result of the relative sophistication of the local capital markets, level of bank disintermediation 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 UK Limited, insures a wide array of obligations in the international markets including infrastructure financings, asset-securitizations, CDOs, utility obligations, whole company securitizations (e.g. securitizations of substantially all of the operating assets of a corporation) and other obligations.

Ambac Assurance’s strategy in the international 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 future flow transactions from top tier issuers (structured transactions secured by U.S. Dollar and Euro cash flows generated from exports or payment remittances) in domestic securitizations and infrastructure financings.

Ambac UK, which is authorized and regulated in the United Kingdom to provide certain classes of general financial guarantees (and is also authorized to conduct business throughout much of the European Union), has been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the United Kingdom and the European Union. In 2005, Ambac UK established a branch office in Milan, Italy. Ambac UK has entered into net worth maintenance and reinsurance agreements with Ambac Assurance pursuant to which Ambac Assurance provides capital support to Ambac UK.

Ambac Assurance is party to an alliance in Japan with Sompo Japan Insurance Inc. (“Sompo Japan”), one of the largest property and casualty insurance companies in Japan. Although the development of the Japanese securitization market has been slow, Ambac has established a strong franchise in the consumer finance and whole business securitization sectors.

European securitization issuance achieved record levels in 2007, despite market turmoil. Residential mortgage-backed, collateralized debt obligations and commercial mortgage-backed sectors represented more than 89% and 85% of total issuance in 2007 and 2006, respectively. Tight credit spreads during 2007 continued to impact the volume available for insurance by Ambac. Accordingly, while active in other sectors, Ambac UK did not underwrite any mortgage-backed transactions in 2007 and has not done so since 2004. The following table sets forth the volume of new issues European securitizations:

 

(€ in Billions)

   Total Volume

2001

   152.6

2002

   157.7

2003

   217.3

2004

   243.5

2005

   327.0

2006

   458.9

2007

   461.0

Source: Amounts are reported by the ESF Securitization Data Report

 

11


Table of Contents

Premiums for international finance policies are generally based on a percentage of principal insured. The timing of the collection of international finance premiums varies among individual transactions; some are collected in a single payment at policy inception date and others are collected periodically (e.g., monthly, quarterly or annually).

Ambac Assurance guaranteed gross par of $20.1 billion, $19.0 billion and $12.7 billion in 2007, 2006 and 2005, respectively, in the international market. International Finance new business guaranteed represented 16%, 15% and 10% of total gross par guaranteed for 2007, 2006 and 2005, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7 for further discussion.

The table below shows our ten largest International Finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2007:

 

($ in Millions)

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

Mitchells & Butlers Finance plc-UK Pub Securitisation

   A +    $ 2,565    0.5 %

CDO of IG Corporate

   AAA      1,970    0.4 %

Telereal Securitisation plc

   AA -      1,845    0.4 %

Punch Taverns Finance plc-UK Pub Securitisation

   A      1,776    0.3 %

Synthetic RMBS

   AAA      1,261    0.2 %

Romulus Finance s.r.l

   BBB      1,086    0.2 %

Synthetic RMBS

   AAA      1,076    0.2 %

Tubelines (Finance) plc

   A      1,051    0.2 %

Metro net Rail(2)

   BIG      1,022    0.2 %

Synthetic RMBS

   AAA      1,022    0.2 %
                

Total

      $ 14,674    2.8 %
                

 

(1) Internal Ambac credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac credit ratings are subject to revision at any time and do not constitute investment advice. Ambac Assurance, or one of its affiliates, has guaranteed the obligations listed and may also provide other products or services to the issuers of these obligations for which Ambac may have received premiums or fees.
(2) Metronet BCV and SSL are separate operating corporate entities with distinguishable risk features. Individually they would not appear on this list, however their exposures are aggregated to reflect common business and financial issues currently confronting each company. This transaction’s rating was upgraded to AA in 2008.

Risk Management

In 2008, Ambac announced that it has reorganized the risk management function. This reorganization contemplates structural and process-related changes related to risk management at Ambac, with an increased emphasis on risk-adjusted returns.

All risk management responsibilities are now consolidated in a newly created Chief Risk Officer position. The Chief Risk Officer is responsible for credit risk management; capital management and deployment; and surveillance and remediation of the existing insured portfolio. In the area of credit risk management, the Chief Risk Officer is charged with responsibility to review and strengthen underwriting policies and procedures, including identification of business sectors which will be emphasized, deemphasized or exited by Ambac. The

 

12


Table of Contents

Chief Risk Officer is also empowered to veto any transaction that has been approved by the relevant credit committee. However, the CEO may override the Chief Risk Officer’s veto, upon notice to the Chairman of the Audit and Risk Assessment Committee of Ambac’s Board of Directors. The Chief Risk Officer reports to the Board of Directors on a “dotted line” basis and will inform and update the Audit and Risk Management Committee of the Board of Directors with respect to risk-related topics. Additionally, a newly created Capital and Risk Analysis Group, which has responsibility for transaction and portfolio based risk/return and capital analyses, reports to the Chief Risk Officer.

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

Ambac has a Transaction Standards Committee which evaluates the suitability of transactions and products for Ambac participation with particular emphasis on potential legal, accounting, regulatory and/or reputation risks.

Underwriting guidelines, policies and procedures have been developed by Ambac Assurance’s management with the intent that Ambac Assurance guarantees 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 and it is Ambac Assurance’s policy to provide for loss reserves on non-derivative insurance policies that are adequate to cover probable and estimable losses. For derivative insurance policies and credit derivatives, changes in fair value and credit impairment are reflected currently in net income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 and Note 7 of Notes to Consolidated Financial Statements, located in Part II, Items 7 and 8, respectively, for further information.

The underwriting process involves review of structural, legal, political and credit issues, including compliance with current Ambac Assurance underwriting policies. These policies 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 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 underwriting group. At a minimum, the primary analyst’s recommendation to qualify or reject an issue must be approved by a concurring analyst and a credit 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. Ambac Assurance has three established credit committees comprised of senior credit officers, credit and market risk managers and attorneys. All large, complex or new types of credits recommended by the underwriting group must be formally presented to the credit committee for approval. For certain issues, the primary analyst’s recommendation must be approved by a concurring analyst and credit officer and need not be formally presented to the credit committee for approval.

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.

 

13


Table of Contents

Public Finance Underwriting:

In addition to general underwriting policies, asset classes, and bond types within those asset classes, have 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 are applied 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 obligations generally entail three forms of risks: (i) asset risk, which relates to the amount and quality of the underlying assets; (ii) structural risk, which relates to the extent to which the transaction’s legal structure and credit support provides protection from loss; and (iii) servicer risk, which is the risk that poor performance at the servicer or manager level contributes to a decline in cash flow available to the transaction. Ambac Assurance addresses these risks through its credit underwriting guidelines, policies 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 securities are usually designed to help protect the investors, and therefore the guarantor, from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to a trustee for the benefit of the issuer. Other potential issues include whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or stayed from remitting to investors cash collections held by it or received by it after the servicer or the originator becomes subject to bankruptcy or insolvency proceedings. Structural features of a transaction, such as control rights that are typically held by the senior note holders, will impact the extent to which underlying asset performance affects the performance of the guaranteed securities.

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 country limits), underwriting procedures and transaction documentation.

Geographically, the international markets that Ambac Assurance focuses on have been the United Kingdom, continental Europe, Australia, Japan and certain emerging market countries. In addition, Ambac Assurance has guaranteed transactions in which the geographic risk is spread over multiple countries. The types of international obligations guaranteed have primarily been CDOs, utilities, cross-border mortgage and asset-backed securities,

 

14


Table of Contents

and infrastructure obligations, whole business securitizations and future flow transactions. Management believes that the risk associated with its international book of business is similar to its U.S. book of business. In fact, international CDOs may include significant components of U.S. exposure.

Surveillance and Remediation:

The Portfolio Risk Management Group is responsible for monitoring outstanding financial guarantee exposures, including credit derivatives. The group’s monitoring activities are designed to detect deterioration in credit quality or changes in the economic, regulatory or political environment which could adversely impact the portfolio. Active surveillance enables Ambac Assurance’s Portfolio Risk Management Group to track single credit migration and industry credit trends. Surveillance analysts also monitor the financial guarantee portfolio for concentrations of risk by (i) specific bond types; (ii) geographic location; and (iii) size of issue.

Surveillance analysts review, on a regular and ad hoc basis, 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 each bond type’s inherent risk profile. The focus of the surveillance review is to assess performance, identify credit trends and recommend appropriate classifications, ratings and review periods. If a problem is detected, the group focuses on loss mitigation by recommending appropriate action and working with the issuer, trustee, bond counsel, servicer and other interested parties in an attempt to remediate the problem and minimize Ambac Assurance’s exposure to potential loss. In some cases, the Surveillance Group will engage attorneys and other outside consultants with appropriate expertise in the targeted loss mitigation strategy to assist management in examining the underlying collateral or providing industry specific advice. Those credits 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 and reported to management and in summary to Ambac’s Board of Directors by preparation of an adversely classified credit listing. Relevant information, along with the plan for corrective actions and a reassessment of the credit’s rating and credit classification, is reviewed with senior management in regular adversely classified credit meetings. Internal and/or external counsel generally reviews the documents underlying any problem credit and if applicable, an analysis is prepared outlining Ambac Assurance’s rights and potential remedies, the duties of all parties involved and recommendations for corrective actions. Ambac Assurance also meets with relevant parties to the transaction as necessary. 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 review the credits underlying Ambac Assurance’s financial guarantees and, in most cases, advise Ambac Assurance of the credit rating each transaction would receive if it were not insured.

Surveillance for collateral dependent transactions focuses on review of the asset and servicer performance transaction cash flows. In connection with our financial guarantee, Ambac will receive periodic reporting from the trustee to the issuer, and the servicer or manager (if applicable). Analysts review these reports and if necessary seek legal or accounting advice to assure reporting and application of cash flows comply with transaction requirements.

Ambac Assurance manages servicer risk for its structured finance exposures in several ways. In connection with the initial decision to guarantee, Ambac Assurance analyzes the capitalization and credit quality, the experience and financial strength of the servicer of the underlying assets. Thereafter, Ambac Assurance monitors the performance of transaction servicers through a combination of (i) on-site servicer reviews; (ii) annual compliance certificates received from servicer management; (iii) independent rating agency information; and (iv) a review of servicer financial information. On-site servicer reviews typically include a review of the collection, default management and quality control processes. Where appropriate, a third-party, such as an independent audit firm, may perform the review. In addition, Ambac Assurance may require a back-up servicer or require “term-to-term” servicing which provides for limited, renewable servicing terms in order to provide greater flexibility regarding the servicing arrangements of a particular transaction.

 

15


Table of Contents

A significant portion of Ambac Assurance’s structured finance exposures relates to the mortgage-backed and home equity loan market. The issuers typically originate or purchase residential mortgages, home equity loans or home equity lines of credit, which are in turn bundled into pools which are sold by the issuers in the form of asset-backed securities. The servicer administers the underlying loans in the pools and may or may not be affiliated with the loans’ originators or the issuer.

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

 

($ in Millions)

   Asset Class    Net Par
Outstanding

Servicer:

     

Countrywide Home Loans.

   Mortgage-backed    $ 13,768

PHEAA

   Student loans      5,573

Nelnet

   Student loans      3,970

RFC - Homecomings Financial

   Mortgage-backed      4,321

Wachovia Bank, N.A.

   Mortgage-backed      3,357

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 estimated that the average life of its guarantees on par in force at December 31, 2007 is 14 years. The 14 year average life is determined by applying a weighted average calculation, using the remaining years to expected maturity of each guaranteed bond, and weighting them on the basis of the remaining net par guaranteed. No assumptions are made for future refundings of guaranteed issues.

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, 2007, the total net par amount of guaranteed bonds outstanding was $524.0 billion. See Note 16 of Notes to Consolidated Financial Statements, located in Part II, Item 8 for further information.

 

16


Table of Contents

Types of Bonds

The table below shows the distribution by bond type of Ambac Assurance’s guaranteed portfolio as of December 31, 2007.

Guaranteed Portfolio by Bond Type

as of December 31, 2007(1)(2)

 

Bond Type

  Net Par Amount
Outstanding
  % of Total Net
Par Amount
Outstanding
 
($ In Millions)          

Public Finance:

   

Lease and tax-backed revenue

  $ 88,147   17 %

General obligation

    63,977   12  

Utility revenue

    37,976   7  

Health care revenue

    27,161   5  

Transportation revenue

    25,466   5  

Higher education

    20,685   4  

Housing revenue

    11,531   2  

Other

    6,010   1  
           

Total Public Finance

    280,953   53  
           

Structured Finance(2):

   

Mortgage-backed and home equity(3)

    43,078   8  

Asset-backed and conduits

    36,407   7  

CDO of ABS > 25% MBS(4)

    29,127   6  

Other CDOs(4)

    22,174   4  

Student loan

    18,372   4  

Investor-owned utilities

    17,055   3  

Other

    4,485   1  
           

Total Structured Finance

    170,698   33  
           

Total Domestic

    451,651   86  
           

International Finance(5):

   

Asset-backed and conduits

    19,290   4  

Other CDOs(4)

    15,572   3  

Investor-owned and public utilities

    10,384   2  

Mortgage-backed and home equity

    10,106   2  

Transportation

    7,784   2  

Sovereign/sub-sovereign

    7,347   1  

Other

    1,891   —    
           

Total International Finance

    72,374   14  
           

Grand Total

  $ 524,025   100 %
           

 

(1) Includes $64,988 of credit derivatives.
(2) Ambac has outstanding commitments to guarantee $22.8 billion of exposure, including a $2.9 billion commitment fee to provide a financial guarantee on a pool of CDO of asset-backed securities, mostly RMBS, which is not included in the numbers above. See Footnote 16 to the Consolidated Financial Statements.
(3) Includes $8,432 million of sub-prime exposure.
(4) See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of CDO exposures
(5) International Finance transactions includes significant components of domestic exposure.

 

17


Table of Contents

Issue Size

Ambac Assurance seeks a broad coverage of the market by guaranteeing small and large issues alike. Ambac Assurance’s financial guarantee exposure in the U.S. public finance market reflects the historical emphasis on issues guaranteed with an original par amount of less than $25 million. However, U.S. structured finance and international finance transactions generally involve larger deals. The following table sets forth the distribution of Ambac Assurance’s guaranteed portfolio as of December 31, 2007, with respect to the original size of each guaranteed issue:

Par Amount Per Issue

as of December 31, 2007

 

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

   8,764    52 %   $ 31,960    6 %

$10-50 million

   5,220    31       92,316    18  

$50-250 million

   2,236    13       172,086    33  

Greater than $250 million

   707    4       227,663    43  
                        
   16,927    100 %   $ 524,025    100 %
                        

Geographic Area

Ambac Assurance and its subsidiary, Ambac UK, are licensed to write business in the U.S. and abroad. The following table sets forth the geographic distribution of Ambac Assurance’s insured exposure as of December 31, 2007:

 

Geographic Area

   Net Par Amount
Outstanding
   % of Total
Net Par Amount
Outstanding
 
($ In Millions)            

Domestic:

     

California

   $ 53,434    10 %

New York

     31,923    6  

Florida

     22,462    4  

Texas

     19,898    4  

New Jersey

     14,309    3  

Pennsylvania

     13,444    3  

Illinois

     12,592    2  

Massachusetts

     10,338    2  

Ohio

     8,219    2  

Colorado

     7,570    1  

Mortgage and asset-backed

     79,485    15  

Other states

     177,977    34  
             

Total Domestic

     451,651    86  
             

International:

     

United Kingdom

     27,207    5  

Australia

     6,400    1  

Germany

     6,157    1  

Italy

     3,017    1  

Japan

     2,753    1  

Internationally diversified

     16,550    3  

Other international

     10,290    2  
             

Total International

     72,374    14  
             

Grand Total

   $ 524,025    100 %
             

 

18


Table of Contents

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

The table below shows the distribution by currency of Ambac Assurance’s guaranteed portfolio as of December 31, 2007:

 

Currency

   Net Par Amount
Outstanding in Base
Currency
   Net Par Amount
Outstanding in
U.S. Dollars
(Amounts in Millions)          

U.S. Dollars

   466,020    $ 466,020

British Pounds

   12,873      25,577

Euros

   16,400      23,935

Australian Dollars

   6,966      6,101

Japanese Yen

   107,650      965

Other

   3,553      1,427
         

Total

      $ 524,025
         

Single Risk

Ambac Assurance has adopted underwriting and exposure management policies designed to limit the net guarantees in force for any one credit, although, as described above, certain of Ambac’s processes and procedures are being reviewed in connection with the reorganization of the risk function. In addition, Ambac Assurance uses reinsurance to limit net exposure to any one credit. The highest single insured risk represented 0.6% of the aggregate net par outstanding at December 31, 2007. 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,” sections.

Competition

Historically, the financial guarantee business has been highly competitive. Ambac Assurance faces competition from other financial guarantors and alternative forms of credit enhancement. Accordingly, each transaction Ambac proposes to guarantee may compete against an alternative execution, e.g. credit derivatives, letters of credit or structures that do not employ third-party credit enhancement, including senior/subordinated structures. Financial guarantee insurance and other forms of credit enhancement also compete in nearly all instances with the issuer’s alternative of foregoing credit enhancement and paying a higher interest rate. If the interest savings from insurance or another form of credit enhancement are not greater than the cost of such credit enhancement, the issuer is unwilling to accept the insurer’s terms and conditions for insurance or does not perceive the insurer to have sufficient financial strength, the issuer will generally choose to issue bonds without credit enhancement. Credit spreads are a significant factor in the issuer’s determination of whether or not to seek credit enhancement. Credit spreads represent the difference in interest cost for issuers between their projected or actual borrowing rate compared to a benchmark rate (such as U.S. Treasuries). As an issuer’s credit rating rises or as credit spreads become compressed (e.g. due to increased amounts of investment capital in the markets), the likelihood that the issuer will choose to issue bonds without credit enhancement increases.

In recent years, the overall business environment became more competitive, with increased competition from bank funding, the uninsured market, senior/subordinated securitizations and other triple-A-rated financial guarantors. As a result of recent rating agency actions, there has been much uncertainty in the financial guarantee markets. In the fall of 2007, each of the major rating agencies (S&P, Moody’s and Fitch) began a review of the capital adequacy of the financial guaranty industry. As a result of their reviews, the major rating agencies have recently (i) changed their rating outlook for certain financial guarantors to “negative”, (ii) placed certain financial

 

19


Table of Contents

guarantee insurers on review for a possible downgrade, (iii) downgraded certain financial guarantee insurers and (iv) affirmed current ratings as “stable” for certain financial guarantors. On January 16, 2008, Moody’s placed Ambac Assurance’s Aaa rating on review for possible downgrade. On January 18, 2008, Fitch downgraded Ambac Assurance’s insurer financial strength rating to AA, Rating Watch Negative. In addition, on January 18, 2008 S&P placed Ambac Assurance’s AAA financial strength rating on Credit Watch Negative. On February 25, 2008, S&P reaffirmed Ambac Assurance’s AAA rating, but kept it on Credit Watch Negative. On February 29, 2008, Moody’s publically announced that it is continuing a review for possible downgrade that was initiated on January 16, 2008. As a result of these actions and the uncertainty regarding future actions to be taken by the rating agencies, Ambac Assurance has been placed in a competitive disadvantage in all three of the financial guarantee markets: public finance, structured finance and international. In particular, it has been placed at a significant disadvantage to two of its competitors, Financial Security Assurance Inc. (“FSA Guarantee”) and Assured Guaranty, which are the only principal competitors in the financial guarantee market, who have had their triple-A financial strength ratings affirmed “stable” by all three of the major rating agencies. In addition, MBIA Insurance Corporation (“MBIA”) and Financial Guaranty Insurance Company (“FGIC”), who have been principal competitors of Ambac Assurance, have also been the subject of recent ratings action. MBIA has had its triple-A financial strength ratings placed under review for possible downgrade by Fitch on February 5, 2008, S&P has affirmed MBIA’s triple-A on February 25, 2008, but has changed the outlook to negative, and Moody’s has affirmed MBIA’s triple-A on February 26, 2008 and has changed their outlook to negative. FGIC has been downgraded from AAA to AA by Fitch and is still on review for downgrade, S&P has downgraded FGIC to A, and remains on credit watch developing. Moody’s downgraded FGIC from AAA to A3 and placed it on rating watch negative. In addition, Berkshire Hathaway has recently entered into the financial guarantee business. Banks, smaller financial guarantee insurance companies, multiline insurers and reinsurers represent additional participants in the market.

The principal competitive factors among the financial guarantors 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) ratings, financial strength and perception of financial strength of the guarantor; (iv) the quality of service provided to issuers, investors and other clients of the issuer; (v) trading value of the financial guarantor’s insured obligations. As explained above, as a result of the recent actions the rating agencies have taken with respect to Ambac Assurance, Ambac Assurance has been placed at a significant disadvantage regarding its ratings and perceived financial strength and trading value as a guarantor versus two of its principal competitors, FSA Guarantee and Assured. With respect to the other three competitive factors, Ambac Assurance believes it is on at least equal footing with each of its principal competitors.

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 appropriate financial strength ratings by the rating agencies. These capital requirements may deter other companies from entering the market. However, there can be no assurance that these capital requirements will deter potential competitors from entering the business. In addition to sufficient capital, the rating agencies have increasingly focused on the viability of the business model of potential entrants. Additionally, the market may increasingly accept guarantees by double–A or lower rated insurers, who have less stringent capital requirements. Under New York law, a monoline financial guarantee 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.

Ambac also faces intense competition in attracting and retaining qualified employees. Ambac’s ability to continue to compete effectively will depend upon the ability to attract employees and retain and motivate existing employees.

 

20


Table of Contents

Reinsurance

Ceded Reinsurance:

State insurance laws and regulations, as well as the independent rating agencies, who rate Ambac Assurance, impose minimum capital requirements on financial guarantee companies, limiting the aggregate amount of insurance and the maximum size of any single risk exposure which may be written. Ambac Assurance uses reinsurance to diversify risk, increase underwriting capacity, manage capital needs and strengthen financial ratios. Currently, Ambac Assurance has treaty and facultative reinsurance agreements 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. Ambac Assurance’s current reinsurance program includes a surplus share treaty that allows Ambac Assurance to secure reinsurance on many insured transactions. Treaties provide coverage for the full term of the policies reinsured during the annual treaty period. Additionally, Ambac Assurance utilizes facultative reinsurance arrangements, when needed, for large transactions or if reinsurance is needed beyond capacity provided by the surplus share treaty. All facultative agreements provide coverage for the full term of the policy reinsured. For exposures reinsured, Ambac Assurance withholds a ceding commission to defray its underwriting and operating expenses.

 

21


Table of Contents

The following table shows the distribution by bond type of Ambac Assurance’s ceded guaranteed portfolio at December 31, 2007:

Ceded Guaranteed Portfolio by Bond Type

as of December 31, 2007

 

Bond Type

   Ceded Par
Amount
Outstanding
   % of Gross Par
Ceded
 
($ In Millions)            

Public Finance:

     

Lease and tax-backed revenue

   $ 12,180    12 %

General obligation

     7,416    10  

Utility revenue

     6,224    14  

Health care revenue

     10,208    27  

Transportation revenue

     6,354    20  

Higher education

     3,434    14  

Housing revenue

     1,423    11  

Other

     370    6  
             

Total Public Finance

     47,609    14  
             

Structured Finance:

     

Mortgage-backed and home equity

     2,801    6  

Other CDOs

     387    2  

CDO of ABS > 25%

     455    2  

Asset-backed and conduits

     6,112    14  

Student loan

     4,821    21  

Investor-owned utilities

     4,394    20  

Other

     1,969    31  
             

Total Structured Finance

     20,939    11  
             

Total Domestic

     68,548    13  
             

International Finance:

     

CDOs

     803    5  

Asset-backed and conduits

     4,758    20  

Mortgage-backed and home equity

     1,325    12  

Investor-owned and public utilities

     6,190    37  

Sovereign/sub-sovereign

     3,152    30  

Transportation

     2,484    24  

Other

     790    29  
             

Total International Finance

     19,502    21  
             

Grand Total

   $ 88,050    14 %
             

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 (i) monitors the financial condition of its reinsurers, (ii) is entitled to receive collateral from its reinsurance counterparty in certain reinsurance contracts, and (iii) has certain cancellation rights that can be exercised by Ambac Assurance in the event of a rating downgrade (S&P or Moody’s) of a reinsurer. For the purposes of determining the financial strength of Ambac Assurance, the rating agencies allow Ambac Assurance “credit” for reinsurance based on the reinsurer’s financial strength ratings. For Ambac Assurance, 100% credit is allowed for

 

22


Table of Contents

AAA reinsurance and 65% to 70% credit is allowed for AA reinsurance and 45% to 50% credit is allowed for A reinsurance. Ambac Assurance’s current primary reinsurers are Assured Guaranty, Blue Point Re Ltd., FSA Guarantee, MBIA, Radian Asset Assurance Inc., RAM Reinsurance Company, Ltd., Swiss Reinsurance Company and Sompo Japan. The current stressed credit environment may have an adverse impact on the financial strength of certain of the reinsurers used by Ambac. Additionally, if the financial strength of these reinsurers declines, it could impair Ambac Assurance’s ability to recover amounts due from such reinsurers. This could limit Ambac’s ability to cede exposures to such reinsurers, and cause Ambac to significantly reduce its own ability to participate in larger single risk or capacity-type credits. See financial strength ratings of reinsurers located in the Risk Management section of Quantitative and Qualitative Disclosures about Market Risk located in Part II, Item 7A.

Assumed Reinsurance:

Under reciprocal reinsurance agreements with various financial guarantor competitors, Ambac Assurance has assumed exposures. Ambac and MBIA have had such a reciprocal reinsurance agreement since 1995 when the two companies created an unincorporated international joint venture. In 2004, Ambac Assurance entered into reciprocal reinsurance agreements with FSA Guarantee for healthcare and international PFI transactions. Additionally, Ambac Assurance’s portfolio has assumed transactions that it obtained in connection with its purchase of Connie Lee in 1998. Under the provisions of each of these reinsurance agreements, the ceding company has certain cancellation rights that can be exercised in the event of a rating downgrade of Ambac Assurance (typically below AAA by S&P and/or Aaa by Moody’s). As noted above, rating agencies give significantly lower capital credit for a reinsurer that is rated double-A than for a reinsurer rated triple-A. For example, under Standard & Poor’s current guidelines for assigning credit to reinsurance, if Ambac Assurance’s rating were downgraded from “AAA” to “AA,” there would be at least a 30% decrease in the benefits the ceding insurers receive based on Standard & Poor’s capital adequacy model. In addition to potential negative effects on future direct business, a downgrade of the ratings assigned to Ambac Assurance by either rating agency would give the ceding insurer the ability to terminate and recapture the reinsured exposures. The cost of such termination is based on the provisions of each reinsurance contract and amounts would be higher than the amount of liabilities (loss reserves and unearned premium reserves) included in the financial statements. Certain contracts require an increase in ceding commission if termination is not elected by the primary insurer.

The following table displays assumed exposures by ceding enterprise as of December 31, 2007:

 

Primary insurers

   Assumed Gross
Par
   Percentage
of total gross
par assumed
    Unearned
premiums
   Case loss
reserves
   Earned
premiums

MBIA Insurance Corporation

   $ 5,758,385    68 %   $ 25,108    $ —      $ 22,472

Financial Security Assurance Inc

     1,259,071    15 %     29,167      —        2,420

Radian Reinsurance Inc

     1,081,344    13 %     322      —        305

Other

     391,839    4 %     1,888      —        6,468
                                 

Total

   $ 8,490,639    100 %   $ 56,485    $ —      $ 31,665
                                 

Rating Agencies

Moody’s, S&P, and Fitch periodically review Ambac Assurance’s business and financial condition, focusing on the quality of the obligations insured, financial performance metrics, and business and strategic plans. The rating agencies perform periodic assessments of the credits insured by Ambac Assurance, as well as the reinsurers and other providers of capital support, to confirm that Ambac Assurance continues to satisfy such rating agency’s capital adequacy criteria necessary to maintain Ambac Assurance’s triple-A rating.

 

23


Table of Contents

Financial and other factors considered by the rating agencies in assessing Ambac Assurance’s ratings include:

 

   

probabilities of default and loss severities with regards to credit risks insured by Ambac Assurance;

 

   

correlations between Ambac Assurance’s insured risks;

 

   

concentrations, and degree of diversification, of insured risks;

 

   

the quality of Ambac Assurance’s investment portfolio;

 

   

the credit quality of Ambac Assurance’s reinsurers;

 

   

credit lines and other third-party capital support arrangements;

 

   

premium revenues expected to be generated from outstanding policies;

 

   

anticipated future new business originations;

 

   

financial flexibility;

 

   

franchise value;

 

   

risk management & underwriting policies and procedures; and

 

   

governance.

In November 2007, Moody’s, Fitch and S&P undertook updated capital analyses of Ambac Assurance and other financial guarantors in response to concerns over the delinquency and loss performance of U.S. residential mortgages and the impact of such performance on Ambac and other companies with exposure to certain RMBS and CDO of ABS transactions. On December 14, 2007, Moody’s affirmed Ambac Assurance’s Aaa financial strength rating with a stable outlook and on January 16, 2008 placed such ratings on review for possible downgrade. Moody’s outlook change followed Ambac’s announcement of $1.1 billion impairment charge on its ABS CDO portfolio and the retirement of Ambac’s Chairman and CEO. On December, 19, 2007, S&P affirmed Ambac Assurance’s AAA financial strength rating with negative outlook, citing the potential for further mortgage deterioration relative to our capital position. On January 18, 2008, Fitch downgraded our AAA financial strength rating to AA Rating Watch Negative following an assessment of our current exposure to structured finance collateralized debt obligations backed by subprime mortgage securities, including ABS CDO securities, as well as our exposure to RMBS. On January 18, 2008 S&P placed Ambac’s AAA financial strength rating on Credit Watch Negative. On February 25, 2008, S&P published results of yet another stress test and reaffirmed Ambac’s triple-A, but the rating remains on Credit Watch Negative. On February 29, 2008, Moody’s publically announced that it was continuing a review for possible downgrade that was initiated on January 16, 2008.

In addition, Moody’s has placed on review for possible downgrade Ambac’s Aa2 senior unsecured debt and financing trusts ratings, Aa3 junior subordinated debt rating, and (P)A1 provisional rating on preferred stock. S&P affirmed the double-A senior unsecured and issuer credit ratings for Ambac, but changed its outlook to negative from stable. Also, S&P affirmed the A+ rating for Ambac’s outstanding subordinated hybrid security, but changed its outlook to negative from stable. Fitch downgraded Ambac’s AA long-term rating and senior unsecured debt rating to A and, AA- subordinated debt rating to A- Rating Watch Negative.

There have been a number of recent developments with respect to ratings actions by the rating agencies. In light of the ongoing nature of ratings actions or announcements by the rating agencies, one should consult announcements by the rating agencies, the websites of the rating agencies and Ambac’s website for the then current publicly available information.

As a result of the rating agency actions described above, as well as significant disruption in the capital markets and investor concern with respect to our financial position, we have been able to write only a limited

 

24


Table of Contents

amount of new financial guarantee business since November 2007. Additional downgrades in our financial strength ratings could have a material adverse effect on our long-term competitive position and our prospects for future business opportunities. In addition, a downgrade of our financial strength ratings below specified levels would allow investment agreement and derivative counterparties to demand collateral or terminate certain agreements, introducing liquidity and market risks. Please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations-Credit Ratings and Collateral” for further information.

Insurance Regulatory Matters

General Law

United States of America:

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, the territory of Guam and the U.S. Virgin Islands. 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, and 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 with the National Association of Insurance Commissioners (“NAIC”), and if required, 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 18 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

United Kingdom:

Ambac UK is licensed to transact credit, suretyship and financial guarantee insurance in the United Kingdom and to offer those services in a number of other European Union (“EU”) countries. EU legislation allows Ambac UK to conduct business pursuant to its license in EU states other than the United Kingdom through a “passporting” arrangement, which eliminates the necessity of additional licensing or authorization in those other EU jurisdictions.

Ambac Credit Products Limited, also an Ambac Assurance wholly-owned subsidiary, is licensed in the United Kingdom to transact credit derivatives, as well as act as agent for Ambac Credit Products LLP and Ambac Capital Funding. Ambac Credit Products Limited is currently able to offer services via EU “passporting” in a number of other EU countries.

Ambac UK and Ambac Credit Products Limited are each subject to regulation by the Financial Services Authority (“FSA”) in the conduct of their business. The FSA is the single statutory regulator responsible for regulating the financial services industry in the U.K., having the authority to oversee the carrying on of “regulated activities” (including deposit taking, insurance and reinsurance, investment management and most

 

25


Table of Contents

other financial services), with the purpose of maintaining confidence in the U.K. financial system, providing public understanding of the system, securing the proper degree of protection for consumers and helping to reduce financial crime. In addition, the regulatory regime in the United Kingdom must comply with certain EU legislation binding on all EU member states.

The FSA requires that non-life insurance companies such as Ambac UK maintain a margin of solvency at all times in respect of the liabilities of the insurance company, the calculation of which depends on the type and amount of insurance business a company writes. In addition, the FSA has established a capital monitoring level for Ambac UK. Breach of the monitoring level requires that Ambac UK inform the FSA and enter into discussions as to the reasons for the breach, and ultimately with a view to a remedy that could include additional capital being required. The monitoring level is an interim arrangement, while the FSA reflects on alternative methodologies for a permanent basis for calculating regulatory capital in respect of Ambac UK and other financial guarantors regulated by the FSA. In addition, an insurer is required to perform and submit to the FSA a solvency margin calculation return in respect of its ultimate parent. Ambac believes that Ambac Assurance and Ambac UK are in compliance with all applicable insurance laws and regulations.

Insurance Holding Company Laws

Under the Wisconsin Insurance Holding Company laws, any acquisition of control of Ambac 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 believes that a holder of common stock having the right to cast 10% of the votes which may be cast by the holders of all shares of common stock of Ambac would be deemed to have control of Ambac Assurance within the meaning of the Wisconsin Insurance Laws. The United Kingdom has similar requirements applicable in respect of Ambac, as the ultimate holding company of Ambac UK.

Pursuant to Wisconsin law, Davis Selected Advisers, L.P. (“Davis Advisers”) obtained approval from the Wisconsin Insurance Commissioner to acquire greater than 10% of Ambac’s outstanding stock. Davis Advisers is making a similar application to the FSA, the relevant United Kingdom authority. As of December 31, 2007, Davis Advisers’ percentage of ownership was approximately 14.02%. In their request for approval from the Wisconsin Commissioner, Davis Advisers disclaimed any present intention to exercise control over Ambac or Ambac Assurance or to control or attempt to control the management or operations of Ambac 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.

Dividend Restrictions

Wisconsin:

Pursuant to the Wisconsin Insurance Laws, Ambac Assurance may declare dividends, subject to restrictions 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 Ambac (other than stock dividends) must be reported to the Wisconsin Commissioner. Additionally, no quarterly dividend may exceed the dividend paid in the corresponding quarter of the preceding year by more than 15% without notifying the Wisconsin Insurance Commissioner 30 days in advance of payment. 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

 

26


Table of Contents

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 2007, 2006 and 2005, Ambac Assurance paid to Ambac cash dividends on its common stock totaling $190.2 million, $136.0 million and $353.4 million, respectively. See Note 18 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

United Kingdom:

U.K. law prohibits Ambac UK from declaring a dividend to its shareholders unless it has “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the U.K. insurance regulatory laws impose no statutory restrictions on a general insurer’s ability to declare a dividend, the FSA’s capital requirements may in practice act as a restriction on dividends.

Statutory Contingency Reserve

Ambac Assurance is required to establish a mandatory contingency reserve in accordance with the NAIC Accounting Practices and Procedures manual (“NAIC SAP”) and the Wisconsin Administrative Code. The mandatory contingency reserve is an additional liability established to protect policyholders against the effect of adverse economic developments or cycles or other unforeseen circumstances. Under 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 defines the scope of permitted financial guarantee insurance and governs the conduct of business of all financial guarantors licensed to do business in New York, including Ambac Assurance. Financial guarantors are also required to maintain case basis credit loss and loss expense reserves and unearned premium reserves on a basis established by the statute.

The New York financial guarantee insurance law establishes single risk limits with respect to obligations insured by financial guarantee 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

 

27


Table of Contents

contingency reserves. As of December 31, 2007 and 2006, 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 the aggregate of the outstanding insured principal, interest and other payments 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, 2007 and 2006, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

Financial Guarantee Insurance Regulation in Other States

Wisconsin laws and regulations governing municipal bond guarantors are less comprehensive than New York law and relate primarily to municipal bond insurance business. The Wisconsin regulations 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 unpaid principal and interest covered by current municipal bond insurance policies, may not exceed its qualified statutory capital. As of December 31, 2007 and 2006, Ambac Assurance and its subsidiaries were in compliance with these regulatory requirements.

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

As described above in part I, Item 1, “Introduction” as part of its plan to raise additional capital and maintain triple-A ratings, in 2008 Ambac has discontinued writing new investment agreements and derivative products. Following is a description of our participation in the financial services business area to date.

Ambac’s Financial Services segment provides financial and investment products including investment agreements, derivative products (interest rate, currency and total return swaps) and funding conduits principally to clients of the financial guarantee business. Financial services revenues are primarily derived from: (i) gross investment income; (ii) net derivative product revenues; and (iii) net realized gains and losses on sales of securities.

The principal competitive factors among providers of financial service products that Ambac offers are: (1) pricing of contracts; (2) investment returns; (3) the financial strength of the provider (including credit enhancements); (4) the ability to provide services tailored to customers’ needs; and (5) the quality of service provided to customers. Ambac has been placed at a competitive disadvantage to other financial guarantors who have had their triple-A financial strength rating affirmed “stable” by all three of the major rating agencies.

 

28


Table of Contents

Investment Agreements

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

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” located in Part II, Item 7 for further information. Ambac Capital Funding is managed with the goal of closely matching the cash flows of the investment agreement liabilities with the cash flows of the related investment portfolio. To achieve this goal, derivative contracts are used.

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 mitigated by provisions in certain of the investment agreements that limit a counterparty’s ability to draw on the funds and provide notice periods prior to the draw of funds. See “Liquidity and Capital Resources” section located in Part II, Item 7 for a discussion on the impact of a ratings downgrade on Ambac Assurance. 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. Ambac Capital Funding maintains a portfolio of fixed income securities, cash and cash equivalents to meet short-term liquidity needs.

Ambac Capital Funding may use interest rate and currency swap contracts as part of its overall cash flow risk management. 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. Currency swap contracts are agreements where Ambac Capital Funding agrees with other parties to exchange foreign currency denominated cash flows for USD denominated cash flows calculated by reference to an agreed upon notional amount.

See Note 9 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information on investment agreements.

Ambac Securities’ Inc. principal business is to serve as the placement agent and dealer for securities issued by Ambac Capital Funding in private placement transactions. Ambac Securities is registered as a broker-dealer with the SEC and in 42 states and the District of Columbia. Self regulatory organizations such as the Financial Industry Regulatory Authority regulate broker-dealers such as Ambac Securities. In addition, state securities and other regulators also have oversight authority over Ambac Securities. 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, 2007, Ambac Securities had net capital, as adjusted, of approximately $0.7 million, which was $0.6 million in excess of its required net capital of $100 thousand. The net capital ratio was 0.01 to 1.

Derivative Products

The primary activities in the derivative products business are intermediation of interest rate and currency swap transactions (through Ambac Financial Services) and taking total return swap positions (through Ambac Capital Services) on certain fixed income obligations. Most of the swap intermediation is hedged on an

 

29


Table of Contents

individual and portfolio basis. A portion of the swap intermediation consists of municipal interest rate swaps which require Ambac to receive a fixed rate and pay either a tax-exempt index rate or an issue-specific bond rate on a variable rate municipal bond. These municipal interest rate swaps are hedged against general interest rate fluctuations but are not hedged between taxable index rates (such as LIBOR) and issue-specific or tax-exempt index rates, which may result in mark-to-market gains or losses. The variable-rate municipal bonds related to our municipal swap transactions typically reset weekly and contain a liquidity facility provided by third party banks. In the event that there is a failed remarketing of the bonds, the liquidity facility provider will purchase the bonds. The underlying variable-rate bonds are wrapped by Ambac. The current dislocation in the credit markets and the recent rating agency actions on Ambac began affecting the marketability of such variable rate bonds in early 2008. This has led to increases in interest rates for those bonds and accordingly increases in Ambac’s payment obligation under the interest rate swaps where we pay an issue-specific rate, resulting in mark-to-market losses. These municipal interest rate swaps contain provisions that are designed to protect against certain forms of basis risk or tax reform. These provisions include the ability of Ambac Financial Services to convert its rate from the underlying issue-specific bond rate to an alternative floating rate that is a tax-exempt index rate or a fixed percentage of taxable index rate, in the event that the interest rate on the bond is adversely affected due to a credit downgrade or other events. In certain transactions one or more of these events have occurred and Ambac is evaluating its available remedies.

All 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 that meet Ambac Assurance’s credit underwriting criteria. These fixed income obligations are typically guaranteed by Ambac Assurance or another financial guarantor.

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” located in Part II, Item 7 for further information.

Funding Conduits

Ambac has transferred financial assets to two special purpose entities. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. The activities of the special purpose entities are contractually limited to purchasing assets from a subsidiary of Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and related administrative services. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of December 31, 2007, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the special purpose entities. Ambac does not consolidate these special purpose entities under Statement of Financial Accounting Standards 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. See Notes 2 and 11 of Notes to Consolidated Financial Statements located in Part II, Item 8 for further information.

Investments and Investment Policy

As of December 31, 2007, the consolidated investments of Ambac had an aggregate fair value of approximately $18.4 billion and an aggregate amortized cost of approximately $18.5 billion. These investments are managed internally by officers of Ambac, who are experienced investment managers. All investments are effected in accordance with the general objectives and guidelines for investments established by Ambac’s Board of Directors. These guidelines encompass credit quality, risk concentration and duration, and are periodically reviewed and revised as appropriate.

 

30


Table of Contents

As of December 31, 2007, the Financial Guarantee investment portfolio had an aggregate fair value of approximately $10.5 billion and an aggregate amortized cost of approximately $10.3 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 while preserving capital. 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,” section above.

As of December 31, 2007, the Financial Services investment portfolio had an aggregate fair value of approximately $7.8 billion and an aggregate amortized cost of approximately $8.1 billion. Ambac Capital Funding’s investment policy is designed to achieve the highest after-tax return, subject to minimum average quality rating of AA on invested assets, and to maintain cash flow that closely matches invested assets to funded liabilities to minimize interest rate and liquidity risk. For further discussion, see “Investment Agreements,” section above.

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

Summary of Investments as of December 31,

 

     2007     2006     2005  

Investment Category

   Carrying
Value
   Weighted
Average
Yield(1)
    Carrying
Value
   Weighted
Average
Yield(1)
    Carrying
Value
   Weighted
Average
Yield(1)
 
($ In Thousands)                                  

Long-term investments:

               

Taxable bonds

   $ 9,133,227    5.42 %   $ 9,323,979    5.52 %   $ 8,447,332    4.86 %

Tax-exempt bonds

     8,369,098    4.54       7,783,460    4.59       6,658,322    4.66  
                           

Total long-term investments

     17,502,325    5.01       17,107,439    5.10       15,105,654    4.78  

Short-term investments(2)

     879,067    4.50       311,759    4.50       472,034    3.74  

Other

     14,278    —         14,391    —         14,173    —    
                           

Total

   $ 18,395,670    4.98 %   $ 17,433,589    5.09 %   $ 15,591,861    4.74 %
                           

 

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

 

31


Table of Contents

Investments by Security Type as of December 31,

 

     2007     2006     2005  

Investment Category

   Carrying
Value
   Weighted
Average
Yield(1)
    Carrying
Value
   Weighted
Average
Yield(1)
    Carrying
Value
   Weighted
Average
Yield(1)
 
($ In Thousands)                                  

Municipal obligations(2)

   $ 8,763,818    4.61 %   $ 8,126,831    4.66 %   $ 6,896,354    4.72 %

Corporate securities

     783,676    6.04       719,625    6.20       556,239    6.08  

Foreign obligations

     317,426    4.77       276,830    4.65       181,744    4.56  

U.S. government obligations

     138,015    4.60       174,022    4.42       184,465    4.21  

U.S. agency obligations

     682,768    5.48       789,394    5.20       946,430    5.06  

Mortgage-backed securities

     4,249,690    5.18       3,953,205    5.29       3,287,080    4.63  

Asset-backed securities

     2,566,932    5.64